Corruption and socially optimal entry

• Free entry under imperfect competition and corrupt entry-certifying officials are two distortions to social efficiency.
• Pre-existing firms (including those in the shadow-economy) mitigate the distortion due to corruption.
• Competition between two corrupt officials restores second-best social efficiency: The two distortions exactly cancel out.
• The conclusions extend in a qualitative sense to the comparison between free entry and first best regulated entry.

The paper investigates the effects of corruption in the entry-certifying process on market structure and social welfare for a Cournot industry with linear demand and costs. To gain entry, a firm must pay a bribe-maximizing official a fixed percentage of anticipated profit, in addition to the usual set-up cost. This would lead to a monopoly, but only in markets without pre-existing or shadow-economy firms. A benevolent social planner may preempt the harmful effects of corruption by either manipulating the number of pre-existing firms in the market, or by setting up two independent (corrupt) licensing authorities. A socially optimal number of firms in the market may be reached by choosing the right number of pre-existing firms or by having exactly two licensing authorities. These mechanisms may be seen as restoring second-best efficiency in settings characterized by two major sources of distortion: Imperfect competition and corruption. We also show in an extension that the basic insights carry over in a qualitative sense to a model with quadratic costs and first best entry regulation.