Corrupting the Transition to Private Ownership

In this chapter, we describe a political economic framework of an economy following transition to private ownership. The transition, characterized by massive privatization, is accompanied by a change in the legal system, which is influenced by the elite who may be described as either corrupt or non-corrupt. The ability of the corrupt elite to influence the ruling party may lead to weak legal institutions, which cause underinvestment, corruption, and capturing of lucrative industries by corrupt investors. By introducing heterogeneity among industries, we show that the corrupt investors corrupt the more lucrative industries, and in corrupt economies corrupt investors may separate themselves from the non-corrupt investors. Furthermore, we identified two methods used by the corrupt investors to siphon profit – output stealing and profit stealing – and illustrate that corrupt investors may substitute between the two methods to alleviate the constraints created by stronger institutions. To this end, strengthening the institutions only in one dimension may, at the end of the day, cause output, as well as investment, to decline.