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How Rent Seeking Impoverishes Nations

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Tags Corporate WelfareCronyism and CorporatismProtectionism and Free TradeTaxes and Spending

01/08/2020

One of the fundamental questions in development economics is how an economy grows. As the reader may know, an economy grows by means of economic freedom, which implies property rights and the emergence of markets and exchange ratios (prices). Further, such chains of events bring about economic calculation. However, are such conditions enough for economic development? That is, does a nation need only property rights to develop?

The answer is no. So long as there is a state — government — there need to be constraints with respect to the actions of politicians. That is, there must be rules to the game, namely rules to the political process. So long as there is discretion — the ability to break rules of the game, rent seeking, which is a form of value (or wealth) destruction, will impoverish a nation.

What is Rent Seeking?

Rent seeking, as mentioned above, is a form of value destruction. However, it should be emphasized that according to the Kirznerian definition of the entrepreneur, such action is a form of entrepreneurship — the realization of a profit opportunity. Therefore, rent and profit seeking have one thing in common: both are forms of entrepreneurship. The difference, of course, is that the former is destructive whereas the latter creates value.

There might be confusion with respect to the term "rent" in "rent seeking." Rents, in economics, are payments above opportunity costs, that is, profits. Rent seeking, therefore, is the process by which a firm seeks payments above its opportunity costs. But, unlike profit seeking, rent seeking occurs by means of the political process — that is, firms must lobby, expend resources — in order to capture profits by means of government legislation. Again, per the Kirznerian interpretation of entrepreneurship, such action is a byproduct of profit opportunities, namely the attraction of artificial scarcity rents.

Rent seeking, however, has massive welfare costs.1 For example, in The Welfare Costs of Tariffs, Monopolies and Theft, Gordon Tullock, one of the creators of the term, noted that the cost of a tariff, which is a means of capturing rents, is not fully captured by the Harberger triangle (deadweight loss).

Prior to Tullock’s groundbreaking work on the welfare costs of rent seeking, mainstream economists underestimated the costs of tariffs. That is to say, according to mainstream microeconomics, a tariff’s cost was quantified and graphed as simply deadweight loss. However, as Tullock stated,

There are a considerable number of costs that are ignored by this procedure. … a collection of a tariff involves expenditure on custom inspectors, etc., who do the actual collection, and coast guards, who prevent smuggling.2

As Tullock demonstrated, tariffs are more than transfers of wealth — that is, producers stealing consumers’ surplus — as such legislation brings about numerous costs, namely a waste of scarce resources which have alternative uses.

To better understand Tullock’s thesis, let us imagine that American car companies expended resources so that the federal government would implement a tariff that would essentially prohibit the importation of cars. As mentioned above, mainstream microeconomics would label such legislation as simply a transfer of wealth — that is, the producer is gaining income at the expense of the consumer.

But, as Tullock emphasized, there is more to the story: that individuals were purchasing imported cars shows that domestic producers must have not been using scarce resources efficiently, since foreign producers were meeting their respective wants instead. Such a tariff would mean that resources are being misallocated in lobbying for its enforcement, in addition to the misallocation of resources toward to the production of American-made cars that it would cause.

Moreover, politicians, who act to increase their respective utilities, do not enforce tariff legislation at random, but rather do so by means of the firms that waste scarce resources to lobby for its existence. Put simply, one must picture the political process as a market (or catallactic) process, with politicians exchanging property rights — monopoly privileges — for resources, namely money or special favors such as employment following the politician’s term.

Once it is clear that the political and market processes are analogous and that the ability for politicians to create rents is a profit opportunity for firms, it should be expected that firms will expend scarce resources on capturing such rents. That is, there will be a tendency not to invest capital, but rather to consume it.2

Rent Seeking and Impoverishment

Besides the study of human action, one of the fundamental questions in economics, as stated above, is how to develop an economy. While Ludwig von Mises and other private property economists, such as Armen Alchian and Harold Demsetz, emphasized the importance of private property as a means to rationally calculate, such rights are not enough to ensure development. So long as there is government and self-interested politicians, who act purposefully — that is, seek to increase their utility — they will create rents, and firms will such policies as profit opportunities for themselves. Therefore, as stated above, one will see a tendency for firms to waste scarce resources on capturing the rents offered by the government, particularly politicians. Ultimately, the ongoing cycle of rent seeking, as Tullock stated, does not promote value creation, but rather value destruction. Indeed, as William Baumol noted in his article entitled "Entrepreneurship: Productive, Unproductive, and Destructive," rent seeking is a form of unproductive, at times even destructive, entrepreneurship.3

Constraints on Politicians and the Emergence of Productive Entrepreneurship

Ultimately, so long as there is government, constraints must be placed on politicians. In particular, they should be prohibited from creating rents, which would, all things being equal, encourage productive, as opposed to destructive, entrepreneurship. One of the great differences between wealthy and impoverished nations lies in the rules of the game — that is, in creating an environment in which entrepreneurs are encouraged to profit, not rent seek.

With constraints placed on politicians, one would see the emergence of entrepreneurs who thoroughly bear the uncertainty of the market with the end of satisfying the wants of their fellow men. This is a form of productive entrepreneurship and thus brings about economic development.

  • 1. See Gordon Tullock, “The Welfare Costs of Tariffs, Monopolies, and Theft,” Economic Inquiry 5, no. 3 (1967): 224–32.
  • 2. a. b. Ibid. p. 223.
  • 3. William J. Baumol, “Entrepreneurship: Productive, Unproductive, and Destructive,” Journal of Business Venturing 11, no. 1 (1996): 915–19.
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