Corruption and hold-up: The role of middlemen

Corrupt contracts are not enforceable in a court of law and are therefore vulnerable to “hold-up". That is, a bureaucrat who has accepted a bribe from a firm in exchange for a license or a permit may still choose not to grant the firm that license. In order to avoid this problem firms frequently employ middlemen or intermediaries to facilitate corrupt transactions. Thus, it has been argued that eliminating these intermediaries can make corruption more difficult, thereby reducing bribery (citation needed). This argument ignores the fact the intermediaries provide many legal services to firms. A recent OECD study on the role of intermediaries in bribery asserts that intermediaries provide many legitimate services to firms" despite the fact that they also engage in bribing foreign officials" (OECD\ 2009). For example, because of their experience, intermediaries may be able to legally lower the firm's navigation cost of obtaining a permit. However, they may also be able to facilitate the bribing of officials (and prevent hold-up) in order to obtain a business permit even when it is illegal to grant the firm such a permit.

This paper studies the role of intermediaries in a context where they can provide a combination of both legal and illegal services to clients. Specifically, in our model intermediaries help firms that are that are legally entitled to receive a permit by reducing the navigation costs of obtaining those permits. However, they may also attempt to obtain permits for firms that are not legally entitled to receive such permits.

Our first result is that intermediaries are welfare enhancing when all firms are legally entitled to receive the license. Second, we show that when some firms are not entitled to a license (perhaps because of negative externalities they generate), then intermediaries will obtain a license for these firms by paying a bribe to an official. Thus, intermediaries will offer a combination of legitimate services to those firms entitled to a license and illegal services to those firms that are not entitled to the license. Importantly, we show that intermediaries can exploit this combination of legitimate and illegitimate services to enforce occasional (i.e. one-shot) bribe contracts even in the presence of hold-up (and without resorting to infinitely repeated play or reputations).