Efficient rents 2 free entry and efficient rent seeking

In the competition for a monopoly right in which the number of bidders is fixed, Tullock and others have found the value of the resources spent in the aggregate to capture the transfer to be sometimes less than and sometimes greater than the value of the monopoly. We think this approach to be incomplete since it leaves unanswered the question of what determines the number of individuals who will vie for the right to be the monopolist. It is unsatisfactory to imagine, for example, that the franchisor sets the number of contestants. One could then foresee that rent seeking would arise to influence the permissible number of bidders, and this merely moves the rent-seeking dissipation question one step back. Our approach has been to extend these models in two ways. First, for a given number of active rent seekers, the monopoly right is granted according to the contest model developed by Nalebuff and Stiglitz (1983). This model clearly reveals that overdissipation of monopoly rents generally occurs only when there is some fixed cost of effort — or what amounts to the same thing, when active participation requires a nonrefundable entry fee. According to the contest model of granting rents, the extent to which rents are dissipated depends positively on the number of active rent seekers. Second, since expected profit in the contest is generally negative beyond some number of contestants less then the potential number of contestants, we construct an economic model of the entry decision. To avoid Tullock's ‘paradox of the liar’ — the absence of a symmetric pure-strategy equilibrium — our potential rent seekers adopt mixed entry strategies. We show that there is a symmetric mixed-strategy zero-profit equilibrium in which each of N potential rent seekers actively engages in the rent-seeking contest with probability p. Thus, the actual number of active rent seekers is a draw from the binomial distribution with parameters N and p. For the expected number of contestants, Np, rents are exactly and fully dissipated. Over- and underdissipation of monopoly rents are possible, but only ex post. The implications of our analysis are straightforward. First, when there are no restrictions on the number of individuals who may vie for the right to capture an artificially created transfer, entry will occur, and resources will be spent up to the point where the expected net value of the transfer is zero. Such competition leads to exact dissipation of the present value of the flow of rents associated with the transfer, and in static terms, makes the social cost of the monopoly equal to the value of the Tullock trapezoid. Second, even if entry is limited, overbidding for the franchise will in general not occur, the value of the Tullock trapezoid sets an upper limit on the social cost of monopoly. The result that rents are fully dissipated depends critically on the assumption of risk neutrality. While we have not analyzed the case of risk aversion completely, several predictions about the characteristics of equilibrium appear straightforward. First, if the marginal contestant is risk averse, then setting net expected utility equal to zero implies that in the limit the monetary value of the rents will not be fully dissipated. Moreover, the extent to which rents are dissipated will be less the greater the degree of risk aversion, the smaller the value of the appropriable rents relative to initial wealth, and the higher the fixed cost of entry (see Hillman and Katz, 1984: 107). Second, the extent of rent dissipation will also depend on the assumptions made concerning the supply of rent seekers and their risk aversion distribution. For example, there may be a large enough pool of potential rent seekers with zero risk aversion that the equilibrium number of active rent seekers will all be risk neutrál. In this case all rent will be dissipated expectationally. Third, and most importantly, with risk aversion as with risk neutrality, overdissipation will not be observed ex ante. Finally, the theory of rent seeking, as exposited here and elsewhere, puts considerable pressure on the argument that monopoly promotes a transfer of wealth from consumers to owners of monopoly firms (Comanor and Smiley, 1975). As Posner (1975: 821) observed, rent seeking implies that monopoly profits are dissipated, not transferred. This argument is correct as far as it goes. Only it does not go far enough, and it would carry us well beyond the scope of this paper to present a careful analysis of the impact of rent seeking on the level and distribution of wealth. Suffice it to say here that the effect of rent seeking on the level and distribution of wealth will be a function of the mechanism used to assign rents in a society, attitudes toward risk, comparative advantages in rent seeking, and so on (Higgins and Tollison, 1984). Copyright Martinus Nijhoff Publishers 1985