In The Papers: Bureaucratic Corruption

In a recent paper, three economists take a look at China’s land market auctions and try to determine if everything is on the up-and-up.  Given that we’re talking about bureaucrats, there’s already a high potential of shady behavior, but China’s Land Market Auctions:  Evidence of Corruption shows just how bad things are.  Abstract:

This paper studies the urban land market in China in 2003–2007. In China, all urban land is owned by the state. Leasehold use rights for land for (re)development are sold by city governments and are a key source of city revenue. Leasehold sales are viewed as a major venue for corruption, prompting a number of reforms over the years. Reforms now require all leasehold rights be sold at public auction. There are two main types of auction: regular English auction and an unusual type which we call a “two stage auction”. The latter type of auction seems more subject to corruption, and to side deals between potential bidders and the auctioneer. Absent corruption, theory suggests that two stage auctions would most likely maximize sales revenue for properties which are likely to have relatively few bidders, or are “cold”, which would suggest negative selection on property unobservables into such auctions. However, if such auctions are more corruptible, that could involve positive selection as city officials divert hotter properties to a more corruptible auction form. The paper finds that, overall, sales prices are lower for two stage auctions, and there is strong evidence of positive selection. The price difference is explained primarily by the fact that two stage auctions typically have just one bidder, or no competition despite the vibrant land market in Chinese cities.

The authors look at two of the three major styles of land auction (because the third style is used only in a few areas, so it would have been difficult to run regressions against it).  The first style is an English auction, the style with which we’re most familiar:  people publicly bid on the property until the highest bidder wins.  The second style, however, is a two-stage auction.  In this setup, there is a 10-day period in which bids occur and are posted online.  After this 10-day period, if more than one buyer is still in the running, there will be an English auction to determine the winner.

In the paper, the authors show how the two-stage auction is actually a signaling mechanism for corruption:  two-stage auctions tend to be the ones where one person or company has bought the bureaucrat doing the auction and will win by default, so it’s not even worth bidding on.  Basically, for a payment, the bureaucrat will promise something along the lines of more lax environmental regulations, ignoring certain laws, or increasing government subsidies for one particular developer, thereby allowing the developer to bid more than the others could afford yet still earn economic profits.  In an English auction, individuals do not know or have a way of signaling that the deal is corrupt, so the price will tend to be rather high.  In the two-stage auction, however, the developer and bureaucrat want to show that a certain piece of land is “claimed,” so they will bid a fairly high amount as soon as the auction begins.  This will deter competitors.  The authors also point out that this is a separating equilibrium:  it doesn’t pay to pretend to have the deal in place; the actual corrupt developer will simply out-bid you and you lose the entrance fee you have to pay.

The authors end the paper with a relatively long discussion of the evidence and point out that significant gains are possible if all of the auctions were of the English variety.  They also point out a few interesting details, such as how the proportion of English auctions increases when a new land authority takes over a region, as the developers try to determine whether he is corrupt.  Because such individuals tend to be corrupt, eventually the proportion goes back down again.