The economics of corporate crime

Why do companies break the law? Poor morals on the part of their executives, perhaps. But another basic economic explanation is that companies are more likely to break the law if the upsides of doing so outweigh the risks. If either the odds of getting caught or the penalties for lawbreaking are too low, then companies will find it profitable to engage in illegal behavior.

Go ahead and fine me. (Chris Ratcliffe/Bloomberg)

And there's some evidence that this is the world we live in: The Economist's Free Exchange column looks at some recent economic research on 283 instances of antitrust behavior between 1990 and 2005. This included companies illegally colluding with each other to overcharge customers. The firms reaped about $300 billion, all told, by doing so. And the penalties levied on companies that got caught (which includes both government fines and private lawsuits) were far too low to offset those profits:

The first step is to measure the expected gain from crime which fines need to offset. In the study by Messrs Connor and Helmers, the median amount that cartel members overcharged was just over 20% of revenue in affected markets.

Next, you need an assumption about the chances of being found out: a detection rate of one cartel in three would mean trustbusters were doing well. In this example, that would mean a fine of 60% of revenue is needed to offset an expected benefit of 20% of revenue — far higher than the fines in the study, which were between 1.4% and 4.9%.

So, judging by recent cartel behavior, penalties for illegal behavior should be set at around 60 percent of a company's revenue. In theory, that would be enough to deter law-breaking. In reality, however, the fines were much, much smaller.

And, while penalties for corporate crime have grown in recent years, they may still be too low. True, Barclay's just got slapped with a $450 million fine for its role in the Libor scandal, in which banks colluded to alter global interest rates. But, the Economist notes, antitrust behavior still appears to pay off under current regulatory regimes: "Britain looks particularly lenient. Its antitrust laws impose fines of up to 10% of revenues; American regulators levy penalties of up to 40%, and the European Commission goes up to 30%."

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Ezra Klein · July 23, 2012