08 Mar 2012  Working Papers

Customer-Driven Misconduct: How Competition Corrupts Business Practices

Executive Summary — Competition is typically thought to generate many positive outcomes including lower prices and higher productivity. But competition can also lead firms to increase quality for their customers in ways that are both illegal and socially costly. This paper examines the impact of competition on the vehicle emissions testing market, and finds that firm misconduct increases with competitive pressure and the threat of losing customers to rival firms. These results have serious implications for policy makers and managers. This paper is among the first to empirically demonstrate that increased competition can motivate firms to provide illicit quality to avoid losing business. Key concepts include:

  • Firms seeking to enforce legal and ethical conduct among managers and employees must be especially vigilant when operating in highly competitive markets.
  • Increased competition within markets may encourage competitors to cross legal boundaries in ways that threaten the profits of legally compliant firms.
  • In the absence of effective monitoring by government institutions, firms may benefit from privately monitoring their competitors' behavior to ensure that rivals do not maintain a competitive advantage through illicit actions.
  • Policy makers must carefully consider the optimal market structure for industries in which illicit actions yield cost reductions or are demanded by customers. While competition may yield lower prices and better choice for customers, it may also bring the increased social costs of illegal behavior by firms.
  • Since managers may be under considerable pressure to cross legal and ethical lines when market competition is high, avoiding government sanctions requires top managers and owners to strengthen monitoring and governance mechanisms to ensure legal compliance.
  • Managers must understand that government policy, firm decisions, or exogenous factors that increase market rivalry may necessitate the monitoring of competitors' behavior. The failure to do so may allow these rivals to gain advantage through illicit strategies, particularly under institutional regimes where regulatory monitoring or enforcement is weak.

 

Author Abstract

Competition among firms can have many positive outcomes, including decreased prices and improved quality. Yet competition can have a darker side when firms can gain competitive advantage through illicit and corrupt activities. In this paper, we argue that competition can lead organizations to provide illicit quality that satisfies customer demand but violates laws and regulations and that this outcome is particularly likely when price competition is restricted. Using 28 million vehicle emissions tests from more than 11,000 facilities, we show that increased competition is associated with greater inspection leniency, a form of illicit quality that customers value but is illegal and socially costly. Firms with greater numbers of local competitors pass customers at considerably higher rates and are more likely to lose customers they fail to pass, suggesting that the alternatives that competition provides to customers intensify pressure to illegally provide leniency. We also show that, at least in contexts when pricing is restricted, firms use illicit quality as an entry strategy.

Paper Information