Abstract

A political economic framework is used to describe an economy following transition to private ownership. Thetransition, characterized by massive privatization, is accompanied by a change in the legal system, which isinfluenced by the elite who may be described as either corrupt or non-corrupt. The ability of the corrupt elite toinfluence the ruling party may lead to weak legal institutions, which cause underinvestment, corruption, andcapturing of lucrative industries by corrupt investors. By introducing heterogeneity among industries, we extendthe literature and show that the corrupt investors corrupt the more lucrative industries, and in corrupt economiescorrupt investors may separate themselves from the non-corrupt investors. Furthermore, we identified twomethods used by the corrupt investors to siphon profit – output stealing and profit stealing – and illustrate thatcorrupt investors may substitute between the two methods to alleviate the constraints created by strongerinstitutions. To this end, strengthening the institutions only in one dimension may, at the end of the day, causeoutput, as well as investment, to decline.

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