Rise of a Network - Political Connections and Allocative Distortions

Abstract

This paper exploits a unique institutional setting to examine the effects of firms' political connections on the allocation of government procurement contracts. After winning the presidential election in Korea in 2007, the new president, Lee Myung Bak, appoints several members of his networks as CEOs of state-owned firms. In turn, these state firms allocate significantly more procurement contracts to private firms with a CEO from the same network. The systematically poor execution of contracts allocated to connected firms suggests that contracts are misallocated. Back of the envelope calculations suggest that each dollar in contract volume transferred from non-connected to connected firms leads to a cost of 17-26 cents to the economy, resulting in a total annual cost of about 0.21-0.32% of GDP.