Property Rights, Extortion and the Misallocation of Talent

How do institutions affect resource misallocation? This paper focuses on a particular class of institutions, namely property rights, and their relation to extortion. Motivated by empirical evidence that there are differences in extortion rates across establishments, both within and across countries, I examine whether extortion is an important channel for understanding resource misallocation. I construct a model in which agents choose between entrepreneurship and working, and where a criminal group can extort entrepreneur capital. While property rights are common across agents, extortion rates arise endogenously as an inverted `u' shape in agent's ability. In economies characterized by weak property rights, extortion is prevalent and resource misallocation can generate TFP and output losses of 10 and 30 percent. TFP and output losses arise from two channels: selection and misallocation. Extortion affects selection by altering the ability threshold required for entry into entrepreneurship, while misallocation occurs because entrepreneurs operate below the optimal scale. As property rights decrease, extortion rates are higher and TFP and output losses from selection and misallocation are magnified.