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Observational methods can be utilized to provide descriptions of behaviors in both quantitative and qualitative research designs. In qualitative research, observations are generally recorded in great detail to investigate the ways in which people act and interact. In quantitative research, observation studies are very different and focus on a specific behavior that can be quantified in some way. Discuss the use of systematic observations as a data collection procedure in quantitative research. Locate a research study on Proquest or EbscoHost (or another search engine through Ashford’s library) that utilized systematic observations in their data collection procedures. Provide a description regarding how the systematic observations were conducted and how the behavior observed was quantified. What are some potential limitations of the methods that were used? Post should be at least 400 words

Emerging Markets Finance & Trade, 57:1271–1283, 2021
Copyright © Taylor & Francis Group, LLC
ISSN: 1540-496X print/1558-0938 online
DOI: https://doi.org/10.1080/1540496X.2019.1612362
The Effect of Political Connections: Model Analysis and
Quantitative Simulation
Xiaoqin Zhao
School of Economics and Management, Xinjiang University, Urumqi, China
ABSTRACT: Based on a two-task principal-agent theoretical models, we model the input of building and
maintaining political connections as non-productive activities. We measure the degree of change in the
external environment. And the level of moral hazard on political connection managers is measured by the
degree of incongruity between a politically connected manager’s income and investor interest. Our
analysis using a quantitative simulation shows that, in the face of more external environmental change,
managers can offset their own lost income by engaging in a high level of moral hazard. Political
connections not only increase managers’ sensitivity to changes in the external environment but also
alleviate the negative impact on their income. Moreover, investor revenue is not sensitive to changes in
the external environment but is sensitive to managers’ moral hazards. In addition, the greater the changes
in external environment and the greater the managers’ moral hazards, the lower the value of total social
welfare. Hence, political connections have a negative impact on total social welfare.
KEY WORDS: external environment, moral hazard, political connections, two-task principal agent model
JEL: G01, G32
The effect of political connections on firm operations has long been a focus of concern. Many studies have
found that firms obtain economic benefits and advantages from having political connections (Blau 2017;
Boubakri, Mansi, and Walid 2013; Guo et al. 2014; Li, Meng, and Zhang 2006; Tetsuji and Michiru 2017;
Wang et al. 2017). Faccio, Masulis, and Connell (2006) and Claessens, Feijend, and Laeven (2008)
suggest that political connections lead to preferred access to credit, regulatory favors and government
assistance in obtaining finance. Bao, Johan, and Kutsuna (2016) show that political connections can help
Chinese-listed firms to reduce the rejection risk of initial public offerings (IPO), yet negatively correlate
with the cost of IPOs. Blau (2017) shows that politically connected firms were substantially more likely to
participate in the US Federal Reserve’s emergency loan programs.
However, political connections are a double-edged sword. Some studies explore the potential
negative effect. Chaney, Faccio, and Parsley (2011) find that accounting quality is lower at politically
connected firms than non-connected firms. Abubakr, Belghitar, and Clark (2016) show that directors
at politically connected firms underperform those at non-connected firms by almost 17% and 15% in
terms of the return on assets and return on equity, respectively. Shen, Lin, and Wang (2015) suggest
that politically connected firms are likely to demonstrate poor governance practices. Cao et al. (2017)
reports that politically connected CEOs have weaker turnover-performance sensitivity than those
without connections and also have a lower probability of turnover. Abubakr, Belghitar, and Clark
(2017) provide strong support for the presence of investment inefficiency and excessive employment
among politically connected firms in Pakistan.
The recent studies report the paradox results in one paper. Chen et al. (2017a) construct a unique
political connections index to capture variations in the strength of firm political relations in China.
Their close examination shows an inverted U-shaped relation between political connections and firm
Address correspondence to Xiaoqin Zhao, School of Economics and Management, Xinjiang University,
Urumqi, China. E-mail: zxq_play@163.com
Color versions of one or more of the figures in the article can be found online at www.tandfonline.com/mree.
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X. ZHAO
value for the full sample in general and for non-SOEs in particular. Firm value increases initially at
a lower level of connections and then begins to decrease at a higher level. Jiaan et al. (2017) show, on
the one hand, the acquisition of subsidies may indeed promote the technical innovation capacity of
enterprises in China, but on the other hand, their technical innovation capacity may be weakened.
Chen et al. (2017b) document that politically connected underwriters increase the likelihood of
clients’ IPO applications, while to charge premium underwriting fees. They further find that the
performance of this post-IPO is weaker, and the minority shareholders’ interests may be impaired.
Many scholars explain the convenience of political connections from the point of view of the theory
of social capital or resource dependence theory and explain the negative impact of political connections
from the perspective of rent-seeking or government intervention. No unified analytical framework has
emerged to explain this paradoxical character of political connections. Using the model of a multitask
principal-agent problem, we propose a framework for an integrated review of political connections.
Then, using a quantitative simulation model, we present the results of our analysis graphically.
Taken together, this research contributes to the literature in the following two fields. First, using
the model of multitask principal-agent theory, it provides a new perspective for understanding the
double-edged influence of political connections in developing countries, especially such as
China. Second, to our knowledge, this study is among the first to show analytical results graphically
using a quantitative simulation method.
The research is organized as follows. In section 2, it is the background characteristics of Chinese
enterprises developing political connections. Section 3, we construct the two-task principal-agent
models and obtain results of our theoretical analysis, which investigates the impact of political
connections on contract parties’ revenue by focusing on two key variables (environmental changes
and moral hazard). Section 4 is the quantitative simulation method and graphical presentation. The
conclusion and discussion of the research are in the final section.
1. Background Characteristics of Chinese Enterprises Developing Political Connections
There have some background characteristics in China as a developing country. Firstly, the managers of
the politically connected enterprises have been deeply influenced by Chinese traditional culture, namely
“guanxi” feature. Because of the “relational” nature of the transformation in Chinese society (Allen,
Qian, and Qian 2005), the politically connected enterprise can take advantage of their political relationships to have more knowledge about relevant government departments, as well as convenient channels
for access, resulting in support for the firm’s fewer efforts cost to get scarce resources. Politically
connected enterprises/managers are also in a good position for rent-seeking. Therefore, for the
politically connected firms, it is more likely that they will get resources controlled by the government.
Thus, the enterprise will be keen to seek and establish this political relationship with the government.
Secondly, China actively promotes the construction of a market economic system. However,
because the market economy mechanism is imperfect, and has path dependence on the planned
economy path, “big government” still retains too much control over social resources. So the process
of interaction between business and government does not result in companies competing all through
market mechanisms, but instead causes firms to compete with each other to obtain more government
control of resources in some fields. As a result of this situation, companies have a strong incentive to
seek to establish and maintain political connections in order to obtain support and protection from the
legal and administrative system. On the flip side, these companies will also face more government
intervention, such as more jobs and more social responsibilities.
Finally, on the one hand, many state-owned enterprises in China grew out of government sector
production units in the planned economy. Even after the reform, this natural “blood relationship” gives
such enterprises more convenient communication with government departments and facilitates access to
government information and resources. But the problem is obvious. These managers are likely to spend
too much energy and wealth on building close relationships with government officials who have high
THE EFFECT OF POLITICAL CONNECTIONS
1273
political status in order to increase their own prestige and reputation. This kind of enterprise manager
presents a serious moral hazard problem in the traditional sense. On the other hand, the outstanding
problem in Chinese-listed corporate is the major conflict of interest between a single large shareholder
and other minority shareholders. The large shareholder has an incentive to actively initiate politically
connected activities. After getting more resources, the large shareholder can undertake projects that are
favorable only to his own interest but not to other shareholders’ interests.
Thus, business manager in China actively pursues political connections, which not only reduces
the uncertainty of external environment but also mixes their own moral hazards. Previous studies
have looked at these factors separately. In practice, political connections are likely interrelated with
agency problems and changes in the external environment.
The relationships within organizations and between organizations can be taken as a variety of
contract. In the analytical framework of contract theory, parties consider the internal and external
environment (participation constraints and incentive compatibility constraint conditions) and then make
decisions in order to maximize their own income (including private gain). So contract theory can be
useful to analyze the objective influences (such as traditional culture, institutional environment, etc.)
and the subjective influences (including moral hazard) faced by the agent in a unified analytical
framework. This shows us that we can re-examine political connections from the point of view of
contract theory. But the classic single-task principal-agent model cannot do a good job of explaining
both sides of the characteristics of political connections in the situation where political connections can
bring in more resource inputs, and at the same time reduce corporate investment efficiency and value.
Based on the view that the politically connected enterprise operators face more external influences and
more serious agency problems, and that the politically connected operators engage in more nonproductive activities, we believe that, at the firm level, political connections can be explained from
the perspective of multi-tasking principal-agent problems. One of our contributions is to re-examine the
influence of the complex objective external environment and the operator’s moral hazard on political
connections and to investigate the economic consequences of political connections.
2. Two-Task Principal-Agent Model of Political Connections
2.1. The Model
Baker (2002) and Gibbons (2005) both research managers’ incentive problems with consideration of
the risk of changes in the external environment (σ2 ) and the incongruity between managers’ and
investors’ income ( cos θ). Baker (2002) uses a multi-task model to develop a two-parameter
characterization of performance measures and show how these two parameters—distortion ( cos θ)
and risk (σ2 ) —affect the value and use of performance measures in incentive contracts. The model
outlines an intuitive geometric interpretation of and trigonometric expression for distortion in
performance measures, and its interpretations can capture and explain many of the issues that plague
actual incentive plans. Gibbons (2005) reviews and emphasize six models in “agency theory”. In part
about the objective performance measurement, the author points out that the essence of the incentive
problem is the divergence between the agent’s incentive to increase p and the principal’s desire to
increase y. If y = a1, and p = a1+ a2, then a contract based on p creates an incentive for the agent to
take action a2, even though a2 is irrelevant to the agent’s total contribution.
The key reference of our paper is the model of Baker (2002) research. Our expansions on model is
mainly how should reflect the difference on the firm with or without the political connection. The
parameter of θ can measure the incongruity between managers’ and investors’ income. The firms
with or without the political connection all have the principal-agent problem, and we assume that the
political connection firms have more serious agency problem. Based on this setting, the variable of λθ
between politically connected managers and investors will be greater.
Inspired by Gibbons (2005) study, we observe those who engage in two types of activities,
productive activities e1 and unproductive political activities e2 . The unproductive activities include
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X. ZHAO
politically connected behaviors, such as establishment, maintenance and utilization of political
connections. The productive activities are directly associated with a project’s value-added activities,
such as improved project production processes and technical innovation.
The function of investor revenue from the project is as follows:
V ¼ f1 e1 þ f2 e2 þ ha þ ε
(1)
eðfe1 ; e2 gÞis the vector of the politically connected manager’s productive and unproductive activities.
f ðff1 ; f2 gÞ is the manager’s marginal product of the vector held by investors in two dimensions. ha is
the increase in the project’s value due to investor (principal) supervision. α is the level of investor
supervision, and h is the investor’s marginal product of supervision. The increase in the project’s
value mainly comes from the manager’s input level, so it is reasonable to set fi > h The variable ε is
the stochastic effect of the external environment on the project outputs. These changes cannot be
controlled by the firm. The impact of external changes meets the normal distribution and is
ε 2 Nð0; σ2ε Þ. The size of the variance equals the degree of interference due to external environmental
changes.
Unlike the investor’s output function, the politically connected manager knows that the real
function of project output is
M ¼ g1 e1 þ g2 e2 þ ha þ ϕ:
(2)
eðfe1 ; e2 gÞ is also the vector of the politically connected manager’s productive and unproductive
activities. gðfg1 ; g2 gÞ is the manager’s real marginal product of the vector. ha has the same meaning as
in equation 1, and gi > h. The meaning of ϕ is the same as εand has the same distribution as ϕ 2 Nð0; σ2ϕ Þ .
The manager’s income function is
CEm ¼ s þ bm M cðe1 ; e2 Þ γvarðs þ bm MÞ
1
1
¼ s þ bm ðg1 e1 þ g2 e2 þ haÞ e21 e22 γb2m ησ2ϕ
2
2
(3)
The variable S is fixed income; bm M represents the performance gains; 12 e21 þ 12 e22 are the cost of the
efforts; and γb2m ησ 2ϕ are the risk premium requirements in the manager’s coefficient of risk aversion.
The function satisfies the following conditions:CEm0 ðei Þ > 0, CEm00 ðei Þ < 0 and γ > 0.
The investor’s revenue function is
1
1
CEp ¼ V s bm M a2 ¼ f1 e1 þ f2 e2 þ ha s bm ðg1 e1 þ g2 e2 þ haÞ a2
2
2
(4)
To meet the politically connected manager’s participation constraint and incentive compatibility constraint conditions, the investor will maximize his revenue. Then, the investor problem is as follows:
1
Maximize CEP ¼ V s bm M a2
bm ;ε;a
2
s:t:

1
1
ei 2 arg max s þ bm ðg1 e1 þ g2 e2 þ haÞ e21 e22 γb2m ησ2ϕ
2
2
1
1
s þ bm ðg1 e1 þ g2 e2 þ haÞ e21 e22 γb2m ησ 2ϕ 0
2
2
(5)
THE EFFECT OF POLITICAL CONNECTIONS
1275
A valid contract can maximize the parties’ joint welfare. Then, the investor problem can be
rewritten as follows:
1
1
1
(6)
Maximize CEj ¼ CEm þ CEp ¼ f1 e1 þ f2 e2 þ ha e21 e22 γb2m ησ 2ϕ a2
bm ;ε;a
2
2
2

1
1
s:t: ei 2 arg max s þ bm ðg1 e1 þ g2 e2 þ haÞ e21 e22 γb2m ησ2ϕ
2
2
1
1
s þ bm ðg1 e1 þ g2 e2 þ haÞ e21 e22 γb2m ησ 2ϕ 0
2
2
For the sake of simplicity, we assume that the total social welfare is the sum of manager’s and
investor’s income.
FG cos λθ
Then, we can obtain bpc
m ¼ G2 þ2γησ 2 þh2 . The variable λθ is the angle between the investor’s and the
Ï•
politically connected manager’s marginal output vector, which measures the incongruity in the parties’
output.
sffiffiffiffiffiffiffiffiffiffiffi
sffiffiffiffiffiffiffiffiffiffiffi
n
n
P
P
fi gi
2
Then cos λθ ¼ kf kkgk , F ¼ kf k¼
fi and G ¼ kgk¼
gi2 .
i¼1
i¼1
Then, the political-connected manager’s optimal input level is
pc
FG cos λθ
FG cos λθ
epc
1 ¼ g1 G2 þ2γησ2 þh2 and e2 ¼ g2 G2 þ2γησ 2 þh2
Ï•
Ï•
The investor’s optimal supervision level is
pc
a
!
FG cos λθ
:
¼h 1 2
G þ 2γησ2ϕ þ h2
Based on equations (4), (5) and (6), the revenue functions of the politically connected manager and
the investor, and total social welfare are, respectively:
CEmpc
1
FG
¼ s þ ðG2 2γησ2ϕ 2h2 Þ
2
2
G þ 2γησ2ϕ þ h2
!2
cos2 λθ þ
h2 FG
cos λθ
G2 þ 2γησ2ϕ þ h2

CEppc

2γησ2ϕ þ 32 h2 F 2 G2
h2 FG
1
2
¼
cos λθ þ h2 s
2 cos λθ 2
2 þ h2
2
G
þ
2γησ
Ï•
G2 þ 2γησ2ϕ þ h2
(7)
CEjpc ¼
1
F 2 G2
1
cos2 λθ þ h2
2 G2 þ 2γησ2ϕ þ h2
2
(8)
(9)
2.2. Key Variables in the Model
2.2.1. The Variable cos λθ
The variable θ is the angle between the investor’s and the manager’s marginal output vector. So it
measures the degree of distortion between the manager’s gain and investor income. In view of the
agent’s moral hazard in principal-agent theory, we argue that θ is the appropriate variable for
representing the severity of the agent’s moral hazard.
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X. ZHAO
To maintain and develop political relationships with government agencies, politically connected
managers engage in more non-productive activities than those without such connections, such as looking
for opportunities to build political relationships, and employing the relatives of officials, represented by
the coefficient λ. Based on this setting, λθ between politically connected
P managers and investors will be
fi gi
Ï€
, the variable cos λθ ¼ kf kkgk equals 1 cos λθ 0.
greater. When 0o θ 90o and1 λ 2θ
Two situations are noteworthy. When θ ¼ 0o ; cos λθ ¼ 1, which means that politically connected managers and investors have the same revenue function: for example, at financing time,
managers will try to obtain more funding, and investors are receptive to this. Thus, at financing
time, the principal and the agent have the same goal. When λθ ¼ 90o ; cos λθ ¼ 0, which means
that politically connected managers take actions that are the opposite of expected investor
behavior. So when λθ gradually increases and cos λθ decreases, the degree of incongruity
between the politically connected manager’s income and the investor’s revenue widens. This
also can be explained as the manager engaging in more unproductive activities and having more
serious moral hazard.
2.2.2. The Variable ησ2ϕ
The variable σ2ϕ reflects the degree of change in the external environment, which interferes with
project revenue. Many empirical studies show that politically connected companies have more
government involvement than those without political connections, such as bearing more of the burden
of employment, tax collection and local development. So a politically connected enterprise will be
more influenced by changes in the external environment. The coefficient η is multiplied by the
variable, and the value is η 1. This means that politically connected managers will be more affected
by changes in the external environment (ησ 2ϕ ).
2.3. Comparative Analysis of Politically Connected Parties’ Gains
In this section, we analyze the results of the first derivative with respect to λ and η in equations (7),
(8) and (9).
2.3.1. Politically Connected Manager’s Income
Proposition 1:
3h
1. When the condition is 3G2γη
>σ2ϕ , namely, the environment fluctuates little, the manager’s
income will decrease to the more serious degree of λθ.
2
3h2
2. When the condition is 3G2γη
3G2 , this means the marginal
If the condition 3G2γη
output power of a politically connected manager is lower. The result can also be explained by the idea
that political connections increase the income of a manager who has lower marginal output power.
THE EFFECT OF POLITICAL CONNECTIONS
1277
2.3.2. Investor Income
Proposition 2:
3h
0:28 can political
connections increase manager income. That shows that the greater the change in the external
environment, the more political connections can help increase manager income.
3.2. Quantitative Simulation of Investor Income
Based on equation (8) and Proposition 2, Figure 3a and b illustrate investor revenue with and
without political connections, respectively. When an agent’s moral hazard (θ) increases, which
cannot be confirmed by a third party, investor revenue rapidly decreases. In other words, investor
(a) without political connections
(b) with and without political connections
Figure 2. Quantitative simulation of manager income.
(a) without political connections
(b) with and without political connections
Figure 3. Quantitative simulation of investor revenue.
THE EFFECT OF POLITICAL CONNECTIONS
(a) without political connections
1279
(b) with and without political connections
Figure 4. Quantitative simulation of social welfare.
revenue is not very sensitive to the impact of change in the external environment (σ2ϕ ), which
partly explains why investors can tolerate managers’ involvement in political connection activities, which will help to cope with change in the external environment of China’s transitional
economy. Figure 3b shows that investor revenue will rapidly decline, because of politically
connected managers with moral hazard.
3.3. Quantitative Simulation of Social Welfare
Based on equation (9) and Proposition 3, Figure 4a and b illustrate overall social welfare with and
without political connections, respectively. Figure 4a shows that social welfare decreases with more
change in the external environment (σ2ϕ ) and more moral hazard among managers (θ). Figure 4b
shows that social welfare is lower with political connections.
4. Conclusions
With the two-task principal-agent models as its basic analytical framework, this paper reconsiders the
impact of political connections on the revenue of politically connected managers, the income of
investors and social welfare. Our main conclusions are as follows.
We model the input of building and maintaining a political connection as non-productive activities
in a two-task principal-agent theoretical models. The variable λθ ( cos λθ) measures the degree of
incongruity between the politically connected manager’s income and investor interests, as well as the
level of moral hazard on politically connected managers. The variable ησ2ϕ reflects the degree of
change in the external environment. The model analysis and the method of quantitative simulation
results show that the degree of change in the external environment, and the degree of manager’ moral
hazard have different effects.
Managers can offset their own income by engaging in behavior with a higher level of moral
hazard. Political connections reduce the impact of changes in the external environment on
manager income and raise managers’ sensitivity to environmental changes. As long as even
a small change exists in the environment, moral hazard can increase the earnings of politically
connected managers. That is, companies actively seek political connections because managers are
not only responding to the dynamic nature of the objective environment but also maximizing
their own interests.
Investor returns are not so sensitive to changes in the external environment, which can partly
explain why investors can tolerate the political connections of managers, whose actions can help to
1280
X. ZHAO
cope with changes in the external environment in China’s transitional economy, but they are sensitive
to moral hazard by managers. Investor revenue suffers a negative impact and rapid decline when
politically connected manager engage in more moral hazard.
As for social welfare, the greater the changes in the external environment and the greater the
manager’s moral hazard are, the lower overall social welfare is. Thus, political connections have
a negative impact on total social welfare.
Overall, to differ from the theory of social capital/the resource dependence theory, or the theory of
rent-seeking/government intervention, our research offers a unified analytical framework (multitask
principal-agent model) to explain the paradoxical character of political connections and presents the
results of our analysis graphically by quantitative simulation method. It is a new insight into the
influence political connections and the economic consequences of political connections in developing
and emerging economy contexts, especially in China.
Funding
The study was supported by the Chinese National Natural Science Foundation [Grant no. 71563051].
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THE EFFECT OF POLITICAL CONNECTIONS
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Appendix
(1) Appendix 1
Proposition 1 Proof: To construct a model, we take the first derivatives of λ and ηin equation 7, and
the research shows that managers’ moral hazard (λθ) and changes in the external environment (ησ2ϕ )
affect politically connected managers’ revenue. The derivative results are as follows:
dCEmpc
¼
dλ
θFG sin λθ
G2 þ 2γησ2ϕ þ h2
h

i
2
2
2
2
2
2
2
2 G 2γησϕ 2h FG cos λθ h G þ 2γησϕ þ h
h

i
γσ2ϕ FG cos λθ
dCEmpc
2
2
2
2
2
2
2
¼
3 FG cos λθ 2γησϕ þ 3h 3G 2h G þ 2γησϕ þ h
dη
G2 þ 2γησ2ϕ þ h2
P
P
fi gi
If cos θ ¼ kf kkgk ,fi > h and gi > h, then k f kkgk cos θ ¼ fi gi ¼ f1 g1 þ f2 g2 > 2h2 . The two
equations can be transformed as follows:
dCEmpc
>
dλ
θFG sin λθ
G2 þ 2γησ2ϕ þ h2
¼
h

i
2
2
2
2
2
2
2
2
2 G 2γησϕ 2h 2h h G þ 2γησϕ þ h
h2 θFG sin λθ
G2 þ 2γησ2ϕ þ h2

2
2
2
2 2γησϕ þ 3h 3G

i
2h2 γσ2ϕ FG cos λθ h
dCEmpc
2
2
2
2
2
2
>
3 2γησϕ þ 3h 3G G þ 2γησϕ þ h
dη
G2 þ 2γησ2ϕ þ h2
¼
2h2 γσ 2ϕ FG cos λθ 2

2
3 2h 4G
G2 þ 2γησ2ϕ þ h2
Ï€
Because 0o θ 90o and 1 λ< 2θ (whenθ ¼ 0o ; λ ¼ 1), then sin λθ > 0; cos λθ > 0. Thus,
pc
3h dCEm
; dλ > 0, This shows that if changes in the external environment are great,
1. When σ2ϕ > 3G2γη
politically connected managers’ gains exceed those of non-politically connected managers.
Thus, political connections help managers to evade the risk of changes in the external
environment and to improve their own earnings.
2 3h2 dCEpc
2. When σ2ϕ < 3G2γη ; dλ m < 0, This shows that if changes in the external environment are low, politically connected managers have smaller gains than non-politically connected managers. pc m 3. Because gi > h; dCE
dη < 0. Thus, the greater the changes in the external environment, the lower the returns for politically connected managers will be. 2 2 QED. (2) Appendix 2 Proposition 2 Proof: To obtain an equation for the first derivatives of λ and η in equation 8, we show that managers’ moral hazard (λθ) and changes in the external environment (ησ2ϕ ) affect investor revenue. The derivative results are as follows: 1282 X. ZHAO dCEppc dλ dCEppc dη ¼ ¼ P If cos θ ¼ θFG sin λθ G2 þ 2γησ2ϕ þ h2 2γσ2ϕ FG cos λθ G2 þ 2γησ2ϕ þ h2 f i gi kf kkgk , h i 2 2 2 2 2 2 2 4γησϕ þ 3h FG cos λθ þ h G þ 2γησϕ þ h h i 2 2 2 2 2 2 2 3 FG cos λθ G 2γησϕ 2h þ h G þ 2γησϕ þ h fi > h andgi > h, then k f kkgk cos θ ¼
P
fi gi ¼f1 g1 þ f2 g2 > 2h2 . The two
equations can be transformed as follows:
dCEppc
dλ
>
θFG sin λθ
G2 þ 2γησ2ϕ þ h2
h

i
2
2
2
2
2
2
2
2h

4γησ
þ
3h
þ
h
G
þ
2γησ
þ
h
2
Ï•
Ï•

h2 θFG sin λθ
2
2
2
¼
2 G 6γησϕ 5h
G2 þ 2γησ2ϕ þ h2
dCEppc
dη
>
2γσ2ϕ FG cos λθ
G2 þ 2γησ2ϕ þ h2
¼
h

i
2
2
2
2
2
2
2
2
3 2h G 2γησϕ 2h þ h G þ 2γησϕ þ h

2h2 γσ2ϕ FG cos λθ 2
2
2
3 3G 2γησϕ 3h
G2 þ 2γησ2ϕ þ h2
Ï€
Because 0o θ 90o and 1 λ< 2θ (when θ ¼ 0o ; λ ¼ 1), then sin λθ > 0, cos λθ > 0. Thus,
dCE
pc
dCE
pc
3h
1. When 3G2γη
< σ2ϕ ; dλ p < 0 and dηp < 0. This shows that if the changes in the external environment are high, investor revenue will decrease because of those changes and greater moral hazard among politically connected managers. 2 2 dCEpc dCEpc 5h 3h 2. When G 6γη < σ2ϕ < 3G2γη ; dλ p < 0 and dηp > 0. This shows that investor income will
decrease because of greater moral hazard among more politically connected managers. But it
will not decrease because of greater changes in the external environment. Thus, investor
revenue is more sensitive to politically connected managers’ moral hazard than the impact of
changes in the environment.
2
2
2
dCEpc
2
dCEpc
5h
> σ2ϕ ; dλp > 0 and dηp > 0, which shows that if changes in the external
3. When G 6γη
environment are low, investor revenue will increase because of changes in the external
environment and politically connected managers’ moral hazard.
2
2
QED.
(3) Appendix 3
Proposition 3 Proof: To seek the first derivatives on λ and η in equation 9, we show that managers’
moral hazard (λθ) and changes in the external environment (ησ 2ϕ ) affect investor revenue. The
derivative results are as following:
dCEjpc
θF 2 G2 cos λθ sin λθ

¼
dλ
G2 þ 2γησ2 þ h2
Ï•
THE EFFECT OF POLITICAL CONNECTIONS
1283
2γσ 2ϕ F 2 G2 cos2 λθ
dCEjpc
¼
2
dη
G2 þ 2γησ2ϕ þ h2
Because 0o θ 90o and1 λ < dCEjpc dλ dCEjpc dη π 2θ (when θ ¼ 0o ; λ ¼ 1), then sin λθ > 0;
cos λθ > 0. Thus,
< 0 and < 0. This shows that overall social welfare decreases because of changes in the external environment and moral hazard among more politically connected managers. Thus, political connections decrease social welfare. QED. Copyright of Emerging Markets Finance & Trade is the property of Taylor & Francis Ltd and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual use. Purchase answer to see full attachment

  
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