1 A mathematician, an accountant and an economist apply for the same job. The interviewer calls in...

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• A mathematician, an accountant and an economist apply for the same job.

• The interviewer calls in the mathematician and asks "What do two plus two equal?" The mathematician replies "Four." The interviewer asks "Four, exactly?" The mathematician looks at the interviewer incredulously and says "Yes, four, exactly."

• Then the interviewer calls in the accountant and asks the same question "What do two plus two equal?" The accountant says "On average, four - give or take ten percent, but on average, four."

• Then the interviewer calls in the economist and poses the same question "What do two plus two equal?" The economist gets up, locks the door, closes the shade, sits down next to the interviewer and says "What do you want it to equal?"

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Chapter 6 – Political Economy

Public Finance

Resource allocation methods for public goods

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Political Economy Defined

• Political Economy is the application of economic principles to the analysis of political decision making.

– Self-interest – in the marketplace, this often leads to efficiency; different implications in “political market.”

– Maximization – one goal may be to maximize social welfare.

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Direct Democracy

• Several kinds of voting procedures:

– Unanimity rules

– Majority voting rules

– Logrolling

• Problems with all of these rules:Arrow’s Impossibility Theorem

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Direct Democracy: Unanimity rules

• Unanimity rules: All parties must agree for a policy to be implemented.– Example: In principle, society could agree

that a public good should be provided rather than not being provided.

• Lindahl prices designed to elicit unanimous agreement for provision of public good.

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•Unanimous Consent on Public Goods Levels

•Lindahl pricing An approach•to financing public goods in•which individuals honestly reveal•their willingness to pay and the•government charges them that•amount to finance the public good.

•marginal willingness to pay The amount that individuals are willing to pay for the next unit of a good

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•Unanimous Consent on Public Goods Levels

•.

•Lindahl Pricing

•Lindahl’s procedure operates as follows:

– 1. The government announces a set of tax prices for the public good.

– 2. Each individual announces how much of the public good he or she wants at those tax prices.

– 3. The government repeats these steps to construct a marginal willingness to pay schedule for each individual.

– 4. The government adds up individual willingnesses to pay at each quantity of public good provided.

– 5. The government relates this overall demand curve to the marginal cost curve.

– 6. The government then finances this public good by charging individuals their willingnesses to pay for that quantity.

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•Unanimous Consent on Public Goods Levels•Lindahl Pricing

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•benefit taxation Taxation in•which individuals are taxed for a•public good according to their•valuation of the benefit they•receive from that good.

•The equilibrium is also the efficient level of public goods provision, the point at which the sum of the social marginal benefits of the public good is set equal to social marginal cost.

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•Unanimous Consent on Public Goods Levels•Problems with Lindahl Pricing

•The first problem is that individuals have an incentive to lie about their willingness to pay, since the amount of money they pay to finance the public good is tied to their stated willingness to pay.

•Preference Revelation Problem

•Preference Knowledge Problem•Even if individuals are willing to be honest about their valuation of a public good, they may have no idea of what that valuation actually is.

•Preference Aggregation Problem•Even if individuals are willing to be honest and even if they know their valuation of the public good, there is a final problem: How can the government aggregate individual values into a social value?

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•Mechanisms for Aggregating Individual Preferences9 . 2

A P P L I C A T I O N

Through three and a half centuries, the tradition of direct democracy, whereby individuals directly vote on the policies that affect their lives, remains strong in America—and, indeed, has grown throughout the twentieth century.

• Direct Democracy in the United States

•referendum A measure placed on the ballot by the government allowing citizens to vote on state laws or constitutional amendments that have already been passed by the state legislature.

•voter initiative The placement of legislation on the ballot by citizens.

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Direct Democracy:Feasibility of Lindahl’s Procedure

• Problems:

• Assumes people vote sincerely– Strategic behavior (e.g., misrepresenting

one’s preferences) may prevent Lindahl equilibrium.

• Finding tax shares may take a lot of time– Imagine many parties, not just two.

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Direct Democracy:Majority Voting Rules

• Majority Voting rules: one more than half of the votes must favor a measure to gain approval.

• Although the rules are familiar, potential problems with them.

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Direct Democracy:Majority Voting Rule Example

• Three people have to choose among three levels of missile provision

– A is small amount of provision

– B is moderate amount of provision

– C is large amount of provision

• People are Cosmo, Elaine, and George

• Preferences are shown in Table 6.1

Table 6.1

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• In Table 6.1, the quantity B would win in an election of B versus A (by a vote of 2-1, with Elaine and George voting for B).

• B would also win in an election of B versus C (by a vote of 2-1, with Cosmo and George voting for B).

• Selection of B in this case is independent of the order in which the votes are taken.

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• Now consider the preferences that are shown in Table 6.2

Table 6.2

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• In Table 6.2, imagine a series of paired elections to determine the most preferred level. Elaine’s preferences are the only ones that have changed.– The quantity A would win in an election of A versus B

(by a vote of 2-1, with Cosmo and Elaine voting for A).

– The quantity B would win in an election of B versus C (by a vote of 2-1, with Cosmo and George voting for B).

– The quantity C would win in an election of A versus C (by a vote of 2-1, with Elaine and George voting for B).

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• Thus, the ultimate outcome depends crucially on the order in which the votes are taken.

• It is clear in this example that whichever quantity was not considered in the first round would ultimately win.

• Agenda manipulation is the process of organizing the order of votes to assure a favorable outcome.

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• Another problem is cycling: paired voting can go on forever without reaching a decision.

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Direct Democracy: Why Difficulties with Majority Voting Rule?

• A peak in an individual’s preferences is a point at which all neighboring points are lower.

– Single-peaked preferences: utility falls as person moves away from most preferred outcome in any and all directions.

– Double-peaked preferences: utility initially falls as person moves away from most preferred outcome, but then rises.

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• In Figure 6.2, Elaine has double-peaked preferences as quantity increases.

• This means she prefers either very large or very small missile expenditures to a quantity in the middle.

Figure 6.2

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• How plausible are double-peaked preferences?

– It depends on the context.

– Missiles: not very plausible

– Public park: more plausible, a good for which there are private substitutes.

– Goods which cannot be ordered on a single dimension, like “size.” The use of a vacant building, for example.

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Direct Democracy:Majority Voting Rules

• Return to case when alternatives can be ranked on a characteristic, like size or quantity.

• The median voter is the voter whose preferences lie in the middle of the set of all voters’ preferences.

– Half of voters want more of the good, and half want less.

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Direct Democracy:Median Voter Theorem

• The median voter theorem states that, as long as all preferences are single-peaked, the outcome of majority voting reflects the preferences of the median voter.

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Direct Democracy:Median Voter Theorem Illustrated

• Consider the five voters in Table 6.3, each with single-peaked preferences.

• Each voter’s individually preferred expenditure is given in the table.

Table 6.3

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Direct Democracy:Median Voter Theorem Illustrated

• A movement from $0 to $5 would be by all five voters.

• A movement from $0 to $100 would be approved by Daisy, Huey, Dewey, and Louie.

• A movement from $100 to $150 would be approved by Huey, Dewey, and Louie.

• Any increase above $150 would be blocked by a majority of voters. Hence, the majority votes for $150, which is the preferred amount of the median voter, Huey.

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Direct Democracy:Logrolling

• Logrolling systems allow people to trade votes and, hence, register how strongly they feel about various issues.

– Vote trading is controversial, but may lead to more efficient provision of public goods.

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Direct Democracy:Logrolling Example

• Consider the benefits from three different projects for three people.

• Negative values mean a net loss.

Table 6.4

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• Table 6.4 shows the net benefit for each project is positive, but under a simple majority rule scheme, none gets approved.

– Net benefit is negative for two of the voters in each case (but small) and positive for one.

• By trading votes, possible to get all three approved, and society gains welfare.

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• Logrolling could lead to inefficient outcomes, however.

• Vary the benefits for all three projects, so that the net benefit of each is now negative in Table 6.5.

• Here vote trading can lead to inefficient passage.

Table 6.5

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• In the second example, a majority of votes form a coalition to vote for projects that serve their interests, but whose costs are borne mainly by the minority of voters.

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Direct Democracy: Problems

• Can any ethically acceptable method for translating individual preferences into collective preferences be free of difficulties discussed so far?

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Direct Democracy - Arrow’s Impossibility Theorem

• “Reasonable” collective decision-making criteria

– It can produce a decision whatever the configuration of voters' preferences

– It must be able to rank all possible outcomes

– It must be responsive to individuals’ preferences

– It must be consistent

– Independence of irrelevant alternatives

– Dictatorship ruled out

• Arrow’s Impossibility Theorem

– All conceivable voting schemes have some potential for being unfair or producing a paradoxical result

• Meaning of theorem

– consistent rule not necessarily impossible to find, but cannot be guaranteed

• Buchanan’s critique

• Use of social welfare functions

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Representative Democracy

• In reality, government doesn’t simply aggregate people’s preferences; rather, the governing is done by politicians, judges, bureaucrats, and so on.

• These players have their own objective functions.

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Representative Democracy:Politicians

• Elected Politicians: If voters have single- peaked preferences, the vote-maximizing politician adopts the preferred program of the median voter.

• See Figure 6.3.– Candidates move to middle of spectrum,

because voters support candidate with view closest to own, and only one wins.

Figure 6.3

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MV Theorem: Outcome of majority voting reflects preferences of median voter

Assumptions of median voter model

• Single dimension voting

• Only 2 candidates

• No selective voting

• No money influence

• Full information

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• Implications:

– Two party systems tend to be “stable” in the sense that both stake out positions near the “center.”

– Replacement of direct referenda (e.g., direct democracy) by a representative system has no effect on outcome. Both mirror the preferences of median voter.

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• Real-life complications

– Ideology matters: politicians care about more than just winning elections.

– Personality: voters care about more than just issues.

– Leadership: politicians do not simply respond to voters’ preferences.

– Voter participation: may be affected by relative difference in candidates.

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Representative Democracy:Public Employees/Bureaucrats

• Bureaucrats: government employees.

• Naïve to assume that a bureaucrat's only aim is to interpret and passively fulfill the wishes of the electorate and its representatives.

• Niskanen (1971) argues that bureaucrats tend to focus on maximizing perquisites of public office, public reputation, power, etc., because opportunities for monetary gains are minimal.

Figure 6.4

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• In previous figure, bureaucrat doesn't choose the efficient amount for the project, Q*, where MB=MC, but rather chooses a larger project, Qbc, where TB=TC.

• Project doesn’t suffer losses, but is inefficient.

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• Bureaucrats have incentive to promote activities that increase the sponsor’s perceptions of the project’s benefits.– Analogous to shifting the V curve upward.

• Bureaucrats have informational advantage, to present the alternatives as “take Qbc or none at all.”

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Representative Democracy:Special Interests

• Special interest groups can form coalitions and exercise a disproportionate amount of power if they vote in blocks or make campaign contributions.

• Groups form based on many factors, including capital versus labor, rich versus poor, industries, regions, and demographics.

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• Rent-seeking is using the government to obtain higher than normal returns (“rents”).

• One example, illustrated in Figure 6.5, is the peanut industry lobbying the government to impose peanut quotas. This enforces a cartel-like arrangement.

Figure 6.5

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• In Figure 6.5, the competitive output would be at Qc.

• The peanut industry could try to form an illegal cartel to restrict output to Qcartel, but each firm has an individual incentive to cheat.

• If producers can lobby for quotas, they can enforce this output level.

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• Standard deadweight loss from reduced output is equal to triangle cde.

• To the extent that the economic rents, abcd, are spent on socially wasteful lobbying (rather than being a transfer to producers), this is also considered deadweight loss.

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Representative Democracy – Other Actors

• Judiciary

• Journalists

• Experts

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Explaining Government Growth

• Citizen Preferences

G = f(P, I)

• Marxist View

• Chance Events

• Changes in Social Attitudes

• Income Redistribution

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Controlling Government Growth

• Government growth as a non-issue

• Government growth as a problem

– Commitments made in the past

– Basic flaws in the political system

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Improving the Workings of the Political System• Change bureaucratic incentives

– financial incentives

– privatization

• Change Fiscal Institutions

– Budget Enforcement Act (BEA) – 1990

– Balanced budget rules at the state level

• Institute Constitutional Limitations

– Balanced budget amendment

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Provisions of a Typical Balanced Budget Amendment1. Congress must adopt a budget statement “in which

total outlays are no greater than total receipts”

2. Total receipts may not increase “by a rate greater than the rate of increase in national income”

3. “The Congress and President shall…ensure that actual outlays do not exceed the outlays set forth in the budget statement”

4. The provisions can be overridden in times of war

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Critique of Balanced Budget Amendments

• Forecasting issues

• Definitional issues

• Penalties for violation of the law

• Economic issues

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Recap of Political Economy

• Political Economy definition

• Direct Democracy

• Representative Democracy

• Government Growth

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Political Economy Defined

• Political Economy is the application of economic principles to the analysis of political decision making.

– Self-interest – in the marketplace, this often leads to efficiency; different implications in “political market.”

– Maximization – one goal may be to maximize social welfare.

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