Transcript Document

• 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?"
1
Chapter 6 – Political Economy
Public Finance
Resource allocation methods for
public goods
2
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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•Unanimous Consent on Public Goods Levels
•Lindahl Pricing
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•Unanimous Consent on Public Goods Levels
•Lindahl Pricing
•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 10
social marginal cost.
•Unanimous Consent on Public Goods Levels
•Problems with Lindahl Pricing
•Preference Revelation Problem
•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 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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9.2
•Mechanisms for Aggregating Individual Preferences

APPLICATION
• Direct Democracy in the United States
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.
•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
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Table 6.1
Direct Democracy:
Majority Voting Rule Example
• 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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Direct Democracy:
Majority Voting Rule Example
• Now consider the preferences that are
shown in Table 6.2
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Table 6.2
Direct Democracy:
Majority Voting Rule Example
• 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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Direct Democracy:
Majority Voting Rule Example
• 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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Direct Democracy:
Majority Voting Rule Example
• 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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Direct Democracy: Why Difficulties
with Majority Voting Rule?
• 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.
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Figure 6.2
Direct Democracy: Why Difficulties
with Majority Voting Rule?
• 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 singlepeaked, 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.
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Table 6.3
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.
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Table 6.4
Direct Democracy:
Logrolling Example
• 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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Direct Democracy:
Logrolling Example
• 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.
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Table 6.5
Direct Democracy:
Logrolling Example
• 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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40
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
• 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
– Independence of
irrelevant alternatives
• Buchanan’s critique
– Dictatorship ruled out
• 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.
42
Representative Democracy:
Politicians
• Elected Politicians: If voters have singlepeaked 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.
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Figure 6.3
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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Representative Democracy:
Politicians
• 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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Representative Democracy:
Politicians
• 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.
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Figure 6.4
Representative Democracy:
Public Employees/Bureaucrats
• 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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Representative Democracy:
Public Employees/Bureaucrats
• 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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Representative Democracy:
Special Interests
• 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.
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Figure 6.5
Representative Democracy:
Special Interests
• 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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Representative Democracy:
Special Interests
• 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 Amendment
1.
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.
64