Chapter 12

Government Imperfections

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Learning Objectives

• What is public choice theory?• How do government officials behave?• How do politicians take away from the weak?• How do politicians destroy the wealth of society?• How does corruption affect the wealth of

society?• What can reduce corruption?• What are the problems with democracies?

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Public Choice Theory

• Public choice theory is the economic study of government.

• It examines how government officials and voters choose.

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A Fictional Tale

Decisions for a congressman:• Which tariff to vote for?• Which group of population to choose to cut

funding from?• How to allocate licenses?• How to protect jobs in your district?• Every congressman tends to favor powerful

interest groups and puts his voters interest above the needs for the country.

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Government Officials

• Economists assume that government officials act in their own interests.

• Government officials are as self-interested as businesspeople.

• However, there is no invisible hand guiding politicians.

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Taking From the Weak in Dictatorships

To maintain power many dictators follow a three-step formula:

1. Take wealth from some disfavored group.2. Build support among some favored group by

giving them the wealth acquired through the earlier step.

3. Suppress or kill the disfavored group so they can’t harm the dictator.

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Taking From the Weak in Democracies

• In modern democracies, even disfavored groups can vote.

• Politicians in democracies use a similar formula.1. Take wealth from politically inactive groups.2. Build support among politically active groups by giving

them the wealth acquired through the earlier step.

• Politically active groups always vote and contribute to campaigns.

• In the U.S., the elderly vote is a much higher percentage than other demographic groups.

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Concentrated vs. Diffused Interest Groups

• Generally, producers are the members of concentrated groups like dairy farmers, truck drivers, lawyers, doctors, etc.

• It is easy for industry-wide organizations to contribute and affiliate with friendly politicians.

• The interests of consumers are almost always diffused. • Hence, the producers of goods often organize to

promote their interests while the consumers of goods rarely do.

• Governments are often pushed to enact pro-producer, anti-consumer laws.

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Destruction of Wealth

• When politicians transfer resources, they distort the market by raising taxes, imposing tariffs, mandating prices or restricting entry into professions.

• These market distortions reduce the wealth of society.

• Transferring money among groups also creates deadweight loss because it encourages rent-seeking.

• “Rents” are money a person receives beyond what the marketplace would ordinarily give him.

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Spending Other People’s Money

• Politicians spend taxpayers’ money in a way that it benefits themselves.

• Much of public choice theory concerns the incentives of self-interested politicians have to gather and spend other people’s money.

• It creates a Prisoners’ Dilemma for taxpayers. Voters from every state want their congressmen to get federal funding for local projects. But when all states do this, taxes go up.

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Corruption

• Corruption is probably as old as government itself.

• Usually, the more powerful a government official is, the more opportunity he has for corruption.

• One means of reducing corruption is to reduce the power of government, e.g. the Mexico city police, Indian bureaucrats, etc.

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Corruption: Wealth Creation and Destruction

• Corruption can sometimes help the economy by allowing businesspeople to circumvent harmful economic regulations, e.g. Soviet Union.

• Corruption usually destroys wealth by discouraging economic activities.

• Corruption is a tax and it discourages wealth creation.

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CorruptionUnstable vs. stable dictatorship:

• Dictatorships with strong central governments tend to have less corruption than ones with decentralized power centers.

• In unstable or weak dictatorships, all government officials are in a decentralized Prisoners’ Dilemma.Abundant natural resources increase corruption:

• The lack of natural resources force countries to have honest governments in order to survive.

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Corruption

Competitive politics reduce corruption:• Political candidates benefit by exposing wrongdoing

committed by their opponents.• Fear of exposure surely prevents some politicians

from engaging in corruption.

A free press reduces corruption:• News organizations benefit from exposing

corruption because doing so attracts customers. • As the Internet is transnational, it can aid people

fighting corruption in nations lacking a free press.

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Corruption

• Corruption breeds corruption.

• Countries can get into a corruption trap in which past corruption causes future corruption.

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Problems With DemocraciesVoting is irrational:

• Each voter has an extremely small chance of deciding the election.

• Further, a voter has no incentive to become informed about the candidates before voting since his vote would almost certainly have no effect on the outcome.

Politicians have short time horizons:• Politicians have little incentive to think beyond their

political term.• Individual voters have minimal incentives to analyze the

long range consequences of politicians’ actions.

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Problems With Democracies

Government programs don’t always have to satisfy consumers.

• Consumers usually have no political power.• Government officials have greater incentives to

satisfy political powerful politicians.

Incumbents rarely lose.• Politicians write election rules. Acting in their

own self-interest, politicians pick these rules to make it difficult for them to lose reelection.

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Famines and Democracies

• “No functional democracy has ever had a substantial famine,” Amartya Sen.

• Avoiding famines strongly serves the self-interest of politicians in democracies.

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Do You Know?

• What is public choice theory?Public choice theory is the economic study of government. It examines how government officials and voters choose.

• Why do democratic politicians often pass pro-producer, anti-consumer laws?The producers of goods often have concentrated interest groups and organize to promote their interests. The consumers of goods often have diffused interests and rarely organize themselves.

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Do You Know?

• How can corruption destroy wealth?

Corruption usually destroys wealth by discouraging economic activities.

• Why is it often irrational to vote?

Each voter has an extremely small chance of deciding the election.

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Summary • Public Choice Theory examines how government

officials and voters choose.• Government officials usually act in their own interests.• Politicians take away from the weak or politically inactive

groups in dictatorships as well as democracies.• Governments are often pushed to enact pro-producer,

anti-consumer laws.• The producers of goods often organize to promote their

interests while the consumers of goods rarely do.• By distorting markets politicians reduce the wealth of

society.• Politicians spend taxpayers’ money in a way that it

benefits themselves.• Corruption is a tax and it discourages wealth creation.

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Summary

• Usually, the more powerful a government official is, the more opportunity he has for corruption.

• Dictatorships with strong central governments tend to have less corruption.

• Abundant natural resources increase corruption.• Competitive politics and a free press reduce corruption.• Voting is often irrational.• Politicians have short time horizons.• Government programs don’t always have to satisfy

consumers.• Incumbent politicians rarely lose reelection.• No functional democracy has ever had a substantial

famine.

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Coming Up

What is the challenge of externality ?

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