chapter 9 political economy jonathan gruber public finance and public policy aaron s. yelowitz -...

Chapter 9 Political Economy

Jonathan GruberPublic Finance and Public Policy

Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

Introduction

In the real world, it is not always easy for the government to maximize welfare.

Politicians have considerations other than getting to the socially efficient level or conducting cost-benefit analyses in order to approve a project. Instead, such economic decisions are made in the context of a political system.

For example, a 2004 spending bill contained many projects of dubious value. $200 million was allocated to build one bridge in Alaska that would connect a small town with an island that housed 50 residents and the area’s airport (offering 6 flights a day). The crossing is now made by a ferry and takes 5 minutes. Alaska’s representative, Republican Don Young,

chairman of the Transportation and Infrastructure Committee, said “This is the time to take advantage of the position I’m in …”

Introduction

This lesson focuses on the fourth question of public finance: Why do governments do what they do?

We start by discussing the “best case scenario” in which government appropriately measures and aggregates the preferences of its citizens in deciding what projects to undertake.

Introduction

Then we examine both direct democracy and representative democracy.

Finally, we examine government failure, the inability (or unwillingness) of government to appropriately address market failures.

UNANIMOUS CONSENT ON PUBLIC GOODS LEVELS: Lindahl

Pricing Ideally, the government could provide

public goods through unanimous consent of its citizens.

Lindahl pricing is a system where individuals report their willingness-to-pay for each quantity of the public good, and the government aggregates preferences to form a measure of the social benefit.

Lindahl Pricing

To illustrate Lindahl’s procedure, imagine that the public good in question is fireworks for two people (Ava and Jack).

First, the government announces tax prices for the public good, that is, the share of the cost that each individual must bear.

Lindahl Pricing

When a tax price is arrived at where both individuals want the same amount of the public good, the government has reached Lindahl equilibrium.

The government produces the public good at that level, and finances it by charging each person their tax price.

Lindahl Pricing

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

If the individual announcements differ, the government raises the tax price for the person who wants more of the good, and lowers it for the person who wants less.

Figure 1Figure 1 illustrates this scenario.

Figure 1 Lindahl pricing

Fireworks

Willingness to pay

0 50

SMB=DAVA+JACK

75

$2

S=SMC

$3

DJACK

DAVA

25 100

$4

$1$0.75

$0.25

Jack’s demand curve for fireworks is fairly steep.

While Ava’s demand curve for fireworks is fairly flat.

Adding up their individual demands curves vertically

gives the aggregate demand.

With this marginal cost, it is socially beneficial to produce

the good.

The socially efficient level is 75 units.

This generates a tax price of 75¢ for Jack in Lindahl

equilibrium.

And a price of 25¢ for Ava in Lindahl equilibrium.

Jack’s surplus is this area

Ava’s surplus is this area

Lindahl Pricing

Fireworks production of 75 units is equilibrium for two reasons.

First, both Ava and Jack are happy to pay those tax prices to get that quantity.

Second, the government has covered the marginal cost of producing the fireworks by charging each person their marginal willingness-to-pay.

Lindahl Pricing

Lindahl pricing corresponds to the concept of benefit taxation, which occurs when individuals are being taxed for a public good according to their valuation of the benefit they receive.

With Lindahl pricing, the government does not need to know the utility functions of individual voters: it gets the voters to reveal their preferences by stating their willingness to pay for different levels of the public good.

Problems with Lindahl Pricing

Lindahl pricing is unlikely to work in practice, however. Preference revelation problem: Individuals

may behave strategically, and pretend their willingness to pay is low in order to get others to bear a larger cost of the public good.

Preference knowledge problem: It is hard for people to properly value goods they do not shop for on a regular basis.

Preference aggregation problem: Aggregating millions of voters’ preferences is difficult in reality.

MECHANISMS FOR AGGREGATING INDIVIDUAL PREFERENCES

This section discusses how voting can serve to aggregate individual preferences into a social decision.

For now, we focus on direct democracy, whereby voters directly cast ballots in favor of or in opposition to particular public projects.

Direct democracy inDirect democracy inthe United Statesthe United States

Direct democracy was very prominent in the news in 2003, when the citizens of California voted to replace their governor, Gray Davis, with Arnold Schwarzenegger in a recall election. A recall election is a special election initiated by

citizens with the goal of replacing a sitting official. Only one sitting governor had been removed

before. 18 states allow the recall of state officials, and 36 allow recall of local officials. About 5,000 recall elections have been held in the

U.S., with nearly half resulting in the removal of an elected official.

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Direct democracy inDirect democracy inthe United Statesthe United States

Two other ways in which voters participate in direct democracy are through referendum and voter initiative. A referendum is 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.

A voter initiative is the placement of legislation on the ballot by citizens.

For example, on October 5, 2003 (two days before he was recalled), Gray Davis signed a health insurance mandate on employers. In a referendum on the November 2004 ballot–Proposition 72–California voters narrowly overturned this law by a 51% to 49% margin.

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Majority Voting: When It Works

The Lindahl pricing scheme had a very high standard for coming to a consensus: only when citizens were unanimously in agreement did the government achieve Lindahl equilibrium.

A common mechanism used to aggregate individual votes into a social decision is majority voting, in which individual policy options are put to a vote, and the option that receives the majority of votes is chosen.


Majority voting does not always provide a consistent means of aggregating preferences.

To be consistent, an aggregation mechanism must satisfy three goals: Dominance: If one choice is preferred by all

voters, then the aggregation mechanism much be such that this choice is made by society.

Transitivity: Choices must satisfy this mathematical property.

Independence of Irrelevant Alternatives: The introduction of a third choice does not change the ranking of the first two choices.


It turns out that with these three conditions, majority voting can only produce a consistent aggregation of individual preferences if preferences are restricted to take a certain form.

This is best illustrated with some examples.

Table 1Table 1 shows a case when majority voting works.

Majority voting delivers a consistent outcomeTypes of voters

Preference rankings

Parents Elders Young Couples

First H L M

Second M M L

Third L H H

Table 1

A town is deciding on education taxes (and spending). There are 3 possibilities: high,

medium, and low spending. There are also 3 groups, represented in equal proportions.The preferences of parents are

for high spending, then medium spending, then low spending.

While the preferences of the elderly are exactly opposite.

Finally, the “young couples” do not have kids and do not want to

pay high taxes right now.

Their preferences are for medium spending, then low, then

high.

Consider pair-wise voting: High vs Low, High vs

Medium, and Medium vs Low.

High vs Low: Parents vote for H, Elderly &

Young vote for L.L wins 2-1.

High vs Medium: Parents vote for H, Elderly & Young vote for M.

M wins 2-1.

Medium vs Low: Parents and Young vote for M,

Elderly vote for L.M wins 2-1.

Since M has beaten both H and L, M is the overall

winner in this case.

Majority Voting: When It Doesn’t Work

Table 2Table 2 shows a different scenario, where majority voting does not work.

Majority voting doesn’t deliver a consistent outcome

Types of voters

Preference rankings

Parents Private Parents

Young Couples

First H L M

Second M H L

Third L M H

Table 2

A town is again deciding on education taxes (and spending). The elderly have been

replaced with “private parents.” The other 2 groups are the same as before.

Consider pair-wise voting: High vs Low, High vs Medium, and

Medium vs Low.

Private parents, first and foremost, want low taxes so they can afford to sent their

kids to private schools.

Assuming that doesn’t happen, however, private parents want high quality public

education.

Thus, their ordering is low, then high, then medium.High vs Low: Only “public

parents” vote for H, L wins 2-1.

High vs Medium: Only Young Marrieds vote for

M, so H wins 2-1.

Medium vs Low: Only private parents for L, so

M wins 2-1.

Hmmm …There is no clear winner. L is preferred to H.H is preferred to M.M is preferred to L.

This violates the transitivity assumption and leads to cycling.


This set of outcomes is problematic because there is no clear winner. These results violate the principle of transitivity resulting in cycling–when majority voting does not deliver a consistent aggregation of individual preferences.

Note that the failure to get a consistent winner from majority voting does not reflect a failure on the part of individuals–each group has a sensible set of preferences.

The problem is aggregation–we are unable to use voting to aggregate these individual preferences into a consistent social outcome.


This creates the problem of the agenda setter, the person who decides the sequencing of the votes.

In the second situation, he can affect the outcome. For low spending to win, for example,

first set up a vote between H and M. H wins. Then a vote between L and H means L will win.

Any outcome can win with appropriate ordering.

Arrow’s Impossibility Theorem

In fact, there is no voting system that will produce a consistent outcome here.

Arrow’s Impossibility Theorem states that there is no social decision (voting) rule that converts individual preferences into a consistent aggregate function without either restricting preferences or imposing a dictatorship.

Restricting Preferences to Solve the Impossibility Theorem

One way to solve this problem is to restrict preferences to “single-peaked” preferences. A “peak” in preferences is a point that is

preferred to all its immediate neighbors. Utility falls in any direction away from this point.

Multi-peaked preferences means that utility may first rise, then fall, then rise again.

If preferences are single peaked, majority voting will yield a consistent outcome.

We can visualize our earlier examples. See Figure 2Figure 2.

Utility

Schoolspending

EldersYoungmarrieds Parents

Utility

Schoolspending

Privateparents

Youngmarrieds

Publicparents

(a) (b)

L M H L M H

The elderly are single

peaked at “L”.

Parents are single peaked

at “H”.

And young marrieds are single peaked

at “M”.

Private parents are different in the second case.

Their utility goes in in either direction

from M.

Figure 2 Voting rules

Restricting Preferences to Solve the Impossibility Theorem

The failure of these preferences for the “private parents” in this second case is what leads to the inability of majority voting to consistently aggregate preferences.

Fortunately, single-peakedness is a reasonable assumption in most cases.

Median Voter Theory

When preferences are single-peaked, then majority voting will deliver a consistent aggregation of preferences of the individual voters.

Even stronger, the median voter theorem states that majority voting will yield the outcome preferred by the median voter if preferences are single peaked. The median voter is the voter whose tastes are

in the middle of the set of voters, so an equal number of other voters prefer more and prefer less of the public good.

Potential Inefficiency of the Median Voter Outcome

Thus, the voting would suggest that the government only needs to find the preferences of the median voter, and implement that level of public goods.

This does not account for intensity of preferences, however, so it does not follow that the social marginal benefits equal the social marginal cost. For example, if small numbers of individuals

derive enormous benefits from the public good, this should be accounted for in the total social marginal benefits.

Potential Inefficiency of the Median Voter Outcome

For example, imagine that there are 1,001 voters in a town, who are considering building a monument that costs $40,040 ($40/person). Assume all 1,001 voters have single-peaked

preferences, so the median voter will determine the outcome.

If 500 citizens value the monument at $100 each, and the other 501 value it at $0, then the social marginal benefit is $50,000, far greater than the cost. However, the monument doesn’t get built.

REPRESENTATIVE DEMOCRACY:

Vote-Maximizing Politicians In reality, voters elect representatives,

who are supposed to aggregate their preferences and take them into account when they vote on the appropriate level of public goods.

If politicians care about maximizing the number of votes they get, they choose the outcome preferred by the median voter.

Vote-Maximizing Politicians

The public good in question is defense; the key question is what fraction of the budget (0% to 50%) should be spent on defense? Voters are uniformly distributed on this continuum.

Two politicians, John and George, are running for office and vying to maximize their votes.

Figure 3Figure 3 illustrates this.

Figure 3

Defensespending

0% 50%25%J1 G1

Voters for John Voters for George

Defensespending

0% 50%25%J2 G1


Defensespending

0% 50%25%J2 G2


Defensespending

0% 50%J3 = G3 = 25%


(a)

(b)

(c)

(d)

By doing so he gets the majority of the votes.

John is trying to appeal to those who don’t want much defense, so he places himself at J1.

In this case, the candidates split the vote

equally.While George chooses a

much higher level of defense, G1.

But now imagine that John changes his position

to J2.

In response, George lowers his position to G2.By doing so, George now

gets a majority of the votes.

This process will continue until the median voter’s

preferences are arrived at.

Assumptions of the Median Voter Model

The median voter model is a powerful tool, but relies on a number of assumptions worth mentioning: Single-dimensional voting: Voters only care about one

issue. Only two candidates: With a 3rd candidate, there is no

stable equilibrium. No ideology or influence: Assumes politicians only

care about votes, not ideological positions. No selective voting: All citizens actually vote. No money as a tool of influence. Perfect information along three dimensions: voter

knowledge of the issues, politician knowledge of the issues, and politician knowledge of voter preferences.

Lobbying

The issues of money and information make it likely that elected officials will be lobbied by highly interested and informed subgroups.

Lobbying is the expending of resources by certain individuals or groups in an attempt to influence a politician.

Lobbying

Lobbyists can: Inform politicians Reward politicians

The problem with lobbying arises when an issue benefits a small group and imposes small costs on a larger (perhaps even a majority) group. In this case, politicians might support

socially inefficient positions.

Lobbying

The key point to remember is that large groups of people with small individual interest on an issue suffer from a free rider problem in trying to organize politically.

Small groups with large interest overcome the free-rider problem.

Farm policy in the United StatesFarm policy in the United States

Even though only 2.5% of workers are employed on farms, this sector receives $25 billion in direct support from the federal government.

This comes in direct subsidy payments to farmers, and price supports (guaranteed minimum prices for crops).

These subsidies costs each American household about $360 per year on average, and the average recipient of a subsidy receives $18,000 per year.

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The 2002 farm bill was estimated to cost $190 billion over the following decade. Although it motivated by preserving “family farms,” this motivation is completely at odds with the facts. Only 8 of 400 crops are eligible for the

subidy. Subsidy increases with productions, so large

farms benefit more than small farms. Two-thirds of all subsidies accrue to 10% of

recipients, most of who earn over $250,000 per year.

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How do such expensive, and poorly targeted subsidies end up surviving?

The total cost per American family is modest ($360), and dwarfed by the enormous gain to the typical farm ($18,000).

The small group of farms are able to effectively organize and lobby, while the much larger group of taxpayers hurt by the programs are not able to do so.

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Evidence on the Median Voter Model

While the median voter model is a potentially powerful tool, does it have predictive power? The empirical evidence is mixed. It

certainly does not completely explain legislator behavior. There is strong evidence that legislators consider their own ideology, and that of their core constituency, when they vote on policies.

Testing theTesting themedian voter modelmedian voter model

Stratmann (2000) found that redistricting, which changes the nature of the district’s median voter for largely exogenous reasons, affected the voting preferences of legislators.

He asked: When districts become more conservative through redistricting (as measured by the vote for the Republican presidential candidate in 1988 and 1992), but were represented by the same politician, did the politician start to vote more conservatively. The answer: Yes.

Empirical

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Testing theTesting themedian voter modelmedian voter model

There is also evidence that “core constituencies” matter as well.

Levitt (1996) compared two senators from the same state but different political parties. Median voter theory suggests they should take the same position on legislation, yet he found that the senators vote very differently. The senators vote very similarly to senators from

other states who are in their party. He found that legislators care roughly equally about

the median voter, voters in their own core constituencies, and the “party line.” Yet most of the voting pattern is explained by individual ideological differences.

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Cycling in Representative Democracies

An issue that arises in direct democracy, cycling, can also arise in representative democracy if legislator preferences are not single peaked.

There is some evidence that such cycling has occurred in Congress from time-to-time.

The Political Business Cycle

Another issue that arises in representative democracy is the “political business cycle.” Pocketbook issues matter. Bill Clinton’s mantra – “It’s the economy,

stupid!” Ray Fair has developed models relating

the fraction of the vote for the incumbent to the economy’s growth rate and inflation rate.

Figure 4Figure 4 shows the results.

Figure 4


On average, predicted share of the vote for the incumbent party is within 2.6 percentage points of the actual vote received.

It has done a pretty good job at predicting winners in presidential elections.


That fact that voters respond to economic conditions close to the Presidential election has led some to posit the existence of a political business cycle, where politicians attempt to manipulate economic conditions.

Although the actual business cycle may or may not exist, it is clear that incumbents do use government powers of taxation and spending to try to win voter favor.

PUBLIC CHOICE THEORY: THEFOUNDATIONS OF GOVERNMENT

FAILURE The analysis in most of this course

assumes a benign government intent on maximizing social welfare.

Public choice theory questions this assumption by noting that governments often do not behave in an ideal manner, so that traditional assumption of a benevolent social-welfare maximizing government may be inappropriate.

PUBLIC CHOICE THEORY: THE FOUNDATIONS OF GOVERNMENT

FAILURE Government failure is the inability or

unwillingness of the government to act primarily in the interest of its citizens. Reasons include: Size maximizing bureaucracy Leviathan theory Corruption

Size-Maximizing Bureaucracy

Niskanen (1971) developed a model of the budget maximizing bureaucrat. In this model, the bureaucrat runs an agency that has a monopoly on the government provision of some good or service.

Bureaucrat’s salary typically unrelated to efficiency. His compensation consists of salary, but also perks like the size of his office and support staff.

The larger government tries to rein in the bureaucrat.

Size-Maximizing Bureaucracy

A key question is then whether goods and services are more efficiently provided by the public or private sector. For most goods and services, it is abundantly clear that

private provision is more efficient. In a review of the literature, Mueller (2003) finds that only

5 of 71 studies found state-owned companies outperformed their private counterparts.

For some goods, such as social services, public provision may be superior, especially when there is a market failure. Hart, Shliefer, and Vishny (1997) compared public and

private prisons. Private prisons were 10% cheaper, through lower wages to guards. The low pay led to more violence, however.

Leviathan Theory

Leviathan theory sees individual bureaucrats and the larger government as one monopolist that simply tries to maximize the size of the public sector.

This view would help explain rules that explicitly tie the government’s hands in terms of taxes and spending.

Corruption

Finally, corruption is where government officials abuse their power in order to maximize their own personal wealth or that of their associates.

Government Government CorruptionCorruption

Former Illinois governor George Ryan was indicted in December 2003 for selling state contracts to his friends in exchange for cash, gifts, loans, and trips for his family. The case is still pending.

This was uncovered as part of “Operation Safe Road,” which investigated bribes that many truck drivers had given to officials at then Secretary of State Ryan’s office to obtain a driver’s license. At least 20 people had died in accidents involving

drivers who had bribed officials for their licenses. The investigation resulted in 70 indictments and

over 60 convictions of many people who were close friends and allies of the former governor.

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The Implications of Government Failure

There is clear evidence that governments fail in some instances to benevolently serve the interests of their citizens.

Can citizens “undo” these harms through actions like direct democracy?

Some evidence suggests that government failures can have long-lasting negative impacts on economic growth.

Government failuresGovernment failuresand economic growthand economic growth

Acemoglu, Johnson, and Robinson (2001) examined two sets of nations that were similar when they were colonized by European powers, yet colonization took very different forms. Treatment group: Nations in the Caribbean,

Central America, and Africa. The colonizers were focused solely on extracting

natural resources, and not interested in setting up institutions to foster economic success.

Control group: Nations in North and South America, Australia, and New Zealand.

The colonizers moved to these nations in large numbers and set up institutions to foster economic success.

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Government failuresGovernment failuresand economic growthand economic growth

Why the lack of “hands-on” governing in the treatment group? The odds of colonists dying from locally

infectious disease was much higher. This exogenously affected settlement patterns of colonizers.

Despite their precolonization similarity, the treatment nations have grown much more slowly post colonization than have the control nations.

The treatment nations continue to suffer from the long-run detrimental effects of inefficient government.

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Recap of Political Economy

Unanimous consent on public goods levels

Mechanisms for aggregating individual preferences

Representative democracy Public choice theory: The foundations

of government failure

chapter 9 political economy jonathan gruber public finance and public policy aaron s. yelowitz -...

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