public choice - uni-jena.depublic+choice/public... · public choice m.sc. in economics ... black,...

© Freytag 2015 1

Public Choice

M.Sc. in Economics (3 Credits)

Winter Term 2015-2016

Tuesday, 8 -10 a.m. c.t., Start October 20, 2015, Carl-Zeiss-Str. 3, HS 9

Prof. Dr. Andreas Freytag LS Wirtschaftspolitik, FSU Jena

© Freytag 2015 2

Announcement: Consulting hour: upon appointment Time and venue of the written exam: Tuesday, March 1, 2016, 10-12 a.m., HS 2 Net time is one hour Friedolin

© Freytag 2015 3

Index 1. Introduction 2. Origins of the State 3. Public Choice in a Direct Democracy 4. Public Choice in a Representative

Democracy 5. Application of Political Economy Models 6. Normative Public Choice

© Freytag 2015 4

Description of the lecture: The course Public Choice offers a concise and comprehensive introduction into the positive foundations of collective action, theoretical, empirical and political. The lecture aims at providing the students with analytical tools to understand the political background of economic policy. After an introduction, the lecture covers the origins of the state. We proceed by analyzing direct democracy. The main part (chapter 4) of the lecture is dedicated to the political economy of a representative democracy. Topics are: federalism, two party competition, multi party competition, paradox of voting, rent seeking, bureaucracy. In a subsequent step, the theory is applied to real world phenomena and tested empirically. Chapter 6 deals with normative issues – how to organise a polity etc. Basic reading is Mueller, D.C. (2003): Public Choice III, Cambridge

© Freytag 2015 5

Literature (suggested Selection) Arrow, Kenneth J. (1951), Social Choice and Individual Values, New

York. Bhagwati, Jagdish and Peter Rosendorff (eds.) (2001), Readings in the

Political Economy of Trade Policy, Cambridge, MA. Becker Gary S. (1983), ‘A Theory of Competition among Pressure

Groups for Political Influence’, The Quarterly Journal of Economics, Vol. 98, pp. 371-400.

Becker, Gary S. (1985), ‘Public Policies, Pressure Groups, and Dead Weight Costs’, Journal of Public Economics, Vol. 28, pp. 329-347.

Black, Philip, Estian Calitz and Tjaart Steenekamp (eds.) (2011), Public Economics, 5th ed., Cape Town.

Brennan, Geoffrey and James M. Buchanan (1985), The Reason of Rules, Cambridge.

Buchanan, James M. and Gordon Tullock (1962), The Calculus of Consent, Ann Arbor.

Coase, Ronald H.(1960), ‘The Problem of Social Cost’, Journal of Law and Economics, Vol. 3, pp. 1-44.

Downs, Anthony (1957), An Economic Theory of Democracy, New York.

Drazen, Allan (2000), Political Economy in Macroeconomics, Princeton.

© Freytag 2015 6

Frey, Bruno S. (2004), Dealing with Terrorism – Stick or Carrot?, Cheltenham and Northampton.

Giersch, Herbert, Karl-Heinz Paque und Holger Schmieding (1994), The Fading Miracle, Cambridge.

Hibbs, Douglas A., Jr., (1977), ‘Political Parties and Macroeconomic Policy‘, American Political Science Review, Vol. 71, pp.1467-87.

Hillmann, Arye L. (1989), The Political Economy of Protection, Chur/New York.

Holcombe, Randall (2006), Public Sector Economics, New Jersey. Magee, Stephen P., William A. Brock und Leslie Young(1989), Black

Hole Tariffs and Endogenous Policy Theory: Political Economy in General Equilibrium, Cambridge.

Mueller, Dennis C. (2003), Public Choice III, Cambridge. Niskanen, William A., Jr. (1971), Bureaucracy and Representative

Government, Chicago. Nordhaus, William D. (1975), ‘The Political Business Cycle‘, Review of

Economic Studies, Vol. 42, pp. 169-90. Olson, Mancur, Jr. (1965), The Logic of Collective Action, Cambridge,

MA. Olson, Mancur, Jr. (1982), The Rise and Decline of Nations: Economic

Growth Stagflation and Social Rigidities, New Haven.

© Freytag 2015 7

Pardo,José Casas and Pedro Schwartz (2007) (eds.), Public Choice and the Challenges of Democracy, Cheltenham

Rose-Ackermann, Susan (1999), Corruption and Government, Cambridge.

Schneider, Friedrich and Dominik H. Enste (2000), ‘Shadow Economies: Size, Causes and Consequences’, Journal of Economic Literature, Vol. 38, pp. 77-114.

Shughart II, Willim F. und Laura Razzolini (eds.) (2001), The Elgar Companion to Public Choice, Cheltenham and Northampton.

Tullock, Gordon (1980), The Welfare Costs of Tariffs, Monopolies and Theft, in: James M. Buchanan et al. (ed.), Toward a Theory of the Rent-Seeking Society, Texas, S. 39-50.

Wintrobe, Ronald (1998), The Political Economy of Dictatorship, Cambridge: Cambridge University Press.

Basic: Dennis Mueller, Public Choice III. Special current references will be given at the very topic.

© Freytag 2015 8

Websites (Selection) OECD: http://www.oecd.org World Bank: http://worldbank.org World Trade Organization (WTO): http://www.wto.org International Monetary Fund: http://www.imf.org European Commission: http://europa.eu.int/comm/ Center for the Study of Public Choice: http://www.gmu.edu/centers/

publicchoice/ Public Choice Society: http://www.pubchoicesoc.org/ European Public Choice Society: http://www.epcs-home.org/ Cato Institute: http://www.cato.org Fraser Institute: http://www.fraserinstitute.org VoxEU: http://www.voxeu.org European Centre for International Political Economy (ECIPE): http://www.ecipe.org

© Freytag 2015 9

1. Introduction Mainstream economics is generally dealing with two types of questions: Normative analysis: how can individual or collective welfare be improved? Positive analysis: What can we learn about human behavior? Is man indeed a utility maximiser? How can we explain minor economic outcome against the background of theoretical analysis? The latter set of questions is relevant for this lecture. We seek to explain the incentives for policymakers, i.e. politicians, bureaucrats and organized interests as well as the outcomes of collective choice.

1. Introduction 2. Origins of the State 3. Public Choice in a Direct

Democracy 4. Public Choice in a

Representative Democracy

5. Application of Political Economy Models

6. Normative Public Choice

© Freytag 2015 10

Individualistic approach, rational behavior Dismissal of the „benevolent dictator“ Thereby, we also try to explain the sometimes huge difference between the policy recommendation, achieved by thorough theoretical analysis, and political reality. Public Choice has taken three directions: • logical, theoretical analysis, • empirical investigation, • normative critique.






© Freytag 2015 11

It has close relations to the New Institutional Economics and Constitutional Economics. The new institutional economics discusses the role of institutions in the market sphere and in the political sphere. “Institutions… are the rules of the game in a society, or more formally, are the humanly devised constraints that shape human interaction ….reduce uncertainty by providing a structure to everyday life.” (Douglas North 1990).






© Freytag 2015 12

Fundamental Questions of Public Choice Analysis • What do political science and economics have in common? • Why do we need the state and public decision making? • What is the incentive structure of decision makers in a direct democracy? a representative democracy? a dictatorship? a cleptocracy? • Do voting rules affect economic outcomes? • Why do some interest groups organize themselves better than others? • Why do countries with a dictator sometimes perform better than democracies?






© Freytag 2015 13

• Why do we observe poverty and starving on the one hand and wealth on the other hand in similar countries? • Why do we observe hyperinflation? • Why is structural change so often repressed? • Why can we observe left governments pursuing supply side policy? • Why are political parties often so similar with respect to their programs? • Why does social spending increase in time? • Do elections terms exert influence of macroeconomic performance? • Why are public enterprises inefficient? • What are the incentives of bureaucrats? • How can we explain the sectoral structure of protection and subsidization?






© Freytag 2015 14

• Is it rational for governments to „support“ criminal activities? • How can we explain violence and civil conflict? • Is terrorism rational? • How can it be combated rationally? • What is the dictator’s dilemma? • How can we explain the disappointing performance of most international organizations (IOs)? • Why is official development aid so ineffective? • Why do reforms not happen? • Why do reforms happen? • Are scientists, e.g. academic economists, different?






© Freytag 2015 15

2. Origins of the State I. The state and rule enforcement II. The state and allocation a) Externalities b) Asymmetrical information c) Natural monopolies III. The state and redistribution Basic literature is Mueller (2003), pp. 8-63.






© Freytag 2015 16

I. The State and Rule Enforcement The state is needed to set rules and take care for enforcement on a just basis. Enforcement needs a strong state: Police Armed forces Independent judiciary Checks and balances Normative statement Constitutional Economics (see below)






© Freytag 2015 17

The view of the state in Economics is that it is the organisational structure of a polity. The state is not regarded as standing above the human being Constitutional Economics or citizens vs. (subjects) Untertanen! Members of society agree unanimously on a social contract or a constitution. As long as actions are made within these rules, the outcome is perceived as being fair. In this view, there are three types of reasons for the existence of the state. It is necessary: • to set and enforce rules, • to take care for allocation, and • to organise redistributive policy.






© Freytag 2015 18

Constitutional Economics: Social contracts 1) A just social contract (John Rawls) Rawls argues with an original position with total equality; each member of the community gives up her knowledge about her position in society and steps behind a veil of ignorance. Equality in the original position leads to unanimity over the social contact. The economic outcome is perceived as being the result of a gamble with random results; therefore it is not acceptable. Two principles of justice: • equal rights to most extensive basic liberties; • equal distribution of social values Maximin!






© Freytag 2015 19

2) Constitutional economics (James Buchanan and Gordon Tullock) Buchanan and Tullock (1962): no normative position, they assume unanimity at the constitutional stage. Homann and Vanberg have given up this assumption fictious consensus is satisfying the conditions. The veil is a veil of uncertainty, as any individual can be sure about the rules of the game, but not its outcome. This will be accepted as long there is no betrayal. Different types of uncertainty: Identity, numbers and payoffs.






© Freytag 2015 20

II. The State and Allocation Allocation theory shows that in general, markets are efficient and generate welfare optima (without notice of distribution). However, there are cases of market failure. Three forms can be distinguished: • externalities, • asymmetrical information, • natural monopolies. For many, these are the main reasons for the state to act economically. If the markets fail, governmental intervention is necessary to care for efficient allocation.






© Freytag 2015 21

a) Externalities aa) Definition: Economic activity of one person (firm) has an impact on the consumption or production of another person or firm. Consumption Ui = Ui (xi, yi, Z), the utility function contains arguments not to be influenced by individual i. Production Πx = Πx (Kx, Lx, Z), the production function of x is influenced by an activity of a third person (firm).






© Freytag 2015 22

In such a case, the government has to try to internalise these external cost. Pigou tax, Pigou subsidy, property rights Economic problem: exact measurement of cost. Political problem: exact definition of property rights. Market Failure versus state failure. State failure implies inappropriate definition of property rights, economically inefficient internalisation of external cost etc. It has no moral dimension.






© Freytag 2015 23

bb) Coase Theorem Ronald Coase has shown that in the absence of transaction cost and with clearly defined property rights external effects do not exist. In addition, it does not matter for the economic efficiency and ecological effectiveness whether the party responsible for damages or that party suffering from damages has the property rights. However, transaction cost is rarely negligible and property rights are sometimes difficult to define. The Coase solution is almost impossible to reach. Nevertheless, Coase demonstrated the irrelevance of distribution of property rights as well as the relevance of transaction cost.






© Freytag 2015 24

Normative and positive aspects of environmental policy There are several ways to internalise external cost: • Ordnungsrecht emission thresholds technological standards • Pigou-tax • Standard-price-approach • private negotiations (Coase) Emission Banking Bubble Policy • Emission certificates Public choice does not analyse the normative properties, i.e. economic cost and ecological effectiveness, but the reason for policymakers to choose a certain environmental policy; again market versus state failure.






© Freytag 2015 25

cc) Public goods Public goods as extreme case of (positive) externalities: non rivalry (jointness) in supply and impossibility of exclusion. Types of goods: • private good, • common pool property, • club good, • public good, • merit goods, Free rider problem as the basic problem of collective choice.






© Freytag 2015 26

Free rider problem What are individuals willing to pay for the provision of a public good? Simple but only seemingly precise answer: nothing. More complicated answer: it depends, on what? • individual gains from cooperating • differences in individual gains • level of state activities already reached • group size • social conventions Prisoners’ dilemma vs. coordination games and chicken games






© Freytag 2015 27

B A

Does not Steal

Steals

Does not steal

1 (10,9)

4 (7,11)

Steals 2 (12,6)

3 (8,8)

Figure 2.1: Prisoners‘s dilemma

Source: Mueller, Dennis C. (2003), …, p.10.






© Freytag 2015 28

D G

Strategy A

Strategy B

Strategy A

1 (a,a)

4 (0,0)

Strategy B

2 (0,0)

3 (b,b)

Figure 2.2: A coordination game







© Freytag 2015 29

D G

Contributes to building fence

Does not contribute

Contributes to building fence

1 (3,3)

4 (2, 3.5)

Does not contribute

2 (3.5, 2)

3 (1,1)

Figure 2.3: A game of chicken







© Freytag 2015 30

The prisoner’s dilemma shows the typical problem related to the provision of public goods, namely free riding. The coordination game is solved, as both individuals gain most from cooperating dominating strategy. No one can improve his situation at the expenses of others. The latter game will at any rate been solved at a maximum when it is repeated, whereas the prisoner’s dilemma can (but not must) evolve again and again. The game of chickens is the most tricky one, as cell 1 is not the dominant strategy. It may be advantageous to signal credibly not to contribute. In this case, the partner may still choose to contribute. Application in international affairs






© Freytag 2015 31

b) Asymmetrical information Principal-agent-problems (PAP), whether defined as adverse selection (ex-ante) or as moral hazard (ex-post), cause markets to fail. Ownership and control are separated. Examples are: • market for insurances, • labour markets, • quality aspects (consumer protection). The regulation of these markets is aiming at healing the market failure; it may, however, lead to state failure: • insurance: overregulation, capture; • labour market: employment protection legislation; • consumer protection: trade protectionism.






© Freytag 2015 32

c) Natural monopoly A natural monopoly exist, if (marginal and) average cost decrease in the relevant demand areas under a given technology. Only one firm can serve the demand without welfare losses. Here is a need for regulation, e.g. by: • price regulation (cost oriented, rentability oriented, ECPR, Price Caps, Ramsey-rule); • capital return regulation; • competition for the market; • prohibition of discrimination; • structural separation of multi product firms; • limitation of activities. Problem: regulatory capture* * Literature: Stigler, George J. (1971), „The Theory of Economic Regulation”, Bell Journal of Economics and Management Science, Vol. 2, pp. 3-21.






© Freytag 2015 33

III. The Redistributive State A Pareto efficient allocation of resources and goods may not be just. Society may feel the need to redistribute income and to even out huge income differentials as well as to insure its members against severe risks of life. These risks include illness, unemployment, wealth losses. Age cannot be regarded as risk, rather as a chance! Nevertheless, there may be the need for collective action with respect to old age protection: externalities, moral hazard.






© Freytag 2015 34

How can the redistributive state act? 1) Redistribution as insurance/ social contract. 2) Redistribution as public good. 3) Redistribution to satisfy fairness norms. 4) Redistribution to increase allocative efficiency. It may be possible to model these types in a way to reach unanimity about it. Notwithstanding, governments may go too far or exploit certain groups by purpose: 5) Redistribution as taking. Of course, the organisation of redistribution has impact on economic incentives shadow economy, corruption.






© Freytag 2015 35

Redistribution as taking Table 2.1 Costs and benefits of the EU’s common agricultural policy in comparison with free market outcome, 1980 (mio of US$)

country producers consumers government net EC-9 -30,686 34,580 11,494 15,388

West Germany -9,045 12,555 3,769 7,279

France -7,237 7,482 2,836 3,081

Italy -3,539 5,379 1,253 3,093

Netherlands -3,081 1,597 697 -787

Belgium/ Luxembourg -1,24 1,4 544 320

UK -3,461 5,174 1,995 3,708

Ireland -965 320 99 -546

Denmark -1,736 635 302 -799

Source: Mueller, p. 62.






public choice - uni-jena.depublic+choice/public... · public choice m.sc. in economics ... black,...

Documents