Gruber4e_ch09

1 of 49Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth PublishersCopyright © 2010 Worth Publishers

2 of 49Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers

9

Dan Sacks

P R E P A R E D B Y

9.1 Unanimous Consent on Public Goods Levels

9.2 Mechanisms for Aggregating Individual Preferences

9.3 Representative Democracy

9.4 Public Choice Theory: The Foundations of Government Failure

9.5 Conclusion

Political Economy

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C H A P T E R 9 ■ P O L I T I C A L E C O N O M Y

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers

9Political Economy

Why do governments do what they do?

• Different ways of organizing government produce different results.

• Ideal case: Government measures preferences and acts accordingly.

• Direct democracy: Voters directly cast ballots in favor of or in opposition to particular public projects.

• Representative democracy: Voters elect representatives, who decide on public projects.

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9.1

Ideal case for public goods:

• 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.

• Based on marginal willingness to pay.

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

Unanimous Consent on Public Goods Levels

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9.1

Lindahl’s procedure operates as follows:

1. Announce tax prices for the public good.

2. Everyone says how much of the public good she wants at those tax prices.

3. Repeat to construct a marginal willingness to pay schedule for each individual.

Lindahl Pricing

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9.1

Recall that efficient provision requires that (Total marginal willingness to pay) = MC.

4. Add up individual willingnesses to pay at each quantity of public good provided.

5. Find Q such that total (Total marginal willingness to pay) = MC.

6. Finance the public good by charging individuals their willingnesses to pay for that quantity.

Lindahl Pricing

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Ava’s marginal willingness to pay

Fireworks

0

Jack’s marginal willingness to pay

Ava & Jack’s willingness to pay

Fireworks

Fireworks

0

0Demand, DA

DJ

DA+J

Marginal Cost, MC1.00

2.00

3.00

$4.00

25 50 75 100

25 50 75 100

25 50 75 100

0.751.502.25

$3.00

0.250.500.75

$1.00

Lindahl Pricing: Graphical Representation9.1

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9.1Lindahl Pricing: Why It Works

Under Lindahl pricing, the government produces the efficient amount of the public good.

• This is because MC = Total marginal willingness to pay.

• Each person’s price is equal to their own marginal willingness to pay, so this is an equilibrium.

• Lindahl pricing also exemplifies benefit taxation.

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

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9.1

Lindahl pricing faces several problems that keep it from being used in practice:

1. Preference revelation problem: Individuals have an incentive to lie about their WTP, to lower their price.

2. Preference knowledge problem: Individuals may not know their WTP.

3. Preference aggregation problem: It is not obvious how to aggregate individual preferences into a social welfare function.

Problems with Lindahl Pricing

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9.2

Direct democracy remains strong in America.

• Direct democracy uses referenda and voter initiatives.

• 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.

Direct Democracy in the United States

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9.2

• Lindahl pricing requires unanimous consent to implement the public good.

• Most governments only use majority voting.o Majority voting: The typical mechanism used to

aggregate individual votes into a social decision, whereby individual policy options are put to a vote and the option that receives the majority of votes is chosen.

Majority Voting: When It Works

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9.2

• To consistently aggregate preferences, majority voting must satisfy three goals:1. Dominance2. Transitivity3. Independence of irrelevant alternatives

• So majority voting can consistently aggregate individual preferences if and only if preferences are restricted to take a certain form.


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9.2

• There are three types of voters in a town: parents, elders, and young couples without children.

• They have different preferences over the level of school spending (high, medium, or low).


Parents(33.3%)

Elders(33.3%)

Young Couples (33.3%)

First choice H L MSecond choice M M LThird choice L H H

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9.2

How to vote among the three options?

• The town could proceed as follows:o First, vote on funding level H versus funding level L.o Then, vote on H versus M.o Then, vote on L versus M.

• M will win each head to vote, and win. • M would win for any order of voting, so majority

voting is consistent.


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9.2

• Cycling: When majority voting does not deliver a consistent aggregation of individual preferences.

Majority Voting: When It Doesn’t Work

Public school

parents(33.3%)

Public school

parents(33.3%)

Young Couples (33.3%)

First choice H L MSecond choice M H LThird choice L M H

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9.2

• Majority-runoff voting didn’t work, but maybe something else would.o We could let everyone vote on their first choice.o We could do weighted voting by assigning.

• In fact, there is no good way to consistently aggregate these preferences.

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

Arrow’s Impossibility Theorem

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9.2

One way to avoid the impossibility problem is to restrict preferences.

• The problem with the private school parents is that their preferences are not single peaked.

• Single-peaked preferences: Preferences with only a single local maximum, or peak, so that utility falls as choices move away in any direction from that peak.

Restricting Preferences to Solve the Impossibility Problem

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9.2Single-Peaked versus Non-Single-Peaked Preferences

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9.2

With single peaked preferences, voting works well.

• Median Voter Theorem: Majority voting will yield the outcome preferred by the median voter if preferences are single-peaked.

• Median voter: The voter whose tastes are in the middle of the set of voters.

• The government need find only the one voter whose preferences for the public good are right in the middle of the distribution of social preferences and implement the level of public goods preferred by that voter.

Median Voter Theory

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9.2

Majority voting and the median voter theorem outcome are potentially inefficient.

• Suppose 51% of voters prefer a project that benefits them $10 on net and 49% oppose it with a net benefit of −$20.

• Under majority voting, the government undertakes the project and, on average, surplus falls by almost $5.

• Majority voting does not recognize intensity of preferences.

Potential Inefficiency of the Median Voter Theorem

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9.3

The median voter model may apply to representative democracies.

• Key assumption: All politicians care about is maximizing the number of votes they get.

• Politicians strategically position themselves to get the most votes.

• End up enacting the median voters’ preferences.

Vote-Maximizing Politicians Represent the Median Voter

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(a)

(b)

0%

Vote-Maximizing Politicians Represent the Median Voter

9.3

(c)

(d)

Defensespending

Defensespending

Defensespending

Defensespending

B3 = M3 = 25% 50%

0% 25% 50%

0% 25% 50%

0% 25% 50%

M2

M1

M1

B2

B2

B1

Voters for Barack

Voters for Barack

Voters for Barack

Voters for Barack

Voters for Mitt

Voters for Mitt

Voters for Mitt

Voters for Mitt

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9.3

The median voter model relies on several assumptions.

• Single-dimensional votingo The median voter model assumes that voters are

basing their votes on a single issue.o Representatives are elected on a bundle of issues. o Different people have may lie at different points of

the voting spectrum on different issues, so appealing to one end of the spectrum or another on some issues may be vote-maximizing.

Assumptions of the Median Voter Model: Single-Dimensional Voting

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9.3

• Only two candidateso The model assumes only two candidateso No equilibrium in the model with three or more

candidates: There is always an incentive to move in response to your opponents’ positions.

o In many nations, the possibility of three or more valid candidates for office is a real one.

Assumptions of the Median Voter Model: Only Two Candidates

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9.3

• No ideology or influenceo The median voter theory assumes that politicians

care only about maximizing votes.o Ideological convictions could lead politicians to

position themselves away from the center of the spectrum and the median voter.

Assumptions of the Median Voter Model: No Ideology or Influence

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9.3

• No selective votingo The median voter theory assumes that all people

affected by public goods vote.o In fact, only a fraction of citizens vote in the United

States.

Assumptions of the Median Voter Model: No Ideology or Influence

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9.3

• No moneyo The median voter theory ignores the role of money as

a tool of influence in elections.o If taking an extreme position on a given topic

maximizes fundraising, even if it does not directly maximize votes on that topic, it may serve the long-run interests of overall vote maximization by allowing the candidate to advertise more.

Assumptions of the Median Voter Model: No Money

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9.3

• Full informationo The median voter model assumes perfect

information along three dimensions: Voter knowledge of the issues Politician knowledge of the issues Politician knowledge of voter preferences

o All three of these assumptions are unrealistic.

Assumptions of the Median Voter Model: Full Information

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9.3

Problems with the median voter model make lobbying likely.

• Lobbying: The expending of resources by certain individuals or groups in an attempt to influence a politician.

• Lobbying can help convey intensity of preferences.

• Lobbying can help inform politicians and the electorate about important issues.

Lobbying

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9.3

• Lobbying suffers from the free rider problem: o Many bills benefit a small number of people a

great deal and harm a huge number of people by a small amount.

o The smaller groups are much more able to organize and so can raise money to lobby more effectively.

o Thus, lobbying helps pass inefficient bills.

Lobbying and the Free Rider Problem

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9.3

• The farming sector receives $23 billion in support from the federal government each year in two forms: o Direct subsidy payments ($11 billion)o Price supports ($12 billion)

• The average farmer receives more than $10,000/year in support.

• The average American pays more than $200/year for this.

APPLICATION: Farm Policy in the United States

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9.3

Why do American families pay such large costs to support the farm sector?

• One answer: This helps preserve the “family farm.”o But most support goes to large farms, and other

countries have farming without subsidies.

• More likely answer: free rider problems.o Farmers have a strong incentive to support a farm

lobby ($10,000/year).o Non-farmers have little reason to oppose.

APPLICATION: Farm Policy in the United States

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EVIDENCE: Testing the Median Voter Model: Making Earmarks Transparent

A large literature attempts to test the median voter model, with mixed results.

• In 2007, the House of Representatives added new rules to clearly associate earmarks with their sponsors.

• The hope may have been to shame representatives into lowering their demand for earmarks.

• The effect was exactly the opposite: Transparency let legislators show their voters what they had done.

9.3

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9.3

Levitt (1996) looks at how Democratic and Republican senators from the same state vote.

• Since they face the same electorate, they should vote the same.

• In fact, they vote very differently from each other…

• … but basically along party lines.

EVIDENCE: Testing the Median Voter Model: Comparing Senators from the Same State

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9.3

Washington (2008) shows that politicians’ preferences matter.

• She compares legislators who have daughters to those with the same family size who have sons.

• Biologically, sex of children is random, so no confounding.

• Senators with more daughters are more likely to support reproductive rights and women’s safety.

EVIDENCE: Testing the Median Voter Model: Changing Politicians’ Preferences

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9.4

The failure of the Median voter model indicates that the government may not enact citizens’ preferences.

• Government failure: The inability or unwillingness of the government to act primarily in the interest of its citizens.

• Public choice theory: School of thought emphasizing that the government may not act to maximize the well-being of its citizens.

Public Choice Theory: The Foundations of Government Failure

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9.4

• Theories of government failure began by examining bureaucracies.o Bureaucracies: Organizations of civil servants, such

as the U.S. Department of Education or a town’s Department of Public Works, that are in charge of carrying out the services of government.

• The budget-maximizing bureaucrat runs an agency that has a monopoly on the government provision of some good or service.

• Maximizes his own revenue or influence.

Size-Maximizing Bureaucracy

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9.4

If government can fail, is it more efficient to provide by the public or private sector?

• For purely private goods and services, such as steel, telecommunications, or banking, it seems abundantly clear that private production is more efficient.

• A large literature finds that when state-owned companies are privatized, efficiency improves dramatically, and a smaller company is required to produce the same level of output.

Private versus Public Provision

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9.4

Privatization is not a panacea.

• Natural monopoly: A market in which, because of the uniformly decreasing marginal cost of production, there is a cost advantage to have only one firm provide the good to all consumers in a market.

• Might be addressed through contracting out.

• Contracting out: An approach through which the government retains responsibility for providing a good or service but hires private-sector firms to actually provide the good or service.

Problems with Privatization

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9.4

Contracting out often takes place without a competitive bidding process.

• Since early 2000s, Wackenhutt Corporation has been the primary security contractor at U.S. weapons plants.o Wackenhutt cheated during safety tests, so the

inspector general reported the results were “tainted and unreliable.”

o Hired by the Nuclear Energy Institute in 2004.

APPLICATION: Contracting Out with Non-Competitive Bidding

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9.4

• In 2003 and 2004, DHB industries won hundreds of millions of dollars of contracts to supply body armor to troops in Iraq.o But in 2002, DHB had to return 6,400 defective

vests to the NYPD.o In 2003, workers accused DHB of sloppy quality

control.o 23,000 vests were recalled from Iraq.


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9.4

• Since 2005, the Pentagon awarded more than $50 million of contracts to Applied Energetics.o Wanted solutions to combat improvised explosive

devices. o Applied Energetics continued to receive funding

after failed test.o Rival company Xtreme Alternative Defense System,

with successful anti-IED technology, has received only $1.5 million.


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9.4

• Leviathan theory: o Government attempts to grow as large as possible.o Voters cannot trust the government to spend their

tax dollars efficiently.o Must design ways to combat government greed.

• This can explain the many rules in place in the United States and elsewhere that explicitly tie the government’s hands in terms of taxes and spending.

Leviathan Theory

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9.4

Corruption is an important form of government failure.

• Corruption: The abuse of power by government officials in order to maximize their own personal wealth or that of their associates.

• May be constrained by electoral accountability, the ability of voters to throw out corrupt regimes.

• Corruption also appears more rampant in political systems that feature more red tape, bureaucratic barriers that make it costly to do business in a country.

Corruption

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9.4

• In 2003, former Illinois governor George Ryan indicted for corruption. o Sold state contracts in exchange for cash, gifts,

loans and trips for his family.

• Replaced by Rod Blagojevich, who campaigned as a reformer.

• In 2008, Blagojevich was arrested on federal corruption charges.o Tried to sell Obama’s Senate seat and pressured

Tribute Company to fire critical journalists.

APPLICATION: Government Corruption

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9.4

• Do these failures have important implications?

• Or can citizens use policies such as property tax limitations to limit harms imposed by government structure?

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

The Implications of Government Failure

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9.4

Poor government structure can have long-lasting negative impacts on economic growth.

• Mauro (1995): Cross-country measures of government quality correlated with GDP.o Red tape in government procedures, corruption

• But nations with high-quality governments (the treatment group) may differ from those with low-quality governments (the control group) for other reasons as well, biasing the estimates of the effect of government quality.

EVIDENCE: Government Failures and Economic Growth

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9.4

Acemoglu, Johnson, and Robinson (2001) attempt to circumvent this problem.

• Look at historical causes of differences in government quality.

• Some European colonies were very dangerous, so rather than govern, Europeans set up “extractive” institutions.

• These different institutions persist to the present, and countries with extractive institutions fare much worse.

EVIDENCE: Government Failures and Economic Growth

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9.5

• The government is a collection of individuals who have the difficult task of aggregating the preferences of a large set of citizens.

• The core model of representative democracy suggests that governments pursue policies preferred by the median voter. Evidence for this model is mixed.

• The extent to which government serves or fails to serve the interests of its citizens is a crucial one for future research in political economy.

Conclusion

Gruber4e_ch09

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