Political economy Government growth

1
Political economyGovernment growth

• Today How do people vote in a democracy?
• Why did the government grow so much in the 20th
  century?

2
Democracy

• Political decision making is important for public
  finance
• Two types of democracy in this mini-lecture
• Direct
• Indirect, or representative

3
Direct democracy

• There are different ways to make decisions in a
  direct democracy
• Unanimity, especially of public goods purchases
• Lindahl prices
• Majority voting rules
• Possible cycling with three or more choices
• Median voter theorem
• Arrows impossibility theorem

4
Unanimity with public goods

• Suppose there are two people trying to find the
  efficient level of public goods purchases
• Each person could decide on a quantity to
  purchase
• Free-rider problem
• Each person could decide on a quantity to
  purchase, given what fraction he or she would pay
• The share paid is known as a Lindahl price

5
Direct democracy Unanimity rules
0
DrE
Eves share (SE)
Notice that by construction of graph, shares add
up to one at each point
S
Adams share (SA)
DrA
0
r per year
r
The Lindahl Model
6
Feasibility of unanimity rules

• Reaching equilibrium
• Time and negotiation costs are usually very high
  when many people are involved
• Strategic behavior
• One person could react to how he or she thinks
  the other will behave
• Strategic behavior can prevent efficient results
  from occurring

7
Majority voting rules

• Majority voting relies on all voters having
  single-peaked preferences
• With single-peaked preferences
• The person with median preferences can
  essentially make the decision (under certain
  conditions)
• Trading votes may or may not increase welfare
• Programs that lower overall welfare are known as
  pork

8
Jen Double-peaked preferences
Single-peaked preferences
Utility
Jen
Double-peaked preferences
Brad
Angelina
Missiles
B
C
A
9
Preferences

• When at least one person does not have
  single-peaked preferences, we can get cycling
• Cycling occurs when no clear winner can be
  established

10
Single-peaked preferences

• Each person has single-peaked preferences here
• Brads peak is at A
• Jens peak is at C
• Angelinas peak is at B
• A vs. B B wins
• A vs. C C wins
• B vs. C B wins
• B is the clear winner

Voter Voter Voter Voter
Choice Brad Jen Angelina
First A C B
Second B B C
Third C A A
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Back to Jens two peaks

• This example is different from the previous one
• Jen now has double-peaked preferences
• A and C are both peaks
• We now get cycling
• A vs. B A wins
• A vs. C C wins
• B vs. C B wins
• No clear winner
• This inconsistency is part of a voting paradox

Voter Voter Voter Voter
Choice Brad Jen Angelina
First A C B
Second B A C
Third C B A
This example is the same as in the graph a few
slides ago
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Suppose Angelina is in charge

• Agenda manipulation Someone can decide on the
  order of votes to get her or his first choice
• Suppose Angelina decides the order of votes to
  get her most-desired choice
• First, A vs. C C wins
• Second, B vs. C B wins
• B is implemented

Voter Voter Voter Voter
Choice Brad Jen Angelina
First A C B
Second B A C
Third C B A
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The median voter theorem

• When preferences of each person are single
  peaked, we can assign a median voter
• Relative to the median voter
• Half of the people want more
• Half of the people want less
• Under certain conditions, the median voters
  preferences will be approved

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The median voter theorem
Voter Most desired expenditure on breast cancer research
Abby 50
Betty 1,000
Christine 1,100
Doris 2,500
Elaine 50,000
Median voter theorem predicts that 1,100 will be
voted on
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Six reasonable criteria for decision making

• Kenneth Arrow studied six criteria that many
  people would consider ethically acceptable
• Unfortunately, there is no guarantee that all six
  criteria can be followed
• This proof is known as Arrows Impossibility
  Theorem
• What are the six criteria?

Kenneth Arrow, 2004
16
The six criteria that Arrow proposed

• It can produce a decision whatever the
  configuration of voters' preferences
• No problems due to multipeaked preferences
• It must be able to rank all possible outcomes
• It must be responsive to individuals preferences
• Example If everyone prefers A to B, then
  society does too
• Preferences must be transitive
• If A is at least as good as B, and B is at least
  as good as C, then A is at least as good as C
• Independence of irrelevant alternatives
• Relative rankings of two goods do not depend on a
  third good
• Dictatorship ruled out
• Social welfare is a function of more than one
  person

17
Representative democracy

• In a representative democracy, a subset of the
  population votes to determine who our elected
  politicians are
• Median voter theorem applies here also, assuming
  single-dimensional rankings and exactly two
  candidates
• Ideology, personality, and leadership abilities
  of the politician may matter to voters
• If no candidate appeals to a voter he or she may
  not vote

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Median voter theorem in one dimension
0
Number of Voters
If a candidate takes position S, the opponent can
take the median voter stance and get a majority
of the votes
Liberal
Conservative
Median voter
S
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Implications of the median voter model

• Based on the median voter model
• Two-party systems tend to be stable
• Replacement of direct referenda by representative
  system has no effect on outcomes

20
Logrolling

• Logrolling is the act of politicians trading
  votes in order to pass legislation that is
  beneficial to their district
• Some logrolling improves welfare
• Some logrolling does not improve welfare
• An example
• Suppose that Waldo, Xavier, and Zach each live in
  a different congressional district
• Note that this example uses a different approach
  than in the book

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Logrolling

• In each case, Waldo, Xavier, and Zachs
  representatives can get together to try to pass
  each others projects
• If all three projects are passed together, Waldo,
  Xavier, and Zach are each better off
• Whether or not the logrolling leads to welfare
  improvements depends on the cost to others

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Welfare-improving logrolling
Project Waldo Xavier Zach others Total net benefits
Park 500 -200 -250 -30 20
Beach restoration -200 750 -300 -100 150
Tree planting -200 -300 750 -75 175
23
Bring on the pork
Project Waldo Xavier Zach others Total net benefits
Park 500 -200 -250 -130 -80
Beach restoration -200 750 -300 -350 -100
Tree planting -200 -300 750 -275 -25
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Public employees

• Public employees fulfill legislated mandates and
  operate many government operatives
• Bureaucrats sometimes have interpretive power
• Red tape criticism
• Unresponsive to reasonable requests
• No market-oriented incentives
• Some bureaucrats want to maximize the size of
  their departments
• Niskanens model of bureaucracy

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Niskanens model of bureaucracy
C

V
Bureaucrats suggested output
Efficientoutput
0
Q
Qbc
Q per year
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What can the politician do?

• A politician can change the quantity to Q if he
  or she knows what Q is
• Sometimes, only the bureaucrat knows what Q is
• Make bureaucrats pay dependent on quality of
  work
• Requires costly oversight
• Hire bureaucrats that are reliable in determining
  what Q is
• Probably difficult

27
Special interests

• Special interests has become a
  politically-charged term in todays political
  arena
• What are some special interest groups?
• Labor groups
• Groups that favor the rich, poor, young, or old
• Groups that favor tax breaks for an industry
• Groups that want to enhance social and religious
  goals
• Rent-seeking behavior
• Attempts for a firm to have positive economic
  profits

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Rent-seeking behavior

Cartel price and quantity
Deadweight loss with a cartel
Rents
Competitive outcome
SMC
D
tons of peanuts per year
MR
29
Other people involved

• Other people help to carve the political
  landscape
• Judges have control to enforce and interpret laws
• Media influence
• Providing information
• Political leanings
• Experts
• Former politicians
• Example Al Gore

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Summary Democracy

• Democracies can be direct or indirect
• Both types of democracies have their own sets of
  problems
• Direct democracies
• Time consuming to people
• Cycling
• Arrows Impossibility Theorem
• Indirect democracies
• Bureaucrats
• Special interests

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Growth of government spending

• Many western countries have had significant
  growth in government spending since 1900
• How is this growth justified?
• Many theories examined
• No single theory fully explains the growth
• Can government growth be controlled?

32
Explaining Government Growth

• Five theories of government growth
• Citizen preferences
• Marxist view
• Chance events
• Changes in social attitudes
• Income redistribution

33
Citizen preferences

• Take the median voters preferences of public
  sector goods and services
• G f(P, I)
• G represents the median voters demand for public
  sector goods and services
• P is the relative price of public sector goods
  and services
• I is income

34
Citizen preferences

• Assume median voter theorem is true
• When income increases, if income elasticity of
  demand is greater than one for the median voter,
  increased public services would be provided
• Growth of the middle class may explain why
  government spending has grown so much
• This theory predicts that voters get what they
  want

35
Marxist view

• A Marxist model would argue that the private
  sector overproduces
• Government must expand expenditures to correct
  this
• Worker discontent is curbed by social service
  spending
• Some argue that this is not sustainable, since
  expenditures will eventually outpace tax revenue
  capacity
• See Figure 18.6, p. 423, for more on tax revenue
  capacity

36
Government shocks

• Chance events lead to shocks on the government
• These shocks require the government to increase
  spending substantially
• Examples The Great Depression the world wars
  the financial crisis of 2008-09
• Inertia ? increased spending sticks
• Special interest groups try to make sure that
  their spending does not go away

37
Changes in social attitudes

• Are people making bigger demands on government?
• Maybe
• Due to median voter theorem?
• Costs and benefits may also be incorrectly
  perceived by the public

38
Income redistribution

• Two views
• Government grows to help low-income voters
• Some politicians can promise redistribution to
  median income and below
• Incomes above the median get taxed to pay for
  income redistribution
• Government grows to help the middle class
• Appeals to voters near median income
• With this view, the upper- and lower-income
  classes pay for the benefit of the middle class

39
Controlling government growth

• Some people believe that government is not too
  big
• Others disagree
• If the government is too big, how can we make it
  smaller?
• Change bureaucratic incentives
• Change fiscal institutions
• Institute constitutional limitations

40
Change bureaucratic incentives

• Recall Niskanens model of bureaucracy
• Bureaucrat often worries about size of
  department, not what is efficient
• Financial incentives for cost-cutting could
  backfire, however
• Q could be below Q
• Private provision may be more efficient

41
Change fiscal institutions

• Is the budget-making process undisciplined?
• Many people believe so
• Congress-imposed solution Budget Enforcement
  Act (BEA) of 1990
• Spending and revenue targets are set
• The cap can be exceeded when an elaborate set of
  parliamentary rules are followed
• Problems with BEA
• Some emergency spending is known in advance
• 2000 census

42
Institute constitutional limits

• If Congress cannot regulate its own spending,
  should there be a constitutional amendment that
  does limit spending?
• Most economists believe no

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Why not to impose constitutional limits

• Revenue and spending is usually uncertain until
  it happens
• If tax revenue was overestimated, severe spending
  cuts would have to occur mid-year
• Spending could be forced on states instead
• States could be mandated to provide part of
  Social Security
• What would the consequences be if Congress
  circumvents the law?
• Judicially-imposed budget?
• Will Congress members be punished?

44
Outcome of government spending

• Estimated public debt in 2010
• 9.9 trillion (up 2 trillion from 2009)
• 67.1 of GDP (up 12.5 percentage points from 2009)

Source Wikipedia article on US public debt
45
Summary Growth of govt spending

• Although political models have appeal on
  government spending, they do not fully explain
  how governments behave
• Many people believe that government spending
  needs more control
• BEA and current incentive structure ineffective
• No constitutional amendment for balanced budget
• Probably goes too far

46
Problems

• Lindahl model
• Majority voting
• Median voter theorem
• Efficient government spending

47
Lindahl problem

• Bill and Hillary have decided to be roommates in
  Washington DC
• They decide to use Lindahl prices to determine
  the amount of money they will spend on a new sofa
• Q represents spending on a new sofa
• Bills share is SB 1 Q/500
• Hillarys share is SH 1 Q/400
• Also note that SB SH 1

48
Lindahl problem

• How do you solve this?
• 3 equations
• 3 unknowns
• Plug in first two equations into the third
  equation
• (1 Q/500) (1 Q/400) 1
• (1 4Q/2000) (1 5Q/2000) 1
• 2 9Q/2000 1
• 1 9Q/2000
• Q 2000/9 222.22

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Majority voting problem

• 5 members on a city council
• 4 options A, B, C, D
• Assume each member will vote no unless specified
  below
• Frank Will only vote in favor of A
• Genevieve Will vote in favor of B will vote
  for A if B is defeated first
• Holly Will definitely vote in favor of B or C
  if either is voted on will vote for A if B and C
  are both defeated first
• Ivan Will definitely vote in favor of A or D if
  either is voted on will vote for B if A and D
  are defeated first
• Jacqueline Will definitely vote in favor of C
  and D if either is voted on

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Majority voting problem

• Which projects have a chance?

Frank Genevieve Holly Ivan Jacqueline
A Y ? ? Y N
B N Y Y ? N
C N N Y N Y
D N N N Y Y
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Majority voting problem

• Which projects have a chance? A and B

Frank Genevieve Holly Ivan Jacqueline
A Y ? ? Y N
B N Y Y ? N
C N N Y N Y
D N N N Y Y
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Majority voting problem

• Can we get A to pass?
• Yes Have Frank to control the voting process
• Step 1 Vote on B ? Only Genevieve and Holly
  will vote in favor
• Step 2 Vote on C ? We know that C will never
  pass
• Step 3 Vote on A ? Since B and C have both
  been defeated, Holly will also vote in favor of A

Frank Genevieve Holly Ivan Jacqueline
A Y ? ? Y N
B N Y Y ? N
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Median voter theorem problem

• In Santa Barbara, the distribution of desired
  spending on beaches in the population is as
  follows
• Normal distribution
• Average desired spending is 600,000 per year
• Standard deviation is 100,000 per year
• If you were a politician running for the Santa
  Barbara city council, what should your stance on
  this be?

54
Median voter theorem problem

• What should your stance be?
• If you believed the median voter theorem, your
  stance should be consistent with the median voter
• In a normal distribution, the mean and the median
  are the same
• Stance should be to spend 600,000 per year

55
Efficient government spending problem

• Q is millions of dollars spent per year on a
  government project
• Thus, total cost is Q
• Total value of the government project
• V 100Q½
• What is efficient?
• What is the output predicted by Niskanens model?

56
Efficient government spending problem

• What is efficient?
• Set MB MC
• MB is the derivative of the total value with
  respect to Q
• MB 50/Q½
• MC is the derivative of the total cost with
  respect to Q
• MC 1
• 50/Q½ 1 ? Q 2,500

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Efficient government spending problem

• What is the output predicted by Niskanens model?
• Set V C
• 100Q½ Q ? Q 10,000

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See you on Wednesday