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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 6 POLITICAL ECONOMY.

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Presentation on theme: "McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 6 POLITICAL ECONOMY."— Presentation transcript:

1 McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 6 POLITICAL ECONOMY

2 6-2 Political Economy  Public decision making in public finance is complicated and not well understood.  Contrary to simple models of democracy, there appear to be forces pulling government expenditure away from levels that would preferred by the median voter.  However, critics of the budgetary process have not come up with a satisfactory alternatives.

3 6-3 Political Economy  The formulation of meaningful rules and constraints for the budgetary process, either at the constitutional or statutory level, is an important item on both the academic and political agendas for the years ahead.  It should be stressed that a judgment that the current system of public finance is inequitable or inefficient does not necessarily imply the government as an institution is “bad.”  People who like market-oriented approaches to resource allocation can nevertheless see to improve markets. The same goes for government.

4 6-4 Political Economy  Public finance in any state aims at redistributing the incomes in an ethically, desirable way. But can it do that???  Political economy determines this redistribution process of incomes taking into consideration selfishness and fairness principles.  Political economy is the product of direct democracy.  A procedure designed to elicit unanimous agreement was proposed in the early 20 th century by Lindahl.

5 6-5 Lindahl Model  An obvious similarity exists between the role of tax shares in the Lindahl model and market prices in the usual theory of demand.  But there is an important difference. Instead of each individual facing the same price, each faces a personalized price per unit of public good, which depends on his or her tax share.  The tax shares are preferred to as Lindahl prices.

6 6-6 Direct Democracy-Unanimity Rules r per year 0 0’ Adam’s share (S A ) Eve’s share (S E ) DrADrA The Lindahl Model DrEDrE r* S*

7 6-7 Feasibility of Unanimity Rules  Reaching equilibrium  Lindahl Model has two practical problems 1. Strategic behavior: sincere decision might not be taken by everyone 2. Time to reach equilibrium through election or referendum.

8 6-8 Direct Democracy-Majority Voting Rules  Majority voting rule – one more than half of the voters must favor a measure for it to be approved.  Majority decisions rules do not always yield such clear-cut results leading to voting paradox which refers to that fact that voter’s preferences are consistent while the community’s are not. Voter ChoiceBradJenAngelina FirstACB SecondBBC ThirdCAA

9 6-9 Direct Democracy-Majority Voting Rules  Problems of Direct Democracy- Majority Voting Rules: 1. Voting Paradox – community preferences can be inconsistent even though individual’s preferences are consistent. 2. Agenda Manipulation – process of organizing order of votes to ensure a favorable outcome. 3. Cycling – when paired voting on more than two possibilities goes on indefinitely without a conclusion ever being reached. Voter ChoiceBradJenAngelina FirstACB SecondBAC ThirdCBA

10 6-10 Graphing Preferences Missiles Utility A BC Brad Jen Angelina Single-peaked preferences Double-peaked preferences

11 6-11 Practical Importance of Double-peaked Preferences  If all voters’ preferences are single peaked, not voting paradox occurs.  But in fact, voters’ preferences are double- peaked or more.  Availability of private substitutes  Majority voting may lead to inconsistent decisions regarding the public goods if some people’s preferences are not single peaked.

12 6-12 The Median Voter  Median voter happens when the voter whose preferences lie in the middle of the set of all voter’s preferences; half the voters want more of the good than the median voter, and half want less.  The median voter theorem states that as long as all preferences are single peaked, the outcome of majority voting reflects the preferences of the median voter.  But remember, there might be two median voters, which must be broken arbitrary.

13 6-13 Direct Democracy - The Median Voter Theorem VoterExpenditure Donald$5 Daisy100 Huey150 Dewey160 Louie700

14 6-14 Logrolling  Logrolling systems allow people to trade votes and hence register how strongly they feel about various issues.  However, minority gains may come at the expense of the greater general losses.

15 6-15 Direct Democracy - Logrolling I Voter Project MelanieRhettScarletTotal Net Benefits Hospital200-50-5595 Library-40150-3080 Pool-120-60400220

16 6-16 Direct Democracy - Logrolling II Voter ProjectMelanieRhettScarletTotal Net Benefits Hospital200-110-105-15 Library-40150-120-10 Pool-270-140400-10

17 6-17 Direct Democracy - Arrow’s Impossibility Theorem  Arrow’s Impossibility Theorem states that, in general, it is impossible t find a decision making rule that simultaneously satisfies a number of apparently reasonable criteria.  The implication is that democracies are inherently prone to make inconsistent decisions.  Nobel Laureate Kenneth Arrow proposed that in a democratic society, a collective decision-making rule should satisfy various criteria.

18 6-18 Reasonable Criteria of Nobel Laureate Kenneth Arrow  Nobel Laureate Kenneth Arrow proposed that in a democratic society, a collective decision-making rule should satisfy various criteria. 1. Producing a decision whatever the configuration of voters’ preferences. 2. Ranking all possible outcomes. 3. Being responsive to individual preferences. 4. Being consistent to all individual preferences. 5. Being independence of irrelevant alternatives. 6. Not reflecting the preferences of only single individual.

19 6-19 Direct Democracy - Arrow’s Impossibility Theorem  “Reasonable” collective decision-making criteria It can produce a decision whatever the configuration of voters' preferences It must be able to rank all possible outcomes It must be responsive to individuals’ preferences It must be consistent Independence of irrelevant alternatives Dictatorship ruled out  Arrow’s Impossibility Theorem All conceivable voting schemes have some potential for being unfair or producing a paradoxical result  Meaning of theorem consistent rule not necessarily impossible to find, but cannot be guaranteed  Buchanan’s critique Inconsistencies of majority voting have beneficial aspects. P#116.  Use of social welfare functions must be chosen collectively. Economists argue that the Arrow is merely a way of introducing value judgments and not representation of society’s preferences.

20 6-20 Representative Democracy - Elected Politicians  Explanations of government behavior require studying the interaction of elected officials, public employees, and special interest groups.  Under the restrictive assumptions, the actions of elected officials mimic the wishes of the median voter.

21 6-21 Representative Democracy - Elected Politicians Number of Voters LiberalConservative

22 6-22 Implications of the Median Voter Model  Two-party systems tend to be stable  Replacement of direct referenda by representative system has no effect on outcomes. Both simply mirror the preferences of the median voter.  Thus government spending cannot be “excessive” because politicians competition for votes leads to an expenditure level which is exactly in accord with median voter’s wishes.

23 6-23 Other Factors Influencing Voting 1. Single-dimensional rankings: If all political beliefs cannot be ranked along a single spectrum, the median voter theorem falls apart because the identity of the median voter depends on the issue being considered. 2. Ideology 3. Personality 4. Leadership 5. Decision to vote

24 6-24 Representative Democracy-Public Employees  Function of bureaucrats  Goals of bureaucrats

25 6-25 Niskanen’s Model of Bureaucracy Q per year $ 0 V C Q* Efficient output Q bc Actual output

26 6-26 Representative Democracy – Special Interests  What are “Special Interests”  Establishment of Special Interest Groups Source of Income: Capital or Labor Size of Income: Rich and poor. Source of Income: Industry of Employment Region: Midwesterners favor agricultural subsidies while northeasterners favor the expenditure of urban development Demographic and Personal Characteristics: The elderly favor health care while young favor good schools and lower payroll taxes.

27 6-27 Representative Democracy – Rent-Seeking tons of peanuts per year $ S=MC D MR Rents

28 6-28 Representative Democracy – Other Actors  Judiciary: Court decisions on the legality of various taxes can affect public finance.  Journalists: They can bring certain issues to public attention which in turn gives press considerable influence.  Experts: Information is an important source of power. Legislation aides who gain expertise on certain programs often play important roles in drafting statues.

29 6-29 Explaining Government Growth  Citizen Preferences Median voter’s demand of public good & services (G) is some function (f) of the relative price of public sector goods and services (P) and income (I). G = f(P, I)  Marxist View: The private sector tends to overproduce, so the capitalist- controlled government must expand expenditure to absorb this production.  Chance Events: This includes wars and economic crisis. For example, the financial assistance given by the various government to save the crumbled business after the global financial crisis.  Changes in Social Attitudes: Increasing demand ignoring the cost of public programs.  Income Redistribution: The low income voters push governments to redistribute incomes towards them. To attract this category of voters, government find no way but to increase its expenditure.

30 6-30 Controlling Government Growth  Government growth as a non-issue  Government growth as a problem Commitments made in the past Basic flaws in the political system

31 6-31 Improving the Workings of the Political System  Change bureaucratic incentives financial incentives privatization  Change Fiscal Institutions Budget Enforcement Act (BEA) – 1990 Balanced budget rules at the state level  Institute Constitutional Limitations Balanced budget amendment

32 6-32 Provisions of a Typical Balanced Budget Amendment 1. Congress must adopt a budget statement “in which total outlays are no greater than total receipts.” 2. Total receipts may not increase “by a rate greater than the rate of increase in national income.” 3. “The Congress and President shall…ensure that actual outlays do not exceed the outlays set forth in the budget statement.” 4. The provisions can be overridden in times of war.

33 6-33 Critique of Balanced Budget Amendments  Forecasting issues  Definitional issues  Penalties for violation of the law  Economic issues


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