Gruber4e ch09

Public Finance and Public Policy Jonathan
CopyrightGruber
2010 Fourth
WorthEdition
Publishers
Copyright 2012 Worth Publishers
1 of 49
Political Economy
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
P R E PAR E D B Y
Dan Sacks
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers
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C H AP T E R 9 P O LI T I C AL E C O N O M Y
Political 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
Unanimous Consent on Public Goods Levels
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.
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9.1
Lindahl Pricing
Lindahls 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.
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9.1
Lindahl Pricing
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.
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9.1
Lindahl Pricing: Graphical Representation

Avas
marginal
willingness
$1.0
0.75
to 0pay
0.50
0.25
0
2
5
5
0
7
5
Demand,
10 DA
Firework
0
Jacks
marginal
willingness
$3.0
to pay
0
2.25
1.50
0.75
0
Ava & Jacks

willingness
to$4.0
pay
D
2
5
5
0
7
5
10 J
0
Firework
s
3.00
2.00
1.00
0
2
5
5
0
7
5
Marginal Cost,
MC
DA+J
10
0
Firework
s
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9.1
Lindahl 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 persons 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
Public Finance
and Public Policy to
Jonathan
Gruber valuation
Fourth Edition Copyright
2012 Worth
Publishers
according
their
of the
benefit
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9.1
Problems with Lindahl Pricing
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.
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9.2
Direct Democracy in the United States
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.
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9.2
Majority Voting: When It Works
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.
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9.2
To consistently aggregate preferences,

majority voting must satisfy three goals:
1. Dominance
2. Transitivity
3. 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 Elders
Young
(33.3%) (33.3
Couples
%)
(33.3%)
First choice
Second
choice
Third choice
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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
Majority Voting: When It Doesnt Work
Cycling: When majority voting does not

deliver a consistent aggregation of
individual preferences.
Public Public
school school
parents parent
(33.3%)
s
(33.3
%)
Young
Couples
(33.3%)
First choice
Second
choice
Third choice
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9.2
Arrows Impossibility Theorem
Majority-runoff voting didnt 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.
Arrows 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.
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9.2
Restricting Preferences to Solve the Impossibility

Problem
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.
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9.2
Single-Peaked versus Non-Single-Peaked

Preferences
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9.2
Median Voter Theory
With single peaked preferences, voting works

well.
Median Voter Theorem: Majority voting
will yield the outcome preferred by the
median voter if preferences are singlepeaked.
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.
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9.2
Potential Inefficiency of the Median Voter Theorem
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.
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9.3
Vote-Maximizing Politicians Represent the Median

Voter
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.
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9.3
Vote-Maximizing Politicians Represent the Median

Voter
(a)
0%
0%
(d
)
B1
Voters for
Barack
(b)
(c
)
Voters for
Mitt
Voters for
Barack
B2
Voters for
Barack
0%
B2
Voters for
Barack
0%
M1
25
%
25
%
25
%
B3 = M3 =
25%
Voters for
Mitt
M1
Voters for
Mitt
M2
Voters for
Mitt
Defense
spending
50
%
50
%
Defens
e
spendi
ng
Defens
e
spendi
ng
50
%
Defens
e
spendi
ng
50
%
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9.3
Assumptions of the Median Voter Model:

Single-Dimensional Voting
The median voter model relies on several
assumptions.
Single-dimensional voting
o 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.
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9.3
Assumptions of the Median Voter Model:

Only Two Candidates
Only two candidates
o The model assumes only two candidates
o 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.
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9.3
Assumptions of the Median Voter Model: No

Ideology or Influence
No ideology or influence
o 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.
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9.3
Assumptions of the Median Voter Model: No

Ideology or Influence
No selective voting
o 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.
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9.3
Assumptions of the Median Voter Model: No Money
No money
o 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.
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9.3
Assumptions of the Median Voter Model: Full

Information
Full information
o 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.
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9.3
Lobbying
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.
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9.3
Lobbying and the Free Rider Problem
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.
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9.3
APPLICATION: Farm Policy in the United States
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.
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9.3
APPLICATION: Farm Policy in the United States
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.
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9.3
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.
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9.3

Comparing Senators from the Same State
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.
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9.3

Changing Politicians Preferences
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
womens safety.
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9.4
Public Choice Theory: The Foundations of

Government Failure
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.
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9.4
Size-Maximizing Bureaucracy
Theories of government failure began by

examining bureaucracies.
o Bureaucracies: Organizations of civil
servants, such as the U.S. Department of
Education or a towns 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.
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9.4
Private versus Public Provision
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 stateowned companies are privatized, efficiency
improves dramatically, and a smaller
company is required to produce the same
level of output.
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9.4
Problems with Privatization
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.
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9.4
APPLICATION: Contracting Out with NonCompetitive Bidding

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.
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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
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 governments hands in
terms of taxes and spending.
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9.4
Corruption
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.
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9.4
APPLICATION: Government Corruption
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 Obamas Senate seat and
pressured Tribute Company to fire
critical journalists.
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9.4
The Implications of Government Failure
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.
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9.4
EVIDENCE: Government Failures and Economic

Growth
Poor government structure can have longlasting 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.
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9.4
EVIDENCE: Government Failures and Economic

Growth
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.
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9.5
Conclusion
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.
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Public Finance and Public Policy Jonathan

9.1 Unanimous Consent on Public Goods

Why do governments do what they do?

Unanimous Consent on Public Goods Levels

Ideal case for public goods:

Lindahls procedure operates as follows:

Recall that efficient provision requires that

Lindahl Pricing: Graphical Representation

Ava & Jacks

Lindahl Pricing: Why It Works

Under Lindahl pricing, the government

Problems with Lindahl Pricing

Lindahl pricing faces several problems that

Direct Democracy in the United States

Direct democracy remains strong in America.

Majority Voting: When It Works

Lindahl pricing requires unanimous consent

Majority Voting: When It Works

To consistently aggregate preferences,

Majority Voting: When It Works

There are three types of voters in a town:

Majority Voting: When It Works

How to vote among the three options?

o Then, vote on H versus M.

Then, vote on L versus M.

M will win each head to vote, and win.

majority voting is consistent.

Majority Voting: When It Doesnt Work

Cycling: When majority voting does not

Arrows Impossibility Theorem

Majority-runoff voting didnt work, but

Restricting Preferences to Solve the Impossibility

Single-Peaked versus Non-Single-Peaked

Median Voter Theory

With single peaked preferences, voting works

Potential Inefficiency of the Median Voter Theorem

Majority voting and the median voter theorem

Vote-Maximizing Politicians Represent the Median

Vote-Maximizing Politicians Represent the Median

Assumptions of the Median Voter Model:

Assumptions of the Median Voter Model:

Assumptions of the Median Voter Model: No

Assumptions of the Median Voter Model: No

Assumptions of the Median Voter Model: No Money

Assumptions of the Median Voter Model: Full

Problems with the median voter model make

Lobbying and the Free Rider Problem

Lobbying suffers from the free rider

APPLICATION: Farm Policy in the United States

The farming sector receives $23 billion in

APPLICATION: Farm Policy in the United States

Why do American families pay such large

EVIDENCE: Testing the Median Voter Model:

EVIDENCE: Testing the Median Voter Model:

EVIDENCE: Testing the Median Voter Model:

Public Choice Theory: The Foundations of

Theories of government failure began by

Private versus Public Provision

If government can fail, is it more efficient to

Problems with Privatization

Privatization is not a panacea.

APPLICATION: Contracting Out with NonCompetitive Bidding

APPLICATION: Contracting Out with NonCompetitive Bidding