Lecture 5

Positive theory
of economic
policy
Economic Policy Analysis
Dr Dragana Radicic
dradicic@lincoln.ac.uk
 Representing social groups
• The normative theory of economic policy is a ‘theory of the
public interest’ and ignores the problem of the realism of the
hypotheses on which it is based.
• The normative theory largely ignores the following aspects
of reality
• The economic system is not composed of indistinct
individuals
• Policymakers are not anonymous, as the theory assumes
• With respect to the first aspect
• We can aggregate individuals into different classes or
groups with shared interests, needs or ideas (interest
groups, lobbies, cartels, unions, political parties etc.)
• These groups have different levels of power
 Representing social groups
• In the mainstream neoclassical economic school, the concepts
of power and class (group) play a limited role.
• Political economics, interest group theory, public choice
theory
• Each group (capitalists, wage earners, consumers, particular
categories of firms) may wish to influence government action:
• In general policy attitudes such as the adoption of
expansionary or restrictive policies
• In more specific actions involving selective interventions
(e.g. different tax rates, protection of specific sectors)
• Ways in which groups exercise their influence on government
• Voting, personal connections, opinion campaigns,
corruption and promises to politicians and bureaucrats of a
lucrative career when they leave government service
 Agency problems: the
objectives of politicians
• The identity of policymakers is entirely ignored in classical
theory.
• Government apparatus is composed of politicians and
bureaucrats and for both an incentive problem arises.
• Political business cycle theory (Nordhaus)
• Basic hypothesis: the primary objective of politicians is
to remain in office.
• Second hypothesis: election results are significantly
influenced by the current economic situation.
• Third hypothesis: government has an ability to expand
the economy using monetary and fiscal instruments in the
short run.
 Agency problems: the
objectives of politicians
• A model of ‘partisan’ politician
• Each political party assigns different weights to different
economic objectives for ideological reasons and/or
because it represents different interests and social groups.
• The cyclical behaviour of the economy is suboptimal, but
inefficiency can be eliminated if the parties commit to a
common cooperative policy rule, which would make the
social groups they represent better off in the long run.
• Empirical evidence give partial support to the various
political business cycle models, lending more weight to the
‘partisan’ version.
 Agency problems: bureaucracy
• The behaviour of government officials can be explained if we assume
that they seek to maximise their own utility (income, prestige, power
besides public interest).
• Many of these factors are related to the size of government, thus the
tendency towards a steady expansion of the public sector is fuelled by
the personal interests of bureaucrats.
• In addition, bureaucracy tends to generate high costs due to
operational inefficiencies.
• Criticisms
• No positive correlation between the centralisation of departments
and the growth of bureaucracy.
• Opposite might hold - an increase in the size of departments
reduces the resources available to pay bureaucrats’ salaries.
 Agency problems: bureaucracy
• The fundamental problems arising when one wants to improve the
performance of government bureaucracies
• Specifying individual tasks in a way that is consistent with the
information handling abilities of each bureaucrat.
• Ensuring that each bureaucrat conscientiously carries out the
tasks assigned by politicians (avoiding shirking, corruption of
bureaucrats, and the formation of bureaucratic oligarchies).
• Ways to achieve goals
• Establishing sufficiently rigid administrative procedures
• Introducing explicit ‘positive’ incentives
 Social groups, institutions and
economic policy

• Depending on the degree of cohesion between social

groups, public policy will be more or less inclusive.
• In a tightly knit society, social groups will act
cooperatively and government policies will be aimed
at the public interest.
• In a society with considerable conflict between its
various groups, public policies will be directed in
favour of one or some groups in the struggle against
others.
‘Non-market’ or government
failures

• Political self-interest
• Information failure
• Excessive bureaucracy
• Policy short-termism
• Government may be influenced by
lobbying from interest groups
 Problems of moral hazard

• There are problems of moral hazard that lead to both

market and non-market failures.
• Three points in comparing the importance of moral
hazard in private and public institutions:
• The measurability of targets
• The extent and nature of agency situations
• The impact of complementary institutions in solving
agency problems.
 Ways to tackle moral hazard in public
institutions

• Public-sector enterprises can provide their

managers with the same incentives as private
enterprises with a broad shareholder base.
• The discretion of politicians and bureaucrats can be
reduced by the introduction of appropriate rules
(e.g. the independence of the central bank).
 Process of defining government
intervention
• Our objective is to construct a normative theory of government
intervention that takes into account of the existing alternatives and the
multiple effects it produces in a varied social environment.
• Stages of defining a programme of public action:
• The origins of government action
• Analysing the operation of other institutions
• The choice between alternative measures
• The choice between alternative measures must take into account these
elements:
• Political and bureaucratic feasibility
• Reactions of the market and other institutions
• Nature of macroeconomic and microeconomic consequences