Chapter 9 Political Economy Public Finance and Public Policy Author: Jonathan Gruber Instructor: Yigang Zhang

Introduction Alaska, bridge to nowhere project Small states advantage; Logrolling: the process by which politicians trade support for one issue or piece of legislation in exchange for another politician’s support, especially by means of legislative votes; Logrolling within a Direct Democracy Implicit Logrolling Distributive Logrolling

Introduction Economists do not get to decide whether public policies are undertaken or not. Decisions are made in the context of a complex political system. Understand the political mechanisms to evaluate whether the intervention is optimal.

Arrangement Best case scenario: Realistic case I: direct democracy; unanimous consent; perfectly measures and aggregates citizens’ preferences; Lindahl pricing; Realistic case I: direct democracy; Realistic case II: representative democracy; Public choice; Government Failure;

Lindahl Pricing Lindahl Pricing Problems with Lindahl Pricing Aggregating individuals’ marginal willingness to pay to form marginal social benefit; Tie tax prices to individuals’ willingness to pay; Charging every individual by the willingness to pay; Benefit taxation; Problems with Lindahl Pricing Individuals underreport the valuation to free ride on others; Individuals have no knowledge about their own valuation on public goods; Preference aggregation is problematic.

Mechanisms for Aggregation Majority voting; Single-peaked .vs. non-single-peaked preferences; When there is other alternatives; Private school option at choice for public school funding; Backyard option at choice for sizes of park; Etc.

Majority Voting TABLE 9-1: Majority Voting Delivers a Consistent Outcome Types of Voters Parents Elders YoungCouples First H L M Second Third TABLE 9-2: Majority Voting Doesn't Deliver a Consistent Outcome Types of Voters PublicParents PrivateParents YoungCouples First H L M Second Third

Arrow’s Impossibility Theorem When voters have three or more distinct alternatives (options), no rank order voting system can convert the ranked preferences of individuals into a community-wide (complete and transitive) ranking while also meeting a specific set of criteria. Criteria: unrestricted domain non-dictatorship Pareto efficiency independence of irrelevant alternatives

Arrow’s Impossibility Theorem No rank-order voting system can be designed that satisfies these three "fairness" criteria: If every voter prefers alternative X over alternative Y, then the group prefers X over Y. If every voter's preference between X and Y remains unchanged, then the group's preference between X and Y will also remain unchanged (even if voters' preferences between other pairs like X and Z, Y and Z, or Z and W change). There is no "dictator": no single voter possesses the power to always determine the group's preference.

Median Voter Theory Assumption: single-peaked preferences Majority voting will yield the outcome preferred by the median voter if preferences are single-peaked. The median voter is the voter whose tastes are in the middle of the set of voters, so an equal number of other voters prefer more and prefer less of the public good.

Mechanisms for Aggregation Median Voter Theory; Difference between mean and median; Intensity of preferences isn’t reflected; Lobbying; Recall the question in quiz #02; MC/3=30; SMB=20+25+50; Monument Example; SMC/1001=40; SMB=500*100+501*0=50000;

Representative Democracy Median Voter Theory in Representative Democracy; Vote maximizing politicians Location model by Hotelling; Example: Obama .vs. McCain in national defense; B0=10, J0=40; B1=20, J1=40; B2=20, J2=28; B3=25, J3=25;

Problems facing Median Voter Assumptions of the Median Voter Model Single-dimensional voting; Bundle issues (less national defense, more education spending, more health care spending, more unemployment benefit, etc.) Only two candidates; Location model with 3 shops; No ideology or influence; Self-interest politicians; No selective voting; Turn-out rate; only voters with intense preferences vote; No money; Full information;

Public Choice Sources of Government Failure: Size-Maximizing Bureaucracy; Problems with Privatization; Leviathan Theory; Corruption; (Is lobbying the same?) Government failure: the inability or unwillingness of the government to act primarily in the interest of its citizens.