1. The Political Economics Approach Advanced Political Economics Fall 2013 Riccardo Puglisi The Political Economy Approach

2. The Political Economy approach Economic AgentsPolitical Agents Political InstitutionsMarkets Economic Policy Economic Aggregates & Prices POLITICAL ECONOMY EQUILIBRA Individuals as ECONOMIC and POLITICAL Agents:  ECONOMIC Agents take Labor, Savings, Consumption Decisions  POLITICAL Agents (Voters) decide over Economic policies (Redistribution, Public Goods, etc.)  Markets and Political Institutions as “aggregators”.

3. Possible Conflicts Citizens typically disagree: Policy instruments are set in the presence of different types of conflicts: (i)among individuals (e.g., redistributive policies), (ii)between individuals and politicians (e.g., rents and corruption); and (iii) among politicians (e.g., rents and elections).

4. Method of Analysis 1. Policy instruments related to conflicts among individuals. KEY ISSUES: redistribution ( how targeted? ), dynamic policies (public debt, growth), rents  one-dimensional conflict Typical of broad redistributive programs (eg: welfare state programs)  n-dimensional conflict Typical of narrowly target redistribution (eg: local public goods, agricultural subsidies, trade protection)

5. 2.Which form of political participation?  voting  voting plus lobbying  Post-electoral politics 3.Which electoral rule? We neglect the effects of electoral rule on party system (always two parties) Yet, majoritarian vs proportional elections directly influence some policies Method of Analysis

6. Tools of Political Economics INDIVIDUAL PREFERENCES AGGREGATION MECHANISM: POLITICAL INSTITUTIONS COLLECTIVE PREFERENCES

7.  (Economic and Politically) Maximizing Agents  Agents may differ according to an individual characteristic α i  Economic Agent: Maximize Utility function w.r.t. economic variable C i subject to a budget constraint H Vector : Economic policies, taken as given Vector p: data determined by the market A General Policy Problem

8. Economic Agent Problem  Examples: Savings, Labor Supply, Purchase of Goods, Investments (given taxes, fiscal incentives and prices)

9. Political Problem  Policy Maker: Set q taking into account p and constraint G If the constraint is binding → p = P(q)  Political Agent: Maximize Indirect Utility function W (by voting, lobbying….) Individual preferences over the policies W(q; α i ) q* c U1U1 U2U2 U3U3 q

10. Political Agent Problem

11. How do we Aggregate Preferences? Arrow’s (1951) IMPOSSIBILITY THEOREM: Shows that there is NO DEMOCRATIC mechanism which allows individual preferences to be aggregated in a consistent way: A1. RATIONALITY (complete & transitive) A2. UNRESTRICTED DOMAIN A3. WEAK PARETO OPTIMALITY A4. INDEPENDENCE (from irrelevant alternatives) Way out: Drop A2 and restrict individual preferences

12. Political Mechanisms 1.Motivation of politicians OPPORTUNISTIC PARTISAN 2.Timing of Policy Choice PRE-ELECTION politics (Commitment) POST-ELECTION politics (No Commitment) MAJORITY RULE VOTING: A1. DIRECT DEMOCRACY A2. SINCERE VOTING A3. OPEN AGENDA

13. One-Dimensional Policy DEF. 1: A CONDORCET WINNER is a policy q* that beats any other feasible policy in a pairwise voting. DEF. 2: Policy preferences of voter i are SINGLE PEAKED if the following statement is true:

14. Single Peakedness Preferences of agents 6 and 7 are not single-peaked.

15.  Voting decision depends only on the single issue at stake  Given the voter’s preferences,  candidates position themselves on this issue so that they can win the election. Single Issue – Two Candidates Election

16. Voter’s Preferences on Two Issues with (Budget) Constrained Political Decision w1w1 w2w2 O*O*

17. Median Voter’s Theorem If all voters have single-peaked policy preferences over a given ordering of policy alternatives, a Condorcet winner always exists and coincide with the median ranked bliss point (q m ) Corollary: q m is the unique equilibrium policy (stable point) under pure majority rule (A1-A3) Idea: Nash equilibrium of the candidate game. A couple of strategies such that –given that the other candidate plays the Nash equilibrium strategy- the candidate chooses the optimal strategy. There is no profitable deviation for either candidate.

18. A slight detour: Game Theory A game is the mathematical representation of a «situation» where agents interact, i.e. the utility each of them obtains depends on her action and the actions chosen by the other players. Elements of a game: 1)Players 2)Strategies (the set of feasible actions) 3)Payoffs (for each player, for each possible combination of strategies) Typical assumptions: rationality and common knowledge of rationality (CKR) Timing of the game: simultaneous-move vs. sequential-move game

19. A slight detour: Game Theory (cont.)

20.  Intuition: in a Nash eqbm each player plays an optimal strategy, conditional on the other player(s) playing the strategy dictated by the Nash equilibrium itself.  It’s easy to check whether a «candidate» Nash Equilibrium is really so: you have to check that for each player there is no profitable deviation, i.e. a different strategy that would deliver to that player a utility that it is higher than the one she obtains when players play the strategies dictated by that candidate Nash equilibrium.  Message: Easy to kill a candidate Nash equilibrium, typically easier than to find a true one. A slight detour: Game Theory (cont.)

21. Sketch of Proof (two candidates committing on platforms) U q A B C qAqA q* qCqC q’q’’ Median voter: B Condorcet winner: q* Hp.: each candidate receives a payoff of one if she wins the election, zero otherwise. Both candidates offering q* as policy proposal is the Nash Equilibrium of the voting game. Check that there is a profitable deviation for any other couple of proposals. But not for this one!

22. DEF. 3: The preferences of the set of voters V satisfy the SINGLE-CROSSING PROPERTY when the following statement is true: If the preferences of voters in V satisfy the single-crossing property, a Condorcet winner always exists and coincides with the bliss point of the voter with the median value of α i Theorem

23. Multidimensional Policy – Unidimensional Conflict DEF. 4: Voters in the set V have INTERMEDIATE PREFERENCES if their indirect utility function W(q,α i ) can be written as: Theorem If voters in V have intermediate preferences, a Condorcet winner exists and is given by q(α i )

24. Multidimensional Policy  SPATIAL VOTING MODELS: Representation of preferences as some measure of the distance from the bliss point  When does an equilibrium exists? MEDIAN in all directions, i.e. a composite-policy such that the voters are splitted in two even parts according to any policy dimension

25. Condorcet Cycles: Spatial Representation of Preferences y x 1 2 3 A C B 123 A to BBAB B to CBCC C to AAAB B wins against A C wins against B A wins against C

26. Voting Models 1. LEGISLATIVE MODELS: (Post Electoral Politics: decision making rules, agenda setting, allocation of policy jurisdiction, etc.)  STRUCTURE INDUCED EQUILIBRIUM (Shepsle 1979)  AGENDA SETTER (Baron-Ferejhon 1989)

27. 2.INTEREST GROUP MODELS / LOBBYING: (Contributions, informational asymmetries, etc.)  Becker (1983, 1985)  Grossman-Helpman (1994) 3.ELECTORAL MODELS: (Electoral competition between two candidates, distribution of voters preferences, etc.)  PROBABILISTIC VOTING (Dixit-Londregan 1996)  CITIZEN CANDIDATE (Besley-Coate 1997; Osborne-Slivinki 1996)

28. Issue by Issue Voting (SIE) y x 1 2 3 x* y* E x 1 (y) 1.Vote reaction function for each voter i: x i (y) and y i (x) 2.Find the median voter on each dimension 3.Equilibrium is the cross point among the median voters’ reaction function x 2 (y)x 3 (y) y 2 (x) y 1 (x) y 3 (x)