1. 1 The Logic of Collective Action

2. 2 All economic activity in a market economy is undertaken and carried through by individuals for their own ideal or material interests Max Weber 1.Cornerstone concept in modern Public Finance theory 2.Main elements of the logic: Organizations (markets, unions, the state) are formed by individuals with common interests. Organizations provide public or collective goods to its members: goods must be available to everyone if they are available to anyone. When organizations are large, it is in the individual interest of the members to let others pay the burden or costs of the organization (free ride benefits)

3. 3 The Logic of Collective Action Three Examples: 1.Firms in a Competitive Market 2.Producers in an industry that desire a tariff imposed by the government 3.The worker, the state and taxes

4. 4 Firms have common interest in a higher price for industrys product. If all firms reduce output, price rises: all firms are better off. Competitive Market (too many firms): One single firm reducing output does not change market price. Logic of Collective Action: Let other firms cut production, price remains high, any individual firm profit more by deviating from cutting production. 1. Firms in Competitive Markets D S S1 Q P P1 P Q1Qq1 q MC P

5. 5 Equilibrium: All firms maximize their individual profit: MC=MR All produce more, price is lower and industry profits are smaller. Point: though all the firms have a common interest of higher price, it is in the interest of each firm that other firms pay the cost. 1.Firms in Competitive Markets q* P=MR P Q D S

6. 6 Assume that most producers in an industry desire a tariff They form a lobbying organization to put pressure on the government They campaign: MUST devote time and money to organization If the tariff is approved by the government, all producers in the industry will be better off. All producers receive benefits, even if they do not campaign actively Logic of Collective Action: (when the organization is big enough) Let other producers invest more time and money on lobbying. Is not in the interest of the individual producer to assume ANY of the costs himself 2. Producers and Tariffs

7. 7 A State is an organization: Provides public goods for its members, the citizens. Public goods are available to everyone (national defense) It is the interest of all citizens to have better and efficient Public goods. Then, they should be willing to pay more taxes to increase the supply of public goods. Logic of Collective Action: -Let other citizens pay the cost. -Individual tax contribution is negligible -In equilibrium: A higher tax rate is required for everyone, or less public goods or transfers available 3. Workers, wages, the State and Taxes

8. 8 -Consider an economy with populated by I identical workers. -Workers optimally pick consumption c by choosing how many hours n to work in a given period t. -f(n): production function. -w: wage. -A government distributes transfers to workers. -Government finance transfers by collecting a tax on the wage (1- )w. -Assume a worker does not value transfers to others as much as income to herself. 3. Workers, wages, the State and Taxes

9. 9 Blue Equilibrium: No Tax Workers equate MRS=wage Red Equilibrium: With Tax and Transfer Workers equate MRS= (1- )w Less Hours Worked, Less taxes paid. 3. Workers, wages, the State and Taxes ntnt CtCt w (1- w

10. 10 C Workers are optimal in A. They prefer everyone else to produce in B (not optimal) Workers in A (free ride) effort and extra revenue paid by workers in B This is NOT an equilibrium The economy moves to C, and this implies more taxes or less transfers to everyone Logic of Collective Action ntnt CtCt (1- w A B