2. Political economy Government growth Today: How do people vote in a democracy? Why did the government grow so much in the 20 th century?

3. Democracy Political decision making is important for public finance Two types of democracy in this “mini-lecture”  Direct  Indirect, or representative

4. Direct democracy There are different ways to make decisions in a direct democracy  Unanimity, especially of public goods purchases Lindahl prices  Majority voting rules Possible cycling with three or more choices Median voter theorem  Arrow’s impossibility theorem

5. Unanimity with public goods Suppose there are two people trying to find the efficient level of public goods purchases Each person could decide on a quantity to purchase  Free-rider problem Each person could decide on a quantity to purchase, given what fraction he or she would pay  The share paid is known as a Lindahl price

6. Direct democracy: Unanimity rules r per year 0 0’ Adam’s share (S A ) Eve’s share (S E ) DrADrA The Lindahl Model DrEDrE r* S* Notice that by construction of graph, shares add up to one at each point

7. Feasibility of unanimity rules Reaching equilibrium  Time and negotiation costs are usually very high when many people are involved Strategic behavior  One person could react to how he or she thinks the other will behave  Strategic behavior can prevent efficient results from occurring

8. Majority voting rules Majority voting relies on all voters having single-peaked preferences With single-peaked preferences…  The person with median preferences can essentially make the decision (under certain conditions) Trading votes may or may not increase welfare  Programs that lower overall welfare are known as “pork”

9. Jen: Double-peaked preferences Missiles Utility A BC Brad Jen Angelina Single-peaked preferences Double-peaked preferences

10. Preferences When at least one person does not have single-peaked preferences, we can get cycling  Cycling occurs when no clear winner can be established

11. Single-peaked preferences Each person has single-peaked preferences here  Brad’s peak is at A  Jen’s peak is at C  Angelina’s peak is at B A vs. B: B wins A vs. C: C wins B vs. C: B wins B is the clear winner Voter ChoiceBradJenAngelina FirstACB SecondBBC ThirdCAA

12. Back to Jen’s two peaks This example is different from the previous one  Jen now has double-peaked preferences A and C are both peaks We now get cycling  A vs. B: A wins  A vs. C: C wins  B vs. C: B wins  No clear winner  This inconsistency is part of a voting paradox Voter ChoiceBradJenAngelina FirstACB SecondBAC ThirdCBA This example is the same as in the graph a few slides ago

13. Suppose Angelina is in charge Agenda manipulation: Someone can decide on the order of votes to get her or his first choice  Suppose Angelina decides the order of votes to get her most- desired choice  First, A vs. C: C wins  Second, B vs. C: B wins  B is implemented Voter ChoiceBradJenAngelina FirstACB SecondBAC ThirdCBA

14. The median voter theorem When preferences of each person are single peaked, we can assign a “median voter” Relative to the median voter  Half of the people want more  Half of the people want less Under certain conditions, the median voter’s preferences will be approved

15. The median voter theorem VoterMost desired expenditure on breast cancer research Abby$50 Betty$1,000 Christine$1,100 Doris$2,500 Elaine$50,000 Median voter theorem predicts that $1,100 will be voted on

16. Six reasonable criteria for decision making Kenneth Arrow studied six criteria that many people would consider “ethically acceptable” Unfortunately, there is no guarantee that all six criteria can be followed  This proof is known as Arrow’s Impossibility Theorem What are the six criteria? Kenneth Arrow, 2004

17. The six criteria that Arrow proposed It can produce a decision whatever the configuration of voters' preferences  No problems due to multipeaked preferences It must be able to rank all possible outcomes It must be responsive to individuals’ preferences  Example: If everyone prefers A to B, then society does too Preferences must be transitive  If A is at least as good as B, and B is at least as good as C, then A is at least as good as C Independence of irrelevant alternatives  Relative rankings of two goods do not depend on a third good Dictatorship ruled out  Social welfare is a function of more than one person

18. Representative democracy In a representative democracy, a subset of the population votes to determine who our elected politicians are  Median voter theorem applies here also, assuming single-dimensional rankings and exactly two candidates  Ideology, personality, and leadership abilities of the politician may matter to voters  If no candidate appeals to a voter he or she may not vote

19. Median voter theorem in one dimension Number of Voters LiberalConservative Median voterS If a candidate takes position S, the opponent can take the median voter stance and get a majority of the votes

20. Implications of the median voter model Based on the median voter model…  Two-party systems tend to be stable  Replacement of direct referenda by representative system has no effect on outcomes

21. Logrolling Logrolling is the act of politicians trading votes in order to pass legislation that is beneficial to their district  Some logrolling improves welfare  Some logrolling does not improve welfare An example  Suppose that Waldo, Xavier, and Zach each live in a different congressional district  Note that this example uses a different approach than in the book

22. Logrolling In each case, Waldo, Xavier, and Zach’s representatives can get together to try to pass each other’s projects If all three projects are passed together, Waldo, Xavier, and Zach are each better off Whether or not the logrolling leads to welfare improvements depends on the cost to others

23. Welfare-improving logrolling ProjectWaldoXavierZachothersTotal net benefits Park500-200-250-3020 Beach restoration -200750-300-100150 Tree planting -200-300750-75175

24. Bring on the pork ProjectWaldoXavierZachothersTotal net benefits Park500-200-250-130-80 Beach restoration -200750-300-350-100 Tree planting -200-300750-275-25

25. Public employees Public employees fulfill legislated mandates and operate many government operatives  Bureaucrats sometimes have interpretive power  Red tape criticism Unresponsive to reasonable requests  No market-oriented incentives Some bureaucrats want to maximize the size of their departments  Niskanen’s model of bureaucracy

26. Niskanen’s model of bureaucracy Q per year $ 0 V C Q* Efficient output Q bc Bureaucrat’s suggested output

27. What can the politician do? A politician can change the quantity to Q* if he or she knows what Q* is  Sometimes, only the bureaucrat knows what Q* is Make bureaucrats’ pay dependent on quality of work  Requires costly oversight Hire bureaucrats that are reliable in determining what Q* is  Probably difficult

28. Special interests “Special interests” has become a politically- charged term in today’s political arena What are some special interest groups?  Labor groups  Groups that favor the rich, poor, young, or old  Groups that favor tax breaks for an industry  Groups that want to enhance social and religious goals  Rent-seeking behavior Attempts for a firm to have positive economic profits

29. Rent-seeking behavior tons of peanuts per year $ S=MC D MR Rents Competitive outcome Cartel price and quantity Deadweight loss with a cartel

30. Other people involved Other people help to carve the political landscape  Judges have control to enforce and interpret laws  Media influence Providing information Political leanings  Experts  Former politicians Example: Al Gore

31. Summary: Democracy Democracies can be direct or indirect Both types of democracies have their own sets of problems  Direct democracies Time consuming to people Cycling Arrow’s Impossibility Theorem  Indirect democracies Bureaucrats Special interests

32. Growth of government spending Many western countries have had significant growth in government spending since 1900 How is this growth justified?  Many theories examined  No single theory fully explains the growth Can government growth be controlled?

33. Explaining Government Growth Five theories of government growth  Citizen preferences  Marxist view  Chance events  Changes in social attitudes  Income redistribution

34. Citizen preferences Take the median voter’s preferences of public sector goods and services  G = f(P, I) G represents the median voter’s demand for public sector goods and services P is the relative price of public sector goods and services I is income

35. Citizen preferences Assume median voter theorem is true  When income increases, if income elasticity of demand is greater than one for the median voter, increased public services would be provided  Growth of the middle class may explain why government spending has grown so much This theory predicts that voters get what they want

36. Marxist view A Marxist model would argue that the private sector overproduces  Government must expand expenditures to correct this Worker discontent is curbed by social service spending Some argue that this is not sustainable, since expenditures will eventually outpace tax revenue capacity  See Figure 18.6, p. 423, for more on tax revenue capacity

37. Government shocks Chance events lead to shocks on the government These shocks require the government to increase spending substantially  Examples: The Great Depression; the world wars; the financial crisis of 2008-’09 Inertia  increased spending sticks  Special interest groups try to make sure that “their” spending does not go away

38. Changes in social attitudes Are people making bigger demands on government?  Maybe  Due to median voter theorem? Costs and benefits may also be incorrectly perceived by the public

39. Income redistribution Two views  Government grows to help low-income voters Some politicians can promise redistribution to median income and below Incomes above the median get taxed to pay for income redistribution  Government grows to help the middle class Appeals to voters near median income With this view, the upper- and lower-income classes pay for the benefit of the middle class

40. Controlling government growth Some people believe that government is not too big Others disagree If the government is too big, how can we make it smaller?  Change bureaucratic incentives  Change fiscal institutions  Institute constitutional limitations

41. Change bureaucratic incentives Recall Niskanen’s model of bureaucracy  Bureaucrat often worries about size of department, not what is efficient Financial incentives for cost-cutting could backfire, however  Q could be below Q* Private provision may be more efficient

42. Change fiscal institutions Is the budget-making process undisciplined?  Many people believe so  Congress-imposed solution: Budget Enforcement Act (BEA) of 1990 Spending and revenue targets are set The cap can be exceeded when an elaborate set of parliamentary rules are followed  Problems with BEA Some “emergency” spending is known in advance  2000 census

43. Institute constitutional limits If Congress cannot regulate its own spending, should there be a constitutional amendment that does limit spending? Most economists believe “no”

44. Why not to impose constitutional limits Revenue and spending is usually uncertain until it happens  If tax revenue was overestimated, severe spending cuts would have to occur mid-year Spending could be forced on states instead  States could be mandated to provide part of Social Security What would the consequences be if Congress circumvents the law?  Judicially-imposed budget?  Will Congress members be punished?

45. Outcome of government spending Estimated public debt in 2010  $9.9 trillion (up $2 trillion from 2009)  67.1% of GDP (up 12.5 percentage points from 2009) Source: Wikipedia article on US public debt

46. Summary: Growth of gov’t spending Although political models have appeal on government spending, they do not fully explain how governments behave Many people believe that government spending needs more control  BEA and current incentive structure ineffective  No constitutional amendment for balanced budget Probably goes too far

47. Problems Lindahl model Majority voting Median voter theorem Efficient government spending

48. Lindahl problem Bill and Hillary have decided to be roommates in Washington DC  They decide to use Lindahl prices to determine the amount of money they will spend on a new sofa  Q represents spending on a new sofa Bill’s share is S B = 1 – Q/500 Hillary’s share is S H = 1 – Q/400  Also note that S B + S H = 1

49. Lindahl problem How do you solve this?  3 equations  3 unknowns  Plug in first two equations into the third equation (1 – Q/500) + (1 – Q/400) = 1 (1 – 4Q/2000) + (1 – 5Q/2000) = 1 2 – 9Q/2000 = 1 1 = 9Q/2000 Q = 2000/9 = 222.22

50. Majority voting problem 5 members on a city council 4 options: A, B, C, D  Assume each member will vote no unless specified below Frank: Will only vote in favor of A Genevieve: Will vote in favor of B; will vote for A if B is defeated first Holly: Will definitely vote in favor of B or C if either is voted on; will vote for A if B and C are both defeated first Ivan: Will definitely vote in favor of A or D if either is voted on; will vote for B if A and D are defeated first Jacqueline: Will definitely vote in favor of C and D if either is voted on

51. Majority voting problem Which projects have a chance? FrankGenevieveHollyIvanJacqueline AY??YN BNYY?N CNNYNY DNNNYY

52. Majority voting problem Which projects have a chance? A and B FrankGenevieveHollyIvanJacqueline AY??YN BNYY?N CNNYNY DNNNYY

53. Majority voting problem Can we get A to pass?  Yes: Have Frank to control the voting process  Step 1: Vote on B  Only Genevieve and Holly will vote in favor  Step 2: Vote on C  We know that C will never pass  Step 3: Vote on A  Since B and C have both been defeated, Holly will also vote in favor of A FrankGenevieveHollyIvanJacqueline AY??YN BNYY?N

54. Median voter theorem problem In Santa Barbara, the distribution of desired spending on beaches in the population is as follows  Normal distribution  Average desired spending is $600,000 per year  Standard deviation is $100,000 per year If you were a politician running for the Santa Barbara city council, what should your stance on this be?

55. Median voter theorem problem What should your stance be?  If you believed the median voter theorem, your stance should be consistent with the median voter In a normal distribution, the mean and the median are the same  Stance should be to spend $600,000 per year

56. Efficient government spending problem Q is millions of dollars spent per year on a government project  Thus, total cost is Q Total value of the government project  V = 100Q ½ What is efficient? What is the output predicted by Niskanen’s model?

57. Efficient government spending problem What is efficient?  Set MB = MC  MB is the derivative of the total value with respect to Q MB = 50/Q ½  MC is the derivative of the total cost with respect to Q MC = 1  50/Q ½ = 1  Q = 2,500

58. Efficient government spending problem What is the output predicted by Niskanen’s model?  Set V = C  100Q ½ = Q  Q = 10,000

59. See you on Wednesday