Public Choice. M.Sc. in Economics (6 Credits) Prof. Dr. Andreas Freytag LS Wirtschaftspolitik, FSU Jena

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1 Public M.Sc. in Economics (6 Credits) Summer Term 2018 Monday, c.t., Start April 9, 2018, Carl-Zeiss-Str. 3, SR 208 Prof. Dr. Andreas Freytag LS Wirtschaftspolitik, FSU Jena Freytag

2 Announcement I: Consulting hour: upon appointment Time and venue of the written exam: tba Net time is one hour Please subscribe at Friedolin Freytag

3 Announcement II: Exercise The exercise is performed by Christoph Dörffel, M.Sc. and Miriam Kautz, M.Sc. Tuesday, c.t., Start April 24, 2018, Carl-Zeiss-Str. 3, HS 9 Consulting hour: upon appointment Freytag

4 Uber is represented in 570 cities, but not in Germany Why? Some run-down areas in the British South-West are rarely considered by British governments when it comes to regional funds Why? Ordinary steel is produced cheapest in China and India, nevertheless the US and the EU protect the steel market - Why? Low interest rate policies have never proven ineffective; the ECB insist on its Why? Jacob Zuma is highly corrupt but was safe for long - Why? Farming in the EU is employing less than 2 per cent of the labor force, its contribution to GDP is about 1.5 per cent. Though, there are own ministries for agriculture Why? Freytag

5 Description of the lecture: The course Public offers a concise and comprehensive introduction into the positive foundations of collective action, theoretical, empirical and political. The lecture aims at providing the students with analytical tools to understand the political background of economic policy. After an introduction, the lecture covers the origins of the state. We proceed by analyzing direct democracy. The main part (chapter 4) of the lecture is dedicated to the political economy of a representative democracy. Topics are: federalism, two party competition, multi party competition, paradox of voting, rent seeking, bureaucracy. In a subsequent step, the theory is applied to real world phenomena and tested empirically. Chapter 6 deals with normative issues how to organise a polity etc. Basic reading is Mueller, D.C. (2003): Public III, Cambridge Freytag

6 Index 1. Introduction 3. Public in a Direct 4. Public in a Freytag

7 Literature (suggested Selection) Aidt, Toke (2018), Corruption. Chapter for the Oxford Handbook in Public, Oxford. Arrow, Kenneth J. (1951), Social and Individual Values, New York. Becker Gary S. (1983), A Theory of Competition among Pressure Groups for Political Influence, The Quarterly Journal of Economics, Vol. 98, pp Becker, Gary S. (1985), Public Policies, Pressure Groups, and Dead Weight Costs, Journal of Public Economics, Vol. 28, pp Black, Philip, Estian Calitz and Tjaart Steenekamp (eds.) (2011), Public Economics, 5 th ed., Cape Town. Brennan, Geoffrey and James M. Buchanan (1985), The Reason of Rules, Cambridge. Buchanan, James M. and Gordon Tullock (1962), The Calculus of Consent, Ann Arbor. Coase, Ronald H.(1960), The Problem of Social Cost, Journal of Law and Economics, Vol. 3, pp Downs, Anthony (1957), An Economic Theory of, New York. Drazen, Allan (2000), Political Economy in Macroeconomics, Princeton. Freytag

8 Frey, Bruno S. (2004), Dealing with Terrorism Stick or Carrot?, Cheltenham and Northampton. Hibbs, Douglas A., Jr., (1977), Political Parties and Macroeconomic Policy, American Political Science Review, Vol. 71, pp Hillmann, Arye L. (1989), The Political Economy of Protection, Chur/New York. Holcombe, Randall (2006), Public Sector Economics, New Jersey. Magee, Stephen P., William A. Brock und Leslie Young(1989), Black Hole Tariffs and Endogenous Policy Theory: Political Economy in General Equilibrium, Cambridge. Mueller, Dennis C. (2003), Public III, Cambridge. Niskanen, William A., Jr. (1971), Bureaucracy and Government, Chicago. Nordhaus, William D. (1975), The Political Business Cycle, Review of Economic Studies, Vol. 42, pp Olson, Mancur, Jr. (1965), The Logic of Collective Action, Cambridge, MA. Olson, Mancur, Jr. (1982), The Rise and Decline of Nations: Economic Growth Stagflation and Social Rigidities, New Haven. Rose-Ackermann, Susan and Bonnie J. Paflika (2016), Corruption and Government, Causes, Consequences, and Reform, Cambridge. Freytag

9 Schneider, Friedrich and Dominik H. Enste (2000), Shadow Economies: Size, Causes and Consequences, Journal of Economic Literature, Vol. 38, pp Shughart II, Willim F. und Laura Razzolini (eds.) (2001), The Elgar Companion to Public, Cheltenham and Northampton. Tullock, Gordon (1980), The Welfare Costs of Tariffs, Monopolies and Theft, in: James M. Buchanan et al. (ed.), Toward a Theory of the Rent-Seeking Society, Texas, S Wintrobe, Ronald (1998), The Political Economy of Dictatorship, Cambridge: Cambridge University Press. Basic: Dennis Mueller, Public III. Special current references will be given at the very topic. Freytag

10 Websites (Selection) OECD: World Bank: World Trade Organization (WTO): International Monetary Fund: European Commission: Center for the Study of Public : Public Society: European Public Society: publicchoice/ Cato Institute: Fraser Institute: VoxEU: European Centre for International Political Economy (ECIPE): Freytag

11 3. Public in a Direct 4. Public in a 1. Introduction Mainstream economics is generally dealing with two types of questions: Normative analysis: how can individual or collective welfare be improved? Positive analysis: What can we learn about human behavior? Is man indeed a utility maximiser? How can we explain minor economic outcome against the background of theoretical analysis? The latter set of questions is relevant for this lecture. We seek to explain the incentives for policymakers, i.e. politicians, bureaucrats and organized interests as well as the outcomes of collective choice. Freytag

12 3. Public in a Direct 4. Public in a Individualistic approach, rational behavior Dismissal of the benevolent dictator Thereby, we also try to explain the sometimes huge difference between the policy recommendation, achieved by thorough theoretical analysis, and political reality. Public has taken three directions: logical, theoretical analysis, empirical investigation, normative critique. Freytag

13 3. Public in a Direct 4. Public in a It has close relations to the New Institutional Economics and Constitutional Economics. The new institutional economics discusses the role of institutions in the market sphere and in the political sphere. Institutions are the rules of the game in a society, or more formally, are the humanly devised constraints that shape human interaction.reduce uncertainty by providing a structure to everyday life. (Douglas North 1990). Freytag

14 3. Public in a Direct 4. Public in a Fundamental Questions of Public Analysis What do political science and economics have in common? Why do we need the state and public decision making? What is the incentive structure of decision makers in a direct democracy? a representative democracy? a dictatorship? a cleptocracy? Do voting rules affect economic outcomes? Why do some interest groups organize themselves better than others? Why do countries with a dictator sometimes perform better than democracies? Freytag

15 3. Public in a Direct 4. Public in a Why do we observe poverty and starving on the one hand and wealth on the other hand in similar countries? Why do we observe hyperinflation? Why is structural change so often repressed? Why can we observe left governments pursuing supply side policy? Why are political parties often so similar with respect to their programs? Why does social spending increase in time? Do elections terms exert influence of macroeconomic performance? Why are public enterprises inefficient? What are the incentives of bureaucrats? How can we explain the sectoral structure of protection and subsidization? Freytag

16 3. Public in a Direct 4. Public in a Is it rational for governments to support criminal activities? How can we explain violence and civil conflict? Is terrorism rational? How can it be combated rationally? What is the dictator s dilemma? How can we explain the disappointing performance of most international organizations (IOs)? Why is official development aid so ineffective? Why do reforms not happen? Why do reforms happen? Are scientists, e.g. academic economists, different? Freytag

17 3. Public in a Direct 4. Public in a I. The state and rule enforcement II. The state and allocation a) Externalities b) Asymmetrical information c) Natural monopolies III. The state and redistribution Basic literature is Mueller (2003), pp Freytag

18 3. Public in a Direct 4. Public in a I. The State and Rule Enforcement The state is needed to set rules and take care for enforcement on a just basis. Enforcement needs a strong state: Police Armed forces Independent judiciary Checks and balances Normative statement Constitutional Economics (see below) Freytag

19 3. Public in a Direct 4. Public in a The view of the state in Economics is that it is the organisational structure of a polity. The state is not regarded as standing above the human being Constitutional Economics or citizens vs. (subjects) Untertanen! Members of society agree unanimously on a social contract or a constitution. As long as actions are made within these rules, the outcome is perceived as being fair. In this view, there are three types of reasons for the existence of the state. It is necessary: to set and enforce rules, to take care for allocation, and to organise redistributive policy. Freytag

20 3. Public in a Direct 4. Public in a Constitutional Economics: Social contracts 1) A just social contract (John Rawls) Rawls argues with an original position with total equality; each member of the community gives up her knowledge about her position in society and steps behind a veil of ignorance. Equality in the original position leads to unanimity over the social contact. The economic outcome is perceived as being the result of a gamble with random results; therefore it is not acceptable. Two principles of justice: equal rights to most extensive basic liberties; equal distribution of social values Maximin! Freytag

21 3. Public in a Direct 4. Public in a 2) Constitutional economics (James Buchanan and Gordon Tullock) Buchanan and Tullock (1962): no normative position, they assume unanimity at the constitutional stage. Homann and Vanberg have given up this assumption fictious consensus is satisfying the conditions. The veil is a veil of uncertainty, as any individual can be sure about the rules of the game, but not its outcome. This will be accepted as long there is no betrayal. Different types of uncertainty: Identity, numbers and payoffs. Freytag

22 3. Public in a Direct 4. Public in a II. The State and Allocation Allocation theory shows that in general, markets are efficient and generate welfare optima (without notice of distribution). However, there are cases of market failure. Three forms can be distinguished: externalities, asymmetrical information, natural monopolies. For many, these are the main reasons for the state to act economically. If the markets fail, governmental intervention is necessary to care for efficient allocation. Freytag

23 3. Public in a Direct 4. Public in a a) Externalities aa) Definition: Economic activity of one person (firm) has an impact on the consumption or production of another person or firm. Consumption U i = U i (x i, y i, Z), the utility function contains arguments not to be influenced by individual i. Production x = x (K x, L x, Z), the production function of x is influenced by an activity of a third person (firm). Freytag

24 3. Public in a Direct 4. Public in a In such a case, the government has to try to internalise these external cost. Pigou tax, Pigou subsidy, property rights Economic problem: exact measurement of cost. Political problem: exact definition of property rights. Market Failure versus state failure. State failure implies inappropriate definition of property rights, economically inefficient internalisation of external cost etc. It has no moral dimension. Freytag

25 3. Public in a Direct 4. Public in a bb) Coase Theorem Ronald Coase has shown that in the absence of transaction cost and with clearly defined property rights external effects do not exist. In addition, it does not matter for the economic efficiency and ecological effectiveness whether the party responsible for damages or that party suffering from damages has the property rights. However, transaction cost is rarely negligible and property rights are sometimes difficult to define. The Coase solution is almost impossible to reach. Nevertheless, Coase demonstrated the irrelevance of distribution of property rights as well as the relevance of transaction cost. Freytag

26 3. Public in a Direct 4. Public in a Normative and positive aspects of environmental policy There are several ways to internalise external cost: Ordnungsrecht emission thresholds technological standards Pigou-tax Standard-price-approach private negotiations (Coase) Emission Banking Bubble Policy Emission certificates Public choice does not analyse the normative properties, i.e. economic cost and ecological effectiveness, but the reason for policymakers to choose a certain environmental policy; again market versus state failure. Freytag

27 3. Public in a Direct 4. Public in a cc) Public goods Public goods as extreme case of (positive) externalities: non rivalry (jointness) in supply and impossibility of exclusion. Types of goods: private good, common pool property, club good, public good, merit goods, Free rider problem as the basic problem of collective choice. Freytag

28 3. Public in a Direct 4. Public in a Free rider problem What are individuals willing to pay for the provision of a public good? Simple but only seemingly precise answer: nothing. More complicated answer: it depends, on what? individual gains from cooperating differences in individual gains level of state activities already reached group size social conventions Prisoners dilemma vs. coordination games and chicken games Freytag

29 Figure 2.1: Prisoners s dilemma 3. Public in a Direct 4. Public in a A B Does not Steal Steals Does not steal 1 (10,9) 4 (7,11) Steals 2 3 (12,6) (8,8) Source: Mueller, Dennis C. (2003),, p.10. Freytag

30 3. Public in a Direct 4. Public in a Figure 2.2: A coordination game D Strategy A G Strategy 1 A (a,a) Strategy B 4 (0,0) Strategy B 2 (0,0) 3 (b,b) Source: Mueller, Dennis C. (2003),, p.15. Freytag

31 3. Public in a Direct 4. Public in a Figure 2.3: A game of chicken G D Contributes to building fence Contributes to building fence 1 (3,3) 4 Does not contribute (2, 3.5) Does not contribute 2 (3.5, 2) 3 (1,1) Source: Mueller, Dennis C. (2003),, p.16. Freytag

32 3. Public in a Direct 4. Public in a The prisoner s dilemma shows the typical problem related to the provision of public goods, namely free riding. The coordination game is solved, as both individuals gain most from cooperating dominating strategy. No one can improve his situation at the expenses of others. The latter game will at any rate been solved at a maximum when it is repeated, whereas the prisoner s dilemma can (but not must) evolve again and again. The game of chickens is the most tricky one, as cell 1 is not the dominant strategy. It may be advantageous to signal credibly not to contribute. In this case, the partner may still choose to contribute. Application in international affairs Freytag

33 3. Public in a Direct 4. Public in a b) Asymmetrical information Principal-agent-problems (PAP), whether defined as adverse selection (ex-ante) or as moral hazard (ex-post), cause markets to fail. Ownership and control are separated. Examples are: market for insurances, labour markets, quality aspects (consumer protection). The regulation of these markets is aiming at healing the market failure; it may, however, lead to state failure: insurance: overregulation, capture; labour market: employment protection legislation; consumer protection: trade protectionism. Freytag

34 3. Public in a Direct 4. Public in a c) Natural monopoly A natural monopoly exist, if (marginal and) average cost decrease in the relevant demand areas under a given technology. Only one firm can serve the demand without welfare losses. Here is a need for regulation, e.g. by: price regulation (cost oriented, rentability oriented, ECPR, Price Caps, Ramsey-rule); capital return regulation; competition for the market; prohibition of discrimination; structural separation of multi product firms; limitation of activities. Problem: regulatory capture* * Literature: Stigler, George J. (1971), The Theory of Economic Regulation, Bell Journal of Economics and Management Science, Vol. 2, pp Freytag

35 3. Public in a Direct 4. Public in a III. The Redistributive State A Pareto efficient allocation of resources and goods may not be just. Society may feel the need to redistribute income and to even out huge income differentials as well as to insure its members against severe risks of life. These risks include illness, unemployment, wealth losses. Age cannot be regarded as risk, rather as a chance! Nevertheless, there may be the need for collective action with respect to old age protection: externalities, moral hazard. Freytag

36 3. Public in a Direct 4. Public in a How can the redistributive state act? 1) Redistribution as insurance/ social contract. 2) Redistribution as public good. 3) Redistribution to satisfy fairness norms. 4) Redistribution to increase allocative efficiency. It may be possible to model these types in a way to reach unanimity about it. Notwithstanding, governments may go too far or exploit certain groups by purpose: 5) Redistribution as taking. Of course, the organisation of redistribution has impact on economic incentives shadow economy, corruption. Freytag

37 3. Public in a Direct 4. Public in a Redistribution as taking Table 2.1 Costs and benefits of the EU s common agricultural policy in comparison with free market outcome, 1980 (mio of US$) country producers consumers government net EC-9-30,686 34,580 11,494 15,388 West Germany -9,045 12,555 3,769 7,279 France -7,237 7,482 2,836 3,081 Italy -3,539 5,379 1,253 3,093 Netherlands -3,081 1, Belgium/ Luxembourg -1,24 1, UK -3,461 5,174 1,995 3,708 Ireland Denmark -1, Source: Mueller, p. 62. Freytag