Lecture I:

Political Economy and Public Finance: Overview

Tim Besley, LSE

Why should economists care about political economy issues?

{ To understand the proper role of the state, it is important to ap-

preciate how incentives work in the public sector.

{ Could inform constitution design issues

{ Helps to appreciate the relevance of normative models of policy

{ Traditionally economists have looked at government through a par-
adigm which ignores the performance of government.

Political economy { new and old

{ The main in uential strand of thinking in economics has been Pub-

lic Choice theory

{ But

It has rarely speci ed in detail the incentive problems that gov-

ernment faces

It throws around terms like government failure and political fail-

ure very loosely
 It works with an excessively pessimistic view of politics.

{ In contrast:

My approach is heavily in uenced by thinking about politics as

a principal agent problem.

Also by worrying about selection issues

{ Clearly government can work in both the public and private interest,
but the question is whether the agency problems can be solved and
what are there implications.
 Comepting Views of Government

Government in the public interest (Pigou)

{ the market failure paradigm

{ the notion of optimal income distributions

link to social choice theory.

Government as a private interest (Buchanan)

{ rent-seeking

{ log-rolling
{ corruption
The public choice literature is that it was born as critique of one of
the most admired political systems in the world (the U.S.)

{ This contrasts with Hayek's critique of socialism which put much

more weight on the problem of omniscience than the problem of
non-benevolence.

{ It is has a special poignancy in view of the triumph of liberal democ-

racy.

{ It is now appreciated that the institutions of liberal democracy are

no panacea.
 The public choice approach (Buchanan)

\Individuals must be modeled as seeking to further their own narrow-

self interest, narrowly de ned, in terms of measured net wealth posi-
tion, as predicted or expected." (Buchanan (1989, page 20)).

This view is shared by Chicago political economy (e.g. Peltzman).

Also David Hume!

\In contriving any system of government and xing several checks

and controls of the constitution, every many ought to be supposed
a knave and to have no other end, in all his actions, than private
interest. By this interest, we must government him, and by
means of it, nothwithstanding his insatiable avarice and ambition,
co-operate to the public good." (Hume (1875) page ...)

\To improve politics, it is necessary to improve or reform rules, the

framework within which the game of politics is played. There is no
suggestion that improvement lies in the selection of morally superior
agents who will use their powers in some \public interest"" (Buchanan
(1989, page 18)).
 My View (owes a lot to Madison)

Motivated agents { those who are willing to perform acts of public

service are a part of the economic and political landscape.

A key issue is to how bene t from such motivated agents.

This means moving beyond a very narrow paradigm based on pure

self-interest

This means that selection matters

\The nature of the workings of goverment depends ultimately on the
men who run it. The men we elect to o ce and the circumstances
we create that a ect their work determine the nature of popular gov-
ernment. Let there be emphasis on those we elect to o ce." V.O.
Key (1956), page 10.
 Background Facts:

Increase in size of government { a feature of democracy

Declining trust?

Increasing transparency?
 Standard Economic Model of Policy

A community of individuals (citizens) have to make a policy choice

denoted by x.

Feasible set of policies by A.

Preferences are V i (x) for i = 1; :::; N .

Pareto e ciency. A policy x is said to be Pareto if e cient if there

is no other policy in A which makes every citizen either weakly or
strongly better o .
 { De nes a set of policies.

n oN
Welfarist social welfare functions are de ned on i
V ( x) .
i=1

{ These will pick from among the Pareto e cient policies

{ Non-welfarist objectives do not necessarily pick Pareto e cient

points.

This de nes a paradigm for good (benevolent) government and has

been taught to generations of economics students.
 Critiques of the Standard Economic Model

Substance:

{ Di culties in de ning social welfare

{ Rights based approaches

Sen

Buchanan

Relevance

{ Public choice critique:

 There is no real reason to expect the government to pick a Pareto
e cient policy

There is even less reason to expect a welfare maximizing policy

The economic model is not closed (it does not have a theory of
government).

\It is not su cient to contrast the imperfect adjustments of unfettered

enterprise with the best adjustment that economists in their studies
can imagine. For we cannot expect that any State authority will
attain, or will even whole-heartedly seek, that ideal. Such authorities
are liable alike to ignorance, to sectional pressure and to personal
corruption by private interest." Guess who?
 Augmenting the Standard Economic Model

I. Process

Consider a vector of \political actions"

{ x = P (y ) :

{ V i (x; yi)

{ We could also allow A to depend on y .

{ We need to de ne equilibrium political actions x = h (P ( )) ; y =

f (P ( )).
We can then de ne optimality relative to processes rather than policies:

v j (P ( )) = V j (h (P ( )) ; f (P ( ))) :

In principle, the standard economic apparatus can be applied to the

study of processes rather than policies

i.e., e ciency and optimality.

II. Politicians

The above was rather a disembodied view of th policy process.

But policy is made by politicians and competition is for political o ce.

{ V i (x; j ) where j is the identity of the citizen who is in o ce.

{ x 2 Aj .

One key issue is how politicians view holding o ce:

{ Pure o ce holding
(
v i ( x) + if i = j
V i (x; j ) =
v i ( x) otherwise.
{ Pure sel sh: V i (x; j ) is just the personal payo from policies (cre-
ates a premium from holding o ce).

{ Pure Policy Oriented: V i (x; j ) = V i (x) with no-indepdent o ce

holding payo .

Comptence is captured by Aj .
 Bottom Line

The standard economic apparatus and welfare economic tools are easily
adapted to political economy.

As we will see below, it is fairly straightforward, therefore, to have

an account of good government which goes beyond the standard eco-
nomic model

{ Good and bad decision making processes

{ Good and bad selection { is the right political class being selected?
 Modeling Elections

Downsian model and its variants

Citizen-candidate model { allows us to think about selection of politi-

cians

Political agency models { focus on information

 Good Government

Welfare economics provides a foundation for the notion of good gov-

ernment in terms of two criteria

{ e ciency

{ equity

{ there is also the murkier criterion of surplus maximization

Buchanan works with quite a di erent paradigm { rooted in classical

liberalism
 { government is a contract that should generate a Pareto improve-
ment over the \no government" situation.

We will not look at three de nitions of political failure that are rooted
in these possibilities.

{ Pareto Ine ciencies

{ Distributional Failures

{ Wicksellian political failures

 Political Resource Allocation and Political Failure

The Model

{ A community of N individuals has to make a single social decision

{ whether to build a discrete public project.

{ Project is denoted by e 2 f0; 1g

{ There are two kinds of citizens { those who get a utility of b from
the project and those who receive nothing.

{ The citizens who enjoy the project are a fraction of the popula-
tion.
{ All citizens have an income of y and the statue costs c. (Assume
that y > Nc .)

{ Observe that e = 0 and e = 1 are both Pareto e cient policy

choices in this setting.

{ Utilitarian perspective (same as social surplus in this context.)

{ Project is worthwhile if
N b c:

{ Lindahl-Samuelson rule

{ Building the project fails Wicksell's unanymity test.

Not true with bene t taxation.

 Public Resource Allocation

Majority rule:

e = 1 if 1=2 and e = 0 otherwise.

The median voter outcome is always Pareto e cient.

The literature is confused about this.

Majority rule need not coincide with the surplus maximizing outcome
if < 1=2 since then the project will not go ahead even though
N b > c.

Majority generates a Wicksellian political failure if 1:

Corruption

{ The policy maker can earn a private monetary rent of r > 0 for
building the project whether or not it is worthwhile.

{ (To keep the model closed, we suppose that this is paid as a transfer
by some subset of the citizens.)

{ Suppose that
r > c=N y:

{ Then the policy maker will implement the project regardless of his
personal preferences for it.

{ The policy outcome is, therefore, always e = 1.

{ The utility of the citizens depends on whether they nance the
transfer.

{ Suppose that a fraction of < do this.

{ Then those who favor the project and share the cost of the transfer
get utility of
b c=N y r=N
while those in favor who do not pay receive:

b c=N y:

{ Citizens who do not favor the project transfer have a payo of

c=N y:
{ Assuming that b c=N y r=N > 0, corruption cannot generate
a Pareto ine cient policy outcome in this setting.

{ The transfers made are individually rational { the e ect is purely

a movement around the Pareto frontier.

{ Since we have assumed that N b > c, corruption here actually

increases social surplus relative to any policy which generates e =
0.

{ Corruption here generates a Wicksellian political failure

But this assumes that is always used to increase intervention.

Corruption could actually be good from a Wicksellian point of

view if it reduces intervention.
Costly Rent-Seeking

{ Suppose that citizen i can pay yi to in uence the policy maker to

go ahead with the project.

{ This uses real resources, i.e. cannot be appropriated by the policy

maker.

{ Let total resources in favor be Ef and the total against is Ea.

{ Probability that the project goes ahead is:

Ef
Ef + Ea

{ We look for a Nash equilibrium in in uence levels where all citizens

have access to the in uence technology and there is symmetry
among the groups in favor and against the project.
{ Consider the decision of citizen i who favors the project. His payo
if he contributes yi is:
Ef c
b yi :
Ef + Ea N

{ Citizen k who opposes the project has a payo of::

Ef c
yk :
Ef + Ea N

{ Solving for the Nash equilibrium in the usual way, it is straightfor-

ward to see that the equilibrium probability that the project goes
ahead is:
c
1 :
bN

{ The key magnitude here is c=bN { the ratio of the cost of con-
 struction per capita to the bene t to having the project for those
who favor it.

{ As the cost per capita becomes small (high N or low c), then
probability that the project is constructed goes to one.

{ The total expenditure on \rent-seeking" at a Nash equilibrium is:

c c
1 :
N Nb

{ Aggregate (ex ante) surplus at the Nash equilibrium is:

!
c (N + 1)
1 N b c :
bN N

{ The sign of this depends on comparing the total bene t (N b)

with the total resource cost c and the per capita in uence cost
 c=N .

{ Where c=N is small, it is clear that whether total surplus is positive

or negative is not really a ected by in uence.

{ The outcome with in uence is ex post Pareto e cient.

{ However, it can be Pareto dominated from an ex ante point of

view by xing the probability that the project is implemented at
q = 1 bN c .

{ Just closing down the in uence activity without committing to the

project with probability 1 bNc would not achieve this outcome.

{ From a surplus maximization point of view, the outcome with costly

in uence activities could be better or worse.
{ If the outcome would be e = 1 with probability one without in u-
ence, then in uence makes things worse.

{ But if it were e = 0, the e ect on social surplus is ambiguous.

{ From a Wicksellian point of view, there is also an ambiguity de-

pending on what the outcome would be without in uence.

{ If this would be e = 0, then clearly in uence makes things worse.

{ However, in uence could be exercised against implementing projects

which fail the Wicksellian test and hence could be bene cial from
a contractarian point of view.
Log-rolling and Legislative Behavior

{ Multi-district world

{ To explore this issue, we extend the model above in a very simple

way.

{ Suppose now that policy decisions are made in a legislature com-

prising representatives selected from geographic regions.

{ The n districts that they represent are labeled j = 1; :::; n.

{ Each district is of equal size containing m citizens so m n = N.

{ A project can be built in each one district and is enjoyed solely by

the residents of that district.
{ The legislature can authorize the building of up to n projects (one
for each district).

{ Let ej 2 f0; 1g denote whether a statue is built in district j .

{ We assume that there is common pool nancing { the taxation

levied equally across the districts is equal to the total cost of
projects that are nanced divided by all citizens in the polity (re-
gardless of residence).

{ We also suppose (following Shepsle, Weingast, and Johnsen (1981))

that project allocation is governed by a \norm of universalism" in
which the representative in each district can unilaterally decide
whether to implement a project in its district.
{ Each representative maximizes the average utility of a district res-
ident which is
Pn
k=1 ek c
ej m b :
n
{ Note that this assumes that each district comprises an equal frac-
tion ( ) of citizens who are in favor of the project.

{ It is apparent that the representative in any district will wish to

have a project located in his district provided that
N b > c:

{ A project is desirable only if the surplus that it generates in the

district that it is located in is positive, i.e., if m b > c.

{ Thus the legislative process that we have posited along with com-
mon pool nancing will yield excessive publicly nanced spending
 if
N b > c > m b:

{ The outcome is Pareto ine cient if b < c=m.

{ The outcome can be Pareto dominated by a cooperative solution in

the legislature, i.e. one where all projects are simultaneously agreed
upon rather than the delegating that decision to the representative
within a district.

{ This outcome fails the surplus maximizing criterion if N b > c >

m b.

{ It also fails Wicksell's test.

Selecting Politicians

{ Suppose that the policy maker in o ce is a citizen from among

the polity and that there are two types of citizens (and therefore
politicians) di erentiated according to the cost of implementing
the public project.

{ Speci cally, ci 2 fcL; cH g for i 2 f1; :::; N g. Suppose that

cH cL
b> > :
N N
{ Conditional on any citizen being in power, the outcome where e = 1
is Pareto e cient.

{ However, if a type H citizen is in power, then all citizens (including

the policy maker!) is worse o than if a type L were choosing
policy.
This begs the question of why any sensible political system would ever
select an incompetent citizen.

Two arguments:

{ rents

{ ideology

Having an incompetent policy may interfere with having a surplus

maximizing outcome if
cH c
> b > L:
N N
In this case, an incompetent policy maker implements the project and
reduces social surplus.

Incompetence may be \good" from a Wicksellian point of view. This

happens if
cH c
> b > L:
N N
A Dynamic Model

We need a model where policy making extends over two periods which
we will label by t 2 f1; 2g.

Suppose that the project can be implemented in each period and let
et 2 f0; 1g denote the policy decision in period t.

There are again two types of citizens: 2 ff; ag where f stands for
\for" and a stands for \against".

The project yields a bene t b (i.e., bf 1 = b) to them in period one if

it is implemented and B (e1) (i.e., bf 2 (e1) = B (e1)) in period two.
 Notice that we allow the period two bene t to depend on whether
the period one project was chosen.

The projects can be either complements B (1) > B (0) or substitutes

B (0) > B (1).

The citizens against the project value neither the period one nor period
two project (i.e., ba1 = ba2 = 0).

The cost of the project is c in each period and is divided by all N

citizens.

Suppose also that there is a rent to holding o ce which we denote by

r which makes being re-elected attractive to the incumbent.
The timing of the model is as follows.

{ Policy maker who earns a rent r and must choose e1 2 f0; 1g.

{ Policy maker faces re-election which can be conditioned on this

decision.

{ The period two incumbent must then make a period two project
choice.

Let et denote the equilibrium project choice in each period.

Period 2:
e2 ( 2; e1) = 1 if and only B (e1) c=N
where t 2 ff; ag denotes the policy maker's type in period t.
Now let:
c
W (e1; 2; ) = e2 ( 2; e1) b 2 (e1)
N
be any citizen's second period utility from the policy choice made by
the period two incumbent.

Let (e1) 2 [0; 1] denote the probability that the incumbent is re-
elected as a function of the period one project that he implements.

There are three cases.

{ Project is neutral if (1) = (0),

{ Politically advantageous if (1) > (0),

 { and politically damaging if (1) < (0).

Period 1: Politician's preference

c
e1 b + (e1) (r + W (e1; ; )) + (1)
N
(1 (e1)) [qW (e1; ; ) + (1 q ) W (e1; ; )] (2)
where q is the probability that the future policy maker is of type and
denotes the policy maker of the opposite type.

This equation embodies the three main considerations that shape pol-
icy making in dynamic settings:

{ Short term policy considerations { these are represented by b c .

N
The policy could be worthwhile or otherwise in terms of its current
bene ts.
{ Long-term policy considerations { these are represented by the
dependence of W (e1; ; ) on e1. The policy a ects future period
policy utilities because the bene t from future policy depends on
today's policy choice. Crucially, this may be true when the future
policy maker does not share the preferences of the current policy
maker as represented by the payo W (e1; ; ). This is the term
that is captured in the public debt papers referred to above.

{ Long-term political considerations { This is represented by the way

in which (e) depends on e1.
The following benchmark result is based on Besley and Coate (1998).

Suppose that

{ (i) the policy is politically neutral and

{ (ii) e2 ( 2; e1) does not depend on e1 for 2 2 ff; ag.

{ Then the policy choice over e1 will be Pareto e cient.

At the heart of political failures in this setting, therefore, are the ways
in which there is an a ect on policy or the choice of policy maker.
Example 1: Suppose also that if the policy maker implements the
project, then he will be removed from o ce while he will be re-elected
for sure if does not implement the project, i.e. (1) = 0 and (0) = 1.
This violates the rst condition required for e cient policy making
above. There is no rent associated with holding o ce, i.e. r = 0. It
should be now be clear that as long as:
ba1 (2 q ) c=N < 0
then the project will not be implemented. The reason for this is that
the cost of implementing the project in period one is to have a period
two policy maker of the opposite type. This would not be an issue
if (1) = 1 since then the policy maker in period one would retain
control of the period two policy outcome. It is only the fact that
political controls is a ected by policy choice that drives the result.
Example 2: In the second example, we assume that the policy is
politically neutral. Speci cally, (1) = (0) = 0. Suppose also that
q = 0 so that the a policy of the opposite preference is anticipated in
period two. Suppose that a period two policy maker of type f values
the project in period two only if the project was implemented in period
one. Formally,
c
bf 2 (1) > > bf 2 (0) :
N
Then, of a period one policy maker is of type a and he implements
the project, he will induce a future type f policy maker to implement
the project whereas if he avoids the period one project, then neither
type of policy maker will wish to implement the project. The project
is not worthwhile for a type a policy maker in period one if:

ba1 2c=N < 0:

If this assumption holds, then a Pareto ine cient policy choice will be
made. Here, the logic is the direct e ect of period one policy choices
on the optimal period two policy outcome. In this case

e2 (f; 1) > e2 (f; 0)

violating the second condition for Pareto e ciency policy above.
 Common Sense Ideas of Good Government

Responsive government

Trust in government

Legitimate Government

Can these ideas be captured or is the framework too restrictive?

 How to Measure the Quality of Government?

La Porta et al (1999) who look at the institutional determinants of

various measures of government performance.

Their main dependent variables are:

{ (i) interference with private sector as measured property rights in-

dex, business regulation index, top tax rate,

{ (ii) e ciency measures such corruption, bureaucratic delays, tax

compliance, average government wages/GDP per capita,

{ (iii) output of public goods as captured by infant mortality, school

attainment, the illiteracy rate, and infrastructure quality,
{ (iv) The size of the public sector as measured by transfers and
subsidies as a proportion of GDP, government as a proportion of
GDP, the importance of state owned enterprises in the economy,
and public sector employment.

{ (v) political freedom as captured by democracy and political rights

indices. As independent variables, they use ethnolinguistic frac-
tionalization, legal origin, religion, income per capita and latitude.

Their main conclusions are

{ (a) that rich countries have better governments than poor ones,

{ (b) ethnolinguistically homogeneous governments have better gov-

ernments than those that are heterogeneous,
{ (c) common law governments have better governments than this
with civil law or socialist law origins,

{ (d) predominantly protestant countries have better governments

than those that are predominantly Catholic or predominantly Mus-
lim.

{ (e) Better performing governments are larger and collect higher

taxes.
 Responses to Political Failure

Constitutional Change

{ Procedural change

{ Policy constitutions

Complementary institutions

{ civil society

{ media

{ watchdogs