Chapter 25

POLITICAL ECONOMICS
MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS
EIGHTH EDITION

WALTER NICHOLSON
Copyright 2002 by South-Western, a division of Thomson Learning. All rights reserved.

Social Welfare Criteria

Analyzing the choice among feasible
allocations of resources is difficult
it involves making choices about the utility
levels of different individuals
in choosing between two allocations (A and
B) the problem arises that some individuals
prefer A while others prefer B

Social Welfare Criteria

We can use the Edgeworth box diagram
to show the problems involved in
establishing social welfare criteria
only points on the contract curve are
considered as possible candidates for a
social optimum
along the contract curve, the utilities of the
two individuals vary, and these utilities are
directly competitive

Social Welfare Criteria

OJ
UJ1
UJ2
US4

UJ3

US3

UJ4
US2

Contract curve

OS

US1

Social Welfare Criteria

If we are willing to assume that utility
can be compared among individuals,
we can use the contract curve to
construct the utility possibility frontier

Social Welfare Criteria

Joness utility

The utility possibility frontier shows those utility

levels for Smith and Jones that are obtainable
from the fixed quantity of goods available

OS

Any point inside the curve is

Pareto-inefficient

OJ

Smiths utility

Equality Criterion
One possible criterion could
require complete equity giving
Smith and Jones the same level
of welfare

Joness utility

OS

This occurs at UJA and USA

UJA

Utility is equal in this

case, but the quantities of
X and Y may not be

45
USA

OJ

Smiths utility

Equality Criterion
XJA

OJ

UJ1

YSA

A
J

US2
A

UJ2
Y

USA

A
S

Contract curve

OS

XSA

US1

Utilitarian Criterion
A similar criterion would be to choose
the allocation on the utility possibility
frontier so that the sum of Smiths and
Joness utilities is the greatest
this point would imply a certain allocation
of X and Y between Smith and Jones

The Rawls Criterion

This was first posed by philosopher
John Rawls
Suppose that each individual begins in
an initial position in which no one knows
what his final position will be
individuals are risk averse
society will only move away from perfect
equality when the worst off person would
be better off under inequality than equality

The Rawls Criterion

Unequal distributions such as B
would be permitted when the
only attainable equal distributions
are below D

Joness utility

OS
B

Equal distributions that lie

between D and A are
superior to B because the
worse-off individual is better
off there than at B

45
OJ

Smiths utility

Social Welfare Functions

A social welfare function may depend
on Smiths and Joness utility levels
such as
social welfare = W(US,UJ)

The social problem is to allocate X and

Y between Smith and Jones as to
maximize W

Social Welfare Functions

The optimal point of social
welfare is where W is
maximized given the utility
possibility frontier

Joness utility

OS

E
J

This occurs at UJE and USE

W2
W1

USE

OJ

Smiths utility

Social Welfare Functions

Note the tradeoff between
equity and efficiency

Joness utility

OS

Even though point F is

Pareto-inefficient, it is still
preferred to point D

F
W2
W1
OJ

Smiths utility

Equitable Sharing
A father arrives home with an 8-piece
pizza and must decide how to share it
between his two sons
Teen 1 has a utility function of the form
U1 2 X 1

Teen 2 has a utility function of the form

U2

X2

Equitable Sharing
The least resistance option would be to
give each teen 4 slices
U1 = 4, U2 = 2

The father may want to make sure the

teens have equal utility
X1 = 1.6, X2 = 6.4, U1 = U2 = 2.53

The father may want to maximize the

sum of his sons utility
X1 = 6.4, X2 = 1.6, U1 = 5.06, U2 = 1.26

Equitable Sharing
Suppose the father suggests that he will
flip a coin to determine who gets which
portion listed under the three allocations
The expected utilities of the two teens
from a coin flip that yields either 1.6 or
6.4 slices is
E(U1) = 0.5(2.53) + 0.5(5.06) = 3.80
E(U2) = 0.5(2.53) + 0.5(1.26) = 1.90

Equitable Sharing
Given this choice, the teens will opt for
the equal distribution because each
gets higher expected utility from it than
from the coin flip

Equitable Sharing
If the father could subject the teens to a
veil of ignorance so that neither would
know his identity until the pizza is
served, the voting might still be different
if each teen focuses on a worst-case
scenario, he will opt for the equal utility
allocation
insures that utility will not fall below 2.53

Equitable Sharing
Suppose that each teen believes that he has a
50-50 chance of being labeled as teen 1 or
teen 2
Expected utilities are
X1 = X2 = 4

E(U1) = 0.5(4) + 0.5(2) = 3

X1 = 1.6, X2 = 6.4

E(U1) = 0.5(2.53) + 0.5(2.53) = 2.53

X1 = 6.4, X2 = 1.6

E(U1) = 0.5(5.06) + 0.5(1.26) = 3.16

The teens will opt for the utilitarian solution

The Arrow Impossibility

Theorem
Arrow views the general social welfare
problem as one of choosing among
several feasible social states
it is assumed that each individual can rank
these states according to their desirability

Arrow raises the following question:

does there exist a ranking on a societywide
scale that fairly records these preferences?

The Arrow Impossibility

Theorem
Assume that there are 3 social states
(A, B, and C) and 2 individuals (Smith
and Jones)
Smith prefers A to B and B to C
A PS B and B PS C and A PS C

Jones prefers C to A and A to B

C PJ A and A PJ B and C PJ B

The Arrow Impossibility

Theorem
Arrows impossibility theorem consists of
showing that a reasonable social ranking
of these three states cannot exist
Arrow assumes that any social ranking
should obey six seemingly
unobjectionable axioms
P should be read is socially preferred to

The Arrow Axioms

It must rank all social states
either A P B, B P A, or A and B are equally
desirable (A I B) for any two states A and B

The ranking must be transitive

if A P B and B P C (or B I C), then A P C

The ranking must be positively related to

individual preferences
if A is unanimously preferred by Smith and
Jones, then A P B

The Arrow Axioms

If new social states become feasible, this
fact should not affect the ranking of the
original states
If A P B, then this will remain true if some new
state (D) becomes feasible

The social preference function should not

be imposed by custom
it should not be the case that A P B regardless
of the tastes of individuals in society

The Arrow Axioms

The relationship should be
nondictatorial
one persons preferences should not
determine societys preferences

Arrows Proof
Arrow was able to show that these six
conditions are not compatible with one
another
because B PS C and C PJ B, it must be the
case that B I C
one persons preferences cannot dominate

both A PS B and A PJ B, so A P B
transitivity implies that A P C
this cannot be true because A PS C but C PJ A

Significance of the
Arrow Theorem
In general, Arrows result appears to be
robust to even modest changes in the set
of basic postulates
Thus, economists have moved away from
the normative question of how choices
can be made in a socially optimal way
and have focused on the positive analysis
of how social choices are actually made

Direct Voting
Voting is used as a decision process in
many social institutions
direct voting is used in many cases from
statewide referenda to smaller groups and
clubs
in other cases, societies have found it
more convenient to use a representative
form of government

Majority Rule
Throughout our discussion of voting, we
will assume that decisions will be made
by majority rule
Keep in mind though, that there is nothing
particularly sacred about a rule requiring
that a policy obtain 50 percent of the vote
to be adopted

The Paradox of Voting

In the 1780s, social theorist M. de
Condorcet noted that majority rule
voting systems may not arrive at an
equilibrium
instead, they may cycle among alternative
options

The Paradox of Voting

Suppose there are three voters (Smith,
Jones, and Fudd) choosing among
three policy options
we can assume that these policy options
represent three levels of spending on a
particular public good [(A) low, (B) medium,
and (C) high]
Condorcets paradox would arise without
this ordering

The Paradox of Voting

Preferences among the three policy
options for the three voters are:
Smith

Jones

Fudd

The Paradox of Voting

Consider a vote between A and B
A would win

In a vote between A and C

C would win

In a vote between B and C

B would win

No equilibrium will ever be reached

Single-Peaked Preferences
Equilibrium voting outcomes always
occur in cases where the issue being
voted upon is one-dimensional and
where voter preferences are singlepeaked

Single-Peaked Preferences
We can show each voters preferences in
terms of utility levels

Utility

Fudd
Jones

For Smith and Jones,

preferences are singlepeaked
Fudds preferences have
two local maxima

Smith

Quantity of
public good

Single-Peaked Preferences
If Fudd had alternative preferences with a
single peak, there would be no paradox

Utility

Fudd

Jones

Option B will be chosen

because it will defeat
both A and C by votes 2
to 1

Smith

Quantity of
public good

The Median Voter Theorem

With the altered preferences of Fudd, B
will be chosen because it is the
preferred choice of the median voter
(Jones)
Joness preferences are between the
preferences of Smith and the revised
preferences of Fudd

The Median Voter Theorem

If choices are unidimensional and
preferences are single-peaked, majority
rule will result in the selection of the
project that is most favored by the
median voter
that voters preferences will determine
what public choices are made

A Simple Political Model

Suppose a community is characterized
by a large number of voters (n) each
with income of Yi
The utility of each voter depends on his
consumption of a private good (Ci) and
of a public good (G) according to
utility of person i = Ui = Ci + f(G)

where fG > 0 and fGG < 0

A Simple Political Model

Each voter must pay taxes to finance G
Taxes are proportional to income and
are imposed at a rate of t
Each persons budget constraint is
Ci = (1-t)Yi

The government also faces a budget

constraint
n

G tYi tnY A
i 1

A Simple Political Model

Given these constraints, the utility
function of individual i is
Ui(G) = [YA - (G/n)]Yi /YA + f(G)

Utility maximization occurs when

dUi /dG = -Yi /(nYA) + fG(G) = 0
G = fG-1[Yi /(nYA)]

Desired spending on G is inversely

related to income

A Simple Political Model

If G is determined through majority rule,
its level will be that level favored by the
median voter
since voters preferences are determined
solely by income, G will be set at the level
preferred by the voter with the median level
of income (Ym)
G* = fG-1[Ym/(nYA)] = fG-1[(1/n)(Ym/YA)]

A Simple Political Model

Under a utilitarian social welfare criterion,
G would be chosen so as to maximize
the sum of utilities:
n

SW U i [(Y A G / n )Yi / Y A f (G )] nY A G nf (G )
i 1

The optimal choice for G then is

G* = fG-1(1/n) = fG-1[(1/n)(YA/YA)]
the level of G favored by the voter with
average income

Voting for Redistributive

Taxation
Suppose voters are considering a lumpsum transfer to be paid to every person
and financed through proportional
taxation
If we denote the per-person transfer g,
each individuals utility is now given by
Ui = Ci + g

Voting for Redistributive

Taxation
The governments budget constraint is
ng = tnYA
g = tYA

For a voter with Yi > YA, utility is

maximized by choosing g = 0
Any voter with Yi < YA will choose t = 1
and g = YA
would fully equalize incomes

Voting for Redistributive

Taxation
Note that a 100 percent tax rate would
lower average income
Assume that each individuals income
has two components, one responsive to
tax rates [Yi (t)] and one not responsive
(Ni)
also assume that the average of Ni is zero,
but its distribution is skewed right so Nm < 0

Voting for Redistributive

Taxation
Now, utility is given by
Ui = (1-t)[Yi (t) + Ni] + g

The individuals first-order condition for a

maximum in his choice of t and g is now
dUi /dt = -Ni + t(dYA/dt) = 0
ti = Ni /(dYA/dt)

Under majority rule, the equilibrium

condition will be
t* = Nm /(dYA/dt)

Representative Government
In representative governments, people
vote for candidates, not policies
Politicians policy preferences are
affected by a variety of factors
their perceptions of what their constituents
want
their view of the public good
the forcefulness of special interests
their desire for reelection

Probabilistic Voting
Assume there are only two candidates
for a political office
each candidiate announces his platform (1
and 2)
also assume that the candidate, once
elected, will actually seek to implement the
platform he has stated

Each of the n voters observe the two

platforms and choose how to vote

Probabilistic Voting
The probability that voter i will vote for
candidate 1 is
i = fi [Ui(1) - Ui(2)]

where f > 0 and f< 0

The probability that voter i will vote for
candidate 1 is 1 - i

The Candidate Game

Candidate 1 chooses 1 so as to
maximize the probability of his election
n

i 1

i 1

expected vote EV1 i fi [U i (1 ) U i (2 )]

Candidate 2 chooses 2 so as to
maximize his expected votes
n

expected vote EV2 (1 i ) n EV1

i 1

The Candidate Game

Our voting game is a zero-sum game with
continuous strategies (1 and 2)
Thus, this game will have a Nash equilibrium
set of strategies for which
EV1(1,2*) EV1(1*,2*) EV1(1*,2)
Candidate 1 does best against 2* by choosing
1 *
Candidate 2 does best against 1* by choosing
2 *

Net Value Platforms

A net value platform is one in which a
candidate promises a unique dollar
benefit to each voter
Suppose candidate 1 promises a net
dollar benefit of 1 to each voter
The candidate is bound by a government
budget constraint:
n

i 1

1i

Net Value Platforms

The candidates goal is to choose 1 that
maximizes EV1 against 2*
Setting up the Lagrangian yields

L EV1

i 1

1i

*
L fi [U (1i ) U (2 )]

i 1

1i

Net Value Platforms

The first-order condition for the net
benefit promised to voter i is given by
L/1i = fiUi + = 0

If the function fi is the same for all voters,

this means that the candidate should
choose 1i so that Ui is the same for all
voters
a utilitarian outcome

Rent-Seeking Behavior
Elected politicians perform the role of
agents
choose policies favored by principals
(voters)

A perfect agent would choose policies

that the fully informed median voter
would choose
are politicians so selfless?

Rent-Seeking Behavior
Politicians might engage in rent-seeking
activities
activities that seek to enhance their own
welfare

This would create an implicit tax wedge

between the value of public goods
received by voters and taxes paid

Rent-Seeking Behavior
Extraction of political rent r would
require that the government budget
constraint be rewritten as
G = tnYA - r
Voters would take such rent-seeking
activities into account when deciding on
public policies
would likely reduce G and t

Rent-Seeking Behavior
Whether political rents can exist in an
environment of open electoral
competition is questionable
Candidate A announces policy (G,t)A
Candidate B can always choose a policy
(G,t)B that is more attractive to the median
voter by accepting a smaller rent

Only with barriers to entry or imperfect

information can positive rents persist

Rent-Seeking Behavior
Private citizens may also seek rents for
themselves by asking politicians to grant
them favors
Thus, economic agents engage in rentseeking activities when they use the
political process to generate economic
rents that would not ordinarily occur in
market transactions

Rent Dissipation
If a number of actors compete in the
same rent-seeking activity, it is possible
that all available rent will be dissipated
into rent seekers costs
Suppose a monopoly might earn profits
of m and a franchise for the monopoly
can be obtained from the government
for a bribe of B

Rent Dissipation
Risk-neutral entrepreneurs will offer
bribes as long as the expected net gain
is positive
If each rent seeker has the same
chance of winning the franchise, the
number of bribers (n) will expand to the
point at which
B = m /n

Important Points to Note:

Choosing equitable allocations of
resources is an ambiguous process
because many potential welfare
criteria might be used
in some cases, achieving equity
(appropriately defined) may require
some efficiency sacrifices

Important Points to Note:

Arrows impossibility theorem shows
that, given fairly general
assumptions, there is no completely
satisfactory social choice mechanism
the problem of social choice theory is
therefore to assess the performance of
relatively imperfect mechanisms

Important Points to Note:

Direct voting and majority rule may
not always yield an equilibrium
if preferences are single-peaked,
however, majority rule voting on onedimensional public questions will result
in choosing policies most favored by the
median voter
such policies are not necessarily efficient

Important Points to Note:

Voting in representative governments
may be analyzed using the tools of
game theory
in some cases, candidates choices of
strategies will yield Nash equilibria that
have desirable normative consequences

Politicians may engage in opportunistic

rent seeking, but this will be constrained
by electoral competition