Chapter 21

POLITICAL ECONOMICS

Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. c

 Ú
al Welfare Crtera
Ô 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 (~ and
) the problem arises that some individuals
prefer ~ while others prefer

m
 Ú
al Welfare Crtera
Ô 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
£
 Ú
al Welfare Crtera
"
‰ 1

‰ 2

‰
Ñ
‰

‰ Ñ ‰

‰
2

‰
1
C tra
t
rve
"

Ñ
 Ú
al Welfare Crtera
Ô 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

{
 Ú
al Welfare Crtera
The utility possibility frontier shows those utility
Jones¶s utility levels for Smith and Jones that are obtainable
from the fixed quantity of goods available
"

Any point inside the curve is
Pareto-inefficient

§
§

" Smith¶s utility


 • alty Crter 
One possible criterion could
Jones¶s utility require complete equity giving
Smith and Jones the same level
"

of welfare
~
This occurs at ‰ ~ and ‰
~
‰ 

Utility is equal in this

case, but the quantities of
Ñ5° º and may not be

‰
 " Smith¶s utility

Ú
 • alty Crter  „ 
"
‰ 1



‰ ~

‰
2

‰ 2

‰
~



‰
1
C tra
t
rve
"
„

‘
 ‰tltara Crter 
Ô A similar criterion would be to choose
the allocation on the utility possibility
frontier so that the sum of Smith¶s and
Jones¶s utilities is the greatest
± this point would imply a certain allocation
of º and between Smith and Jones

^
 ghe Rawls Crter 
Ô This was first posed by philosopher
John Rawls
Ô 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
c
 ghe Rawls Crter 
Unequal distributions such as
Jones¶s utility would be permitted when the
only attainable equal distributions
"

are below

 Equal distributions that lie

between
and ~ are
  superior to because the
worse-off individual is better
off there than at
Ñ5°

" Smith¶s utility

cc
 Ú
al Welfare F
t s
Ô A social welfare function may depend
on Smith¶s and Jones¶s utility levels
such as
social welfare = 0(‰
,‰ )
Ô The social problem is to allocate º and
between Smith and Jones as to
maximize 0

cm
 Ú
al Welfare F
t s
The optimal point of social
Jones¶s utility welfare is where 0 is
maximized given the utility
possibility frontier
"

•
 This occurs at ‰ • and ‰
•
‰

02

01

‰
 " Smith¶s utility

c£
 Ú
al Welfare F
t s
Note the tradeoff between
Jones¶s utility equity and efficiency

"

Even though point · is

Pareto-inefficient, it is still
preferred to point

02

01

" Smith¶s utility

cÑ
 • table Úhar
Ô A father arrives home with an 8-piece
pizza and must decide how to share it
between his two sons
Ô Teen 1 has a utility function of the form
1 å º1

Ô Teen 2 has a utility function of the form

2 å º2
c{
 • table Úhar
Ô The least resistance option would be to
give each teen Ñ slices
± ‰1 = Ñ, ‰2 = 2
Ô The father may want to make sure the
teens have equal utility
± º1 = 1.6, º2 = 6.Ñ, ‰1 = ‰2 = 2.5
Ô The father may want to maximize the
sum of his sons utility
± º1 = 6.Ñ, º2 = 1.6, ‰1 = 5.06, ‰2 = 1.26
c
 • table Úhar
Ô Suppose the father suggests that he will
flip a coin to determine who gets which
portion listed under the three allocations
Ô The expected utilities of the two teens
from a coin flip that yields either 1.6 or
6.Ñ slices is
•(‰1) = 0.5(2.5 ) + 0.5(5.06) = .80
•(‰2) = 0.5(2.5 ) + 0.5(1.26) = 1.90
cÚ
 • table Úhar
Ô
iven this choice, the teens will opt for
the equal distribution because each
gets higher expected utility from it than
from the coin flip

c‘
 • table Úhar
Ô If the father could subject the teens to a
³veil 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
Ô insures that utility will not fall below 2.5

c^
 • table Úhar
Ô Suppose that each teen believes that he has
a 50-50 chance of being labeled as ³teen 1´
or ³teen 2´
Ô Expected utilities are
º1 = º2 = Ñ •(‰1) = 0.5(Ñ) + 0.5(2) =
º1 = 1.6, º2 = 6.Ñ •(‰1) = 0.5(2.5 ) + 0.5(2.5 ) = 2.5
º1 = 6.Ñ, º2 = 1.6 •(‰1) = 0.5(5.06) + 0.5(1.26) = .16

Ô The teens will opt for the utilitarian solution

m
 ghe Arr w Imp ssblty
ghe rem
Ô Arrow views the general social welfare
problem as one of choosing among
several feasible ³social states´
± it is assumed that each individual can rank
these states according to their desirability
Ô Arrow raises the following question:
± does there exist a ranking on a society-wide
scale that fairly records these preferences?
mc
 ghe Arr w Imp ssblty
ghe rem
Ô Assume that there are social states
(~, , and ) and 2 individuals (Smith
and Jones)
± Smith prefers ~ to and to 
Ô ~
and 
 and ~

± Jones prefers  to ~ and ~ to
Ô  ~ and ~ and 

mm
 ghe Arr w Imp ssblty
ghe rem
Ô Arrow¶s impossibility theorem consists of
showing that a reasonable social ranking
of these three states cannot exist
Ô Arrow assumes that any social ranking
should obey six seemingly
unobjectionable axioms
± ³´ should be read ³is socially preferred to´

m£
 ghe Arr w Ax ms
Ô It must rank all social states
± either ~ , ~, or ~ and are equally
desirable (~P ) for any two states ~ and
Ô The ranking must be transitive
± if ~ and (or P ), then ~
Ô The ranking must be positively related to
individual preferences
± if ~ is unanimously preferred by Smith and
Jones, then ~
mÑ
 ghe Arr w Ax ms
Ô If new social states become feasible, this
fact should not affect the ranking of the
original states
± If ~ , then this will remain true if some
new state (
) becomes feasible
Ô The social preference function should
not be imposed by custom
± it should not be the case that ~ 
regardless of the tastes of individuals in
society m{
 ghe Arr w Ax ms
Ô The relationship should be nondictatorial
± one person¶s preferences should not
determine society¶s preferences

m
 Arr w¶s Pr f
Ô Arrow was able to show that these six
conditions are not compatible with one
another
± because 
 and  , it must be the
case that P 
Ô one person¶s preferences cannot dominate
± both ~
and ~ , so ~
± transitivity implies that ~
± this cannot be true because ~
 but  ~
mÚ
 Úf
a
e f the
Arr w ghe rem
Ô In general, Arrow¶s result appears to be
robust to even modest changes in the set
of basic postulates
Ô 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 m‘
  re
t V t
Ô oting is used as a social decision
process in many 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

m^
 Ãaj rty Rle
Ô Throughout our discussion of voting, we
will assume that decisions will be made
by majority rule
± there is nothing particularly sacred about a
rule requiring that a policy obtain 50
percent of the vote to be adopted

£
 ghe Parad x f V t
Ô 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

£c
 ghe Parad x f V t
Ô 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 [(~) low, ( ) medium,
and () high]
± Condorcet¶s paradox would arise even
without this ordering
£m
 ghe Parad x f V t
Ô Preferences among the three policy
options for the three voters are:

th J e udd

~


 ~

 ~

V

V
££
 ghe Parad x f V t
Ô Consider a vote between ~ and
± ~ would win
Ô In a vote between ~ and 
±  would win
Ô In a vote between and 
± would win
Ô No equilibrium will ever be reached

£Ñ
 Úle-Peaked Prefere
es
Ô Equilibrium voting outcomes always
occur in cases where the issue being
voted upon is one-dimensional and
where voter preferences are ³single-
peaked´

£{
 Úle-Peaked Prefere
es
We can show each voters preferences in
terms of utility levels
Utility
For Smith and Jones,
preferences are single-
Fdd
peaked

r es Fudd¶s preferences have

two local maxima

Úmth

ùuantity of


public good
£
 Úle-Peaked Prefere
es
If Fudd had alternative preferences with a
Utility single peak, there would be no paradox

Option will be chosen

Fdd
because it will defeat
both ~ and  by votes 2
r es
to 1

Úmth

ùuantity of


public good
£Ú
 ghe Ãeda V ter ghe rem
Ô With the altered preferences of Fudd,
will be chosen because it is the
preferred choice of the median voter
(Jones)
± Jones¶s preferences are between the
preferences of Smith and the revised
preferences of Fudd

£‘
 ghe Ãeda V ter ghe rem
Ô 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 voter¶s preferences will determine
what public choices are made

£^
 A Úmple P lt
al à del
Ô Suppose a community is characterized
by a large number of voters () each
with income of

Ô The utility of each voter depends on his
consumption of a private good (
) and
of a public good () according to
utility of person
= ‰

()
where  > 0 and  < 0
Ñ
 A Úmple P lt
al à del
Ô Each voter must pay taxes to finance 
Ô Taxes are proportional to income and
are imposed at a rate of 
Ô Each person¶s budget constraint is

(1-)

Ô The government also faces a budget

constraint


å 
å 

åc Ñc
 A Úmple P lt
al à del
Ô
iven these constraints, the utility
function of individual
is
‰
() = [ ~  (/)]
/ ~ + ()
Ô Utility maximization occurs when
‰
/  = -
/( ~) + () = 0
 = -1[
/( ~)]
Ô esired spending on  is inversely
related to income
Ñm
 A Úmple P lt
al à del
Ô If  is determined through majority rule,
its level will be that level favored by the
median voter
± since voters¶ preferences are determined
solely by income,  will be set at the level
preferred by the voter with the median level
of income (
)
* -1[
/( ~)] = -1[(1/)(
/ ~)]

Ñ£
 A Úmple P lt
al à del
Ô Under a utilitarian social welfare
criterion,  would be chosen so as to
maximize the sum of utilities:
n
A A
SW 'Ui ' 
y
g  n y i  y f
g  ny A
g nf
g
i c

Ô The optimal choice for  then is

* = -c
c = -c
c
~ ~ 
± the level of  favored by the voter with
average income ÑÑ
 V t f r Redstrbtve
gaxat 
Ô Suppose voters are considering a lump-
sum transfer to be paid to every person
and financed through proportional
taxation
Ô If we denote the per-person transfer ’,
each individual¶s utility is now given by
‰
= 
’

Ñ{
 V t f r Redstrbtve
gaxat 
Ô The government¶s budget constraint is
’ ~

’= ~

Ô For a voter with
> ~, utility is

maximized by choosing ’ = 0
Ô Any voter with
< ~ will choose  = 1
and ’ = ~
± would fully equalize incomes
Ñ
 V t f r Redstrbtve
gaxat 
Ô Note that a 100 percent tax rate would
lower average income
Ô Assume that each individual¶s income
has two components, one responsive to
tax rates [
()] and one not responsive
(
)
± also assume that the average of 
is zero,
but its distribution is skewed right so 
< 0
ÑÚ
 V t f r Redstrbtve
gaxat 
Ô Now, utility is given by
‰
(1-)[
() + 
] + ’
Ô The individual¶s first-order condition for a
maximum in his choice of  and  is now
‰
/  = -
( ~/ ) = 0


/( ~/ )
Ô Under majority rule, the equilibrium
condition will be
* = 
/( ~/ ) ё
Represetatve G vermet
Ô In representative governments, people
vote for candidates, not policies
Ô Politicians¶ policy preferences are
affected by a variety of factors
± their perceptions of what their constituents
want
± their view of the ³public good´
± the forcefulness of ³special interests´
± their desire for reelection
Ñ^
 Pr bablst
V t
Ô 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
Ô Each of the  voters observe the two
platforms and choose how to vote
{
 Pr bablst
V t
Ô The probability that voter
will vote for
candidate 1 is
g
= 
[‰
(‰1) - ‰
(‰2)]
where  > 0 and ‰
(‰*) is the utility that
voter
expects to receive from platform *
Ô The probability that voter
will vote for
candidate 1 is 1 - g

{c
 ghe Caddate Game
Ô Candidate 1 chooses ‰1 to maximize the
probability of his election
n n

    EVc i fi U i ‰c

U i ‰

i c i c

Ô Can i a  hs s‰2 to maximize his

expected votes

EV c i
 EVc
i c
{m
 ghe Caddate Game
Ô Our voting game is a zero-sum game
with continuous strategies (‰1 and ‰2)
Ô Thus, this game will have a Nash
equilibrium set of strategies for which
•
1(‰1,‰2*)  •
1(‰1*,‰2*)  •
1(‰1*,‰2)
± Candidate 1 does best against ‰2* by
choosing ‰1*
± Candidate 2 does best against ‰1* by
choosing ‰2* {£
 ¬et Vale Platf rms
Ô A ³net value´ platform is one under which
a candidate promises a unique dollar
benefit to each voter
Ô Suppose candidate 1 promises a net
dollar benefit of ‰1
to each voter
Ô The candidate is bound by a government
budget constraint:
n

'

i c
ci
{Ñ
 ¬et Vale Platf rms
Ô The candidates¶ goal is to choose ‰1
that
maximizes •
1 against ‰2*
Ô Setting up the Lagrangian yields
 n 
9 EVc
 ‰ci 
i c 
  


9 i U ci

U  
  ci šš
 i c
{{
 ¬et Vale Platf rms
Ô The first-order condition for the net
benefit promised to voter
is given by
º9/º‰1
= 
‰
 = 0
Ô If the function 
is the same for all voters,
this means that the candidate should
choose ‰1
so that ‰
 is the same for all
voters
± a utilitarian outcome
{
 Ret-Úeek Behav r
Ô Elected politicians perform the role of
agents
± choose policies favored by principals
(voters)
Ô A perfect agent would choose policies
that the fully informed median voter
would choose
± are politicians so selfless?
{Ú
 Ret-Úeek Behav r
Ô Politicians might engage in rent-seeking
activities
± activities that seek to enhance their own
welfare
Ô This would create an implicit tax wedge
between the value of public goods
received by voters and taxes paid

{‘
 Ret-Úeek Behav r
Ô Extraction of political rent ? would
require that the government budget
constraint be rewritten as
 ~ ?
Ô oters would take such rent-seeking
activities into account when deciding on
public policies
± would likely reduce  and 
{^
 Ret-Úeek Behav r
Ô Whether political rents can persist in an
environment of open electoral
competition is questionable
± Candidate ~ announces policy (,)~
± Candidate can always choose a policy
(,) that is more attractive to the median
voter by accepting a smaller rent
Ô Only with barriers to entry or imperfect
information can positive rents persist

 Ret-Úeek Behav r
Ô Private citizens may also seek rents for
themselves by asking politicians to grant
them favors
Ô Thus, economic agents engage in rent-
seeking activities when they use the
political process to generate economic
rents that would not ordinarily occur in
market transactions
c
 Ret  sspat 
Ô 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
Ô Suppose a monopoly might earn profits
of g
and a franchise for the monopoly
can be obtained from the government
for a bribe of ( < g
)
m
 Ret  sspat 
Ô Risk-neutral entrepreneurs will offer
bribes as long as the expected gain
exceeds the cost of the bribe
Ô If each rent seeker has the same
chance of winning the franchise, the
number of bribers () will expand to the
point at which
g
/
£
Imp rtat P ts t ¬ te:
Ô 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

Ñ
Imp rtat P ts t ¬ te:
Ô Arrow¶s 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

{
Imp rtat P ts t ¬ te:
Ô irect voting and majority rule may
not always yield an equilibrium
± if preferences are single-peaked,
however, majority rule voting on one-
dimensional public questions will result
in choosing policies most favored by the
median voter
Ô such policies are not necessarily efficient


Imp rtat P ts t ¬ te:
Ô oting 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

Ú
Imp rtat P ts t ¬ te:
Ô Politicians may engage in
opportunistic rent seeking, but this
will be constrained by electoral
competition

‘