Week 5:

Rationales for Public Policy 3

PA 241
RBCruz, UP NCPAG
 Agenda for Today
• Recap of Last Week
• Government Failures
• Correcting Market and Government Failure
• Important Dates
– Annotated Bibliography
– Mid-term Exam
• Readings for Next Week
Summary
Market Failures Implications for Efficiency
Public Goods Pure public goods (undersupply)
Open access/common property (overconsumption,
underinvestment)
Toll goods (undersupply)
Externalities Positive externalities (undersupply)
(Missing Markets) Negative externalities (oversupply)
Natural monopoly Declining average cost (undersupply)
With costly monitoring (undersupply, X-inefficiency)
Information Quality overestimation of experience, post-experience
Asymmetry goods (overconsumption)
Quality underestimation of experience, post-experience
goods (underconsumption)
Summary
Market Failures Implications for Efficiency
Thin Markets Cartelization (undersupply)
Preference Problems Endogenous preferences (typically overconsumption)
Utility interdependence (distributional inefficiency)
Unacceptable preferences (overconsumption)
Uncertainty Problems Moral hazard, adverse selection, unique assets (incomplete
insurance)
Misperception of risk (violation of expected utility
hypothesis)
Intertemporal Nontraded assets, bankruptcy (incomplete capital markets)
Problems
Adjustment Costs Sticky prices (underemployed resources)
Macroeconomic Business cycles (underemployed resources)
Dynamics
 Readings for Today
• Weimer and Vining (2005). Policy Analysis:
Concepts and Practice. Chapter 8 and 10.
 Government Failures:
Limits to Government Intervention
Government Failures
In the context of:
• Direct democracy
• Representative government
• Bureaucratic supply
• Decentralized government
Problems Inherent in
Direct Democracy
 Direct democracy
• A form of democracy where people decide on
matters directly
• Problems inherent in Direct Democracy
• Paradox of voting
• Possibility of minorities with intense preferences
• The problem of bundling
 Paradox of Voting
• In democracies, voting serves as the
mechanism for combining the preferences of
individuals into social choices.
• Reliance on referenda for the revelation of
social values suffers from a more fundamental
problem: no method of voting is both fair and
coherent.
Paradox of Voting
 Implications
• Arrow’s general possibility theorem
– Axiom of unrestricted domain (transitivity)
– Axiom of Pareto choice
– Axiom of independence
– Axiom of nondictatorship
• Agenda manipulation by those who control the agenda
(or the power to propose an alternative to the status
quo).
• Introduction of alternative policies that create cycles is
often an attractive strategy for voters who would
otherwise face an undesirable social choice.
 Preference Intensity and Bundling
• Direct democracy can lead to tyranny by the
majority.
– Inflict costs on minority
– Voting schemes do not allow people to express
the intensity of their preferences.
• Whenever people must vote on a bundle of
policies, it is not necessarily the case that any
particular policy in the winning bundle
represents the will of a majority.
 Problems Inherent in
Representative Government
 Representative Government
Factors affecting the behavior of representatives
• Representatives have their own private
interests.
• Individuals must incur costs to monitor the
behavior of their representatives
• Party discipline may constrain the self-interest
behavior of individual representatives.
Diffuse and Concentrated Interests
• Collective choices will be biased towards policies
with concentrated benefits and away from
policies with concentrated costs.
• Rent-seeking
• Efforts to use government to restrict competition,
e.g., local monopolies, regulations
• Outright grants, exemptions from regulations and
taxes
• Use government to generate rents for producers
by directly setting prices in markets
Price Floor
Price Ceiling
 Problems of
Geographic Representation
• Geographic
Representation: District-
based Legislature
– Constituencies with
heterogeneous preferences
– Representatives serve the
narrow interests of their
constituencies
– Reelection encourages
them to pay special
attention to the interests of
Other problems? their districts
 Shortened Time-Horizons
• Representatives should select policies for which the
present value of benefits exceeds the present value of
costs.
• In making comparison, each representative should apply
the same social discount rate to the streams of benefits
as to costs.
• Representative discounts heavily costs and benefits that
will not occur in the short run.
• Myopic judgement
– Perception of vulnerability in reelection bid
– Ease with which an opponent can draw attention of electorate
to yet unrealized future costs
 Posturing to Public Attention
• Candidates for public office must compete for the
attention of the electorate
• Media offers opportunity for representatives to
reach the public.
• A policy agenda strongly influenced by the pattern of
media coverage and political advertising is not
necessarily consistent with the concept of public
policy as a rational search for ways to improve social
welfare.
• Sunk costs; Precedents; Perceptual biases
Problems Inherent in
Bureaucratic Supply
Problems in Bureaucratic Supply
• Governments often create
publicly funded organizations to
deal with perceived market
failures.
• Agency Loss
– Costs of undesirable behavior of
employees + costs to monitor and
control it
– Asymmetry of information
– E.g., discretionary budget
Problems in Bureaucratic Supply
• The difficulty in valuing public outputs (and,
therefore, performance)
• The lack of competition among bureaus
• The inflexibility of civil service systems

Examples or cases?
Problems Inherent in
Decentralization
 Decentralization
• Provides a system of “checks and balances”
• Facilitates both the production of public goods
at efficient levels and the matching of local
public goods to local preferences
• Brings citizens closer to public decisions
• But limits the effectiveness of public policies
– Hinder implementation
– Allows for fiscal externalities
 Implementation Problem
• Policy based on incorrect theory may produce
unintended consequences.
• But effective design is only a necessary, but
not a sufficient condition for an effective
policy.
• Problem of non-compliance
• Problem of interorganizational cooperation
• Problem of monitoring compliance of multiple
jurisdictions
Other implementation problems?
 Fiscal Externalities
• Tiebout model – citizens “voting with their
feet”
• Jurisdictions have an incentive to exclude
those who would have below-average tax
shares and above-average demands on public
services (and vice-versa)
• Or those who would impart a negative fiscal
externality to established residents.
Correcting Market and
Government Failure
 Generic Policies
• The process of freeing, facilitating, and
simulating markets
• Using taxes and subsidies to alter incentives.
• Establishing rules
• Supplying goods through non-market
mechanisms
• Providing economic protection
Freeing, Facilitating, and Simulating
Markets
Using Subsidies and Taxes
to Alter Incentives
Using Subsidies and Taxes
to Alter Incentives
Establishing Rules
Supplying Goods through
Nonmarket Mechanisms
Providing Insurance and Cushions
 Reminders
Annotated Bibliography
• Due date: 11 March 2017 (Sat)
• Email the following
– Annotated biblio
– Copy of articles in pdf
• Email at rbcruz@up.edu.ph
Mid-term Exam
• 16 March 2017, Thursday, 5:30-8:30pm
Readings for Next Week
• Henry, Nicholas (2007). Chapter 10.
• Anderson, James (2015). Chapter 1.

Read in advance:
• Cruz, RB. Political Markets.
• Ostrom, E. Beyond Markets and States.
• Salamon et al. The Tools Approach: Basic
Analytics.