Public Choice

Public Choice
Prelude
 Expenditure on private goods – determined by prices
 Competitive economy – private goods

 Price plays the key role (remember endowment → Pareto set)
 Supply side – upward sloping supply schedule (cost minimization/profit
maximization duality)
 Demand side – downward sloping (utility maximization/expenditure
minimization duality)
 Equilibrium – intersection of demand and supply schedules
 Expenditure on public goods – determined by political process
2
Prelude
 Decisions about resource allocations in the public sector are quite
differently made
 Individuals vote for elected representatives
 Elected representatives vote for a public budget
 The money itself is spent by a variety of administrative agencies
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Prelude
 Thus, there is a major difference between how an individual decides to
spend his or her own money and Government decides to spend the
public money
 The vote of a member of Parliament is supposed to reflect the viewsof
constituents
 In deciding how to vote, members of Parliament face two problems

1. they must ascertain the views of their constituents, and
2. because these views are likely to differ, they must decide how much
weight to assign to various positions
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Questions to start with
 In what ways does collective decision making, such as determining
the level of public goods, differ from standard decision making within
a household?
 What is the problem of eliciting preferences?
 When individuals differ in what they want, say, about the level of
expenditures on a public good, how are those differences resolved?
 What is meant by the problem of “aggregating preferences”?
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The Problem of Preference Revelation
 Individuals’ desirability of one private good versus another is revealed
by a simple action—by buying the good or not
 Desirability of one public good versus – no comparably effective way
 Elections of public officials convey only limited information about

voters’ attitudes toward specific public goods; at best, they convey a
general notion that voters prefer more or less government spending
 Even if individuals were asked directly about their preferences, would

they truthfully and meaningfully reveal them?
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 Election results are quite confusing – some polls suggest that voters
would be willing to pay higher taxes or accept expenditure cuts to
reduce the deficit, but other polls suggest otherwise!
 Example from the US: Polls voters consistently say they believe that
the government should spend less on assistance to foreign countries,
when asked how much should be spent, they give a number
considerably in excess of what the United States is currently spending
 Only some concrete trade-offs might help them think more precisely
 Problem – reveal truthfully their preferences concerning public

goods
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 If what they have to pay does not depend on their answer – one would
normally like more public goods as long as one does not have to pay
for them
 However, if what an individual says affects how much he or she has to

pay, there is an incentive for the individual to pretend that he or she
enjoys the good much less than he or she really does— the individual
knows that the answer will have a negligible effect on the total amount
supplied, and he or she would like to be a free rider
 In public decisions, however, the decision maker must ascertain the

preferences of those on whose behalf he or she is making the decision.
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Individual Preferences for Public Goods
 Collective decision making is difficult because different individuals
have different views
 Sometimes there are simply differences in tastes.
 Most of the times it’s about incomes and taxes….
 Richer individuals have higher incomes, so normally they prefer to

spend more on all goods, both public and private.
 When the government spends more on public goods, however, richer

individuals often have to pay a relatively large share of the additional
cost.
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 In the case of private goods, rich and poor individuals typically pay the
same price; with public goods, in effect, richer individuals typically
have to pay a higher price
 The tax price is the additional amount an individual must pay when
government expenditures increase by one dollar.
 The tax price multiplied by total government expenditures equals the

individual’s tax payment
 A higher tax price by itself means that richer individuals would want a
lower level of expenditures on public goods
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 Income effect leading to a higher desired demand; price effect leading
to a lower desired demand – the net effect is ambiguous
 Assume there are N people and each must pay the same amount,
regardless of income (uniform taxation) – tax price is just 1/N and
the tax payment is G/N
 With proportional taxation, everyone pays the same percentage of

income –
 Suppose Y is average income, NY is total income; if t is the tax rate, then
tNY is total government revenue;
 Government expenditures will be G = tNY. Tax rate t=G/NY
 The tax payment of an individual with income Yi is 𝑡𝑡𝑌𝑌𝑖𝑖 = 𝐺𝐺𝑌𝑌𝑖𝑖 /𝑁𝑁𝑁𝑁
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 If government expenditures increase by a dollar, the individual’s
incremental tax—the tax price—is just Yi /NY.
 Thus, an individual with average income (Yi = Y) faces a tax price of 1/N
 An individual with above-average income (Yi > Y) faces a higher tax price
 An individual with below-average income faces a lower tax price.
 A progressive tax system is one in which tax payments increase more

than proportionately with income;
 A regressive tax system is one in which they increase less than
proportionately.
 Accordingly, the tax price for a high-income individual under a
progressive tax system is typically greater than Yi /NY.
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 Given the individual’s tax price, we can derive his or her preferred
level of public goods expenditure
 Individuals with different incomes face different budget constraints;
 The preferred levels of public goods expenditure are at the tangencies

of the indifference curves with the budget constraints
 With proportional taxation, individuals with lower incomes face a

lower tax price (flatter budget constraint)
 The income and substitution effects work in opposite directions
 Ambiguous whether the most preferred level of government expenditure
is higher or lower
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 Different individuals will differ with respect to their preferred level of
expenditures.
 With proportional taxation, poorer individuals face lower tax prices,

and on that account, their preferred level of expenditures, GP, is
higher.
 Poorer individuals have lower incomes, however, and with lower
incomes they demand less public as well as private goods.
 The net effect is ambiguous.
 If the substitution effect (lower tax price) dominates the income

effect, so the poorer individual does prefer a higher level of public
goods than the richer person
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 With uniform taxation, all individuals face the same tax price, so
there is only an income effect – rich individuals prefer higher levels of
expenditure.
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 With progressive taxation, lower-income individuals will face a
lower tax price than with proportional taxation, so their preferred
level of expenditures will be even higher than with proportional
taxation.
 How does utility depend on the level of government expenditures?
 The individual’s most preferred level of expenditures occurs at G*, but

utility is maximized under a budget constraint, at the point of
tangency with the indifference curve.
 The further away the actual level of expenditures is from the preferred
level of expenditures, G*, the lower the level of utility.
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18
 Relationship between the level of utility and the level of public goods
expenditure for three different groups—the rich, the poor, and the
“middle”
 Let’s assume uniform taxation
 Each has its own preferred outcome, and utility decreases as

expenditures deviate either above or below that level
 For expenditures above the middle, the marginal benefits of increased

public expenditure are less than the marginal costs the individual bears
in additional tax payments, whereas the converse holds for
expenditures below the preferred level.
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 Assuming the rich prefer higher levels of expenditure to the middle
class, who prefer higher levels than the poor –
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The Problem of Aggregating Preferences
 In the public sector decisions are made collectively.
 For example, when a politician votes to increase expenditure on some

public good, it is intended to represent the interests of his or her
constituents
 But their opinions are not likely to be unanimous: some individuals
would like more military spending, others less; some individuals
would like more expenditures on welfare, others less
 What “the people” want - how can a social decision be made from
these divergent views?
 In a dictatorship, the answer is easy: the dictator’s preferences
dominate.
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The Problem of Aggregating Preferences
 There is no such easy resolution in a democracy
 A number of different voting rules have been suggested,
 Unanimity voting,
 Simple majority voting, and
 Two thirds majority voting.
 Of these, perhaps the most widely employed rule for decision making
in a democracy is simple majority voting.
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Majority Voting and the Voting Paradox
 A majority voting equilibrium requires that there is one alternative
that can win a majority in a contest against any alternative
 However, there may not exist any majority voting equilibrium!!!
 Example: three voters and three alternatives, denoted A, B, and C (A

could be spending more money on health care for children, B reducing
the deficit, C cutting taxes)
 Voter 1 prefers A to B to C.
 Voter 2 prefers C to A to B.
 Voter 3 prefers B to C to A.
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 Assume we vote on A versus B.
 Voters 1 and 2 vote for A, so A wins.
 Now we vote on A versus C. Voters 2 and 3 prefer C to A, so C wins.
It appears that C should be the social choice. C wins against A, which
wins against B.
 But let us now have a direct confrontation between C and B. Both
Voter 1 and Voter 3 prefer B to C.
 This is referred to as the voting paradox, or the paradox of cyclical

voting.
 There is no clear winner
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 Assume we began by saying we were going to first  Voter 1
vote on B versus C, and put the winner against A. prefers
 B beats C, and then A beats B. A to B to C.
 But just to check that we had made the right decision
(A), we decide to put A against C.  Voter 2
 C beats A. So we think C is the winner. prefers
 But then we check that by challenging C with B. C to A to B.
 B beats C—which was our original vote.
 B again appears to be the winner.  Voter 3
 But just to check, we again challenge it with A. A prefers
again beats B, as we knew from our earlier vote. B to C to A.
 The voting process thus goes on and on …..
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 Often, to avoid these voting cycles, democracies organize their
decision making as a sequence of votes
 In that case, it may be very important to control the agenda—the

order in which the votes occur.
 The winner of each of these elections is determined solely by the

order in which the pairwise comparisons were made.
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 Note, too, that if individuals realize there is going to be a particular
sequence of votes, they may wish to vote strategically.
 That is, in the first round of the vote, Voter 1 may not vote his or her
true preferences on, say, A versus B, but think through the consequences
of that for the eventual equilibrium.
 The voter may vote for B, even though he or she would prefer A,
knowing that in a contest between C and B, B will win, whereas in a
contest between A and C, C might win.
 Because this voter prefers B to C, he or she votes initially for B.
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 This analysis leads to two questions –
1. Are there voting rules that will ensure a determinate outcome for
any vote?
2. Are there any circumstances under which simple majority voting
will yield a determinate outcome?
 It turns out that the voting paradox cannot be resolved through voting
rules, but there are indeed circumstances in which majority voting
yields clear decisions.
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Arrow’s Impossibility Theorem
 An endless cycle of voting is clearly an unsatisfactory state of affairs.
 It is natural to ask, then, whether there is any other political
mechanism (any other set of rules for making social decisions) that
eliminates this problem.
 An ideal political mechanism should have four characteristics –

 Transitivity: simple majority voting lacks this essential property, lack
of this property may lead to cyclical voting.
 Nondictatorial choice: give all decision-making powers to a dictator;
as long as the dictator has consistent preferences, then there will never
be a voting cycle. However, a meaningful political mechanism must
ensure that the outcomes do not simply reflect the preferences of a
single individual
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 Independence of irrelevant alternatives: if we have to make a
choice between, say, a swimming pool and a tennis court, the outcome
should not depend on whether there is a third alternative, such as a
new library
 Unrestricted domain: The mechanism must work no matter what the
set of preferences and no matter what the range of alternatives over
which choices are to be made
 In looking for a system that would satisfy all four of these properties, a
number of alternative rules have been examined, but each fails one or
more of the requirements.
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 For instance, rank-order voting (individuals rank the alternatives,
then the ranks assigned by all individuals are added together, and the
alternative with the lowest score wins) does not satisfy the
“independence of irrelevant alternatives” criterion.
 Arrow’s impossibility theorem: there was no rule that would

satisfy all the desired characteristics
 “The government seems to be acting in an inconsistent manner,” or

“Why doesn’t the government determine its priorities and then act on
them?”
 treating the government as if it were an individual

31
 We come to expect that government should act consistently like a
rational individual.
 Arrow’s impossibility theorem suggests that, unless some individual is

granted dictatorial powers, the government should not be expected to
act with the same degree of consistency and rationality as an
individual.
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Notations and Pareto Criteria
 𝑅𝑅𝑖𝑖 is person i's preference relation: implying 𝑥𝑥𝑥𝑥𝑖𝑖 𝑦𝑦 means 𝑖𝑖 likes 𝑥𝑥 as
well as 𝑦𝑦.
 𝑃𝑃𝑖𝑖 is the associated strict preference relation
 𝐼𝐼𝑖𝑖 is the associated indifference relation
 Also, 𝑢𝑢𝑖𝑖 is person i's utility function
 Let 𝑥𝑥 and 𝑦𝑦 be two alternatives

 Then 𝑥𝑥 is Pareto superior to 𝑦𝑦 (written as 𝑥𝑥𝑥𝑥𝑥𝑥) if
𝑥𝑥𝑥𝑥𝑖𝑖 𝑦𝑦 for all individuals and
𝑥𝑥𝑃𝑃𝑖𝑖 𝑦𝑦 for at least one individual
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Characteristics
 Completeness and transitivity: either xRy or yRx must hold and
xRy and yRz must imply xRz.
 Majority voting gives non-transitive social rankings.
 Universality: An Arrow social welfare function should work no

matter what individual preferences happen to be
 Pareto Consistency: For any pair of alternatives x and y, if both

individuals prefer x to y, x must be socially preferred to y.
 Non-dictatorship: if xPi y implies xPy for all x and y, irrespective

of Pj, then, i is said to be a dictator (his wishes prevail).
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Characteristics
 Independence of irrelevant alternatives: If people's feelings
change about some set of irrelevant alternatives, but do not change
about the pair of alternatives x and y, then an Arrow social welfare
function must preserve the social ordering of x and y.
 The social preference between x and y must be independent of

individual orderings on other pairs of alternatives.
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Example
 Two individuals (1, 2) and three alternatives (x, y, z)
 No individual is ever indifferent between any two alternatives
 xPi y ⇒ i prefers x to y
 Individual i's preference ordering is assumed to be complete and

transitive
 Given 3 alternatives, there are only six ways individual 1 can order the
alternatives
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Example
 He can prefer x to y to z, or he can prefer x to z to y, and so on…
 Same for individual 2
 Hence, there are exactly (6 x 6 = )36 different constellations of

individual preferences, or preference profiles, possible in this small
society
 Each cell in this table shows a possible pair of rankings of the three
alternatives by individuals 1 and 2
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Preference Profiles
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Arrow social welfare function
 Our concern here is whether or not there is a foolproof rule to transform
any cell in the table into a social preference relation.
 Such a rule is called an Arrow social welfare function.
 An Arrow social welfare function takes preference profiles and produces

social preferences.
 Let R stand for a social preference relation, so xRy means x is socially at least
as good as y.
 P is the corresponding strict social preference relation: xPy means x is socially

preferred to y; i.e., xRy and not yRx
 I is the social indifference relation: xIy means x and y are socially indifferent;
i.e., xRy and yRx
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Applying the requirements
 Let’s apply the Pareto principal first. It requires that a collective
choice rue must respect unanimous opinion – if both 1 and 2 prefer
one alternative to another, then that should also be followed by the
society
 For example, consider this cell
 Pareto requirement says x must be socially preferred to y and x must

be socially preferred to z. That is, we must have xPy and xPz.
 Application of Pareto consistency over the entirety of the previous

table gives rise to this new table –
40
41
 Now let’s apply the condition of Independence of irrelevant
alternatives
 Suppose that when person 1 prefers x to y to z and person 2 prefers y

to x to z, an Arrow social welfare function (or, a collective choice rule)
declares x is socially preferred to y, or xPy.
 Then independence requires that xPy hold whenever xP1 y and yP2 x
no matter how 1 and 2 rank alternative z.
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 Similarly, if yPx (or xIy) holds when person 1 prefers y to x to z and
person 2 prefers x to y to z, then yPx (or xIy) must hold whenever
yP1 x and xP2 y
 In short, the independence requirement forces an Arrow social welfare

function to give rise to social preferences that agree over certain
preference profiles
 Independence requires that all the cells in the table where

xP1 y and yP2 x must yield identical social rankings of x and y.
 Similarly, all the cells where yP1 x and xP2 y must yield identical
social rankings of x and y.
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 Let’s consider the cells again such that we can indicate them in terms
of the following preferences –
if xPy ( xP1 y and yP2 x), cell is marked with ×
if yPx ( yP1 x and xP2 y ), cell is marked with 0
 Similarly we can indicate the social rankings over x-z and y-z
44
 The crossed cells all produce the same x-y social rankings. The circled
cells all produce the same x-y social rankings (which need not be the
same as in the crossed cells).
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 The crossed cells all produce the same x-z social rankings. The circled
cells all produce the same x-z social rankings (which need not be the
46
 The crossed cells all produce the same y-z social rankings. The circled
cells all produce the same y-z social rankings (which need not be the
47
Arrow's Impossibility Theorem
 Does there exist a foolproof rule for discovering, or for defining,
social preferences?
 Arrow showed that, if foolproof means consistent with the five

requirements above, the answer is No.
 Statement: Any Arrow social welfare function which is consistent

with the requirements of (1) completeness and transitivity, (2)
universality, (3) Pareto consistency, and (5) independence of irrelevant
alternatives, makes one person a dictator. Therefore, there is no rule
which satisfies all five requirements.
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Arrow's Impossibility Theorem
 We start by looking at the preference profile of the first row, second
column cell of the first table
 For these preferences Pareto consistency requires xPy and xPz
 There are three and only three complete and transitive social
preference orderings which satisfy xPy and xPz.
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Case 1: yPz
 If yPz holds in the first row, second column cell, then independence
requires that y be socially preferred to z whenever individual
preferences about y and z are the same as they are in that cell.
 Therefore yPz holds in all the cells indicated in
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Case 1: yPz
 Now consider the first row, fifth column cell, or cell number 2 in the
last table.
 Pareto consistency requires that xPy here, but xPy and yPz implies xPz,
by transitivity.
 So in this cell we must also have xPz.
 But if xPz holds in cell number 2, then independence requires that x be

socially preferred to z whenever individual preferences about x and z
are the same as they are in that cell.
 Therefore, xPz holds in all the cells indicated in the following table
51
Case 1: yPz
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Case 1: yPz
 Now we have xPz in cell 3.
 We again invoke Pareto consistency and transitivity to conclude that

xPy must hold in cell 3 as well.
 But this allows us to use independence again to fill in eight more bits
of information
 When done, the result is the pattern of social preferences will be like -
53
Case 1: yPz
54
Case 1: yPz
 But the social preferences shown in the last table are identical to
person 1's preferences.
 Therefore, in Case 1, 1 is a dictator.
 He gets his way, no matter how 2 feels.
 When you calculate the other 2 cases you will find
 Either 1 or 2 is a dictator
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What we have already learned
 The Problem of Preference Revelation – reveal truthfully their
preferences concerning public goods
 Problem of collective decision making
 Individual Preferences for Public Goods depending on tax pattern –

uniform, proportional, progressive
 Utility and level of Government expenditure
 Problem of Aggregating Preferences
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 What “the people” want - how can a social decision be made from
these divergent views?
 In a dictatorship, the answer is easy: the dictator’s preferences

dominate.
 Any solution for a democratic system? Voting?
 Majority Voting and the Voting Paradox
 Order of Voting, strategic voting
57
 Arrow’s Impossibility Theorem
 Preference profiles
 Arrow Social Welfare Function, Five Characteristics
 Application of the characteristics – proof of the theorem
58
Voting System
 Arrow established that there does not exist any way of adding together
the preferences of different individuals to satisfy all the desired
characteristics of a choice mechanism
 Similarly, there does not, in general, exist any voting system in which
individuals will always vote their true preferences
 A voting system is any set of voting rules by which a group

of individuals tries to reach a decision
59
Single-peaked Preferences
 Arrow established that there is no voting rule that always satisfies the
five desirable properties of a social choice mechanism
 However, under some conditions, the simple system of majority voting

yields a determinate outcome
 Let’s reconsider individual the utility curves (as a function of the level
of expenditure on public goods)
 There, each individual has a single peak to his or her preference profile
- single-peaked preferences
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 This property of single-peaked preferences is enough to
guarantee the existence of a majority voting equilibrium.
 The single peak can be interior or border
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Double-peaked Preferences
 Example of double-peaked preference
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Double-peaked Preferences
 Why double peaked?
 Example of a rich individual and level of public expenditure in

education
 High level of expenditure is preferred to no expenditure, but no

expenditure is preferred to an intermediate level of expenditure.
 There may be no majority voting equilibrium in this case.
63
 Preferences for a single public good (with no private good option, unlike
education) are usually single-peaked,
 However, when we have to rank choices involving more than one

public good, those rankings are seldom single-peaked.
 This we have already seen in the circularity case
 To obtain single-peakedness, we have to restrict ourselves to voting

on one issue at a time.
 More importantly, for most distribution issues there will not be a

majority voting equilibrium
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 This can be seen most clearly in considering the structure of income
taxation.
 Suppose we are voting among three income tax schedules that are
designed to raise the same amount of revenue.
 Let’s assume that there are three groups of individuals with equal
numbers—the poor, the middle class, and the rich
 They vote in solid blocks
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 The three tax schedules are denoted as A, B, and C
 Tax schedule A is strictly proportional; it takes the same fraction of

income from each individual
 The poor and the middle class then get together and propose tax
schedule B
66
 The three tax schedules are denoted as A, B, and C
 This reduces the taxes they pay but taxes the rich much more heavily.
 Clearly, tax schedule B will win a majority over A.
67
 Now, the rich propose to the poor: “Because you are more needy, why
don’t we lower your taxes somewhat more? At the same time, we’ll
adjust the tax schedule at the upper end, to reduce the inequities
associated with excessive taxation.”
 Thus, they propose tax schedule C, which, relative to B, lowers the

taxes on low and high income and raises them on middle income, so
that now both the middle- and upper-income individuals pay a larger
proportion of their income in taxes than do the poor.
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 Clearly, tax schedule C wins a majority over B.
 Now, however, the middle class proposes going back to straight

proportional taxation.
 Because both the upper- and middle-income individuals prefer

schedule A, A defeats C.
 We again get a cyclical pattern of voting.
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The Median Voter
 When preferences are single-peaked, we asserted that there is a well-
defined majority voting equilibrium.
 What does it look like?

 How does it correspond to the Pareto efficient equilibrium.
 When preferences are single-peaked, we can rank individuals by their

preferred levels of, say, expenditure on the public good, from the
individual who prefers the least to the individual who prefers the
most.
 The median individual is the individual such that half prefer less and
half prefer more than he or she does
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The Median Voter
 Consider the preferred levels of expenditure (in $) on public goods
Lucy Tom Jim John Jill
600 800 1000 1200 1400
 Jim is the median voter.
 The outcome of majority voting corresponds to the preferences of

the median voter.
 In this case, it is Jim’s preferred level ($1000) that wins
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The Median Voter
 If any level of expenditure below $1000 is voted on against $1000, Jim
plus all of those who want more than $1000 vote for $1000
 Because Jim is the median voter, a majority cast their vote for $1000.
 If any level of expenditure above $1000 is voted on against $1000, Jim

and all of those who want less than $1000 vote for $1000.
 Again, $1000 wins.
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The Inefficiency of the Majority Voting
Equilibrium
 The median voter determines the level of expenditure on public goods
 To ascertain whether there is too much or too little expenditure we

need only examine how the median voter votes, and contrast that with
the conditions for efficiency
 The median individual is assumed to compare only the benefits he or

she receives with the costs that he or she bears.
 The median voter’s benefits are lower than total social benefits (which
includes all the benefits that accrue to others), but so are his or her
costs.
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Equilibrium
 Whether there is too much or too little expenditure on public goods
thus depends on whether the median voter’s share of total (marginal)
costs is less or greater than his or her share of total (marginal)
benefits.
 For a wide variety of public goods, with proportional or progressive

taxation majority voting will result in an oversupply of public goods.
 Assume there are N individuals
 With uniform taxation, the tax price for each individual would be 1/N
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Equilibrium
 With proportional taxation, it would be Ym/YN, where Ym is the
income of the median voter and Y is average income
 With progressive taxation, the tax price would be still lower
 With a symmetric distribution of income the income of the median

individual equals the average income (Ym=Y)
 However, most income distributions are skewed – there are a few very
rich individuals, which increases the average income
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Equilibrium
 As a result, average income exceeds the income of the median
individual (Ym<Y) so that with proportional taxation the tax price is
even less than 1/N.
76
Equilibrium
 What fraction of the total marginal benefits accrues to the median
voter?
 If the marginal benefits are uniform, then the median voter gets 1/N
of the total marginal benefits.
 So, with uniform taxation, the median voter would get 1/N of the
total social benefits and bear 1/N of the total costs.
 Therefore, the median voter would vote for an efficient level of

expenditure.
77
Equilibrium
 With proportional or progressive taxation, however, the median
voter’s share of the cost would be smaller than his or her share of the
benefits, and he or she would vote for excessive expenditures—that is,
for a level of expenditure at which the sum of the marginal benefits is
less than the total marginal cost to society.
 Some forms of public expenditures are actually enjoyed

disproportionately by the poor: the rich may make less use of public
parks because they have large yards of their own.
78
Equilibrium
 According to the median voter theory, there is an especially large
tendency for an oversupply of such goods.
 In many cases, it is difficult to ascertain the balance: the median voter

gets a smaller share of the benefits and bears a smaller share of the
costs.
 In the examples discussed so far, the median voter corresponds to the

voter with the median income.
 This is often, but not necessarily the case
79
Two-party System and Majority Voting
Equilibrium
 An elected representative bears a negligible fraction of the costs of,
and receives a negligible fraction of the benefits from, an increase in
government expenditure.
 What can economic theory say about how he or she should vote?
 A natural supposition is that the politician wishes to stay in office and

that, accordingly, this individual wishes to maximize his or her votes,
given the position taken by his or her rival.
80
Equilibrium
 Assume there are two parties, “R” and “D.” Party R takes the position
of Party D as a given.
 Focusing on a single issue, the level of expenditure, denote by GR the

position of Party R (that is, the level of public expenditure advocated
by the party) and by GD the position of Party D.
 For each value of GD there is an optimal (that is, vote-maximizing)

position for GR.
 What will each party do (each seeks to maximize vote)?
81
Equilibrium
 Let Gm be the preferred level of expenditure of the median voter.
 Suppose Party D chooses GD >Gm.
 Then, if Party R takes a position between Gm and GD, it will get all the
voters who prefer an expenditure level less than or equal to Gm, and
some who prefer slightly more; thus Party R gets over 50 percent of
the votes and wins.
82
Equilibrium
 In response, Party D will choose a position, G’D, between Gm and GR,
which wins against GR.
 Then, however, Party R chooses a position, G’R, between G’D and Gm.
 The process continues until both parties stand for the same position:
that of the median voter (Gm).
83
Equilibrium
 This result is consistent with the widely observed allegation that with
our two-party system, voters get no choice: both parties take a
“middle-of-the-road” position
 Limitations –
 There may not be a majority voting equilibrium. Equilibrium exists if
individuals have single-peaked preferences (single dimension). Multi-
dimension may lead to the problem of cyclicity
 Participation in the political process (costs of being informed and
voting)
84
Equilibrium
 In particular, voters whose preferences are near the median have little
incentive to be politically active, particularly if they believe that the
political process will reflect their preferences anyway .
 Thus, it may be in the interests of those who are more extreme to
attempt to pull their party away from the center.
 This tendency for greater political activism at the extremes may
partially off set the median-directed tendencies.
 There is a tension between the centripetal force of the median voter
model and the centrifugal force of the base voter mobilization model.
85
Majority Voting – Summary
 Proposal that gets a majority against all other wins.
 When majority voting equilibrium exists, it reflects preferences of the

median voter.
 In a two-party system, both parties will converge to the position of the median
voter.
 Majority voting equilibrium is not, in general, Pareto efficient.
 Majority voting equilibrium may not exist.

 Cyclical.
 Majority voting equilibrium exists if preferences are single peaked.
 Arrow’s Impossibility Theorem: There does not exist an alternative voting

mechanism that avoids problems of majority voting (and satisfies certain
other desired properties).
86
Any alternative?
 Majority voting – quite a few problems
 However, it’s the most commonly used method of making collective

decisions
 There might not exist an equilibrium
 If exists, then also can easily be Pareto inefficient
 Strategic voting – true preferences not revealed
 No ideal mechanism, but, is there an alternative?
87
Lindahl Equilibrium
 Erik Lindahl came up with the famous alternative known as the
Lindahl solution.
 Lindahl focused on efficiency
 It draws heavily from the way that the market works in providing
private goods
 Market equilibrium for private goods: intersection of the demand and

supply curves
 All individuals face the same price and market clears
88
Lindahl Equilibrium
 For public goods, efficient level that can be provided can be
interpreted as – intersection of the “collective’’ demand curve (formed
by adding vertically each individual’s demand curve) with the supply
curve
 The demand curves are generated by asking the individual how much
of the public good he or she would demand if he or she were to pay so
much for each unit produced
 So, if an individual faces a tax price p1, he will demand G* amount of

the public good
89
Lindahl Equilibrium
 For public goods, efficient level that can be provided can be
interpreted as – intersection of the “collective’’ demand curve (formed
by adding vertically each individual’s demand curve) with the supply
curve
 The demand curves are generated by asking the individual how much
of the public good he or she would demand if he or she were to pay so
much for each unit produced
 So, if an individual faces a tax price p1, he will demand G* amount of

the public good
 Similarly for individual 2 (p2 and G*)
90
Individual 1
91
Individual 2
92
Lindahl Equilibrium
 Vertical addition of demand curves and intersection with the supply
curve leads to Lindahl equilibrium
 Price, along the supply curve, measures the marginal cost of

production.
 p1 measures the first individual’s marginal benefit (marginal

willingness to pay for an additional unit of government expenditure) at
G*, and what he or she has to pay, and p2 measures the same thing for
the second individual.
 At G*, the sum of the marginal benefits (the total marginal willingness
to pay) just equals the marginal cost.
93
Lindahl Equilibrium
94
Lindahl Equilibrium
 The Lindahl equilibrium is thus a set of tax prices (the amount each
individual has to pay if one more unit of the public good is produced)
adding up to the marginal cost of production, such that, given those
tax prices, every individual prefers the same level f expenditures, G*.
 Because at the Lindahl equilibrium the sum of the marginal benefits

equals the marginal cost, the Lindahl equilibrium is Pareto efficient.
 However, there can be many Pareto efficient allocations, Lindahl

equilibrium being one of them.
 There can’t be an unanimous choice
95
Lindahl Equilibrium
 Individuals who are disadvantaged by this particular Pareto efficient
point will not agree to the use of this mechanism for determining the
allocation of public goods
 They would prefer Pareto inefficient allocations as long as the level of

utility they obtain is higher
 Criticism: individuals do not have an incentive to tell the truth

because their tax price increases as their stated demand does
 The higher their stated demand (given the demand statements of

others), the higher the equilibrium expenditures on public goods will
be.
96
Lindahl Equilibrium
 Higher expenditures on public goods, of course, necessitate higher
equilibrium tax prices.
 The demand curves that are used in the Lindahl analysis were drawn
under the hypothesis that individuals face a given tax price; they
believe that nothing they say will alter what they have to pay per unit
of public expenditure.
 If they understand the Lindahl mechanism, however, they will realize

that what they say does alter what they have to pay per unit of public
expenditure, and thus they will not truthfully reveal their demands.
97
Comparison
 Majority voting
 Equilibrium may not exist.
 When equilibrium exists, in general, it is not Pareto efficient.
 Lindahl equilibrium
 Equilibrium always exists.
 Equilibrium is always Pareto efficient.
 Individuals do not have incentive for truthful revelation of
preferences.
98
A Simple Model
 A good is public if it is by nature available to all: if one man uses it,
everyone can use it.
 Public goods can be viewed as goods with extreme external effects: if

person i's consumption of the good is X, then X appears in each and
every person's utility function.
 The model we use here has both production and consumption,

because one principal question we want to answer is this: How much
of the public good should be produced?
99
A Simple Model
 The answer to the question depends both on people's demand for it,
and on the nature of the productive sector of the economy.
 We assume that there are only two goods, one private, and one public.
 Also we assume that the productive sector of the economy can

transform units of the private good into units of the public good, in
the ratio of one to one.
 Therefore, we assume the equilibrium prices of the two goods are 1

and 1.
100
A Simple Model
 We assume that person i's utility is the sum of the quantity of the
private good he consumes, plus a well-behaved function of the
quantity of the public good produced and available to all, including i.
 Such a utility function is said to be separable between private and

public consumption.
 X = the quantity of the public good
 Note that x can be viewed as the quantity (or size) of the public good
in physical units, or in dollars, since we assume that the prices of both
the public and the private good are one
101
A Simple Model
 yi = person i's quantity of the private good
 person i's utility function: ui = vi ( x) + yi
 That is, i's utility is the sum of the function vi, which depends only on
X, plus i's quantity of the private good.
 assume that vi is continuous, smooth, monotonic, and concave
 MU of the public good for i, when the quantity of the public good is x,
vi' ( x)
102
A Simple Model
 We also assume that each person starts with an initial endowment of
the private good. ωi
 Feasibility condition:
 Pareto Optimal output (Samuelson condition):
103
Wicksell-Lindahl Tax System
 A central government authority called the Public Good Board decides
on the output of the public good X, and collects taxes to pay or X.
 Requirements –
 it should somehow provide for a Pareto optimal output of the public
good
 it ought to link a person's taxes to the benefits he receives
 Why should a person who gets little or no utility from the public good
pay the same taxes as a person who gets lots of utility from it?
104
 Let Ti stand for person i's total tax payment to the Public Good Board.
 With the total tax Ti, i's budget becomes – yi + Ti = ωi

where, yi is the expenditure on consumption of the private good
with price 1 and ωi is the income (endowment)
 Prices of private and public good are 1 and 1
 Therefore, Ti can be interpreted either as a payment in dollars (or

currency), or as a payment in units of the private good
 Assumption: each person i has to bear a fractional share of the

expenditure on the public good ti
105
 Since, ti is the “share”, we must have ∑t i =1
 If the total quantity of the public good produces is x, then, Ti = ti .x
 So, the individual utility maximization problem will be –
max ui = vi ( x) + yi
s.t. yi + ti x = ωi
 Re-write: max vi ( x) − ti x + ωi
 Hence, i's desired quantity of the public good xî (ti ) will be
determined by vi' ( x) = ti
106
 Observation – the higher is person i's share ( ti ), the lower is the
quantity of the public good xî (ti ) he wants produced (analogous to
law of demand)
 If the actual output of the public good happens to coincide with i's
desired output of the public good, that is, x = xî (ti ) , then, then i's
marginal utility from the public good vi' ( x) equals his tax share ti
 But how can the actual output be made to agree with i's desired
output?
 If there are n people, then there might be with n optimized levels of x!
107
 How can the Public Good Board find a way to insure that each and
every person's tax share is linked to his marginal benefit?
 The trick of the W-L tax scheme is to adjust the tax shares until every
person agrees on the desired output of the public good.
 Suppose 2 individuals with t1 = t 2 = 1

2
 But, xˆ1 ( 12 ) = 10; xˆ2 ( 12 ) = 20
 So, no agreement on optimal x given tax share
108
 Solution: decrease t1 and increase t 2
 As t1 decreases, 1 wants more and more of the public good produced.
 As t 2 increases, 2 wants less and less of the public good produced.
 Eventually, a point is reached where each thinks the same quantity of

the public good should be produced.
 Say that point is reached when xˆ1 ( 13 ) = 14 = xˆ2 ( 23 )
109
 Formally, a Lindahl equilibrium is defined to be a vector of tax shares
(t1 , t 2 ,..., t n ) and a level of output x for the public good, such that,
for all i, when i's tax share is ti his desired level of public good output
equals x.
 That is, for all i, x̂ maximizes ui = vi ( x) + yi ; s.t. yi + ti x = ωi
 Lindahl equilibrium, as characterized by the W-L tax system, equates

tax shares and marginal benefits for every person
 what people pay is connected to what they get
110
 It should be emphasized that the connection is with marginal utility
rather than total utility.
 Does a Lindahl equilibrium level of public good output x have to be

optimal?
 Yes! Under W-L tax system, we have –
 Now, ∑t i =1
 Hence, ∑ i ( x) = ∑ ti = 1 (Samuelson optimality condition)

v '
111
 Drawbacks of the W-L tax system (or the Lindahl equilibrium)
1. Lindahl equilibrium might not exist! Take for example,

v1 ( x) = 0.75 x + ln x
and
v2 ( x) = 0.25 x + ln x
Check, that equilibrium doesn’t exist (hint: ∑ i ( x) ≠ 1 )
v '
2. Excludability
3. Lindahl equihbrium concept is one in which individuals are "price-

takers," i.e., they take their tax shares, or personalized prices, as
given.
112
 Problem of Incentives: When the Public Good Board calculates the
Lindahl equilibrium, when it calculates the appropriate vector of tax
shares (t1 , t 2 ,..., t n ) and the output for the public good X, it relies on
information it receives from the individuals.
 It needs each individual's xî (ti ) schedule, which we might call i's
demand schedule for the public good.
 Alternatively, it needs vi' ( x) ∀ i = 1,2,..., n
 You will lie!!! (free riding)
113
 So, when n is large, lying will induce the Board to produce a slightly
smaller x.
 Moreover, given the mechanism, tax share will drop dramatically.
 So the person who is willing to conceal his demand for the public good
will end up with almost as much of it as he would have otherwise, and
he'll pay a lot less per unit than the would have otherwise!
 Major problem: demand revelation.
114
Fixed Tax Shares
 Fixed tax share, median voter, majority voting
 ti = 1/n; T=n.ti
 ti = wi/sum wi
 ti, x
 X*=Xm (ti), Xi (ti)
 Vi’not=ti as you choose the median xm over all other xi through

majority voting
115
The Demand-Revealing Tax Scheme
 Ideal tax system must have the following 2 properties –
 Optimal output of x
 A system that rules out misrepresentation (this rule would lea to solve for
incentive compatibility)
 Under demand revealing tax system, each i sends a signal (nothing

but vi )
 This might be true, might not be true!
 Government derives vi' such that ∑ i =1

v '
 Aggregate net benefit maximization: x̂ such that ∑ v ( x) − x is

i
maximized SUCH THAT sum Ti> x̂
116
 Under W-L tax system people might lie
 Under demand revealing tax system the Government sets total tax Ti
instead of ti following the rule –
Ti = xˆ − ∑ v j ( xˆ ) j≠i
j
 Let’s consider the ith individual. He doesn’t know whether v−' i is true
or not
 He only maximizes ui = vi ( xˆ ) + yi ; s.t. yi + Ti = ωi
 Board chooses x̂ and Ti but i shares vi which indirectly gives x̂

and hence, Ti
117
 Individual i (and everyone else) knows that Ti = xˆ − ∑ v j ( xˆ )
j
 Therefore, max vi ( xˆ ) − [ xˆ − ∑ v j ( xˆ )]
j
 If i lies (say, reports ~ ), Board comes up with, say, ~

x
vi
 If i truly reports ( vi ), Board comes up with x̂
 Can i lie in a way such that he is better off?
118
 Individual i knows that if i truly reports ( vi ), Board comes up with x̂
such that
max ∑ vi ( x) − x = vi ( x) + ∑ v j ( x) − x = vi ( x) − [ x − ∑ v j ( x)]
i≠ j i≠ j
 Hence, Board’s goal and i’s objectives coincide.
 Lying is sub-optimal
 Holds for every individual (telling truth is the dominant strategy)
 Same logic of Vickrey (truth serum)
119
 Disadvantage – insufficient funds.
 Can be solved but will lead to ∑T i > xˆ
 But we can’t have a tax system such that (i) truth, (ii) Pareto
optimality and (iii) non-wastage ( ∑T i = xˆ )
 However, surplus, if any, is very small
 X=1000; v1=0; v2=500; v3=100; v4=200; v5=300

 T1=1000-(500+100+200+300)=-100, T2=400;T3=0; T4=100;
T5=200
120
References
 Stiglitz, JE and JK Rosengard (2015). Economics of the Public Sector,
4th Edn. WW Norton. Chapter 9
 Feldman, AM and R Serrano (2006). Welfare Economics and Social

Choice Theory, 2nd Edn. Springer. Chapters 8 and 13.
121

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Public Choice

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Public Choice

 Competitive economy – private goods

 Equilibrium – intersection of demand and supply schedules

 Expenditure on public goods – determined by political process

 Individuals vote for elected representatives

 Elected representatives vote for a public budget

 The money itself is spent by a variety of administrative agencies

 In deciding how to vote, members of Parliament face two problems

 What is the problem of eliciting preferences?

 What is meant by the problem of “aggregating preferences”?

 Desirability of one public good versus – no comparably effective way

 Elections of public officials convey only limited information about

 Even if individuals were asked directly about their preferences, would

 Problem – reveal truthfully their preferences concerning public

 However, if what an individual says affects how much he or she has to

 In public decisions, however, the decision maker must ascertain the

 Sometimes there are simply differences in tastes.

 Most of the times it’s about incomes and taxes….

 Richer individuals have higher incomes, so normally they prefer to

 When the government spends more on public goods, however, richer

 The tax price multiplied by total government expenditures equals the

 With proportional taxation, everyone pays the same percentage of

 A progressive tax system is one in which tax payments increase more

 Individuals with different incomes face different budget constraints;

 The preferred levels of public goods expenditure are at the tangencies

 With proportional taxation, individuals with lower incomes face a

 With proportional taxation, poorer individuals face lower tax prices,

 If the substitution effect (lower tax price) dominates the income

 How does utility depend on the level of government expenditures?

 The individual’s most preferred level of expenditures occurs at G*, but

 Let’s assume uniform taxation

 Each has its own preferred outcome, and utility decreases as

 For expenditures above the middle, the marginal benefits of increased

 For example, when a politician votes to increase expenditure on some

 A number of different voting rules have been suggested,

 Simple majority voting, and

 Two thirds majority voting.

 However, there may not exist any majority voting equilibrium!!!

 Example: three voters and three alternatives, denoted A, B, and C (A

 This is referred to as the voting paradox, or the paradox of cyclical

 There is no clear winner

 In that case, it may be very important to control the agenda—the

 The winner of each of these elections is determined solely by the

 Because this voter prefers B to C, he or she votes initially for B.

 An ideal political mechanism should have four characteristics –

 Arrow’s impossibility theorem: there was no rule that would

 “The government seems to be acting in an inconsistent manner,” or

 treating the government as if it were an individual

 Arrow’s impossibility theorem suggests that, unless some individual is

 Let 𝑥𝑥 and 𝑦𝑦 be two alternatives

 Universality: An Arrow social welfare function should work no

 Pareto Consistency: For any pair of alternatives x and y, if both

 Non-dictatorship: if xPi y implies xPy for all x and y, irrespective

 The social preference between x and y must be independent of

 No individual is ever indifferent between any two alternatives

 Individual i's preference ordering is assumed to be complete and

 Same for individual 2

 Hence, there are exactly (6 x 6 = )36 different constellations of

 Such a rule is called an Arrow social welfare function.

 An Arrow social welfare function takes preference profiles and produces

 P is the corresponding strict social preference relation: xPy means x is socially

 For example, consider this cell

 Pareto requirement says x must be socially preferred to y and x must