Ec 201: Principles of Microeconomics

Political Economy

Tim Besley

March 2022

TJB (LSE) Ec 201 March 2022 1 / 53

Introduction

Week 7: Lectures 13 & 14: How do governments behave?

Having explored the possibility of policy making markets work better,
we will ask whether we would expect governments to …x market
failures and promote equity.
This means thinking about government failure as well as market
failure.
And you will get a brief overview of the …eld of political economy
uses economic models and ideas to explore how politics a¤ects
economics and policy

TJB (LSE) Ec 201 March 2022 2 / 53

Two Main Themes

We will explore the following two aspects of political economy:

1 Preference aggregation (…rst lecture)

How can diverse views of the world be reconciled?

2. Constraining power (second lecture)

How can we control those who make decisions on our behalf?

Quis custodiet ipsos custodes

TJB (LSE) Ec 201 March 2022 3 / 53

The Idea of Political Failure

Main government functions are taxation, regulation and spending.

What would it mean to say that government is not doing its job
properly?
There are two broad main ways of approaching this:
Distributional issues:
do the distributional consequences of government action conform to
reasonable normative criteria?
i.e. a social welfare function
E¢ ciency issues
does the government spend/tax/regulate e¢ ciently?
can there be Pareto ine¢ cient policy?

TJB (LSE) Ec 201 March 2022 4 / 53

Example: The Problem of Corruption
Government o¢ cials may take bribes and/or favour their
friends/family
Recognized to be a widespread problem in many political systems
For example, the Transparency International Ranking:
https://www.transparency.org/cpi2018

TJB (LSE) Ec 201 March 2022 5 / 53

Example: The Problem of Corruption

Leads to arbitrary forms of redistribution via the state

towards those who have “political connections”
can skew policies away from those with broad societal bene…ts
Can increase the costs of delivering public projects
poor quality public infrastructure delivered at high cost
Creates poor societal incentives
entrepreneurs become rent-seekers

TJB (LSE) Ec 201 March 2022 6 / 53

Aggregating Preferences

People have di¤erent views and interests

The process of preference aggregation determines whose
views/interests are re‡ected in policy
This depends on the structure of political institutions
for example elections serve to aggregate preferences
We will begin by studying Arrow’s theorem
apply this to majority rule
then think about its implications for real political systems

TJB (LSE) Ec 201 March 2022 7 / 53

Aggregating Preferences
This topic operates in the spectre of Arrow’s theorem
Kenneth Arrow (1921-2017)

TJB (LSE) Ec 201 March 2022 8 / 53

Arrow’s Theorem

Can a consistent social welfare function be derived from set of

agreeable procedures?
if so, we could employ them and justify the use of that social welfare
function
Arrow set out to explore this in a work which was eventually
published in 1951 based on his PhD thesis
the result became known as Arrow’s impossibility theorem
We will brie‡y explore its content and then look at its implications for
political economy.

TJB (LSE) Ec 201 March 2022 9 / 53

Basics

Consider a set of possible government policies g1 , ...gV with typical

element gv .
Suppose that we have a collection of individuals i with preferences
u i (gv ).
We want to …nd a way of ranking the policies based on individual
preferences
and then we might want to use that rule to make policy decisions
Then Arrow said that a reasonable aggregation process ought to
satisfy four reasonable conditions
begin with three obvious ones and then one that is slightly trickier to
grasp and less intuitively appealling.

TJB (LSE) Ec 201 March 2022 10 / 53

Three Easy Ones

Unrestricted domain (U)

the procedure should work for all policies and con…gurations of
preferences
Non-dictatorship (D)
we cannot have a ranking that is simply one person’s ranking
Pareto principle (P)
if everyone prefers one policy to another, then the ranking should prefer
that policy to another
All of these seem uncontroversial

TJB (LSE) Ec 201 March 2022 11 / 53

Independence of Irrelevant Alternatives?

IIA: The ranking between two policies ga and gb should depend only
the individual preference ranking between a and b
What does it mean in practice?
Think of a jury of …ve people deciding to rank 5 candidates in a
competition
It decides to rank them 1,2,3,4,5
Then add up the score (this is called the Borda count)
It then announces the winner
This violates IIA as if one judge changes their ranking between two
candidates, it can change ranking between the winning two

TJB (LSE) Ec 201 March 2022 12 / 53

Independence of Irrelevant Alternatives?

Suppose that the ranking of the judges is

J1 J2 J3 J4 J5
C1 1 1 1 5 5
C2 2 2 2 4 4
C3 3 3 3 1 2
C4 4 4 4 2 3
C5 5 5 5 3 1

The order is

C 3(12) > C 1(13) > C 2(14) > C 4(17) > C 5(19).

TJB (LSE) Ec 201 March 2022 13 / 53

Independence of Irrelevant Alternatives?

Suppose that this changes to

J1 J2 J3 J4 J5
C1 1 1 1 5 5
C2 2 2 2 2 3
C3 3 3 3 1 2
C4 4 4 4 4 4
C5 5 5 5 3 1

Now the order is:

C 2(11) > C 3(12) > C 1(13) > C 5(19) > C 4(20).

TJB (LSE) Ec 201 March 2022 14 / 53

Independence of Irrelevant Alternatives?

The judges change their preferences only over the pairs [C2, C4], [C2,
C5] and [C4, C5].
BUT
The choice has changed the ranking of [C2, C1] and [C2, C3].
This violates IIA
C2 now wins instead of C3, even though no voter changed their
preference over [C2, C3]!
This rules out the Borda count as a way of deciding if we care about
IIA
but what about everything else?

TJB (LSE) Ec 201 March 2022 15 / 53

Arrow’s Theorem

There is no consistent rule for the V > 2 which satis…es U, D, P and

IIA!
So we face a dilemma
Maybe we throw out one of the axioms?
People do often use the Borda count which violates IIA
But does this have practical implications?
It is generally thought of as motivating the instability of majority rule
as a means of making decisions
And we will explore this next

TJB (LSE) Ec 201 March 2022 16 / 53

Instability of Majority Rule

The starkest version of this can be seen with three voters and three
alternatives

Voter 1 Voter 2 Voter 3

Alternative 1 1 2 3
Alternative 2 2 3 1
Alternative 3 3 1 2

The society will base its decision on what the majority wants
BUT: 1 beats 2, 2 beats 3, and 3 beats 1.
So whichever pair of alternatives is voted over, there would not be a
clear winner.
(And if all three were on the table they would tie.)

TJB (LSE) Ec 201 March 2022 17 / 53

The Brexit Conundrum which Mrs May faced last year

After the 2016 referendum where citizens voted for Brexit, there was
a question of how to leave
There was no single alternative
Eventually Mrs May reached a deal with the EU
But she had to get it through Parliament
And there was an eye to what the public wanted too
sooner or late the government has to face the electorate

TJB (LSE) Ec 201 March 2022 18 / 53

The Brexit Conundrum which Mrs May faced last year

See https://blogs.lse.ac.uk/politicsandpolicy/brexit-condorcet/
What would happen with three alternatives
Deal
Remain
No Deal
In some polling data: Deal > Remain > No-deal > Deal
So there was no majority for anything over anything else just as in the
example above!
In the jargon of voting theory, there is no Condorcet winner, i.e.
something beats everything else in pair-wise comparisons.

TJB (LSE) Ec 201 March 2022 19 / 53

The Brexit Conundrum which Mrs May faced last year

What happens if Parliament decides?

Mrs May controlled the agenda
But she could not get a deal through
Mrs May could have called a second referendum between her deal and
remain!
but there would probably have been no agreement on that either
but in the end, the impasse was resolved by a change of Prime minister
and a general election

TJB (LSE) Ec 201 March 2022 20 / 53

Take Home

It is a tall order to expect societies to be able to design ways of having

a social decision made as if it comes from a social welfare function
Societies have to …nd ways of making decisions which reconcile
competing interests which will fall foul of Arrow’s framework
But they restrict the domain of politics quite a lot.
But democracy does seem to work and it is worth exploring some
models where voting does yield some kind of determinate outcome
But this will mean working with a somewhat restricted model
which economists have tended to do.

TJB (LSE) Ec 201 March 2022 21 / 53

Application to the Provision of Public Good: A Median
Voter Result

Suppose that there are three equal-sized groups of individuals, fA, B, C g

whose preferences are
θ i log G + x i
where xi is consumption of a private good.
Suppose that
θA < θB < θC

The public good can be provided via taxation at a per capita cost of
c.
Each has the same income of m

TJB (LSE) Ec 201 March 2022 22 / 53

Application to the Provision of Public Good: A Median
Voter Result

How much public good does each group want?

The optimal level maximizes

θ i log (G ) + m cG

or
θi
Gi =
c
and
GA < GB < GC .

TJB (LSE) Ec 201 March 2022 23 / 53

Downsian Politics

Named after Anthony Downs (born 1930)

Wrote "An Economic Theory of Democracy" (1957)
Applied the logic of the market to politics
Two parties who want to win an election compete by o¤ering
alternatives to voters
Voters the choose which one to vote for
Party strategies must form a Nash equilibrium
We now apply this model to the public goods case above

TJB (LSE) Ec 201 March 2022 24 / 53

Downsian Politics

Label the two parties 1 and 2 competing to win the election

n o
Each can propose a policy G 2 G A , G B , G C to win the election

Preference rankings over alternatives

Group A Group B Group C

GA 1 ? 3
GB 2 1 2
GC 3 ? 1

Group B’s preference prevails.

TJB (LSE) Ec 201 March 2022 25 / 53

Why?

Suppose that a party proposes G B .

can anything beat it?

Group A Group B Group C

GA 1 ? 3
GB 2 1 2
GC 3 ? 1

G B will always command 2/3rds of the vote against any other

alternative.
So G B is a Condorcet winner.

TJB (LSE) Ec 201 March 2022 26 / 53

A Median Voter Result

So the outcome is in the middle, the median value of G A , G B , G C

And both parties converge to o¤ering the same thing
This is because preferences are “single-peaked”
i.e. A and C prefer B to any of the extremes
this is domain restriction in the sense of Arrow’s theorem
This is often held up as a good “prediction" for how politics works
But it is a bit simplistic
However, it captures the basic logic for how moderate policy
outcomes constitute a viable electoral strategy

TJB (LSE) Ec 201 March 2022 27 / 53

Is the median voter outcome a welfare optimum?

Not in general
Suppose that the social welfare function is Utilitarian:
h i h i h i
θ A log G + x A + θ B log G + x B + θ C log G + x C
.
3
What level of public goods maximizes this?
θ A +θ B +θ C
Let θ̄ = 3 then this maximizes

θ̄ log (G ) cG

or
θ̄
G = .
c

TJB (LSE) Ec 201 March 2022 28 / 53

Is the median voter outcome a welfare optimum?

So welfare wants the outcome for the mean public goods preference
Politics delivers what the median voter, B, wants
They need not be the same.
The proposition is true in general for any social welfare function
unless by chance, the welfare function is perfectly aligned with the
median voter.
But this is a purely distributional di¤erence
it a¤ects who gets what.
This reinforces the idea politics will not generally maximize a social
welfare function.
And we could regard this as a “government” failure if there us a big
di¤erence between what a welfare function says what we want and
what politics delivers.

TJB (LSE) Ec 201 March 2022 29 / 53

Quis custodiet ipsos custodes?

A fundamental problem of politics is making sure that people exercise

power responsibly
abuse of the state for private gain is real issue in many countries
In the previous lecture we assumed that government spent only on
thing that citizens wanted
all expenditures were on public good
But government can also be used to “selectively reward” groups that
are close to the ruling elite
We will now explore how this can be modeled
And explore how building representative institutions can make a
di¤erence.
I will show that this creates potentially serious problems of
government failure.

TJB (LSE) Ec 201 March 2022 30 / 53

The Role of Institutions

This has been a major theme in recent political economy literature

Institutions provide the constraints on power that make government
work more in the public interest
In their well-known book "Why Nations Fail", Acemoglu and Robinson
call these “inclusive institutions".
They argue this on the basis of theory as well evidence
But there are still many debates
is it politics or culture?
The following well-known picture gives a hint

TJB (LSE) Ec 201 March 2022 31 / 53

Do political institutions matter?

Satellite image from 2012:

TJB (LSE) Ec 201 March 2022 32 / 53

Outline

Will develop a theoretical example to illustrate the main ideas

Shows how the tools that we have developed in the course can be used
to study resource allocation via government
We will suppose that there is a government in place
for the moment we will not consider how it got there
question is how the government use its power to tax
there is the possibility of using public resources to favour private
interests

TJB (LSE) Ec 201 March 2022 33 / 53

Motivation in Public O¢ ce

Do we assume that those who enter government care about the

citizens
Or are they self-interested?

“Political writers have established it as a maxim, that, in

contriving any system of government, and …xing the several
checks and controls of the constitution, every man ought to be
supposed a knave, and to have no other end, in all his actions,
than private interest. By this interest we must govern him, and,
by means of it, make him, notwithstanding his insatiable avarice
and ambition, cooperate to public good.” David Hume
(1711-1776)

For the purposes of the analysis, we will suppose that the ruling elite
is somewhat self-interested.

TJB (LSE) Ec 201 March 2022 34 / 53

Theoretical Example

A government has a source of tax revenue per capita of T

This re‡ects the “coercive” power of the state.
It can spend resources either on
transfers to the ruling elite: B
a public good which bene…ts all citizens: G
The governments budget constraint is

B + G = T,

It cannot spend more than it has in the form of tax revenues

TJB (LSE) Ec 201 March 2022 35 / 53

Theoretical Example

We will now suppose that citizens are identical and value public goods
equally
So we do not worry about preference aggregation across citizens
Preferences of citizens are

θ log (G ) + m T

where m is income and taxes reduce private consumption.

Preferences of the elite are

θ log (G ) + log (B ) + m

where log (B ) is the utility from the transfers that they receive which
are funded out of taxation.
For simplicity, we are assuming that the elite do not pay taxes.

TJB (LSE) Ec 201 March 2022 36 / 53

The Ruler’s Behaviour

Substituting in the ruler’s budget constraint she chooses G to

maximize
θ log (G ) + log (T G ) .
The …rst order condition is
θ 1
= 0
G T G
θ [T G] = G

so
θ
G = T < T.
1+θ
She spends a proportion θ/ (1 + θ ) of tax revenue on public goods
Citizens would like G = T .

TJB (LSE) Ec 201 March 2022 37 / 53

Diagrammatic Illustration

TJB (LSE) Ec 201 March 2022 38 / 53

Welfare Consequences

The outcome is Pareto e¢ cient with …xed T

there is no way of making both the ruler and the citizens better o¤.
So if there is a government failure it must be based on a
distributional criterion/social welfare function
Some people think that B is a social bad, i.e. as a matter of principle
rulers should not use tax revenue to enrich themselves
But could appeal to a social welfare function which dislikes inequality
generated by the state
especially if political elites are on average richer than other citizens.

TJB (LSE) Ec 201 March 2022 39 / 53

Building Institutions

Government over history has evolved ways of constraining rules in law

Formation of Parliaments
Creation of independent courts
Free media
Organized civil society
We will focus on citizen representation through a Parliament as a
means of getting a better outcome for citizens

TJB (LSE) Ec 201 March 2022 40 / 53

Magna Carta
Perhaps the most basic change in constitutional history has been
empowering citizens in tax raising
It was the essence of Magna Carta
one of the most celebrated constitutional documents in history

TJB (LSE) Ec 201 March 2022 41 / 53

Key Ideas

The citizens are represented in a Parliament which “bargains” with

the ruling elite over however public resources are spent
The rules can only raise additional taxes if Parliament agrees.
So T is the tax revenue that can be raised without Parliamentary
approval.
Could, for example, be government ownership of natural resources and
other assets.
Citizens use Parliamentary institutions to o¤er to pay more taxes in
exchange for more public goods
It strikes a “social contract” between citizens and the ruling elite.
This can result in a Pareto improvement

TJB (LSE) Ec 201 March 2022 42 / 53

When is a Pareto improvement possible?

We need to see whether the utility of citizens is higher when they pay
more tax as long as that tax is used to …nance public goods
starting from
θ
G = T
1+θ
Their utility is

V (R ) = θ log (G + R ) + m R T

They get G + R in public goods now and pay a bit more tax which
reduces their income.
Is V (R ) increasing in R?

TJB (LSE) Ec 201 March 2022 43 / 53

When is a Pareto improvement possible?

Is
V (R ) = θ log (G + R ) + m R T
increasing in R at R = 0.
Di¤erentiate with respect to R :

∂θ log (G + R ) R θ
= 1>0
∂R G +R
θ
Set G = 1 +θ T and R = 0 when this becomes

θ 1+θ
1= 1
θ
1 +θ T
T

which holds if T is low enough or θ high enough.

TJB (LSE) Ec 201 March 2022 44 / 53

When is a Pareto improvement possible?

Intuitively, the government is not spending enough on public goods

citizens are willing to pay more tax as long as this is spent on public
goods
so this additional taxation is voluntary!
If public goods are valuable enough, this will be the case.
To agree, the ruler has to be no worse o¤
So a Parliamentary institution facilitates this kind of bargaining
arrangement.

TJB (LSE) Ec 201 March 2022 45 / 53

Do people pay their taxes voluntarily?

The World Values asks: "Is it justi…able to cheat on your taxes if you have
a chance?"
answered on 10 point scale
asked in all six survey waves across 94 countries (1981-2014)
about 250,000 observations
around 63% of the population do not think that cheating is justi…able
Justi…able cheating
increasing in income
decreasing in education and age
more prevalent among men
correlated with lack of con…dence in government

TJB (LSE) Ec 201 March 2022 46 / 53

Do people pay their taxes voluntarily?

https://www.ft.com/content/4b3e6db0-e57a-11e7-8b99-0191e45377ec

TJB (LSE) Ec 201 March 2022 47 / 53

The Social Contract

Citizens can o¤er to pay additional taxes R

so total taxation is now T + R
In general the new levels of public spending are:
(B 0 , G 0 ) where B 0 + G 0 = T + R.
The ruler has to agree to this proposition as well as the citizens
So if an agreement is reached, it must be a Pareto improvement over
the status quo

TJB (LSE) Ec 201 March 2022 48 / 53

Range of Pareto Improvements

TJB (LSE) Ec 201 March 2022 49 / 53

The Best Possible Outcome for Citizens for Given R?

TJB (LSE) Ec 201 March 2022 50 / 53

Advanced: What is the best possible value of R?

(R, B 0 , G 0 ) maximizes
θ log G 0 R
subject to

θ log G 0 + log B 0 [θ log (θ ) + (1 + θ ) log (1 + θ )] T

and
B 0 + G 0 = T + R.

TJB (LSE) Ec 201 March 2022 51 / 53

Implications

So we have shown that there is scope for using institutions to improve

the working of government
Representative institutions can create a Pareto improvement
Although that does not mean that …nd mean that reducing B is not
also a legitimate goal on social welfare grounds

Implicit in the way we have conceptulaized this is that the Parliament

“represents” the citizens
so is tied to having representation in the form of elections
and many societies also elect the “executive”, i.e. those who we are
calling the rulers
An alternative would be to rely on having those in public o¢ ce be
publicly spirited.
but then we need to be sure that we can …nd such people and select
them.

TJB (LSE) Ec 201 March 2022 52 / 53

Back to the Important Questions

It is dangerous to think that good policy "just happens"

It rests on a bedrock of institutional arrangements that make
"government work"
Thinking about public goods provision is a good example
How much public good should be provided?
And how can we be sure that tax revenues collected actually …nd their
way into providing public goods?
Understanding these issues about making government work are now
routinely part of economics.
But we have only been able to scratch the surface in this lecture.

TJB (LSE) Ec 201 March 2022 53 / 53