Part 2

ECONOMICS, POLITICS, AND PUBLIC POLICY

 Government = An economic actor

Government : The only entity within a territory that can dictate what people must
do/not do, and can legitimately use force and restraints on an individual’s freedom
to achieve that end.

The government is different from other economic actors:

● Much larger
● Engage in activities that can improve quality of life for citizens (other entities
could too)
 Government = Part of the solution
Private economic interactions —> inefficiency and Unfairness —> Policies to
address it

Methods :

● Incentives (taxes, subsidies, Nudge)

● Regulation
● Persuasion or information - Altering available information or expectations
about what others will do, to promote coordination
 Government = Part of the problem

Any organization with enough power to address the problems of efficiency and
fairness also has the power to do great harm

Examples include using force to silence opponents and acquiring huge incomes
for officials and leaders to use privately

Well-governed societies place limits on government power:

● Democratic elections
● Constitutional restrictions on what the government can do
 Dictatorship model: Government as monopolist
Dictator is entirely selfish

● Chooses how much to tax the citizens

● Uses tax for public services but also personal use
● If he takes too much for himself —> a citizen uprising

The dictator aims to maximize his total political rents.

● His time in office is inversely related to the amount of tax he collects.

● Duration curve shows how many more years the dictator expects to remain in
power, given the tax revenue per year
 Political competition

Governing elite: Top government officials, unified by a common interest such as

political party membership.

Political competition —> likelihood of losing an election more dependent on the

government’s performance —>The duration curve becomes flatter

Increased competition has an ‘income’ and ‘substitution’ effect.

● Income effect : Government receives lower rents at every level of taxation

● Substitution effect Raising taxes bears a higher risk of being dismissed

Increased political stability lengthens the maximum expected duration of the

government.
 Defining democracy

Democracy: A form of government with 3 political institutions:

● Rule of law – all individuals are bound by the same laws

● Civil liberties
● Inclusive, fair, and decisive elections

No government perfectly satisfies these 3 criteria. But how a government actually

works also depends on political preferences and electoral competition.
 Modelling democracy: Median voter model

Why do political parties sometimes adopt similar platforms?

The Nash equilibrium is to both locate in the middle of the spectrum —> Each
party gets half the voters

Median voter: If voters can be lined up along a single dimension, the median
voter is the one ‘in the middle’ of the spectrum.

● Can choose between 2 platforms, both close to her preferences.

● A ‘swing voter’ – can cause political parties to move by changing her
preferences.
 Median voter model in reality

In reality, political parties may not always choose to locate ‘in the middle’, for
several reasons :

● Not everyone votes – voters will abstain if neither platform is attractive

● Importance of money and political activities beyond voting
● their own values
● Voters are not evenly distributed along a political spectrum
 Democracy
Democratic governments differ in their spending patterns
There are 2 principles essential to democratic government:
● Democratic accountability : A governing party not serving the interests of
most citizens will lose an election and leave office.
● Removal from office is usually via losing an election
The extension of voting rights to virtually all adults meant that governments
devoted tax revenues to public services and other expenditures that helped the
less well off.
 Government failure

Government failure: A failure of political accountability

Market failures and unfairness still persist in democracies, due to:

● Economic infeasibility
● Administrative feasibility
● Special interests (opposition by certain groups)
 1) Economic infeasibility

An economically feasible policy must be a Nash equilibrium.

Policies can change the Nash equilibrium

Short run – Wage-setting curve shifts up

Long run – New Nash equilibrium

But inclusive unions can raise the price-setting curve, mitigating these effects
 2) Administrative infeasibility

Administrative infeasibility arises due to:

1. Limited information
2. Limited capacities
3. Fiscal capacity: The ability of a government to impose and collect taxes at low
administrative (and other) costs.
Example: Educational reform may be impossible given the skills of the current
teaching force.
 Special interests

Democracies hold periodical elections

Officials have incentives to undertake projects whose desired objectives will

become visible before the next election (short-termism)

Citizens are far from having an equal say in policy matters.

Wealthy citizens may have disproportionate voice because of campaign

contributions, their influence over investment, and their control over the electronic
and print communication.
 Summary

The government as an important and powerful economic actor ( maximize political

rent)

Democracy as a political institution

● Median voter model explains how political parties choose platforms to get
elected
● Effect of democracy on economic outcomes
● The limits of democratic governments