Econ0002 - Unit 22 Notes PDF

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Econ0002 – Unit 22Economics, Politics and Public Policy22 The Government as an Economic Actor Governments’ facilitations: o A government can allow people to do things together that they could not do individually and also engage in activities that vastly improve living standards of citizens, such as...

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Econ0002 – Unit 22 Economics, Politics and Public Policy 22.1 The Government as an Economic Actor 

Governments’ facilitations: o A government can allow people to do things together that they could not do individually and also engage in activities that vastly improve living standards of citizens, such as:  Poverty: even in wealthy countries people were left in poverty when elderly, but government transfers have eliminated serious economic deprivation among the elderly  Economic Security: Government spending increases economic security by reducing the volatility of the business cycle  Increased life expectancy and reduced child mortality: improved sanitation and water supply made these two improve dramatically

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Coercion and Providing Public Services: o The government is the largest single economic actor o To distinguish governments and private firms we can define the government as  The only body in geographical territory (the nation) that can legitimately use force and the threat of force on citizens of that nation o It distinguishes itself from private firms by two distinct factors:  Coercive Powers: It can use force to restrict one’s civil and economic liberties  Obligations to its citizens based on civil and human rights  They use tax funds to provide services like national defence, police protection, and schooling – they tend to be free and anyone can use them o Disregarding income, everyone is entitled to these rights

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Part of the Solution: o Governments act to reduce external effects, market failures, and correct unfairness o Governments adopt the twin objectives twin objectives we have used in the course:  Ensuring that the mutual gains possible through our economic interactions are as large as possible and are fully realized  Sharing these gains in a fair manner o Examples of policies used to address market failures and unfairness include:  Competition policy: to reduce the price-setting powers of monopolies  Environmental policies: to reduce emissions of pollutants  Stabilisation Policies: making AD stable to encourage investment  Subsidies: For R&D  Public provision of healthcare or compulsory insurance  Providing information: to allow people to make better decisions  Central bank Policies: that require commercial banks to minimise their risk exposure by restricting the leverage of their balance sheets  Minimum wage laws: that prohibit contracts that pay below a stated minimum wage o Governments pursue these objectives by some combination of four means:  Incentives: Taxes, subsidies, and other expenditures that alter the costs and benefits of activities that have external effects which could lead to market failure if left unaccounted for

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 Regulation: Direct regulation of economic activities such as the degree of competition, including mandatory universal participation in social and medical insurance and the regulation of AD  Persuasion of information: Altering the availability of information so to allow people to coordinate their actions in a desirable way  Public provision: In-kind provision or through monetary transfers, including merit goods such as basic education, legal representation and income transfers to redistribute equitably 

Part of the Problem: o For the government to be a successful problem-solver, it must also be powerful enough to potentially be a problem o Well-governed societies have created ways to limit the damage that the use of government powers can inflict without undermining the government’s capacity to solve society’s problems, this has been a combination of:  Democratic Elections: allow citizens to dismiss a government that is using its powers for its own benefit, or the interests of some other small group  Institutional checks and Balances: plus constitutional restrictions on what the government can do o An essential limit for governments is the inability (except in exceptional circumstances) to enrich themselves at your expense o Governments can however – fail, consider the case of a natural monopoly  For example, the provision of tap water, here the government cannot provide a perfect allocation of resources  It is necessary for one firm to be in the market due to the high fixed costs, and it would face a downward sloping demand curve  Giving the ability to the monopoly to reduce output and charge a higher price where the price is above MC o Would a government do a better job?  Ideally the government would set price equal to fixed cost and finance it through effective taxation  However the government has little incentive to reduce costs in the long run  The public company may have to over-employ resulting in high costs o This case illustrates the similarities between the economic accountability provided by the market and political accountability provided by the government  Both the government and the firm may act to further their own interests at the expense of the consumer or the taxpayer, but they would both operate within constraints  The firm cannot charge whatever price it wants as it is limited by the demand curve  The government may also not irresponsibly manage the firm at risk of being voted out at the next general election o These two cases show a market failure and a government failure o It is not binary, there is a spectrum of combinations, including:  Private ownership under public regulation  Public ownership with competition among private firms for the time-limited right to produce and price the service

22.2 Government acting as a Monopolist  2

Problems caused by heads of states:

o A few examples:  France: Louis XIV - French Revolution - constructed Versailles  Ivory Coast: Felix Boigny - amassed a fortune of between 7 and 11 billion dollars

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Preferences and Feasible Sets: o To understand why governments do what they do, we first model the government as a single individual and use the usual concepts:  His preferences  The constraints which determine which actions and outcomes are feasible for him o The following motives exits within government leadership roles:  Benevolence: Look to boost welfare  Nepotism: Pay special interest to a certain group or individuals  Self-interest: Using the position in the government to benefit themselves o To begin, we model the government as a ‘political monopolist,’ which means there is no competition from elections that could remove it from power – dictatorship  Even though there are no elections, the dictator faces a constraint:  His powers are not unlimited, because if he takes too much from the population, it could lead to a citizens uprising o This government could use the tax revenue it collects for a variety of reasons:  The Provision of services to virtually all citizens  The delivery of government services to a narrowly targeted group  Granting substantial incomes to themselves

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A Rent-seeking Dictator: o Assumptions/important aspects of the problem:  The dictator is entirely selfish  He decides on a tax that he will collect from the citizens  Keeps all tax revenue except for that used for basic public services (such as healthcare or basic schooling)  He only provides anything to the populous to prevent an uprising o The cost of the public services include what the dictator would earn as a normal civilian, the amount the dictator receives is called a political rent  It is rent because his welfare is greater than what it would be otherwise  It is political because it came about through the political institution in place o These rents are an example of persistent rents, they do not play a useful role in the economy, and are simply an award for having power  Rent-seeking from a dictator involves using the economies resources to police the population to keep him in power o To simplify the dictator’s decision making problem, we assume that the dictator does not choose the public service to supply – the public service is taken as given, the dictator only chooses how much to collect in taxes

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Even a Dictator faces Constraints on what he can do: o There are a couple key constraints the dictator must abide to:  The dictator must keep the population alive  The dictator must keep the citizens happy enough for them not to revolt o We assume 2 reasons for removing a dictator:  Performance related reasons: they collect too much tax revenue

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 Reasons unrelated to performance: the dictator has no control over these o The dictator wants to maximise the total political rent that he can expect to get over his period in office, so he must consider  The length of his rule  The lower the tax rates the longer his duration in office will be o A forward-looking dictator would evaluate two possible levels of taxation:

o Higher tax:  The dictator collects T2 in taxes, and expects to be in office for D2 years  His political rent it (T2 – C)D2 , where C is the cost of supplying public goods  Lower Tax:  He will expect to be in office longer at D 1  His political rent is (T1 – C)D1 o We can look at this relationship between tax and the duration of office as a constraint, like a downward-sloping demand curve as the two are inversely related 

o Dmax is the longest duration possible, where the dictator loses interest of all money The duration curve does not go below the cost line as then it would have to be covered by the dictators own money o The duration curve is a dictator’s feasible frontier, points in the feasible frontier set above the cost curve result in positive rents for him the curve represents a familiar trade-of:  Higher taxes: More rents in the short run at the cost of a greater likelihood of an early dismissal from office. A short duration in office is the opportunity cost of higher rents per year  Lower taxes: lower rents per year is the opportunity cost of a longer duration in office  

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The Dictator Chooses a Tax to Maximise his Total Rents:

o  Expected Rent = rent per year x expected duration (in years)  = (T – C)D o We can use a dictators isorent curves to determine the tax rate to maximise rent  Higher isorent curves are further from the origin  Slope = (T – C) / D  They are convex towards the origin  The ‘no rent’ isorent curve is the horizontal cost line (slope = 0) o Suppose a dictator wants to set a tax expecting a long tenure in office  This is point A  But the isorent is flatter than the duration curve, so we could be better off by moving upwards to B and bearing the opportunity cost  Similarly at F, the duration curve gets the dictator a large surplus per year, but not enough to offset a short duration of his government  A lower tax rate would increase his expected rent o To maximise the rent:  Select point B, at T* - tax and D* - duration  So rent = (T* - C)D*  At this point the slope of the highest isorent curve is equal to the slope of the feasible frontier  MRT = MRS  Slope of the duration curve = slope of highest feasible isorent curve

22.3 Political Competition Afects how the Government will Act 

Competition within Democracies: o The prospect of being removed from office alters what politicians do, even in undemocratic circumstances  For example the provision of village-level elections in China led to increased provision of local public services, such as health and schooling, and arguably a reduction in corruption

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Political Competition as a Constraint: o Government leadership is now represented by a governing elite instead of a lone dictator, unified by a common belief, and organised into a party  The elite can only be removed from power by an election , not a citizen uprising o There are two ways a governing elite can be removed from office:  Performance-related reasons: collecting too much tax  Reasons unrelated to performance: Even governing bodies that act in the interest of the citizens sometimes get voted out o A key idea in this model is that the reason for being outed is more to do with performance than in the dictator model

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o The duration curve is generally flatter than in a dictatorship where it is steep So, an increase in taxes by the government will have a larger efect on the elite’s expected duration in office than if there was no political competition  The response of expected duration to the change in taxes is:  Δ�/Δ�= −change in duration associated with a change in taxes  This is the inverse of the slope of the duration curve  If we have weak political competition, the duration curve is steep, like steep (inelastic) demand reflects weak competition in the market  The flatter, more competitive, duration curve shows a situation in which raising taxes above the cost of providing the public services is associated with a reduction in current governing elite’s period in power o The model shows why governing elites, and the wealthy and powerful members of society who are allied to these elites, have often tried to resist democracy and limit the political rights of the less well off  When everyone can vote the feasible frontier shrinks  However, the duration remains the same in this case  Although, if the conditions become more or less competitive the duration can change o The reason why it may not change are:  Raising taxes bears a heavier risk of the governing elite being dismissed: we can see the duration curve is flatter, this is the substitution efect: leading the governing elite to choose a higher expected duration and lower rent per year  The governing elite has lost some of its power: the inward shift of the duration curve means that it will now receive lower rents whatever it does, this is the income efect that results in the governing elite choosing a lower expected duration and lower tax rate  In this case the substitution effect happens to exactly ofset the income effect  

22.4 Why an Erstwhile Dictator might Submit to Political Competition 

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Dictators becoming Governing Elites: o This happens in many cases because governing elites have found it in their interest to concede to a more competitive political system, or even introduce one of their own initiative o In an undemocratic political system,  The incumbent governmental elite could use coercion to remove competition (for example by locking away political opponents) o Another way to ensure stability is to introduce changes in the political system that make it more democratic, providing the dissatisfied with legal means to seek a change in government

o A greater degree of democracy will flatten the duration curve  This will reduce the feasible set

o However, greater stability may allow the elite to get a greater expected rent at A’ This would be possible as the increased expected duration of the government, due to increased stability, would more than ofset the reduced taxes that could be imposed due to the increased power of the citizens to dismiss the government for excessive rent-taking  The greater expected rent at A’ is shown by (T** - C)D** o Therefore, a dictator state in an unstable society would submit to a democratic system, as the increased stability would allow them to gain greater governmental rents in the long term, due to the extension of D max  

22.5 Democracy as a political institution 

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Political Institutions: o The government is a stage for economic actors (individual politicians) as well as an actor in itself o The political institutions of a country are also the rules of the game that determine who has power and how it is exercised in a society  Democracy is a political institution, which means it is a set of rules that determine  Who makes up the government  The powers they can use when governing  Political institutions difer from country to country and over time o The key value motivating democracy is political equality  Citizens should have substantially equal opportunities to be able to express their views in ways that can shape the policies and other activities of the government  Abraham Lincoln: “Democracy is a government of the people, by the people and for the people” o Democracies hold common characteristics:  Rule of law: everybody is bound by the same set of laws – no one is ‘above the law’  Civil liberties: the members of a society are guaranteed rights of free speech, assembly and the press  Inclusive, fair and decisive elections: no major population group is excluded from voting o Ideally, in a democracy those who have power are elected in an inclusive and open competitive process, and the rule of law and civil liberties limits the things they can do with that power o Democracy has been advocated as a good political system on two very different grounds:  Democracy in its own right: As a political system consistent with individual dignity and freedom

Democracy as a means of addressing national problems: As a system that works better than other methods o Some consequences of democracy for addressing problems, not on its intrinsic merits:  No existing democracy fulfils the ideal of every individual having equal influence over an outcome  No existing government perfectly matches the three characteristics of democracy 

22.6 Political Preferences and Electoral Competition: The Median Voter Model 

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Democracy doesn’t offer a real choice? o In a system with two main political parties, very often they are similar and this raises the question of is there really any choice and therefore democracy:  What size should the government be?: The size of the government in Britain hasn’t changed much since the second world war  What should the government do?: The fundamental priorities of governments changes little depending on the type of government o To explain why parties often develop ‘lookalike’ policies, we draw from an economic model  Just as firms compete for consumers, parties compete for voters by offering party platforms, which consist of policies that they say they will enact if elected The Median Voter and Party Platform in an ideal Democracy: o Consider there are only 2 parties, one which represents ‘left’ politics and the other the ‘right’ o A few questions:  If parties care about winning an election, in what conditions will they offer distinctive platforms tailored to their respective core supporters?  If they offer similar programs, at which point on the political spectrum will that be? o Harold Hotelling answers this, looking at the example of a beach with identical ice cream lenders, of which each ice cream is the same price and people go to the one closest to them

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A single vendor: A, arrives at the beach and locates her ice cream stand at A0 A second seller: B, arrives and sets up at B0, midway between A and the right-hand side of the beach B shifts to the left: B realises he could expand his sales by moving left towards A to point B1

A responds: by moving to the right of B to A1 B responds again: moving to B2 Process Continues until they are ‘back-to-back’ The middle: at this point, neither has an incentive to move as they have divided the customers exactly in half, this is the Nash equilibrium  A parallel with politics: imagine that the bathers on the far-left of the beach are not going to buy any ice cream under any condition (non-voting citizens), then A and B would locate in the centre of those who do vote at An and Bn  Bathers benefit from this as their trip is shorter too o To model this in politics we can say that people in society are on a left to right spectrum  Hence votes will pick the one closest to their alignment  So the best option for both parties would be in the middle of the spectrum  Hence party platforms would be very similar o The ‘median voter’ has two advantages  They get to choose very close to their preferences  She is a ‘swing voter’  Which means that if they position themselves slightly to the left or right, the party would have to follow them to make sure the distribution is 50/50  Other voters polit...