The Economics of Collective Decision Making

1
The Economics of Collective Decision Making
1. The Size and Growth of Government
2. Market vs Government Actions
3. Economic Insights on Political Behavior
4. Democratic Government and Economic Efficiency
5. Conflicts Between Winning Politics and
Economic Efficiency?
6. Economic Organization and Efficient Resource
Use
2
Government Spending as a Share of the Economy,
1930-2003

• Total government spending accounted for only 9.4
  of GDP in 1929, and only one third of this
  spending was at the federal level.
• Government spending, particularly at the federal
  level, soared from 1929 to 1970.
• Total government spending rose from 9.4of GDP
  in 1929 to 30.2 of GDP in 1970.
• Since 1970, government spending has been
  relatively constant at about one-third of the
  U.S. economy.

3
The Size of Government
Government Expenditures as a Share () of GDP
Federal
1930
State local
1940
1950
1960
1970
1980
1990
2000
2003

• As is shown here, government expenditures as a
  share of GDP have risen over time.

4
How the Federal Government Spends
Defense
Social Security
Net Interest
3.1
15.5
11.8
21.7
Sources Economic Report of the President, 2004,
and Statistical Abstract of the United States,
2003.

• A breakdown of the government expenditures at
  the federal level in 2003 are listed above.

5
How State Local Government Spends
Public welfare Health
7.7
32.2
22.3
7.9
12.2
6.3
7.1
4.3
Sources Economic Report of the President, 2004,
and Statistical Abstract of the United States,
2003.

• Government expenditures at the state and local
  level in 2000

6
The Growth of Government Transfer Payments
Transfer payments as a of national income
1960
1970
1980
1990
2000
2002
1930
1940
1950
Sources Bureau of Economic Analysis,
http//www.bea.gov.

• Government transfer payments have grown rapidly
  in the last 75 years.

7
Differences and Similarities Between Government
and Markets

• Both the market and public sectors are
  competitive.
• a. Politicians for office
• b. Bureaucrats for budgets and authority
• c. Lobbyists for program funding.

2. Public sector organization can break the
payment for consumption link. - costs do not
always match benefits derived
8
3. Scarcity imposes opportunity costs for
both. - even free goods 4. Private sector
voluntary mutual agreement -like trade Public
sector (when democratic) majority rule.-
-direct voting or legislation - minority must
accept it
9
Differences and Similarities Between Government
and Markets
5. Voters must choose among candidates who
represent a bundle (slate) of positions on
issues. Shoppers can choose for each item
6. People who supply valued resources in the
marketplace have higher incomes. (money talks)
vs 1 person, one vote in a
democratic government.
10
Public Choice Analysis

• economics meets politics

• Self-interested behavior is present in both
  sectors.
• The political process is a complex interaction
  among
• voter-taxpayers
• politicians
• bureaucrats

11
Public Choice Analysis

• Voter incentives

• Voters support candidates who will provide them
  with the most government services and transfer
  benefits, net of personal costs.
• Rational Ignorance Effect Recognizing their
  vote is unlikely to be decisive, most voters have
  little incentive to obtain information on issues
  and alternative candidates.
• Because of the rational ignorance effect, voters
  will be uninformed on many issues such issues
  will not enter into their decision making process.

12
Public Choice Analysis

• The Politician-Supplier

• Political officials must win elections to be
  successful and achieve their goals.
• Rationally uninformed voters often must be
  convinced to want a candidate.
• Face competition from other suppliers

13
Public Choice Analysis

• The Bureacrats

• Bureaucrats get the job done
• Often are focused on their budget and their
  agencys goals.
• Leads to expanding budgets beyond what is
  economically efficient.

14

• When The Process Works

15
Benefits and Costs Among Voters
Distribution of benefitsamong voters
Widespread
Concentrated
Widespread
Distribution of costs among voters
Concentrated

• Consider how the 4 possible distributions of
  benefits and costs among voters affect the
  operation of representative government.

• When benefits or costs are either both
  widespread or concentrated (type 1 or type
  3), representative government tends to undertake
  projects that are productive and reject those
  that are unproductive.

16
When Voting Works Well

• Other things constant, legislators will have a
  strong incentive to support political actions
  that provide voters with large total benefits
  relative to costs.

• If a government project is productive, it will
  always be possible to allocate the projects cost
  so that all voters will gain.
• When voters pay in proportion to benefits
  received, all voters will gain if the government
  action is productive (and all will lose if it is
  unproductive).
• Under these circumstances, there is a harmony
  between good politics and economic efficiency.

17
Benefits Derived by Voters from Hypothetical Road
Project
Tax payment
Plan A
Plan B
Voter
Benefits received
Adams
Chan
Green
Lee
Diaz
Total
40
25
25.00

• Plan A may be simple and seem fair, but even as
  Adams is getting a real deal (she values the
  program at 20 and only pays 5) Green, Lee,
  and Diaz do not even receive the value of their
  taxes.

• When each voter pays in proportion to benefits
  received (plan B), each receives more
  benefits than costs. If tax plan B is used, all
  voters gain and the program would pass
  unanimously, showing that harmony between
  politics and economic efficiency can exist.

18
Voter Benefit Equal Tax Benefit Tax Benefit Equal Tax Benefit Tax
Adam 140 50 105 5 40 6
Bob 40 50 30 50 40 60
Cathy 20 50 15 45 40 54
Totals 200 150 150 100 120 120

• Proposal A creates a total benefit of 200, and
  the total cost of the project (as shown by the
  total tax needed) is 150.
• - Is project A efficient?
• - Is project B efficient?

b. Suppose only the equal tax plans are
considered and majority rule is used to make the
decisions. - Would proposal A pass (win
majority approval) under the equal tax-sharing
arrangement? - Would proposal B pass under the
equal tax-sharing arrangement?
c. Are the outcomes in part b consistent with
the criterion of efficiency in part a?
19
Voter Benefit Equal Tax Benefit Tax Benefit Equal Tax Benefit Tax
Adam 140 50 105 5 40 6
Bob 40 50 30 50 40 60
Cathy 20 50 15 45 40 54
Totals 200 150 150 100 120 120

• Under the benefits shown, each taxpayer is
  assessed the same proportion of the total tax as
  the proportion of the benefits they receive from
  the project.
• - Under the benefits of the plan, would proposal
  A pass?
• - Would proposal B pass under the benefits tax?

e. Are the outcomes in part d consistent with
the criterion of efficiency in part a? - If you
want government to pass only efficient projects,
would it be better to use equal taxes or taxes in
proportion to benefits received?
20

• When It Does Not work well

21
Benefits and Costs Among Voters
Distribution of benefitsamong voters
Widespread
Concentrated
Widespread
Distribution of costs among voters
Concentrated

• When benefits are concentrated and costs
  widespread (type 2), representative
  government is biased towards the adoption of
  counterproductive (inefficient) activity.

• Last, when benefits are widespread but the costs
  are concentrated (type 4), the political
  process often rejects productive projects.

22
Special Interest Effect

• A special interest
• - large personal benefit for a small number of
  constituents
• -a small individual cost on a large number of
  others.
• Interest group members feel strongly about issues
  that provide them with substantial personal
  benefits. Such issues will dominate their
  political choices.

• In contrast, voters bearing the cost often are
  uninformed on the issue because it exerts only a
  small impact on their personal welfare (rational
  ignorance effect.)

23
Classify each of the following as type 1, 2, 3 or
4 according to Table
a. For which types of action is government
likely to work the best (that is most consistent)
with economic efficiency?
Distribution of benefitsamong voters
Widespread
Concentrated
Widespread
b. For which types of action is government
likely to have a bias against adopting actions
even if they are inefficient?

Distribution of costs among voters
Concentrated
c. For which types of action is government
likely to have a bias against adopting actions
even if they are efficient?
a
c
b
24
Classify each of the following as type 1, 2, 3 or
4 according to Table
d. A 1 tax on every citizen to provide large
subsidies to tobacco farmers.
Distribution of benefitsamong voters
Widespread
Concentrated
e. A 10 percent tax on the profits of major
gasoline retailers (BP, Shell, Exxon, etc.) to
finance government-funded research on solar
energy.
Widespread

Distribution of costs among voters
f. An increase in the income tax to finance an
increase in national defense spending.
Concentrated
g. A 5 increase in student tuition to finance
increases in professor salaries.
h. A law allowing consumers to buy prescription
drugs on the advice of their pharmacist without a
visit to a medical doctor (who are strongly
represented by the AMA).
25
Classify each of the following as type 1, 2, 3 or
4 according to Table
Distribution of benefitsamong voters
Widespread
Concentrated
h. A 1 percent increase in Social Security
taxes on current workers to finance large benefit
increases for those currently receiving Social
Security payments.
Widespread

Distribution of costs among voters
Concentrated
i. Reductions in subsidies to sugar farmers to
finance the increases in Social Security benefits.
26
Special Interest Effect

• Politicians have a strong incentive to favor the
  views of special interests even if action is
  inefficient.
• Logrolling and pork-barrel legislation strengthen
  the special interest effect.

27
Vote Trading and Passing Counterproductive
Legislation
Net Benefits () or Costs (-) to the Voters in
Respective District
New bridge
Dredging harbor
Voters of
New military base

district

Total
in A
in B
in C
A
B
C
D
E
Total

Assume the districts are of equal size.

• Benefits to A, B, and C voters vary by project.
  

In total, voters in A, B, C districts come out
ahead despite the costs of paying taxes for
activities in other districts if they agree to
vote together. (logrolling)

• With this bill, there are no benefits to voters
  in D and E further, the sum of benefits
  costs for all voters together is negative.

• With majority rule, the majority can pass
  counterproductive legislation benefiting
  themselves but creating negative net
  benefits for the whole.

28
Net Benefits () or Costs (-) to District
Representative of District New Road in District A New Park in District B New Dam in District C
A 10 -5 -2
B -6 9 -2
C -6 -5 13
Totals -2 -1 9

• By looking at the Totals row at the bottom of
  the table, which of these projects are efficient?
  
• - Which are inefficient?

• If each project was put up for vote individually
  (by majority rule), which would pass?
• - Which would fail?

29
Net Benefits () or Costs (-) to District
Representative of District New Road in District A New Park in District B New Dam in District C
A 10 -5 -2
B -6 9 -2
C -6 -5 13
Totals -2 -1 9

• Suppose you were the representative of District
  A and wanted to get your new road passed. You
  only need on more vote for a majority.
• - Would both you and the representative from
  District B be willing to trade votes to get
  your projects passed? That is, would you be
  willing to vote for Bs park if he voted for your
  road?
• - Would he agree to the trade as well?

d. Now consider a pork-barrel bill that
contained all three projects. How would each
representative vote on the total bill containing
all three projects?
30
When Voting Conflicts with Economic Efficiency

• Shortsightedness EffectIssues that yield
  clearly defined current benefits at the expense
  of future costs that are difficult-to-identify.

• Political process is biased toward the adoption
  of such proposals even when they are inefficient.
• The shortsightedness effect explains why
  politicians will find debt financing and unfunded
  promises attractive
• (current benefits to voters without levying
• taxes to pay for them).

31
When Voting Conflicts with Economic Efficiency

• Rent SeekingActions by individuals and interest
  groups designed to restructure public policy to
  either directly or indirectly redistribute more
  income to themselves.

• Widespread use of the taxing, spending, and
  regulatory powers of government that favor some
  at the expense of others will encourage rent
  seeking.
• Rent seeking moves resources away from productive
  activities. The output of economies with
  substantial amounts of rent seeking will fall
  below their potential.

32
Economics of the Transfer Society

• A large and growing part of government is
  dedicated to transferring income.

• Why large-scale redistribution will reduce the
  size of the economic pie
• More taxes, less fun working.
• More taxes, more resources flow into
  rent-seeking.
• More taxes induces tax payers to focus less on
  income-producing activities, and protecting their
  income.

33

• Consider the supply and demand for public sector
  action, and decide whether each of the following
  illustrates
• rent-seeking behavior by private parties,
• vote-seeking behavior by elected officials, or
  the
• rational ignorance effect.

1. Members of Congress rejected bills that would
   have restricted the lobbying activities of
   political action committees (PACs).

b. Election results are often distorted by
poorly informed voters and low voter turnouts
c. Liquor wholesalers in most states have lobbied
for state laws that compel retailers to buy their
liquor supplies only from the nearest available
wholesaler instead of shopping around
d. Many voters support import tariffs and quotas
on foreign goods even though such protectionism
costs consumers billions of dollars.
e. A steel company sends a 50 million campaign
contribution to a legislator in a year in which a
bill is being debated that would affect the steel
industry.
34
Economic Inefficiency and Government Operated
Firms

• Consider the lack of incentive for a government
  firm or agency to operate efficiently.

• In the public sector
• -no profit motive to try keeping costs low.
• -no bankruptcies to weeding out inefficient
  producers.
• - Managers seldom gain personally from measures
  that reduce costs.
• - OPM.

35

• Economic Organization
• Who Produces, Who Pays,
• and Why It Matters

Many major economic problems, including rising
health-care costs and dissatisfaction with
schools, reflect the structure of economic
organization.
36
Who Pays? and Who Produces?
Good is paid for by
Consumer purchaser
Taxpayer or third party
Privateenterprise
Good is produced by
Government enterprise or contracting

• The incentive to economize is influenced by who
  produces a good and who pays for it.

• Economizing behavior will be strongest when
  consumers purchase goods produced by private
  firms (quadrant 1)

• The incentive to economize is reduced when
  payment is made by a third party and when
  production is handled by the government.

37
Economic Organization Incentives
Good is paid for by
Consumer purchaser
Taxpayer or third party

• Quadrant 1

Privateenterprise
Good is produced by
Government enterprise or contracting

• Consumers have a strong incentive to economize
  because they are spending their own money.
• Producers have a strong incentive to offer
  consumers value and produce efficiently because
  failure to do so will mean fewer customers and
  lower profits.

• This combination leads to efficient outcomes.

38
Economic Organization Incentives
Good is paid for by
Consumer purchaser
Taxpayer or third party

• Quadrant 2

Privateenterprise
Good is produced by
Government enterprise or contracting

• Consumers have little incentive to economize
  because someone else is paying the bill.
• Producers have little incentive to provide the
  good at a low cost because consumers are more
  interested in obtaining the highest quality,
  regardless of price.

• This mix leads to high prices large
  expenditures on the good.

39
Economic Organization Incentives
Good is paid for by
Consumer purchaser
Taxpayer or third party

• Quadrant 3

Privateenterprise
Good is produced by
Government enterprise or contracting

• Consumers will search for value because they
  are spending their own money.
• Government producers are likely to be high-cost
  suppliers, particularly if they are a monopolist.

• High prices and inefficiency in production are
  a likely outcome.

40
Economic Organization Incentives
Good is paid for by
Consumer purchaser
Taxpayer or third party

• Quadrant 4

Privateenterprise
Good is produced by
Government enterprise or contracting

• Political process determines what will be
  produced, how it will be produced, and how it
  will be allocated.
• Consumers are in a weak position to discipline
  the suppliers.

• The outcome is likely to be high production
  costs and a disconnect between the good
  produced and the preferences of consumers.

41

• The Economic Way of
• Thinking about Government

42
The Economic Way of Thinking About Government

• Both markets and the political process will
  sometimes fail to allocate goods resources
  efficiently.

• Public choice analysis - there is sometimes a
  conflict between winning elections and following
  sound policies.
• For some types of activities, there is reason to
  believe that the political action that will help
  one get elected will, at the same time, reduce
  income levels and living standards.

43
The Role of a Constitution

• Constitutions establish the procedures used to
  make political decisions. They can also limit the
  activities of government.

• U.S. Constitution incorporates restraints on the
  economic role of government.
• Public-choice study highlights the importance of
  constitutional rules and procedures capable of
  restraining government activities to those areas
  where it will promote prosperity.
• The challenge before us is to develop
  constitutional rules and political institutions
  more consistent with economic efficiency and
  prosperity.

44
1. In 2003, the combined expenditures of federal,
state, and local governments in the United States
were approximately a. 14 of GDP. b. 24 of
GDP. c 34 of GDP d. 44 of GDP.

• 2. Which of the following provides the best
  summary of the basic idea of public choice
  analysis?
• Public choice analysis applies the principles of
  economics to political science topics
• Public choice analysis takes the principles of
  political science and applies them to the
  traditional topics of economics.
• Public choice analysis uses the principle of
  majority rule to determine the efficiency of an
  action.
• Public choice analysis indicates there is a sharp
  distinction between economic and political topics.

45

• 3. The rational-ignorance effect is a result of
• externalities that lead to an excess supply of
  information.
• the limited incentive of the news media to cover
  political campaigns.
• the expectation of individual voters that their
  vote will not be decisive
• the lack of a college education on the part of
  most voters in the United States.

• 4. When voters pay taxes in proportion to the
  benefits they receive from government projects,
• efficient projects will tend to be opposed by a
  majority of voters.
• inefficient projects will often be favored by a
  majority of voters.
• projects that are efficient will tend to be
  favored by an overwhelming majority of voters
• democratic political decision making can be
  expected to work poorly.

46

• 5. Most voters will likely be concerned with
• most issues since most issues have some impact,
  however slight, on each citizen.
• only a few special issues (those that exert the
  most impact on the voters personal welfare)
• most issues since information on most issues can
  be obtained at a low cost.
• the views of a particular political candidate on
  all issues.

6. Special-interest programs are highly
attractive to vote-seeking politicians because
a. these programs are highly efficient, and
therefore, they tend to enhance the general
welfare of the populace. b. members of special
interest groups favoring these programs are less
likely to vote than the taxpayers who pay for
them. c. low-income recipients are the primary
beneficiaries of special-interest
programs. d members of special interest groups
favoring these programs feel strongly about them
while most other voters are rationally
uninformed about them
47
7. Current tax rates are insufficient to finance
the benefits promised by both the Social Security
and Medicare programs. Are these unfunded
promises surprising according to economic
theory? a. Yes, political representatives have a
strong incentive to levy taxes that are
sufficient to cover the cost of all programs they
favor. b No, the unfunded promises reflect the
shortsighted nature of the political
process c. Yes, political representatives
generally favor balancing the government budget
because this is best for the economy. d. No,
even though debt financing often makes sense,
politicians are reluctant to use it because it
will damage their chances of being reelected.
8. Public choice theory suggests politicians will
be most likely to favor redistribution of income
from a. the rich to the poor. b unorganized
taxpayers to well-organized interest
groups c. middle-income taxpayers to both the
rich and the poor. d. well-organized businesses
and labor groups to consumers.
48

• 9. Which of the following explains why managers
  of government agencies have little incentive to
  achieve operational efficiency?
• Public-sector managers need not fear bankruptcy
  when operational efficiency is not achieved.
• Public-sector managers seldom receive personal
  benefits if they find ways to improve the
  efficiency of their operations.
• Public-sector agencies typically do not face
  competition.
• All of the above explain why government agencies
  have little incentive to be efficient

• 10. When goods are produced privately, but the
  cost of their purchase is paid for by the
  taxpayer or some other third party,
• consumers have a strong incentive to search out
  those firms offering them the best deal.
• private producers of such goods will have little
  incentive to control costs and provide them at
  low prices
• goods and services will only be supplied if
  consumers are willing to pay an amount sufficient
  to cover their production costs.
• the invisible hand will direct consumers and
  producers toward an efficient level of output.