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© Freytag 2016 1
Public Choice
M.Sc. in Economics (6 Credits)
Winter Term 2016-2017Tuesday, 8 -10 a.m. c.t., Start October 18, 2016,
Carl-Zeiss-Str. 3, HS 9
Prof. Dr. Andreas FreytagLS Wirtschaftspolitik, FSU Jena
© Freytag 2016 2
Uber is represented in 570 cities, but not in Germany –
Why?
Some run-down areas in the British South-West are
rarely considered by British governments when it comes
to regional funds – Why?
Ordinary steel is produced cheapest in China and India,
nevertheless the EU protects the steel market - Why?
Low interest rate policies have never proven ineffective;
the ECB insist on its – Why?
Jacob Zuma is highly corrupt but seem to be safe - Why?
Agriculture in developed is employing less than 2 per
cent of the labor force, its contribution to GDP is about
1.5 per cent. Nevertheless, there are own ministries for
agriculture – Why?
© Freytag 2016 3
Announcement I:
Consulting hour: upon appointment
Time and venue of the written exam (for 3 credits):
16-02-2017, 8-10 am, HS 1
Net time is one hour
Please subscribe at Friedolin
© Freytag 2016 4
Announcement II: Exercise
The exercise is only needed for those students who want
to acquire 6 credits.
In the exercise, we discuss background papers to public
choice. Students write short essays (3 credits).
Three afternoon-long exercises are lead by Andreas
Freytag, Susanne Fricke and Sebastian Spiegel
respectively. Dates will be announced soon. Students are
requested to visit all three exercises.
Please sign in to the exercise with an e-mail to:
sebastian.spiegel@uni-jena.de
Launch session: Thursday, November 11, 18.00,
© Freytag 2016 5
Index
1. Introduction
2. Origins of the State
3. Public Choice in a Direct Democracy
4. Public Choice in a Representative
Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 6
Description of the lecture:
The course Public Choice offers a concise and
comprehensive introduction into the positive foundations
of collective action, theoretical, empirical and political. The
lecture aims at providing the students with analytical tools
to understand the political background of economic policy.
After an introduction, the lecture covers the origins of the
state. We proceed by analyzing direct democracy. The
main part (chapter 4) of the lecture is dedicated to the
political economy of a representative democracy. Topics
are: federalism, two party competition, multi party
competition, paradox of voting, rent seeking, bureaucracy.
In a subsequent step, the theory is applied to real world
phenomena and tested empirically. Chapter 6 deals with
normative issues – how to organise a polity etc.
Basic reading is Mueller, D.C. (2003): Public Choice III,
Cambridge
© Freytag 2016 7
Literature (suggested Selection)
Arrow, Kenneth J. (1951), Social Choice and Individual Values, New
York.
Becker Gary S. (1983), ‘A Theory of Competition among Pressure Groups for Political Influence’, The Quarterly Journal of
Economics, Vol. 98, pp. 371-400.
Becker, Gary S. (1985), ‘Public Policies, Pressure Groups, and Dead
Weight Costs’, Journal of Public Economics, Vol. 28, pp. 329-
347. Black, Philip, Estian Calitz and Tjaart Steenekamp (eds.) (2011), Public
Economics, 5th ed., Cape Town.
Brennan, Geoffrey and James M. Buchanan (1985), The Reason of
Rules, Cambridge.
Buchanan, James M. and Gordon Tullock (1962), The Calculus of Consent, Ann Arbor.
Coase, Ronald H.(1960), ‘The Problem of Social Cost’, Journal of Law
and Economics, Vol. 3, pp. 1-44.
Downs, Anthony (1957), An Economic Theory of Democracy, New
York.Drazen, Allan (2000), Political Economy in Macroeconomics, Princeton.
© Freytag 2016 8
Frey, Bruno S. (2004), Dealing with Terrorism – Stick or Carrot?,
Cheltenham and Northampton.
Hibbs, Douglas A., Jr., (1977), ‘Political Parties and Macroeconomic Policy‘, American Political Science Review, Vol. 71, pp.1467-87.
Hillmann, Arye L. (1989), The Political Economy of Protection, Chur/New
York.
Holcombe, Randall (2006), Public Sector Economics, New Jersey.
Magee, Stephen P., William A. Brock und Leslie Young(1989), Black Hole Tariffs and Endogenous Policy Theory: Political Economy in
General Equilibrium, Cambridge.
Mueller, Dennis C. (2003), Public Choice III, Cambridge.Niskanen, William A., Jr. (1971), Bureaucracy and Representative
Government, Chicago.Nordhaus, William D. (1975), ‘The Political Business Cycle‘, Review of
Economic Studies, Vol. 42, pp. 169-90.
Olson, Mancur, Jr. (1965), The Logic of Collective Action, Cambridge,
MA.
Olson, Mancur, Jr. (1982), The Rise and Decline of Nations: Economic Growth Stagflation and Social Rigidities, New Haven.
Rose-Ackermann, Susan (1999), Corruption and Government,
Cambridge.
Schneider, Friedrich and Dominik H. Enste (2000), ‘Shadow Economies:
Size, Causes and Consequences’, Journal of Economic Literature, Vol. 38, pp. 77-114.
© Freytag 2016 9
Shughart II, Willim F. und Laura Razzolini (eds.) (2001), The Elgar
Companion to Public Choice, Cheltenham and Northampton.
Tullock, Gordon (1980), The Welfare Costs of Tariffs, Monopolies and Theft, in: James M. Buchanan et al. (ed.), Toward a Theory of
the Rent-Seeking Society, Texas, S. 39-50.
Wintrobe, Ronald (1998), The Political Economy of Dictatorship,
Cambridge: Cambridge University Press.
Basic: Dennis Mueller, Public Choice III.
Special current references will be given at the very topic.
© Freytag 2016 10
Websites (Selection)OECD: http://www.oecd.org
World Bank: http://worldbank.org
World Trade Organization (WTO): http://www.wto.org
International Monetary Fund: http://www.imf.org
European Commission: http://europa.eu.int/comm/
Center for the Study of
Public Choice: http://www.gmu.edu/centers/publicchoice/
Public Choice Society: http://www.pubchoicesoc.org/
European Public Choice Society: http://www.epcs-home.org/
Cato Institute: http://www.cato.org
Fraser Institute: http://www.fraserinstitute.org
VoxEU: http://www.voxeu.org
European Centre for International
Political Economy (ECIPE): http://www.ecipe.org
© Freytag 2016 11
1. Introduction
Mainstream economics is generally dealing with two
types of questions:
� Normative analysis: how can individual or
collective welfare be improved?
� Positive analysis: What can we learn about
human behavior? Is man indeed a utility
maximiser? How can we explain minor economic
outcome against the background of theoretical
analysis?
The latter set of questions is relevant for this lecture. We
seek to explain the incentives for policymakers, i.e.
politicians, bureaucrats and organized interests as well as
the outcomes of collective choice.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 12
� Individualistic approach, rational behavior
� Dismissal of the „benevolent dictator“
Thereby, we also try to explain the sometimes huge
difference between the policy recommendation, achieved
by thorough theoretical analysis, and political reality.
Public Choice has taken three directions:
• logical, theoretical analysis,
• empirical investigation,
• normative critique.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 13
It has close relations to the New Institutional Economics
and Constitutional Economics.
The new institutional economics discusses the role of
institutions in the market sphere and in the political
sphere.
“Institutions… are the rules of the game in a society, or
more formally, are the humanly devised constraints that
shape human interaction ….reduce uncertainty by
providing a structure to everyday life.” (Douglas North
1990).
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 14
Fundamental Questions of Public Choice Analysis
• What do political science and economics have in
common?
• Why do we need the state and public decision
making?
• What is the incentive structure of decision
makers in
� a direct democracy?
� a representative democracy?
� a dictatorship?
� a cleptocracy?
• Do voting rules affect economic outcomes?
• Why do some interest groups organize
themselves better than others?
• Why do countries with a dictator sometimes
perform better than democracies?
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 15
• Why do we observe poverty and starving on the
one hand and wealth on the other hand in similar
countries?
• Why do we observe hyperinflation?
• Why is structural change so often repressed?
• Why can we observe left governments pursuing
supply side policy?
• Why are political parties often so similar with
respect to their programs?
• Why does social spending increase in time?
• Do elections terms exert influence of
macroeconomic performance?
• Why are public enterprises inefficient?
• What are the incentives of bureaucrats?
• How can we explain the sectoral structure of
protection and subsidization?
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 16
• Is it rational for governments to „support“
criminal activities?
• How can we explain violence and civil conflict?
• Is terrorism rational?
• How can it be combated rationally?
• What is the dictator’s dilemma?
• How can we explain the disappointing
performance of most international organizations
(IOs)?
• Why is official development aid so ineffective?
• Why do reforms not happen?
• Why do reforms happen?
• Are scientists, e.g. academic economists,
different?
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 17
2. Origins of the State
I. The state and rule enforcementII. The state and allocation
a) Externalitiesb) Asymmetrical informationc) Natural monopolies
III. The state and redistribution
Basic literature is Mueller (2003), pp. 8-63.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 18
I. The State and Rule Enforcement
The state is needed to set rules and take care for
enforcement on a just basis. Enforcement needs a strong
state:
� Police
� Armed forces
� Independent judiciary
� Checks and balances
� Normative statement
� Constitutional Economics (see below)
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 19
The view of the state in Economics is that it is the
organisational structure of a polity.
The state is not regarded as standing above the human
being � Constitutional Economics or citizens vs.
(subjects) Untertanen!
Members of society agree unanimously on a social
contract or a constitution. As long as actions are made
within these rules, the outcome is perceived as being fair.
In this view, there are three types of reasons for the
existence of the state. It is necessary:
• to set and enforce rules,
• to take care for allocation, and
• to organise redistributive policy.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 20
Constitutional Economics: Social contracts
1) A just social contract (John Rawls)
Rawls argues with an original position with total equality;
each member of the community gives up her knowledge
about her position in society and steps behind a veil of
ignorance.
Equality in the original position leads to unanimity over
the social contact. The economic outcome is perceived
as being the result of a gamble with random results;
therefore it is not acceptable.
Two principles of justice:
• equal rights to most extensive basic liberties;
• equal distribution of social values � Maximin!
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 21
2) Constitutional economics (James Buchanan and
Gordon Tullock)
Buchanan and Tullock (1962): no normative position,
they assume unanimity at the constitutional stage.
Homann and Vanberg have given up this assumption
� fictious consensus is satisfying the conditions.
The veil is a veil of uncertainty, as any individual can be
sure about the rules of the game, but not its outcome.
This will be accepted as long there is no betrayal.
Different types of uncertainty:
Identity, numbers and payoffs.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 22
II. The State and Allocation
Allocation theory shows that in general, markets are
efficient and generate welfare optima (without notice of
distribution).
However, there are cases of market failure. Three forms
can be distinguished:
• externalities,
• asymmetrical information,
• natural monopolies.
For many, these are the main reasons for the state to act
economically.
If the markets fail, governmental intervention is
necessary to care for efficient allocation.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 23
a) Externalities
aa) Definition:
Economic activity of one person (firm) has an impact on
the consumption or production of another person or firm.
Consumption
Ui = Ui (xi, yi, Z),
the utility function contains arguments not to be
influenced by individual i.
Production
Πx = Πx (Kx, Lx, Z),
the production function of x is influenced by an activity of
a third person (firm).
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 24
In such a case, the government has to try to internalise
these external cost.
� Pigou tax,
� Pigou subsidy,
� property rights
Economic problem: exact measurement of cost.
Political problem: exact definition of property rights.
� Market Failure versus state failure.
State failure implies inappropriate definition of property
rights, economically inefficient internalisation of external
cost etc. It has no moral dimension.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 25
bb) Coase Theorem
Ronald Coase has shown that in the absence of
transaction cost and with clearly defined property rights
external effects do not exist.
In addition, it does not matter for the economic efficiency
and ecological effectiveness whether the party
responsible for damages or that party suffering from
damages has the property rights.
However, transaction cost is rarely negligible and
property rights are sometimes difficult to define.
� The Coase solution is almost impossible to reach.
Nevertheless, Coase demonstrated the irrelevance of
distribution of property rights as well as the relevance of
transaction cost.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 26
Normative and positive aspects of environmental policy
There are several ways to internalise external cost:
• Ordnungsrecht
� emission thresholds
� technological standards
• Pigou-tax
• Standard-price-approach
• private negotiations (Coase)
� Emission Banking
� Bubble Policy
• Emission certificates
Public choice does not analyse the normative properties,
i.e. economic cost and ecological effectiveness, but the
reason for policymakers to choose a certain environmental
policy; � again market versus state failure.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 27
cc) Public goods
Public goods as extreme case of (positive) externalities:
� non rivalry (jointness) in supply and
� impossibility of exclusion.
Types of goods:
• private good,
• common pool property,
• club good,
• public good,
• merit goods,
Free rider problem as the basic problem of collective
choice.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 28
Free rider problem
What are individuals willing to pay for the provision of a
public good?
Simple but only seemingly precise answer: nothing.
More complicated answer: it depends, on what?
• individual gains from cooperating
• differences in individual gains
• level of state activities already reached
• group size
• social conventions
Prisoners’ dilemma vs. coordination games and chicken
games
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 29
B
A
Does not
Steal
Steals
Does not
steal
1
(10,9)
4
(7,11)
Steals 2
(12,6)
3
(8,8)
Figure 2.1: Prisoners‘s dilemma
Source: Mueller, Dennis C. (2003), …, p.10.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 30
D
G
Strategy
A
Strategy
B
Strategy
A
1
(a,a)
4
(0,0)
Strategy
B
2
(0,0)
3
(b,b)
Figure 2.2: A coordination game
Source: Mueller, Dennis C. (2003), …, p.15.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 31
D
G
Contributes tobuilding fence
Does not
contribute
Contributes to
building fence
1
(3,3)
4
(2, 3.5)
Does not
contribute
2
(3.5, 2)
3
(1,1)
Figure 2.3: A game of chicken
Source: Mueller, Dennis C. (2003), …, p.16.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 32
The prisoner’s dilemma shows the typical problem
related to the provision of public goods, namely free
riding.
The coordination game is solved, as both individuals
gain most from cooperating � dominating strategy. No
one can improve his situation at the expenses of others.
The latter game will at any rate been solved at a
maximum when it is repeated, whereas the prisoner’s
dilemma can (but not must) evolve again and again.
The game of chickens is the most tricky one, as cell 1 is
not the dominant strategy. It may be advantageous to
signal credibly not to contribute. In this case, the partner
may still choose to contribute.
� Application in international affairs
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 33
b) Asymmetrical information
Principal-agent-problems (PAP), whether defined as
adverse selection (ex-ante) or as moral hazard (ex-post),
cause markets to fail.
Ownership and control are separated. Examples are:
• market for insurances,
• labour markets,
• quality aspects (consumer protection).
The regulation of these markets is aiming at healing the
market failure; it may, however, lead to state failure:
• insurance: overregulation, capture;
• labour market: employment protection legislation;
• consumer protection: trade protectionism.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 34
c) Natural monopoly
A natural monopoly exist, if (marginal and) average cost
decrease in the relevant demand areas under a given
technology. Only one firm can serve the demand without
welfare losses. Here is a need for regulation, e.g. by:
• price regulation (cost oriented, rentability
oriented, ECPR, Price Caps, Ramsey-rule);
• capital return regulation;
• competition for the market;
• prohibition of discrimination;
• structural separation of multi product firms;
• limitation of activities.
���� Problem: regulatory capture*
* Literature: Stigler, George J. (1971), „The Theory of Economic
Regulation”, Bell Journal of Economics and Management Science, Vol.
2, pp. 3-21.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 35
III. The Redistributive State
A Pareto efficient allocation of resources and goods may
not be just.
Society may feel the need to redistribute income and to
even out huge income differentials as well as to insure its
members against severe risks of life.
These risks include illness, unemployment, wealth
losses.
Age cannot be regarded as risk, rather as a chance!
Nevertheless, there may be the need for collective action
with respect to old age protection:
� externalities, moral hazard.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 36
How can the redistributive state act?
1) Redistribution as insurance/ social contract.
2) Redistribution as public good.
3) Redistribution to satisfy fairness norms.
4) Redistribution to increase allocative efficiency.
It may be possible to model these types in a way to
reach unanimity about it. Notwithstanding, governments
may go too far or exploit certain groups by purpose:
5) Redistribution as taking.
Of course, the organisation of redistribution has impact
on economic incentives � shadow economy, corruption.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
© Freytag 2016 37
Redistribution as takingTable 2.1 Costs and benefits of the EU’s common agricultural
policy in comparison with free market outcome, 1980 (mio of US$)
country producers consumers government net
EC-9 -30,686 34,580 11,494 15,388
West
Germany -9,045 12,555 3,769 7,279
France -7,237 7,482 2,836 3,081
Italy -3,539 5,379 1,253 3,093
Netherlands -3,081 1,597 697 -787
Belgium/
Luxembourg -1,24 1,4 544 320
UK -3,461 5,174 1,995 3,708
Ireland -965 320 99 -546
Denmark -1,736 635 302 -799
Source: Mueller, p. 62.
1. Introduction
2. Origins of the State
3. Public Choice in a Direct
Democracy
4. Public Choice in a Representative Democracy
5. Application of Political Economy Models
6. Normative Public Choice
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