chap9 - Supply and demand in political markets.pdf

CHAPTER 9 Supply and Demand In Political Markets

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CHAPTER 9 Supply and Demand In Political MarketsIn chapter 8, we concluded that the demand for public, sector output approximates the demand of the median voter. This does not necessarily imply that the output produced in the public sector corresponds to what the median voter most prefers. In private markets, consumers can sometimes find their Options limited by cartels that conspire to reduce output and raise prices or by firms with monopoly power that push buyers into tie-in sales. Firms with market power might be able to price discriminate so that some customers can buy at more favorable terms than others can. Similar problems can confront demanders for public sector output. Chapter 8 noted the power of special interests in the political process that produces public sector output, so in the public sector it is also likely that some "customers" are treated differently from others. Public sector demanders who spend time and money lobbying legislators for beneficial legislation show that they are politically aware and that they are high demanders for certain types of legislation. Demanders who lobby the legislature hope to demonstrate that they control campaign contributions, votes, and other political support so that if legislators help the special interests, those, interests can in turn help the legislators. The legislature acts as a political market where different interests can demonstrate their demand for legislation. Legislatures then weigh the supply and demand for legislation and pass the legislation that has the most political support. This chapter examines how that political market works by combining the, model, of public sector demand from the previous chapter with models of public sector supply. Suppliers and demanders interacts in the political arena to determine the composition and level of public sector output, just as in private markets the level and composition of output is determined by the interaction of supply and demand. Suggesting that political exchange has similarities to market exchange actually does not go far enough, for both politics and markets function through exchange and gains from: trade, and there actually is a political market where public sector decisions are made. Political markets differ from economic markets in important ways, of course, but both are true markets where exchange and gains from trade determine output. Even in market economies such as the United States, the public sector produces well over a third of the nation's GDP, so understanding how political markets work is very important in gaining an understanding about bow economic resources are allocated throughout the economy. SPECIAL INTERESTS AND GOVERNMENT PROGRAMS Chapter 8 introduced the idea that special interests have undue influence over political decisions because they have an incentive to be informed about political decisions in areas that directly affect them, while the general public is rationally ignorant of most of the governments activities. A special interest program provides concentrated benefits to a small group by spreading the cost over a large group; each person in the large group pays relatively little. A few dollars paid by everyone can turn into thousands of dollars for each member of the special interest group. The general public has little incentive to become informed about the cost of a few dollars, whereas the special interest has a big incentive to become informed about the possibility of a much larger gain. If a legislator decides to vote in favor of the general public interest and against a special


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interest, few in the general public will even know enough to be grateful, but such a decision will cost the legislator the political support of the special interest. The government budget is not determined all at once in a forum in which Congress decides what the median voter would most like. Rather, individual policies and programs are decided one at a time in a forum in which special interests are able to influence the outcome of legislation. The surgeon general of the United States speaks out against cigarette smoking and looks forward to the day when all public areas will be smoke free, but, at the same time, Congress votes subsidies to tobacco farmers, helping them to grow the crop the surgeon general opposes. How can one make sense of these policies? The policies are not determined together but rather in separate forums in which special interests are able to influence legislation. There is no mystery to seemingly contradictory policies when one understands that the policies are determined separately and that special interests have a substantial influence over government policies. Special Interests and Political Exchange Special interests do have substantial influence over legislative decisions, but they do not typically get everything they want. The reason is that there are also interests on the other side of any issue, and legislators must weigh the demands of the special interests against the demands of those interests on the other side of the issue. Tobacco interests do have strong representation in Washington, as do the National Rifle Association, the American Medical Association, the Airplane Owners and Pilots Association, and many other organizations. These groups interact with the legislature to try to get benefits for themselves, but these benefits come at a cost to others, and those others have some representation, too. Sometimes there will be one wellorganized interest group opposing another. Other times interests on the other side of the issue are simply members of the general public who might notice that certain legislators tend to be the pawns of special interests on many issues, so they vow not to vote for them in the next election, The legislature is a political market in which legislators must weigh interests on one side of an issue against interests on the other. This political market can be examined with the help of figure 9.1, which shows the political support and opposition generated by providing special interest benefits. Consider an example of an industry that wants a tariff placed on foreign competitors to protect domestic manufacturers and allow the domestic industry to charge higher prices. Such an issue not only provides clearly defined special interest benefits to the industry protected by the tariff but also produces costs on those who would sell the imported goods, on consumers who would have to pay more for the domestic goods, and on other domestic industries that might find more demand for their products and more labor available if other industries did not have tariff protection. In addition, foreign manufacturers will be hurt by tariffs on their products (and foreign firms do hire lobbyists to try to influence domestic legislation). The benefits are concentrated on the protected industry, but the costs are diffused among many producers and consumers. How much tariff protection should the legislature give the industry demanding it? Figure 9.1 shows that as the amount of protection rises, the marginal political support to legislators behind the tariff will decline. For example, an increase on a tariff on shoes from 5 percent to 10 percent will benefit the domestic shoe industry, and the industry will provide political support to legislators who back the tariff. An increase from 10 percent to 15 percent would provide fewer benefits to the industry, and an increase from 15 percent to 20 percent still fewer, so as the quantity of special interest benefits increases, the marginal political support to


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legislators from providing those benefits declines. Meanwhile, a higher tariff would do increasing harm to those who they would be hurt by the tariff, so the marginal political costs of increasing the special interest benefit would rise as the benefit is increased. If the only thing that mattered was what the special interest wanted, and legislatures gave special interests everything they asked for, the amount of special interest benefits produced would be Q', out to the point where there would be no additional benefit to the special interest. However, because there are opponents to special interest benefits, legislators must also consider the political costs of special interest programs and will provide special interest benefits only to the point where the marginal political benefits from the special interests out weigh the marginal political costs from those who are opposed. In figure 9.1, Q* will be the level of special interest benefits produced.1

Note that in the weighing of various interests, no interest gets everything it wants. The special interest wanting benefits prefers to get benefits of Q', but the political marketplace provides only Q*, while those opposing the special interests prefer zero, and again get Q*. Interests on both sides of the political market have their demands weighed against each other to result in an equilibrium amount of special interest benefits. Those who are dissatisfied with the outcome in the political marketplace can devote more resources to trying to change the outcome. If the special interest asking for the benefit increases the resources it devotes to trying to get political benefits, the Marginal Political Support curve will shift upward and Q* will rise. If opponents devote more resources, the Marginal Political Opposition curve will rise and Q* will fall. In this way, the legislature acts as a political marketplace, balancing the interests on all sides of an issue.


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As the quantity of benefits to a special interest increases, the marginal benefit to the interest declines, while the marginal political opposition to the benefit increases. The legislature must weigh the marginal political support from helping the special interest against the marginal political opposition that helping the interest generates to decide on the optimal amount of benefit, Q*, to provide to the special interest. Representation of Interests and the Organization of Congress The orientation of representative democracy toward special interests is in part designed into the political system because of the geographic nature of representation. By design, representatives are elected to represent the interests of constituents in their districts. Representatives make no secret of trying to generate more benefits for their constituents, and not infrequently those constituents will be employed in a particular industry that might be looking for benefits. Representatives whose districts contain navigable rivers help constituents get waterway maintenance, locks and dams, and flood control. In drier areas in the West, representatives get federal money for irrigation and other water projects. Representatives try to get military contracts for firms in their districts, try to obtain new military installations (or prevent old ones from closing), and try to get federal offices to open in their districts. In urban districts, many industries will be represented but no one industry will be dominant, with some exceptions like Detroit, where the auto industry is a major force. In rural districts, farming will be the main industry, and because there are many rural districts, farming as an industry tends to have more representatives than other industries. This overrepresentation of farming as an industry is why there are many federal programs that support agriculture when compared with other industries of equal size. But because of the rational ignorance of voters, representatives often will push interests that represent only a few voters in a district. If the interest can provide political support in the form of campaign contributions and favorable publicity, there do not need to be a large number of constituents represented by an interest for a legislator to be willing to help that interest. Because represent on is geographically based, special interests will tend to look for support from the representatives in their geographical area. This does raise an important question. Although a special interest can influence its representative to support a program for its benefit, it may be able to influence only a few representatives out of the many in Congress. How is it possible for only a few legislators to gather enough support for a special interest program that it can gain a majority of the legislatures votes? LOGROLLING AND POLITICAL EXCHANGE Logrolling is the exchange of political support on one issue for political support on another issue. For voters in general elections, such as those for seats in Congress, or when voting for president, logrolling is not feasible because high transactions costs impede political exchange. When there are large numbers of voters, it is difficult for voters to exchange votes in a political market where those who place little value on their votes can sell them to those who value votes more. Furthermore, the secret ballot impedes the trading of votes because one cannot guarantee that one voted as promised. You could, for example, offer to vote for a certain candidate in exchange for a $50 payment, but because of the secret ballot, you could not prove that you voted as you were paid to. For representatives in a legislature, logrolling is feasible. There are a relatively small number of legislators, all of whom will know one another, which lowers transactions costs.


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Furthermore, the votes of legislators are a matter of public record, so, if a legislator offers to trade his vote, there is a record that can be checked to verify that the legislator voted as promised. In this type of situation, legislators can engage in political exchanges to gain support on particular issues they favor by trading their votes on issues they do not care much about for the votes of others on issues in which they have intense preferences.2 Logrolling and Special Interests If everyone were perfectly informed about all political issues and transactions costs among voters and legislators were low, the Coase theorem would apply and the political marketplace would allocate resources efficiently. In reality, most voters are rationally ignorant about most issues and find access to the political process costly in any event. Most citizens see little point in trying to influence legislators on most issues, so there are high transactions costs between the legislature and its constituents that prevent bargaining. Special interests, because they follow issues closely and invest resources to hire lobbyists, supply campaign contributions, and otherwise try to influence issues, have lower transactions costs and can bargain directly with legislators over issues that have a significant effect on them. And because there are relatively few legislators and they all know one another, transactions costs among legislators are low, and it is relatively easy to trade votes on issues. Legislators want to favor interests that can offer them support, and this is how interests express their demands. Legislators can obtain votes for interests they support by trading votes with other legislators, though the logrolling process may be more complex than simply trading votes on one issue for votes on another. A legislator may receive needed votes on a particular issue in exchange for an IOU to vote for an unspecified future program for another legislator. In a relatively small group, legislators have an incentive to honor those IOUs to retain a reputation for cooperation. If a legislator does not repay IOUs, he will find it impossible to trade votes on any issues in the future. Thus, to retain effectiveness, legislators must trade votes with one another in the political marketplace and must keep track of and honor IOUs. In this way, logrolling facilitates political exchange to produce the outcomes that are most highly valued by the legislators. Logrolling creates a market and votes are the medium of exchange in the legislative market. Because legislators benefit from special interest programs, logrolling is especially helpful in getting special interest programs passed. This is the way that programs that benefit a minority can get the approval of a majority. Logrolling and Economic Efficiency To this point, logrolling has been presented as a mechanism whereby special interests can get their programs approved by the legislature. This can occur when no one represents the general public interest in the political marketplace. As was suggested earlier in the chapter, however, all sides tend to be represented to some degree as legislators balance the interests of those in favor of specific legislation against those opposed. The better-organized interests can be, the better they will be represented, but all sides tend to be represented to some degree. Because legislative bargaining involves small numbers, some of the problems inherent in majority rule voting can be overcome by application of the Coase theorem. With relatively few legislators, the outcome most highly valued to the legislators will tend to be chosen regardless of the political process used to choose the outcome. An example can illustrate.


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Table 9.1 lists the hypothetical preferences of three voters numbered 1, 2, and 3 for three projects labeled A, B, and C. The amount that each option is worth to each voter is given in the table. For example, voter I places a value of $1,000 on option A, $2 on option B, and $1 on option C. Assume that the three voters must select one of the options by majority rule. The preferences listed in the table will produce a cyclical majority if each voter can express a preference by casting only one vote. Under simple majority rule, A can defeat B, C can defeat A, and B can defeat C. There is no clear majority winner, so the winning option will be chosen based on the way in which the alternatives are considered. This example is identical to the cyclical majority examples in chapter 8, and under simple majority rule, with no more information on the selection process, each of the outcomes is equally likely.

If logrolling is possible, however, project A is almost certain to win. Option A is clearly worth more to voter 1 than any of the other options are worth to the other voters, so with logrolling, voter 1 can offer to trade for the votes of 2 or 3. Because their votes are worth more to voter 1 than to themselves, a mutually advantageous trade can certainly be made, and option A will be chosen. The total value to the voters of option A is $1003, whereas B and C are worth $6 each, so the highest valued option will be chosen when logrolling is possible. In the absence of logrolling, a cyclical majority occurs, but with logrolling, the highest valued option is selected. This simple example shows how logrolling can lead to economic efficiency when all parties are able to trade. When small numbers of voters are involved and transactions costs are low, the Coase theorem applies, and the most highly valued option is selected. Special interest legislation tends to be inefficient not because of the logrolling that produces it, but rather because the general public finds it too costly to participate in the political exchange process. Special interests are party to the exchange but the general public is not, so the legislature tends to produce outcomes that are most highly valued to those who are party to the exchange, which are the special interests and the legislators themselves. If everyone could participate in the logrolling process at low cost, rather than just legislators and special interests, logrolling would allocate resources efficiently. AGENDA CONTROL In the previous chapter on public sector demand, the suppliers of legislation were depicted as engaging in competitive behavior to try to satisfy the demands of the median voter. This competitive political behavior makes a at deal of sense when voters are equally informed about


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political issues and when candidates must satisfy the demands of the median voter to maximize their chances of reelection. In cases in which some voters are not well informed or in which there is little direct competition for reelection, legislators may behave monopolistically. Monopolistic behavior can be exhibited through control of the agenda. Agenda control can occur any time some group has the power to determine what options a larger group is able to choose from. The political agenda is simply the collection of issues that are to be decided. In all settings other than a pure direct democracy, some individuals will have more control over the agenda than others will. In a competitive setting, the agenda setter has an incentive to set the agenda most preferred by the median voter, but sometimes the agenda setter is insulated from political competition and will be able to manipulate the agenda to produce an outcome closer to the setters preference than the outcome most preferred by the median voter. A Referendum Example Consider an example in which a referendum will be held to determine the level of output of a public good, much like the referendum process described in chapter 8. To give the agenda setter some power, this section will assume that only one referendum will be held, and that if the referendum issue fails, the level of the public good produced will be much less than would be preferred by the median voter. Further, assume that the voters have no ready way of replacing the agenda setter if they do not like the agenda that is proposed and that the agenda setter prefers a larger level of expenditures than does the median voter. The actions of the agenda setter can be illustrated in figure 9.2.

Assume that if the referendum issue fails, amount QR of the public good will be produced. This level is the reversion level, which the public good reverts to in the event of a


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failure. The median voter would most prefer QM, which would provide the median voter with consumer surplus equal to triangle abc when compared with QR. If the agenda setter wants to maximize the amount of output to be produced, the setter can propose QA as the alternative to QR, where the consumer surplus gain in triangle abc is slightly larger than the consumer surplus loss in triangle cde. Thus the choice between QR and QA can be viewed as the choice between the consumer surplus gain of abcBcde. As long as there is a light gain, the median voter benefits from voting for QA, and the agenda controller will have succeeded in getting the median voter to select an option that is closer to the agenda setters preference than to the median voters. The power of the agenda setter comes because the agenda setter can manipulate the options available to the voters. Most studies of agenda control in referenda like the one just described conclude that agenda setters actually choose options close to the median voters preference and that the outcome approximates what the median voter most prefers.3 However, a referendum setting may be the one most friendly to the median voter because a single issue is considered on which there is a direct vote and often the same voters who vote in referenda also directly vote for the agenda setters. Furthermore, referenda are most frequently held at the local level where voters may have more direct control over their representatives. In other settings, and at the state or national level, agenda control may be more likely. Agenda Control in the Real World The referendum case clearly illustrates the principle of agenda control and the power that an agenda setter can have by controlling the options that a group can vote on. Few decisions are made in a referendum, so this example may have relatively limited direct applicability. However, the agenda can be controlled in other types of political settings. A good example is the power of committees and committee chairs in the U.S. Congress. Committees are responsible for delivering bills in their particular areas to the floor of Congress, which gives them a great deal of influence over the contents of those bills. Special interests can concentrate their lobbying efforts on the committee members who determine the provisions of the bills, and, although the resulting bill may not be exactly what the median member of Congress would prefer, the member may vote in favor anyway, preferring the bill as it stands to no bill at all. The principle is exactly the same as in the referendum case, where the outcome is moved from that preferred by the median voter toward the outcome preferred by the person (or group) who controls the agenda. Because congressional committee members tend to be relatively high demanders for the types of public goods their committees oversee, the result of the agenda control of committees is likely to be that legislation produces more than even the median member of Congress would most prefer. Another form of agenda control occurs when a committee can decide who can run for political office. Many dictatorships hold elections for their leaders, but only one candidate appears on the ballot. This gives the illusion of popular elections and support for the dictator, but because the agenda is controlled, the voters really have no choice but to elect the candidate chosen by the agenda controllers. This form of agenda control occurs in many organizations. The Southern Economic Association holds an annual election to select a president, but, again, only one name appears on the ballot. Needless to say, the nominating committees choice is always selected. In many organizations such as clubs and fraternities, a group of officers often determines the agenda of a meeting ahead of time, which enables it to control which issues are considered and enables it to achieve the results it wants.


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Agenda control may be slightly more subtle. There is a story about Arthur Burns, former chairman of the Board of Governors of the Federal Reserve, controlling the agenda of the governors meetings by taking straw votes on issues. During the course of a meeting, Bums would ask the governors how they would vote if a vote were to be taken on an issue right then. If the governors were going to vote against Burnss preferences, he would talk to them some more about the issue and then ask them again how they would vote. Bums would continue doing this until the governors said they would vote his way, at which time he would say, We will now vote on the issue, thus controlling the agenda to get the outcome he wanted. That example might not be so subtle, but it shows how the chair of any meeting can control the outcome of a meeting by controlling the agenda. Control over the agenda of a collective decision-making group has the potential to give substantial control over the outcome of the groups decisions. Even if the entire group votes on the outcome of an issue, the agenda controller can manipulate the outcome to reflect the preferences of the controller. RENT SEEKING If one views the political decision-making process as a market, it might seem that an efficient outcome would result from the weighing of the various demands of competing interest groups. Indeed, we have noted that this would be the case if everyone had access to the public sector bargaining process. However, special interests tend to register their demands more strongly because they have a concentrated interest and have much to gain, albeit at the expense of the general public who pays a small amount to support each special interest program. If a simple transfer of resources was all that occurred, the process might be redistributive but not inefficient. However, interest groups expend resources to obtain their special interest benefits, and this expenditure is a waste of resources from a social standpoint. Consider an example in which an industry association lobbies Congress to try to get a tariff put on competing imported goods. This restriction raises the domestic price and creates profits for domestic producers. The lobbyists, lawyers, and employees of the industry association use valuable resourcesCincluding their laborCwhich could be used for productive activities. These people could be producing goods and services, which not only would make them better off but also would add to the total output of the economy. Instead, they are using valuable resources to try to get a private gain, but at the expense of others in the market. They are producing nothing of social value and nothing that adds to the total output of the economy. Thus, resources that could have been used productively to increase the economy's output are instead used to try to produce a private gain at a cost to others. Thus, from a social standpoint, these resources that are used to try to capture transfers through the political process are wasted. Economists call this type of activity rent seeking. The use of the term rent in this way goes back to David Ricardo, an economist who early in the nineteenth century argued that the payment of rent for the use of land was unproductive because the land would be there to use regardless of how much rent was paid. Labor required wages (because people would not work if they were not paid), and capital investment could only be attracted if it earned interest (because people would consume rather than invest unless investment was profitable), but land had no other alternative. Thus, Ricardos view was that payment of rent for the use of land was unproductive. Ricardos ideas on rent payments to land might be called into question because rents do serve to ration land and allocate it to its highest valued use, but the term has stuck and has been applied to payments that are made to factors of production for their private benefit


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when those factors do not add anything to social output. This clearly applies to lobbyists seeking special interest benefits. They could produce something adding to social output, but instead they use resources to try to get transfers from others to the interests for which they lobby. Sometimes firms try to get tariffs or quotas to give them an advantage over foreign competitors but at the expense of those foreign competitors and consumers who prefer less expensive goods. Some firms seek protection from domestic competitors. Businesses would like for government to create regulations and other barriers to entry to keep new firms from competing with established firms. Professional organizations want government to prevent others from competing in their professions without meeting stringent government regulations. For example, medical doctors, real estate agents, barbers, and certified public accountants all have government-imposed barriers to entry that prevent people from entering those professions without incurring large costs and securing government approval. Government-enforced barriers to entry of any type create rents for those who are in the industry and who are sheltered from competition. Another source of rents would be government-guaranteed price supports. Farm price supports, for example, increase the profits from farming because farmers are guaranteed a price no lower than the government support price. Farmers have an incentive to seek higher support prices, or, if Congress is debating lowering or eliminating supports, they have an incentive to lobby to keep them. This lobbying is rent seeking and has the associated rent-seeking losses because while the price supports provide private benefits to farmers, they provide no social benefits and add nothing to the total output of the economy. (They may actually lead to more wasted resources if farmers produce output that is not consumed.) Businesses might also seek rents by trying to get the government to undertake expenditures to lower a firms costs, such as by undertaking government-financed research and development, building a road or an airport to benefit a business, or giving a business a tax break if it locates in a certain area. These examples give an idea of the types of activities included in rent seeking, but the list could be longer. It includes any activity in which resources are expended to try to secure a private gain that adds nothing to social output. In contrast, when firms produce goods and services for consumers, the firms benefit by selling their output, and they also add to the total amount of output that everyone can consume. The Welfare Costs of Rent Seeking What are the social costs of rent-seeking activity? This question can be analyzed with the assistance of figure 9.3, which shows the potential results of rent seeking. The figure starts with the assumption of a competitive market with a constant marginal cost, so that MC is also the industry supply curve. If a barrier to entry, price support, or other factor creates a price increase and restricts output, the conventional analysis on the welfare loss because of monopoly would be that the darkly shaded triangle abc would represent the welfare loss caused by the reduction in output in the market. In addition, monopoly profit equal to the lightly shared rectangle PMabP* would also be produced. However, this analysis ignores the resources devoted to rent seeking. If a firm realized that there was the potential for monopoly profits equal to the lightly shaded rectangle if the government would create a barrier to entry in the industry, how much would the firm be willing to pay to secure that profit? The answer is that the firm would be willing to spend up to the amount of the expected profits to secure the profits. Assume, for example, that a firm estimates that a tariff could produce about. The waste from rent $10 million in benefits for the firm. Then the firm would be willing to spend up to $10 million to get the


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benefits, and the entire monopoly profit from rent seeking might be expended. The social loss from the barrier to entry is not just triangle abc, then, but abc plus PMabP*, or the entire shaded triangle and rectangle.4

In political competition, like market competition, some firms do better than others. Thus, some firms may get rent-seeking benefits far in excess of the amount they expend. Other firms may spend a great deal to try to secure benefits but not get anything. In those cases, the rentseeking losses far exceed the benefits to the firm. How much, on average, would one expect these rent-seeking costs to be? If most firms that engaged in rent-seeking activities received above-normal profits from their rent-seeking expenditures, this would encourage entry into rent seeking, just as profits encourage entry into any activity. Thus, more rent-seeking expenditures will be made until there is just a normal rate of return to be earned from rent seeking. Similarly, if rent seeking was, on average, a losing activity, that would encourage exit from rent seeking until a normal rate of return was earned. Thus, just like in any market, entry and exit of firms in rent seeking should occur to make the rate of return to rent seeking the same as the rate of return to other activities in the economy. Therefore, one would expect that on average, rent-seeking expenditures would equal the entire amount of monopoly profit that interests are competing for, which means that the welfare loss from rent seeking equals the total shaded area, PMacP*, in figure 9.3. The social costs of government transfer activity and associated special interest benefits are thus larger than at first they appear. Resources used up in trying to influence the legislature to provide benefits to interests are all a part of these social costs, and the competitive political process suggests that those welfare losses will approximate the value of the rent-seeking benefits that the legislature grants.


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PUBLIC SECTOR SUPPLIERS This section looks directly at the supply side of the public sector by examining the structure and incentives implied in government bureaucracy. In terms of supply conditions in the private sector of the economy, firms are assumed to be profit maximizers. Of course, the individuals who run firms have other goals as well, but the assumption of profit maximization in the private sector has produced simple models that have significant explanatory power. Public sector suppliers differ in important ways from private sector suppliers, and one of the most significant differences is that suppliers in the public sector do not have the incentive to maximize profits. In fact, most public sector output-public education, highways, national defense-is not sold directly on the market but is allocated to the user at little or no charge when compared with the costs of production. If public sector suppliers do not maximize profits, then how do they decide how much output to produce? The profit maximization assumption for private firms can be explained in terms of the incentives faced by suppliers. The individuals in the firm benefit most when they maximize the profits of the firm, and, in many situations, the only way that a firm can remain in business is to act like a profit maximizer. Likewise, the behavior of public sector suppliers can be explained in terms of the incentives faced by those suppliers who are motivated to maximize their budgets in the same way that private sector suppliers are motivated to maximize profits. In examining the institutions within which public sector suppliers work, we can see what it means to be a budget maximizer in the public sector and what the implications are when public sector supply and demand interact. Incentives in Bureaucracy The public sector counterpart of firms that produce output in the private sector is the government bureaucracy. The Department of Defense (DOD) oversees military production, the Department of Energy (DOE) runs energy programs, and so on. In the private sector of the economy, the market evaluates the worth of a firm's output, and a firms profits represent the difference between the value of the resources the firm uses in production and the value of the firm's final output. By contrast, public sector output is not usually sold in the market, so market tests cannot be used to determine whether the value of the governments output is greater than its resource cost. Nor can the success of a government bureau be measured by its profits, unlike the success of a firm in the private sector. Utility and Budget Maximization in the Public Sector The goal of profit maximization in the private sector is based on the concept of utility maximization. The managers of firms have an incentive to maximize profits because this provides them with the most income. The people who work for the government are not necessarily any better or worse than those who work in the private sector of the economy, and they probably are motivated by the same types of things. Certainly, they want to further the public interest, just as citizens in the private sector want to, but they also are interested in pursuing their own self-interests. To fully understand their behavior, we must understand the incentives they face and the actions they must take to achieve those goals. In the private sector, managers are rewarded based on the profits that they bring to the firm, which obviously gives them an incentive to maximize profits. But in the public sector,


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managers do not seek, and they cannot be rewarded for, the profits they generate. Rather, they typically are rewarded for the budgets they oversee. Bureaucrats who oversee larger bureaus with bigger budgets tend to earn higher incomes. Because a bureaucrats income will tend to rise as the budget the bureaucrat oversees gets larger, bureaucrats have an incentive to be budget maximizers.5 Undoubtedly, bureaucrats have other motivations besides increasing their incomes, but these other incentives tend to be positively related to the size of the budgets they oversee as well. For example, a bureaucrat may be interested in the power and prestige associated with the job, but the larger the bureaucrats budget, the more power and prestige the bureaucrat will have. Bureaucrats will also be interested in a congenial working environment, which is also more likely to exist in a growing bureau than in one that is stagnant or shrinking. In a growing bureau, there will be the opportunity to promote current employees to make room for more employees underneath, which enlarges the budget and gives everyone more income, power, and prestige. In a stagnant or shrinking bureau, opportunities will be limited and the work environment will be less pleasant. For a number of reasons, bureaucrats benefit from large and growing budgets, which gives them an incentive to be budget maximizers. The Public Interest and Budget Maximization The reasons just given for bureaucrats to be budget maximizers all have to do with the personal self-interests of bureaucrats, but it also likely to be true that bureaucrats will tend to be employed in agencies that undertake missions the bureaucrats believe in. Those who work in the Department of Defense are more likely to believe in the benefits of a strong military force than is the general public, while those who work for the Consumer Products Safety Commission are likely to believe in the benefits of government regulation to enhance public safety. Similarly, those who work for the Environmental Protection Agency (EPA) are more likely to believe in the benefits of government regulation to protect the environment. Thus, bureaucrats who believe in the mission of their bureaus will want to maximize their bureaus budgets to further their perception of the public interest, in addition to the private incentives they have for budget maximization. This public interest argument can only be taken so far, however. The individual working for the EPA may believe in the mission of the agency, but the individual still has an incentive to pursue her own self-interest. After all, if individuals can be counted on to pursue the public interest when it conflicts with their narrow self-interests, then managers of polluting firms could be expected to reduce pollution of their own accord, without the government requiring it. In reality, we expect self-interest to be a powerful motivating factor of those who work in business, but we should not expect any different from people who work for government. People who work for the EPA must be just as cognizant of their own interests as those who work in the private sector. In the private sector, we expect to see firms act to maximize their profits. By the same reasoning, in the public sector we expect to see bureaus act to maximize their budgets. The Bureaucrats Maximand The hypothesis that bureaucrats are budget maximizers is persuasive, but that is only one hypothesis among many put forth by students of bureaucracy. In a more complex formulation of the budget-maximizing hypothesis, bureaucrats might try to maximize their discretionary budgets rather than their total budgets.6 Following this line of reasoning, funds used to produce


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the bureaus output are not as valuable to the bureaucrat as discretionary funds that can be used for such benefits as vacations disguised as fact-finding trips and funds for conferences to which bureaucrats can invite all their out-of-town friends for expensive meals and luxury accommodations. There is undoubtedly much truth to this view, but the hypothesis of maximization of discretionary funds does not consider the benefits, such as power and prestige, inherent in overseeing a large budget. In reality, the bureaucrat probably wants both a large total budget and a large amount of discretionary funds within the budget. Just as profit maximization is an oversimplification of the activities of individuals who are running firms, so budget maximization is an oversimplification of the behavior of bureaucrats. But recognizing the complex and sometimes conflicting incentives facing bureaucrats, the budget maximization hypothesis is a good first approximation. Many useful implications can be drawn from this hypothesis even while recognizing its limitations. THE PUBLIC SECTOR BARGAINING PROCESS Having established that bureaus are budget maximizers in the same way that firms are profit maximizers, we still do not have enough information about the public sector supply process to understand how much output will be produced by public sector suppliers. For example, although all firms in the private sector have an incentive to maximize profits, a monopolized industry will produce less output and sell at a higher price than a competitive industry under similar circumstances. This section will examine the public sector bargaining process to see what type of bargain is likely to emerge between a bureau and the legislature that funds the bureau. The Bureau and the Legislature For most government bureaucracies, the legislature determines the bureaus budget. For example, the U.S. Congress determines the budget of the EPA, the Department of Defense, and other federal agencies. Likewise, state legislatures, city and county commissions, school boards, and so forth determine the budgets of state and local bureaucracies, For simplicity, this section will consider the bargaining process between a bureau and the legislature, recognizing that the model applies more generally to the bureau and whatever organization determines the bureaus budget. An important difference between the bargaining process that determines a bureaus output and the process that determines the output of a firm in the private sector is that the private sector firm sells output at a certain price per unit and customers decide how much to buy at that price. In contrast, a bureaus total output is determined at the same time as its budget. Thus, the legislature decides to purchase a certain amount of output from the bureau at a certain price, simultaneously negotiating both the price and the quantity of output. This puts the bureau in the position of being able to try to make an all-or-nothing sale to the legislature, attempting to extract all the legislatures consumer surplus from the bureaus output. The Bureaus Bargaining Advantage In essence, the bureau and the legislature are engaged in a bilateral bargaining situation, and for several reasons the bureau will have a superior bargaining position relative to the legislature. This superior bargaining position will aid the bureau in capturing all the gains from trade in the exchange of a budget for the bureau's output. The first advantage that the bureau has is that the


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bureau has only one legislature to deal with, so it can specialize in trying to work out a favorable bargaining agreement. The legislature, in contrast, will oversee many bureaus. For example, the Department of Defense deals only with the U.S. Congress in negotiating its budget, but Congress also oversees the EPA, DOE, DOT (Department of Transportation), and an alphabet soup of other agencies. Thus, the bureau is able to devote more time and effort to the bargaining process than is the legislature. Second, the legislature typically gets all its information about the bureaus characteristics from the bureau itself, so the bureau can reveal to the legislature only the information that is in the bureaus interest. This means that information on the cost of various programs and how much could be produced if the budget were a little larger or a little smaller must be obtained from the bureau. The legislature, on the other hand, typically reveals its demand curve by votes on issues, speeches, campaign statements, and so forth. In short, while the bureau will have good information about the legislatures demand for its output, the legislature will have only the information about the bureaus supply conditions that the bureau chooses to reveal. Third, much work is done in committees before the full legislature votes on an issue, and members of committees tend to be high demanders for the services of bureaus they oversee. Members of the Agriculture Committee, for example, will be more sympathetic than the typical legislator to the interests of farmers, while members of the Armed Services Committee will tend to be high demanders of military services. This makes it easier for bureaus to present good cases for larger than optimal budgets, which puts bureaus in a good bargaining position in their quest to maximize their budgets. The Bureaucratic Bargaining Process The challenge to the budget-maximizing bureau is to produce the largest budget that the legislature will accept. The bargaining process is illustrated in figure 9.4, where the legislatures demand curve for the bureaus output is labeled D. The bureaucracy is assumed to have supply conditions like a constant cost industry, so the marginal cost curve, MC, is horizontal, and MC would be the supply curve if this output were produced by a competitive industry. A competitive industry would produce output level Q*, where supply equals demand, and a monopolist, setting marginal cost equal to marginal revenue, would produce QM. If a government bureau were to produce Q*, like a competitive industry, the bureau would produce consumer surplus for the legislature equal to the area of the shaded triangle above the MC curve. In an effort to maximize its budget, the bureau will propose to the legislature to produce a level of output larger than Q*, and, if the legislature sees no better alternative, it will be willing to accept the bureaus proposal as long as there is some consumer surplus produced by the bureau. The budget maximizing strategy is for the bureau to propose to produce output level QB at price per unit P*. At QB, the consumer surplus gained from the production of units below Q* (the shaded triangle above MC) is slightly greater than the consumer surplus lost on units above Q* (the shaded triangle below MC). The shaded triangle above MC is only slightly larger than the triangle below MC, meaning that the legislature gets very little consumer surplus from approving the bureaus budget to produce QB at price P* per unit. The legislature might try a counteroffer, saying that it wants less output at price P*, but because the bureau bargains for a total level of output in exchange for a total budget, it can follow the strategy of telling the legislature that if the level of output is reduced, the price per unit will rise dramatically. For example, if the legislature wants output Q*, the bureau could tell the legislature that it would cost price P' per unit to produce that output. This might be done, for


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example, if the Department of Defense says that it will be very expensive to produce ten aircraft because of the development costs, but once the research and development is done, if many aircraft are built on an assembly line, the cost per unit will fall substantially. The legislature would get more consumer surplus from buying QB at price P* than Q* at price P', so because of the bargaining advantage of the bureau and the bureau's ability to control the flow of information to the legislature, the legislature is likely to decide that its best alternative is to choose output level QB.

Curve A in figure 9.4 represents the legislatures all-or-nothing demand curve for the bureaus output. An all-or-nothing demand curve shows the price-quantity combinations where the purchaser receives no consumer surplus from the purchase. For example, at quantity QB and price P* the legislature is indifferent between that amount at that price and no output at all if the shaded triangle of consumer surplus gained from the output below Q* is equal to the shaded area for the consumer surplus lost for output between Q* and QB. The budget for the bureau will be maximized when the bureau is able to get a budget to produce QB which is where the all-ornothing demand curve intersects the bureaus marginal cost curve. By contrast, a competitive industry will produce the optimal output, Q*, and a monopolistic industry will produce less than the optimal output at QM. The conclusion of this analysis is that bureaus have an incentive to be budget maximizers, and because they have a bargaining advantage in negotiating their budgets with the legislature, they are able to obtain budgets that are larger than optimal. Thus, while a monopolist misallocates resources by restricting output and producing too little, government bureaus misallocate resources by producing too much.


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THE GOVERNMENT AS AN INTEREST GROUP The role of special interests in government has been discussed at some length. One significant factor in the perpetuation of government programs once they are instituted is that government agencies themselves can act as interest groups. Before a particular program is started, there will be a demand from some constituency, but the program may also have some opponents. Once the program is passed and put into place, a government bureaucracy is created (or an existing one expanded) to administer the program, and the people in the bureaucracy will become another interest group favoring the program. This means that in addition to the interest groups that wanted the program passed in the first place, the government employees who run the program will form yet another interest group. Government employees exert significant influence because they are the governments source of expertise on the program. For example, in determining whether a program should be continued, the government can, check with its experts-the individuals in the administering agency-whose jobs depend on the continuation of the program and who have an incentive to maximize the programs budget. Furthermore, if the individuals who work for the agency believe in the agency's mission, they have yet another reason to defend the programs they work for and argue that they need even larger budgets. The result is that once government programs are instituted, they are very difficult to eliminate. The interest groups that originally wanted the programs will still want them, and a new and powerful interest group created by the program will help ensure its survival. This helps to explain why a government program, once started, will tend to perpetuate itself. FISCAL FEDERALISM One way to limit the influence of special interests and control the power of government bureaucracies is to produce government goods and services at the lowest possible level of government. Fiscal federalism is a system in which government programs are undertaken at different governmental levels, such as local, state, and national. Because chapter 25 focuses on federalism, this section just introduces the topic and suggests some implications within the context of the supply and demand for public sector output. Special interests operate at each level of government, but the problems posed by special interests can be reduced by producing government output at lower levels, for three main reasons. Federalism and Special Interests First, the influence of special interests can be limited if the government producing the program does not extend beyond the special interests that will benefit from the program. Consider, for example, waterway shippers in Alabama, who benefit from the federal governments maintenance of navigable waterways in the state. A study of the costs and benefits of these waterways estimated that the total cost of maintaining them was greater then the total benefits produced by them. However, Alabama was a net beneficiary of the program because most of the benefits accrued to shippers in that state while most of the costs were paid by taxpayers in other states. It makes sense that people in Alabama would favor maintenance of the waterways by the national government because the cost to the state was less than the benefits, even though the cost to the nation was greater than the benefits.


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Because the benefits of the program accrue to the people in Alabama, it would make more sense for Alabama to finance the waterway program through taxes levied on people in that state. In this case, the people of Alabama would be much less likely to favor the special interest expenditures because they would bear the total cost. This would be even more true if the taxes were levied on the waterway shippers themselves rather than on all the taxpayers in a state. The same logic would apply to all government programs. If the people of North Carolina paid for their own tobacco price support programs and the people of Wisconsin paid for their own dairy price support programs, special interests would have a lot more trouble getting these programs passed. At the federal level, the total cost to each taxpayer is very diluted, but, if such programs were financed at the state level, the costs would be, on average, fifty times higher, giving taxpayers more incentive to actively oppose them or at least to become more aware of the relative benefits and costs. Federalism and Consumer Choice A second reason that special interest expenditures can be mitigated by placing government programs at the lowest level of government possible is that voters will have more choices over what types of programs they want. For example, if public education were produced by the federal government, citizens who wanted public education would have to accept the type of education provided by that one government. However, when public education is produced by local governments, people can choose to live in areas that provide the kind of education they want at a price they are willing to pay. By moving to jurisdictions that are more in line with their preferences, voters can, in a sense, vote with their feet. They can move to a location with a local government that will provide them with the types of government services they want.7 To attract residents and a tax base, local governments have an incentive to produce the type of output their residents want, making government more responsive to the general public and less responsive to special interests. Comparisons with Other Governments The third, and perhaps most important, reason for producing government goods and services at the lowest possible level is that it enables voters to compare what they are getting for their tax dollars with what other people are getting for their tax dollars. If voters are not satisfied with how their local government compares with other nearby governments, either they can move or they can vote their local officials out of office. This provides local government leaders with an incentive to look good in comparison with other governments. This type of intergovernmental competition need not require that people continually move from one jurisdiction to another. It only requires that voters replace their existing elected officials if their government does not compare favorably with others. Production at Lower Levels of Government By producing government output at the lowest level of government possible, the influence of special interests can be reduced, consumers of government output can be given a wider range of choices, and citizens will have other governments to compare theirs with when evaluating their government's performance. These are good arguments for maintaining a federal system and for trying to shift production to lower levels of government when possible, but this does not mean


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that the federal government should do nothing. Some government programs are truly national in scope. National defense is a good example, and the interstate highway system provides another example. Local traffic uses interstate highways, of course, but people who are passing through a state on a limited access highway also benefit. For programs that are national in scope, the national government is the appropriate level of government to produce the good. But when the benefits of a program are geographically concentrated, it makes more sense to produce the program at a lower level of government, thereby limiting the ability of special interests to foster programs that are not cost-effective. CONCLUSION Part 2 of the text illustrated that the market may not always allocate resources in the most efficient manner possible because of the problems of externalities, public goods, and incomplete assignments of property rights. However, this does not necessarily mean that the government can do any better. The government can also encounter problems in allocating resources efficiently. Some of these problems were touched on in the previous chapter. For example, individual preferences may be such that majority rule produces a cyclical majority, and, even if there is a median voter outcome, it is unlikely to be completely efficient. There are other incentive problems in the public sector, however, so it is likely that the public sector will not produce the output that allocate resources the median voter most prefers. Government output typically is produced by government bureaucrats who have an incentive to maximize the budgets of their agencies in the same way that managers of private firms have an incentive to maximize their profits. This tendency toward budget maximization means the government produces greater-than-optimal output. Another problem is that most voters are rationally ignorant about most of the activities of the government, whereas special interests have an incentive to become informed and to influence government policies to favor their interests. Elected representatives, who need political support to keep their jobs, are more inclined to favor special interests than the general public interest because that increases the political support they can obtain. In small settings such as legislatures, logrolling and vote trading can lead to the passage of special interest programs that could not be passed if they were all voted on individually by the general public. Also, the fact that some individuals can control the agenda of a representative body for their own benefit contributes to a level of production of public sector output that is not completely reflective of the demands of the median voter. Placed in proper perspective, this picture is not as grim as it first appears. Just as the discussion of externalities, public goods, and so on implied that market allocation of resources is inefficient, much of the discussion of this chapter centered on reasons why public sector resource allocation is likely to be inefficient. But in the real world, things rarely work perfectly, and, by understanding the limitations of government activity, we can better use, the government. Frequently resources are allocated more efficiently through the public sector. Few people would want to rely on the private sector to produce national defense, for example, and it is unlikely that any organization other than the federal governmentCincluding state governmentsCcould have developed the interstate highway system. But although the government can most effectively allocate resources for some purposes, it is clearly not the answer to allCor even most resourceCallocation problems. Where externalities and public goods exist, or where property rights are not well defined, there is good reason to regard the government as a possible solution to the resource-allocation


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problem. However, the successes of the government in some areas should not obscure the fact that in many other areas, the incentive structure of the government is inappropriate for resource allocation. Moreover, understanding the strengths and limitations of government resource allocation is of more than just academic interest because ultimately a democratic society chooses the activities that it wants its government to perform. That most people will be ignorant of most of what the government does is good reason for choosing carefully when the opportunity arises. It is ironic that in these matters that collectively are so important, individuals have a minimal incentive to become informed. QUESTIONS FOR REVIEW AND DISCUSSION 1. Because most voters are rationally ignorant about most government activities, but special interests have an incentive to become informed, special interests tend to have their demands better represented in the political marketplace. Does this mean that special interests get what they want from the legislature? Explain how the political marketplace weighs interests on all sides of a political issue. Use a graph to help illustrate your explanation. 2. In general elections, votes are cast by secret ballot, but the votes of legislators are a matter of public record. Explain how this difference influences the ability of voters to engage in logrolling. 3. The Coase theorem would suggest that if transactions costs are low, political exchange should lead to the efficient allocation of resources. Are transactions costs higher for some groups than for others? Explain how differences in transactions costs for political exchange among different groups of citizens can affect the allocation of resources in the public sector. 4. If others tend to be rationally ignorant, why are special interests well informed about issues? Are they well informed about all issues or just some issues? 5. Explain why the typical college student knows more about the differences between various brands of pizza than about the debate on national health care, even though health care is more important than pizza. 6. How can control over a group's agenda give an individual control over the decisions the entire group will vote on? Illustrate in a graph how the agenda can be controlled using the example of a referendum. 7. What is meant by the term logrolling? What are the effects of logrolling on legislative outcomes? When will logrolling be efficient or inefficient? 8. Why is budget maximization the goal of a government bureau in the same way that profit maximization is the goal of a private sector firm? 9. Explain the bargaining arrangements that lead to the level of output that will be produced by a government bureaucracy. Compare the level of output produced by a bureaucracy with the levels that would be produced by a competitive market and by a monopolist.


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10. What is fiscal federalism? Why is it desirable? List and explain several reasons why programs produced at lower levels of government tend to be more efficient when it is feasible to produce them at lower levels. 11. Explain how the government acts as an interest group. What are the implications of government agencies acting like special interests? 12. How does the use of a secret ballot in elections aid in preventing the outright buying and selling of votes? NOTES FOR CHAPTER 9 1. This discussion is based on Gary Becker, A Theory of Competition among Pressure Groups for Political Influence, Quarterly Journal of Economics 98 (August 1983): 371B400. 2. James M. Buchanan and Gordon Tullock, The Calculus of Consent (Ann Arbor: University of Michigan Press, 1962), gives a classic discussion of the economic implications of log rolling. 3. The possibility of agenda control in a referendum is discussed by Thomas Romer and Howard Rosenthal, Political Resource Allocation, Controlled Agendas, and the Status Quo, Public Choice 33, no. 4 (1978): 27B43. Empirical studies concluding that referenda tend to produce what the median voter wants include Randall G. Holcombe, An Empirical Test of the Median Voter Model, Economic Inquiry 18, no. 2 (April 1980): 260B74, and Rodney D. Fort, The Median Voter, Setters, and Non-Repeated Construction Bond Issues, Public Choice 56, no. 3 (March 1988): 213B31. 4. The concept of rent seeking and the model of welfare losses from rent seeking was introduced by Gordon Tullock, The Welfare Costs of Tariffs, Monopolies, and Theft, Western Economic Journal 5 (June 1967): 224B32. The name rent seeking came from Anne 0. Krueger, The Political Economy of the Rent-Seeking Society, American Economic Review 64, no. 3 (June 1974): 291B303, who described the rent-seeking activity and associated welfare losses in the economy of India. 5. The budget-maximizing hypothesis with respect to bureaucracy was popularized by William A. Niskanen, Bureaucracy and Representative Government Chicago and New York: AldineAtherton, 1971).6.

This idea was developed by William A. Niskanen, Bureaucrats and Politicians, Journal of Law & Economics 18 (December 1975): 617B43. Niskanen was extending his own model from his book, Bureaucracy and Representative Government.

7. The classic article on this subject is Charles M. Tiebout, A Pure Theory of Local Expenditures, Journal of Political Economy 64, no. 5 (October 1956): 416B24.

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