The Economics of Collective Decision Making 1. The Size and Growth of Government 2. Market vs Government Actions 3. Economic Insights on Political Behavior

The Economics of Collective Decision Making

1. The Size and Growth of Government2. Market vs Government Actions

3. Economic Insights on Political Behavior4. Democratic Government and Economic Efficiency5. Conflicts Between Winning Politics and Economic Efficiency?

6. Economic Organization and Efficient Resource Use

• Total government spending accounted for Total government spending accounted for only 9.4% of GDP in 1929, and only one only 9.4% of GDP in 1929, and only one third of this spending was at the federal third of this spending was at the federal level.level.

• Government spending, particularly at the Government spending, particularly at the federal level, soared from 1929 to 1970. federal level, soared from 1929 to 1970. • Total government spending rose from 9.4%Total government spending rose from 9.4%

of GDP in 1929 to 30.2% of GDP in 1970.of GDP in 1929 to 30.2% of GDP in 1970.• Since 1970, government spending has Since 1970, government spending has

been relatively constant at about one-third been relatively constant at about one-third of the U.S. economy. of the U.S. economy.

Government Spending as a Shareof the Economy, 1930-2003

Federal

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

The Size of Government

State & local

Government Expenditures as a Share (%) of GDP

1930

1940

1950

1970

1980

1990

2000

3.0 6.5 9.4

8.4 15.77.3

1960 24.116.5 7.6

30.219.4 10.9

32.821.0 11.8

34.221.6 12.6

31.919.0 12.9

21.114.7 6.3

2003 34.320.6 13.7

How the Federal Government Spends

Sources: Economic Report of the President, 2004, and Statistical Abstract of the United States, 2003.

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

18.8%

7.1%Transportation

Other

22%

Income Security

Medicare and health

Defense

Net Interest

Social Security

3.1%

11.8%

21.7%

15.5%

How State & Local Government Spends

• Government expenditures at the state and local level in 2000

Sources: Economic Report of the President, 2004, and Statistical Abstract of the United States, 2003.

Insurance trusts

Public welfare & Health

Police &Fire Protection

Transportation

Utilities &liquor stores

Education

Administration & other

Interest on debt

22.3%

Public welfare & Health

7.7%

32.2%

12.2%

4.3%7.1%

6.3%

7.9%

Sources: Bureau of Economic Analysis, http://www.bea.gov.

Transfer payments as a % of national income

The Growth of Government Transfer Payments

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

1960

5.2%

1970

7.7%

1980

11.1%

1990

11.3%

2000

11.8%

2002

13.4%

1930

1.1%

1940

2.6%

1950

5.1%

State & local governmentsFederal government

1. Both the market and public sectors are competitive. a. Politicians for office

b. Bureaucrats for budgets and authorityc. Lobbyists for program funding.

2. Public sector organization can break the payment for consumption link.- costs do not always match benefits derived

Differences and Similarities Between

Government and Markets

3. Scarcity imposes opportunity costs for both.- even “free goods”

4. Private sector: voluntary mutual agreement-like trade

Public sector (when democratic) : majority rule.- -direct voting or legislation- minority must accept it

5. Voters must choose among candidates who represent a bundle (slate) of positions on issues.

Shoppers can choose for each item

6. People who supply valued resources in the marketplace have higher incomes.

(money talks) vs 1 person, one vote in a democratic

government.

Differences and Similarities Between

Government and Markets

• –economics meets politicsPublic Choice Analysis

• Self-interested behavior is present in both sectors.

• The political process is a complex interaction among:• voter-taxpayers• politicians• bureaucrats

• Voters support candidates who will provide them with the most government services and transfer benefits, net of personal costs.

• Rational Ignorance Effect: Recognizing their vote is unlikely to be decisive, most voters have little incentive to obtain information on issues and alternative candidates.

• Because of the rational ignorance effect, voters will be uninformed on many issues; such issues will not enter into their decision making process.

Public Choice Analysis• Voter incentives:

• The Politician-Supplier:• Political officials must win elections to be

successful and achieve their goals.

• Rationally uninformed voters often must be convinced to “want” a candidate. $$$

• Face competition from other “suppliers”

Public Choice Analysis

• The Bureacrats:

• Bureaucrats get the job done

• Often are focused on their budget and their agency’s goals.

• Leads to expanding budgets beyond what is economically efficient.

Public Choice Analysis

When The Process Works

Benefits and Costs Among Voters

Type1

Type4

Widespread

Concentrated

Widespread Concentrated

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Distribution of benefitsamong voters

• Consider how the 4 possible distributions of benefits and costs among voters affect the operation of representative government.• When benefits or costs are either both widespread or concentrated (type 1 or type 3), representative government tends to undertake projects that are productive and reject those that are unproductive.

Type2

Type3

When Voting Works WellOther things constant, legislators will have a strong

incentive to support political actions that provide voters with large total benefits relative to costs.

• If a government project is productive, it will always be possible to allocate the project’s cost so that all voters will gain.

• When voters pay in proportion to benefits received, all voters will gain if the government action is productive (and all will lose if it is unproductive).

• Under these circumstances, there is a harmony between good politics and economic efficiency.

Voter

Adams Chan Green Lee Diaz Total

Tax payment

Benefits received

$ 20 12

4 2 2

$40

Plan A

$ 5 5 5 5 5

$25

Plan B

$ 12.50 7.50 2.50 1.25 1.25

$25.00

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

B), each receives more benefits than costs. If tax plan B is used, all voters gain and the program would pass unanimously, showing that harmony between politics and economic efficiency can exist.

Benefits Derived by Voters fromHypothetical Road Project

Voter Benefit Equal Tax

Benefit Tax Benefit Equal Tax Benefit Tax

Adam $140 $50 $105 $5 $40 $6

Bob 40 50 30 50 40 60

Cathy 20 50 15 45 40 54

Totals $200 $150 $150 $100 $120 $120

a. Proposal A creates a total benefit of $200, and the total cost of the project (as shown by the total tax needed) is $150.

- Is project A efficient? - Is project B efficient?b. Suppose only the equal tax plans are considered and majority rule is used to make the decisions. - Would proposal A pass (win majority approval) under the equal tax-sharing arrangement? - Would proposal B pass under the equal tax-sharing arrangement?c. Are the outcomes in part b consistent with the criterion of efficiency in part a?

Voter Benefit Equal Tax Benefit Tax Benefit Equal Tax Benefit Tax

Adam $140 $50 $105 $5 $40 $6

Bob 40 50 30 50 40 60

Cathy 20 50 15 45 40 54

Totals $200 $150 $150 $100 $120 $120

d. Under the benefits shown, each taxpayer is assessed the same proportion of the total tax as the proportion of the benefits they receive from the project.

- Under the benefits of the plan, would proposal A pass? - Would proposal B pass under the benefits tax?

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

When It Does Not work well

Benefits and Costs Among Voters

Type1

Type2

Type4

Type3

Widespread

Concentrated


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

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

• A special interest • - large personal benefit for a small number

of constituents • -a small individual cost on a large number of

others.• Interest group members feel strongly about

issues that provide them with substantial personal benefits. Such issues will dominate their political choices.

Special Interest Effect

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

Type1

Type2

Type4

Type3

Widespread

Concentrated


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Classify each of the following as type 1, 2, 3 or 4 according to Table

a. For which types of action is government likely to work the best (that is most consistent) with economic efficiency?

b. For which types of action is government likely to have a bias against adopting actions even if they are inefficient?

c. For which types of action is government likely to have a bias against adopting actions even if they are efficient?

a b c

Type1

Type2

Type4

Type3

Widespread

Concentrated


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d. A $1 tax on every citizen to provide large subsidies to tobacco farmers.e. A 10 percent tax on the profits of major gasoline retailers (BP, Shell, Exxon, etc.) to finance government-funded research on solar energy.f. An increase in the income tax to finance an increase in national defense spending.

g. A $5 increase in student tuition to finance increases in professor salaries.h. A law allowing consumers to buy prescription drugs on the advice of their pharmacist without a visit to a medical doctor (who are strongly represented by the AMA).

Type1

Type2

Type4

Type3

Widespread

Concentrated


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h. A 1 percent increase in Social Security taxes on current workers to finance large benefit increases for those currently receiving Social Security payments.

i. Reductions in subsidies to sugar farmers to finance the increases in Social Security benefits.

• Politicians have a strong incentive to favor the views of special interests even if action is inefficient.

• Logrolling and pork-barrel legislation strengthen the special interest effect.

Special Interest Effect

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

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

New bridge in A

Dredging harbor in B

Voters ofdistrict*

A B C D E Total

–– Net Benefits (+) or Costs (-) to the Voters in Respective District ––

+$10 - $03 - $03 - $03 +$10 - $03 - $03 - $03 +$10 - $03 - $03 - $03 - $03 - $03 - $03

New military base in C

+$4 +$4 +$4 - $9 - $9

- $02 - $02 - $02 - $6

Total

*Assume the districts are of equal size.

• With this bill, there are no benefits to voters in D and E; further, the sum of benefits & costs for all voters together is negative.• With majority rule, the majority can pass counterproductive

legislation benefiting themselves but creating negative net benefits for the whole.

Vote Trading and Passing Counterproductive Legislation

Representative of District

New Road in District

A

New Park in District B

New Dam in District C

A $+10 $-5 $-2

B -6 +9 -2

C -6 -5 +13

Totals -2 -1 +9

Net Benefits (+) or Costs (-) to District

a. By looking at the Totals row at the bottom of the table, which of these projects are efficient?

- Which are inefficient?

b. If each project was put up for vote individually (by majority rule), which would pass?

- Which would fail?

Representative of District

New Road in District

A

New Park in District B

New Dam in District C

A $+10 $-5 $-2

B -6 +9 -2

C -6 -5 +13

Totals -2 -1 +9

Net Benefits (+) or Costs (-) to District

c. Suppose you were the representative of District A and wanted to get your new road passed. You only need on more vote for a majority.

- Would both you and the representative from District B be willing to “trade” votes to get your projects passed? That is, would you be willing to vote for B’s park if he voted for your road?

- Would he agree to the trade as well?d. Now consider a “pork-barrel” bill that contained all three projects. How would each representative vote on the total bill containing all three projects?

Shortsightedness Effect:Issues that yield clearly defined current benefits at the expense of future costs that are difficult-to-identify.• Political process is biased toward the adoption

of such proposals even when they are inefficient.

• The shortsightedness effect explains why politicians will find debt financing and unfunded promises attractive:

• (current benefits to voters without levying • taxes to pay for them).

When Voting Conflicts with Economic Efficiency

Rent Seeking:Actions by individuals and interest groups designed to restructure public policy to either directly or indirectly redistribute more income to themselves. • Widespread use of the taxing, spending, and

regulatory powers of government that favor some at the expense of others will encourage rent seeking.

• Rent seeking moves resources away from productive activities. The output of economies with substantial amounts of rent seeking will fall below their potential.

When Voting Conflicts with Economic Efficiency

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

• Why large-scale redistribution will reduce the size of the economic pie:1. More taxes, less fun working.2. More taxes, more resources flow into rent-

seeking.3. More taxes induces tax payers to focus less

on income-producing activities, and protecting their income.

Economics of the Transfer Society

Consider the supply and demand for public sector action, and decide whether each of the following illustrates

(a) rent-seeking behavior by private parties,

(b) vote-seeking behavior by elected officials, or the (c) rational ignorance effect.

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

b. Election results are often distorted by poorly informed voters and low voter turnouts

c. Liquor wholesalers in most states have lobbied for state laws that compel retailers to buy their liquor supplies only from the nearest available wholesaler instead of shopping around

d. Many voters support import tariffs and quotas on foreign goods even though such protectionism costs consumers billions of dollars.

e. A steel company sends a $50 million campaign contribution to a legislator in a year in which a bill is being debated that would affect the steel industry.

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

• In the public sector:-no profit motive to try keeping costs low. -no bankruptcies to weeding out

inefficient producers.- Managers seldom gain personally from

measures that reduce costs.- OPM.

Economic Inefficiencyand Government Operated Firms

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

Many major economic problems, including rising health-care costs and dissatisfaction with schools, reflect the structure of economic organization.

Who Pays? and Who Produces?

Privateenterprise

Governmententerprise or

contracting

Consumer purchaser Taxpayer or third party

Goo

d is

pro

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d by

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Good is paid for by:

• The incentive to economize is influenced by who produces a good and who pays for it.• Economizing behavior will be strongest when consumers purchase goods produced by private firms (quadrant 1)• The incentive to economize is reduced when payment is made by a third party and when production is handled by the government.

Quadrant 1:Apples, oranges, TV sets, food, housing, & most other goods

Quadrant 3:Post Office, water &electricity in manycities, toll roads, and many hospitals

Quadrant 2:Health care, food purchased with food stamps

Quadrant 4:Public schools, roads, national defense, and law enforcement

Economic Organization & Incentives


Privateenterprise


contracting


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• Quadrant 1




• Consumers have a strong incentive to economize because they are spending their own money.

•Producers have a strong incentive to offer consumers value and produce efficiently because failure to do so will mean fewer customers and lower profits. • This combination leads to efficient outcomes.


Privateenterprise


contracting


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• Quadrant 2

• Consumers have little incentive to economize because someone else is paying the bill.

• Producers have little incentive to provide the good at a low cost because consumers are more interested in obtaining the highest quality, regardless of price.• This mix leads to high prices & large expenditures on the good.





Privateenterprise


contracting


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• Quadrant 3:

• Consumers will search for value because they are spending their own money.

•Government producers are likely to be high-cost suppliers, particularly if they are a monopolist.• High prices and inefficiency in production are a likely outcome.






Privateenterprise


contractingGoo

d is

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• Quadrant 4:

• Political process determines what will be produced, how it will be produced, and how it will be allocated.

•Consumers are in a weak position to discipline the suppliers.

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







The Economic Way ofThinking about Government

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

• Public choice analysis - there is sometimes a conflict between winning elections and following sound policies.

• For some types of activities, there is reason to believe that the political action that will help one get elected will, at the same time, reduce income levels and living standards.

The Economic Way of Thinking About Government

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

• U.S. Constitution incorporates restraints on the economic role of government.

• Public-choice study highlights the importance of constitutional rules and procedures capable of restraining government activities to those areas where it will promote prosperity.

• The challenge before us is to develop constitutional rules and political institutions more consistent with economic efficiency and prosperity.

The Role of a Constitution

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

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

3. The rational-ignorance effect is a result ofa.externalities that lead to an excess supply of information.b.the limited incentive of the news media to cover political campaigns.c.the expectation of individual voters that their vote will not be decisived. the lack of a college education on the part of most voters in the United States.4. When voters pay taxes in proportion to the benefits they receive from government projects,a.efficient projects will tend to be opposed by a majority of voters.b.inefficient projects will often be favored by a majority of voters.c.projects that are efficient will tend to be favored by an overwhelming majority of votersd.democratic political decision making can be expected to work poorly.

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

6. Special-interest programs are highly attractive to vote-seeking politicians because

a. these programs are highly efficient, and therefore, they tend to enhance the general welfare of the populace.

b. members of special interest groups favoring these programs are less likely to vote than the taxpayers who pay for them.

c. low-income recipients are the primary beneficiaries of special-interest programs.

d members of special interest groups favoring these programs feel strongly about them while most other voters are rationally uninformed about them

7. Current tax rates are insufficient to finance the benefits promised by both the Social Security and Medicare programs. Are these unfunded promises surprising according to economic theory?

a. Yes, political representatives have a strong incentive to levy taxes that are sufficient to cover the cost of all programs they favor.

b No, the unfunded promises reflect the shortsighted nature of the political process

c. Yes, political representatives generally favor balancing the government budget because this is best for the economy.

d. No, even though debt financing often makes sense, politicians are reluctant to use it because it will damage their chances of being reelected.8. Public choice theory suggests politicians will be most likely to favor redistribution of income from

a. the rich to the poor.b unorganized taxpayers to well-organized interest

groupsc. middle-income taxpayers to both the rich and the poor.d. well-organized businesses and labor groups to

consumers.

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

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

Documents

The Economics of Collective Decision Making 1. The Size and Growth of Government 2. Market vs Government Actions 3. Economic Insights on Political Behavior