Public Economics

Lecture 6: Political Economics

Noelia Bernal

Contact information: [email protected]; Of.I-610

September 3, 2022

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Public choice

Different process compared to private decisions (i.e. prices).

In general, citizens elect representatives through a voting
system (e.g. President, Parlamentarians), which decide or
vote, in turn, a public budget, and the money is spent by
various administrative agencies.
There is, therefore, an important difference between the way a
person decides to spend his own money and the way in which
Government decides to spend the money of the citizens.

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Basic questions

How is collective decision-making different -such as

determining the level of public goods - of individual
decision-making? i.e. prices
What is the problem with gathering information about
preferences? i.e. revelation problem
When the wishes of individuals - for example, about the level
of spending in a public good- vary from one to another, how
are these differences resolved? i.e. aggregation problem
What is meant by the problem of ”adding preferences”? i.e.
social preference

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Preference’s revelation problem
There is no an effective channel for people to express
preferences for one public good or another.
For instance, general elections provides only limited information
about voters’ attitudes towards each of the public goods; at
best, they convey a general idea about preferences regarding
public spending; 2021 Peruvian presidential elections survey.
Problems:
knowledge of preferences: individuals might not know their own
valuation because they have no experience with public goods.
individuals have an incentive to lie about their willingness to
pay because it will set the tax amount they will have to pay
(free rider problem).
The person who has to make a private decision knows his/her
own preferences. The one that has to make public decisions
has to find out the preferences of those on whose behalf the
decision is made. This is the first difference between public
and private allocation of resources.
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Preference’s aggregation problem

How can make a social (collective) decision when we have

different points of view?
When the wishes of individuals - for example, about the level
of spending in a public good- vary from one to another, how
can we resolve these differences?
in a dictatorship: it is the dictator’s preferences that are
imposed
in a democracy: the solution is not so easy.
Different systems have been proposed: voting by unanimity
(unanimous consent), voting by majority simple,
two-thirds majority voting.
Simple majority voting is perhaps the most widely used
mechanism for making decisions in democracies.

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Individual preferences for public goods (1)

Each person has different opinion about the amount that

should be spent on public goods. Reasons:
different tastes: e.g. public parks and education
different incomes and taxes: the richest people have a higher
income and spend more on all goods, both public and private,
but when the Government spends more on public goods, the
richest people often have to pay a relatively large part of the
additional cost.
Two important concepts: i) tax price is the additional
amount a person has to pay when public spending increases
one unit; and ii) individual’s tax debt is the tax price
multiplied by public spending.

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Individual preferences for public goods (2)

A higher tax price means that richer people will not want to
spend much in public goods. However, as the income effect
causes an increase in desired demand and the (substitution)
price-effect causes a decrease in desired demand, the net
effect is ambiguous.
Given the tax price, we can find out the preference for the
level of spending to public goods.
People with different incomes face different budget
constraints; the preferred levels of spending are found at the
tangencies of the indifference curves and the budget
constraints.

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Individual preferences for public goods (3)

Tax system:
Proportional: low-income individuals face a price in taxes lower
(more horizontal budget constraint). The income effect and
the substitution effect (a lower tax price) are opposite, so the
net effect is ambiguous. Figure (panel A) shows the case in
which the substitution effect is greater than the income effect,
so low income individuals prefer a level of public goods higher
than the richest person.
Progressive: people with low-income are faced with a lower tax
price than in a proportional system, so their preferred level of
spending is even higher.
Uniform: all people face the same price in taxes, therefore,
there is only one income effect. The rich and poor prefer a
higher level of spending (Panel B, assumed that rich and poor
have the same indifference curves (preferences); they differ
only in the budget constraints).

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Individual preferences for public goods (4)

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Individual preferences for public goods (5)

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Utility depends on the level of public spending (1)

Level of expenditure that the individual prefers the most is G*

(utility is maximized subject to a budget constraint).
Utility decreases if the actual level of spending is far from this
preferred level of spending. When it is higher, the marginal
benefit of an increase in spending is less than the marginal
costs in the form of additional individual tax debt, while when
spending is below the preferred level, it occurs the opposite.
Next figure shows the relationship between the level of utility
and the level of spending on public goods of three different
groups: rich, poor and middle-income, assuming a certain tax
system.

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Utility depends on the level of public spending (2)

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Unanimous consent

Government determines the public good level through the

unanimous consent of the citizens.
Lindahl pricing: system by which individuals report their
willigness to pay for the next unit of the public good and
Government aggregates those willignesses to build up an
overall measure of the social benefit (estimated of SMB).
SMB can be compared to SMC and the public good optimal
level can be determined.
The good can be financed by charging individuals what they
are willing to pay.

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Lindahl pricing (1)
Public good: fireworks
MC= US$1
Two individuals: Ava and Jack. Procedure:
Government announces a prices set (taxes); percentage of the
cost each individual must cover, example: 50 each, Ava 90c
and Jack 10c.
Each individual announces how much of the public good he or
she wants at those tax prices.
The Government repetas these steps to construct a “marginal
willigness to pay curve”, for each individual, shows the
relationship between willigness to pay and quantity of the
public good desired.
The Government adds up individual willignesses to pay at each
quantity of the public good to get an overall demand curve
It compares it to the marginal cost curve and determines the
optimal amount of the public good.
The Government finances the public good by charging
individuals their willigness to pay.
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Lindahl pricing (2)

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Lindahl pricing (3)

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Lindahl pricing (4)

Lindahl equilibrium: 75 fireworks, Ava pays 25c and Jack 75c.

It’s an equilibrium because:
Ava and Jack are happy.
Government covers the cost of producing the fireworks
charging each individual their own valuation.
Benefit taxation: individuals pay taxes for a public good
according to their valuation of the benefit they receive from
this good.
Equilibrium gives an efficient level of the public good,
aggregates the individual demands (SMB) and then it equals
to SMC.
There is no need for individual utility functions, they have
revealed their preferences.

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Main problem

Lindahl pricing requires unanimous consent; on practice this is

difficult.
How to aggregate the preferences of every individual?: even if
individuals are honest and they know their valuation of the
public good, how to aggregate individual values into a social
value?

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Democracies

How does Government operate when it makes decisions about,

for example, providing a public good?
Best scenario: Government measures and aggregates correctly
the preferences of individuals regarding the execution of a
public project.
Direct democracy: people are asked if they are in favor or
against
Representative democracy: voters choose representatives and
they decide about the project.

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Parliamentarian’s or representative’s decision

A parliamentarian, when voting, is supposed to reflect the

views of the electors and not only theirs.
When he/she decides her vote, she solves two problems: i) find
out what electors’ views are and ii) since these views are likely
to differ, she decides what weight should be assigned to each.

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Majority voting (1)

Common mechanism to aggregate preferences: majority

voting, on which projects are subject to voting and the one
that receives the most votes is elected.
Necessary conditions:
Dominance: if a choice is preferred by every voter, the
mechanism of aggregation must be such that this choice is
preferred by society.
Transitivity: choices must satisfy transitivity property
Independence of irrelevant alternatives: if a choice is preferred
to another, the introduction of a third choice (independent)
will not change the ranking.
Necessary conditions for an aggregation mechanism to provide
successful translation of individual preferences to aggregate
decisions.

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Majority voting (2)

Example: The city must decide between different forms of

education financing.
Schools are financed through property taxes.
3 possibilities: high (H), medium (M), low (L)
3 types of voters, with equal numbers on each group.
Parents: prioritize education; prefer H, M, L
Elders: prioritize low taxes; prefer L, M, H
Young couples without children: worry about future education;
prefer L, M, H

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Majority voting (3)

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Majority voting (4)

Pairwise votes:
H versus L: parents will vote for H, elders and young couples
for L; L wins
H versus M: parents will vote for H; elders and young couples
will vote for M; M wins
L versus M: parents and young couples will vote for M; elders
for L; M wins
Winner: M
Majority voting has aggregated individual preferences in one
decision for society: medium level of taxes to finance
education.

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Does majority voting always work?

Does the common rule through majority voting always

produce a perfectly defined result?

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Problems with Majority voting (1)

Instead of elders we have parents that prefer private education;

will prefer lower taxes and low financing to public schools (L)
Their second option will be higher taxes and high financing
(H)
Worst case scenario for them is medium tax level and
financing (M)

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Problems with Majority voting (2)

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Problems with Majority voting (3)

Pairwise votes:
H versus L: parents will vote for H, new parents and young
couples will vote for L; L wins
H versus M: parents and new parents will vote for H; young
couples will vote for M; H wins
L versus M: parents and young couples will vote for M; new
parents will vote for L; M wins.
There is no winner; given H≺ L and M≺ H we should have
M≺ L but we have L≺ M; contradiction (transitivity is not
satisfied).
This is called “paradox of the vote or paradox of the cyclical
vote”.
Majority voting cannot aggregate individual preferences
consistently.
Problem is not the individual preferences but the aggregation
mechanism.
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Common solution

To avoid cyclical voting, democracies often make decisions

making the votes in a certain order.
For example, between H and L and between the option that
wins in that vote and M; the final decision depends on the
result of that vote, without further rounds.
However, this solution does not meet the criterion of
”independence of irrelevant alternatives”.

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How to resolve this problem?

Is there a procedure of voting that gives a perfectly defined

result in all the situations?
When the result is perfectly defined, is it necessarily efficient?

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Arrow’s impossibility theorem

There is no voting system that converts individual preferences

in a single consistent aggregated result without:
making an assumption about the type of preferences; or
imposing a dictatorship; dictator can always make a consistent
decision imposing his preferences.

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Single-peaked preferences (1)

Preferences with a local maximum: point that its preferred to

all it’s neighbors.
Utility is maximum at that point; it falls as choices move away
in any direction from the peak choice.
There are multi-peaked preferences (more than a local
maximum)
If preferences are single-peaked, majority voting leads to
consistent results.

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Single-peaked preferences (2)

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Single-peaked preferences (3)

Single-peaked preferences are a reasonable assumption.

Most individuals will prefer a certain level of the public good
(i.e. national defense); utility will fall if expenditure increases
or falls below this level.
This assumption is problematic when there is a private good
that can substitute the public one (i.e. private education).

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Median voter theorem

If preferences are single-peaked, majority voting leads to a

consistent aggregation of preferences: a result that belongs to
the median voter.
Median voter is the one that has preferences located at the
center of the voters; equal number of voters prefer more or
less of the public good.
On the previous example: young couples are the median voter.
Convenient: Government needs only to find a voter whose
preferences for the public good are in the middle of the
distribution of social preferences and implement this voter’s
preferred level.

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Does the median voter outcome necessarily efficient?

Median voter outcome is not always socially efficient.

Social efficiency requires SMB=SMC, this is not necessarily
accomplished, result does not consider preferences’ intensity.
SMB is the sum of marginal private benefits of every
individual. If a reduced number of individuals benefit
enormously from consuming the good, this should be
considered in SMB.
Median voter theorem does not necessarily consider this:
result depends only on voters’ ranking and not on their
preferences intensity.
Is there is any way to ensure an efficient level of spending on
public goods?

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Representative democracy

Voters elect representatives; they decide about the project.

Median voter model still works
Assumptions:
uni-dimensional voting;
only two candidates;
no ideologies;
everyone votes;
money does not matter;
complete information;
Lobbying: spending money to influence politicians
Read section 9.3.

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Government failures (1)

So far, we have assumed that all people are fully aware of the
consequences of all the options considered; all vote and vote
according to the consequences of these choices on their own
(private) welfare.
Many believe that this description of the political process is
not correct.
The outcome of the political process reflects the political
power of the pressure groups.
Powerful groups in society determines the level of spending on
a public good.
Read papers: Bruns et al. (2019) and Marcel (2016).

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Government failures (2)

Bureaucracy: organization of public servers who are more

interested in their own welfare than doing their tasks
efficiently; which is the optimal size?
Public provision vs private provision: literature finds that
when public companies are privatized efficiency rises;
Government size is reduced; problems:
some markets are monopolies: due to the good’s nature, its
better to have one provider (i.e. water, electricity); sufficient
scale is required; high fixed costs; economies of scale;
privatization leads to high costs for consumers.
sub-hiring: Government holds the responsibility to provide the
good but hires the private sector to provide it; competitive
bidding sub-hiring

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Government failures (3)

Privatization is good on some markets, but in health? in

national security?
Market for social services involves market failures that inhibit
efficient private provision (i.e. health insurance externalities)
Corruption
Government failures have long term negative effects that
affect growth.

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References

Chapter 9 of Gruber, Jonathan. Public Finance and Public

Policy, Fourth edition, Worth Publishers, 2013.
Chapter 7 of Stiglitz, Joseph. La Economı́a del Sector
Público. Antoni Bosch, 3ra. edición, 2000.
Practice exercises!

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