Economic Perspectives On Government 3030197069, 9783030197063

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FOUNDATIONS OF GOVERNMENT AND PUBLIC ADMINISTRATION

Economic Perspectives on Government Keith Dowding · Brad R. Taylor

Foundations of Government and Public Administration Series Editors Jos C. N. Raadschelders Faculty Development Ohio State University Columbus, USA R. A. W. Rhodes University of Southampton Southampton, UK

This series explores the values and ideals that ground a society at large and the nature of the various relations between society and government. Organised around three overarching themes—Great Thinkers about Government’s Role and Position in Society, Foundations of Public Administration: Approaches to Studying Government, and Foundations of Government: Core Concepts and Ideas—the series will analyse government at its constitutional and foundational level. Such an approach is not yet mainstream, with public administration scholars more commonly focusing on the specific challenges, methods, skills, policies, and organizational structures of government’s operations. This series will address that trend by providing a conceptual map of these fundamentals and making new knowledge and approaches relevant for understanding government accessible to readers by helping them to grasp their origins, meaning and relevance. More information about this series at http://www.palgrave.com/gp/series/15900

Keith Dowding · Brad R. Taylor

Economic Perspectives on Government

Keith Dowding School of Politics and International Relations Australian National University Canberra, ACT, Australia

Brad R. Taylor School of Commerce University of Southern Queensland Springfield, QLD, Australia

ISSN 2523-7624 ISSN 2523-7632  (electronic) Foundations of Government and Public Administration ISBN 978-3-030-19706-3 ISBN 978-3-030-19707-0  (eBook) https://doi.org/10.1007/978-3-030-19707-0 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG, part of Springer Nature 2020 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover illustration: © Melisa Hasan This Palgrave Pivot imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Preface

For better or worse, economics is enormously influential in the study and administration of government. This book provides a non-technical introduction to and overview of the methods and assumptions of economics as applied to public policy and public administration. Although economics is a technical discipline, we firmly believe that a non-technical introduction can and should rigorously explain the assumptions which go into economic models and show how these assumptions drive the resulting conclusions. We thank the series editors, Jos Raadschelders and Rod Rhodes, for the opportunity to write the book as well as their insightful comments on an earlier draft. We are also grateful to Jemima Warren and Oliver Foster from Palgrave Macmillan for their assistance. Finally, we thank Anne Gelling for copy-editing the manuscript and Brittany Pooley for creating the graphs. The book would be much less pleasant to look at without their input. Canberra, Australia Springfield, Australia

Keith Dowding Brad R. Taylor

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Contents

1 Introduction 1 2 Markets, Market Failure and the Role of Government 17 3 Irrationality and Public Policy 47 4 Collective Choice and Bargaining 69 5 Bureaucracy and Levels of Government 95 6 Conclusion 119 Index 131

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List of Figures

Fig. 2.1 Fig. 2.2 Fig. 2.3 Fig. 2.4 Fig. 2.5 Fig. 2.6 Fig. 2.7 Fig. 2.8 Fig. 2.9 Fig. 4.1 Fig. 4.2 Fig. 4.3 Fig. 4.4 Fig. 4.5 Fig. 4.6 Fig. 4.7 Fig. 5.1 Fig. 5.2 Fig. 5.3 Fig. 5.4 Fig. 5.5 Fig. 5.6 Fig. 5.7 Fig. 5.8 Fig. 5.9 Fig. 5.10

Pareto efficiency Demand curve Market equilibrium Negative externality Pigouvian tax Positive externality Inframarginal externality The perfectly competitive firm Monopoly Principal–agent relationship in government Appointing a conservative minister Appointing a close minister Cabinet vetoes change PM expends capital PM uses cabinet committee PMs apparent strength Competitive firm profit-maximizes Bureau budget maximizes Romer and Rosenthal’s setter model Dunleavy’s three budgets Slack-seeking bureaucrats Moral hazard—accountability conspiracies Costs of rent-seeking Spatial Tiebout representation Matching grants Unconditional grants

19 22 24 28 29 30 32 37 38 75 83 84 84 85 86 87 97 98 100 101 102 104 105 109 113 114 ix

CHAPTER 1

Introduction

Abstract   This chapter introduces the economic or public choice approach to studying politics and public administration. It explains the rationality assumptions as predictive devices and how they are applied to types of agent rather than biological ones. It introduces the idea of formal models to provide predictions and how they can be applied to actual social and political processes. It introduces four concepts central to this way of thinking: opportunity costs, incentives, thinking at the margin and voluntary trade. It then introduces the main themes of several schools of public choice and then introduces the themes of the rest of the book. Keywords  Public choice · Revealed preference theory · Rationality assumptions · Opportunity costs · Incentives · Marginal analysis · Voluntary trade

The Economic Way of Thinking Economics is best considered not as an area of study, but rather as an approach to understanding the social world. Economists do spend a lot of time studying markets, but the economic method can be applied to topics as diverse and seemingly non-economic as marriage (Becker 1981), religion (Iannaccone 1998), terrorism (Phillips 2011) and, as we © The Author(s) 2020 K. Dowding and B. R. Taylor, Economic Perspectives on Government, Foundations of Government and Public Administration, https://doi.org/10.1007/978-3-030-19707-0_1

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show in this book, politics and public administration. At the core of the economic approach is the assumption of instrumental rationality: that individuals have preferences and act in order to satisfy them. On its strongest interpretation, instrumental rationality can be taken to mean that individuals know what’s best for them and will ruthlessly pursue their own interests at all costs. This notion gives rise to Homo Economicus, the hyper-rational and sociopathic character who has earned the scorn of critics from outside the economics profession, as well as heterodox economists. More modestly, instrumental rationality forms the basis of rational choice theory as an organizing principle around which theoretical and empirical investigation can be structured. This requires only that preferences satisfy the basic conditions required for coherence. Beyond that, any instrumental preference (i.e. preferences over states of the world) can be straightforwardly modelled using rational choice theory. By making rationality assumptions about agential behaviour, we enable scientific prediction and hence explanation of that behaviour. These rationality conditions are assumptions that are designed for scientific prediction; considered in this way, they have no normative status beyond that, though we will see later that evaluative standards have been built on top of these assumptions. The idea of rational choice or revealed preference theory is to construct preference orderings or utility functions for agents by examining their behaviour in one context and using those orderings to predict their behaviour in another context. Scientific prediction is not the same as forecasting or pragmatic prediction, though it can contribute to such forecasting (Dowding and Miller 2019). However, many forecasting models make no use of revealed preference theory. Rational choice uses consistency conditions in order to interpret actions. To see how this works in rational choice theory, we need to introduce a few technical definitions. We define the following terms and symbols. We assume there is a finite set X composed of elements a, b, c and so on. These elements can be considered as observable outcomes such as ‘voting for the Liberal candidate’ or ‘taking a bribe’, and we will refer to these as ‘alternatives’ in an opportunity set. We then define a set of ‘preference relations’ in terms of three categories: Weak preference. An individual i weakly prefers x to y when she considers x at least as good as y. We represent this relationship by the symbol ≽. So individual i is represented as weakly preferring x to y by x ≽ iy.

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Indifference. An individual i is indifferent between x and y when she weakly prefers x to y and weakly prefers y to x: x ≽ iy and y ≽ ix. This is represented by the symbol ~; thus x ~ iy. Strict preference. An individual strictly prefers x to y when she weakly prefers x to y and does not weakly prefer y to x: x ≽ iy and ¬ (y ≽ ix) (where ¬ means ‘not’). This relationship is represented as x ≻ iy. The relation ≻ is asymmetric, which means that if x ≽iy then necessarily ¬ (y ≽ ix). But ~ is symmetric, because x ~ iy implies x ~ iy. ≽ is thus composed of an asymmetric and a symmetric part. If we suppose that an agent is choosing between three alternatives— say a voter between three parties or a politician between three policies—x, y and z, the axioms of rational choice are: Reflexivity. For an alternative x, x = x; Completeness. For any two alternatives x and y, either x ≽ y or y ≽ x or both; Transitivity. If x ≽ y and y ≽ z then x ≽ z; Continuity. For any alternative x, we define a set A(x) as the ‘at least as good as’ set of alternatives and B(x) as the ‘no better than x’ set. Sets A and B are ‘closed’, meaning they include everything in their boundaries. Then, if x ≻ y and z is an alternative close enough to x, z ≻ y. From all this, we can define agents’ preferences over all alternatives when reflexivity, completeness and transitivity hold. When they hold, we can view an agent’s behaviour in several choice situations to construct their preferences, which we can then apply to a different choice setting and predict their behaviour. These assumptions give us the basis of revealed preference theory or rational choice. The three assumptions, often called ‘rationality assumptions’, are better thought of as predictive assumptions. When they hold, we can scientifically predict and therefore explain behaviour. That is, our interpretation of behaviour in the first setting enables our interpretation in other settings. We consider criticisms of these assumptions in Chapter 3. Continuity is a condition that shifts us from revealed preference to cardinal utility functions. This enables us not just to calculate the order in which people rank alternatives, but to give a scale showing the size of the differentials. Once we can scale alternatives, we can start the process of welfare calculations by some form of social utility function. We say no more here about cardinal utility functions, as all of the simple models in this book utilize only preferences.

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We should also note that preference and utility thus considered are completely empty concepts. They do not represent happiness or satisfaction or other psychological experiences; they are just mathematical formulation to enable scientific prediction. Our interpretation of behaviour might well fill in some of these psychological experiences for biological agents, but the conditions work equally well, if not better, for agents without such psychology, such as firms or political parties. Simply using ordering is often thought to bring advantages, since we do not have to attempt to make interpersonal comparisons of utility, which are problematic (Binmore 2009; Dowding 2009). This is one important difference between markets and government. Markets operate with a pricing tool which automatically provides cardinal comparisons. When a person purchases private goods, she pays only up to the amount that the good is worth to her. Now, that price cannot be simply equated with that individual’s utility and certainly price cannot measure interpersonal utility. The amount of money one has available to spend in any given week does not equate to the amount of utility one can gain in any given week—not even the amount of utility one gains from market goods. The fact that people have very different levels of income and wealth means that money cannot be used for interpersonal comparisons. Nevertheless, the market operates on cardinal grounds. When we aggregate utility in a public setting, we usually do so by voting, and that only measures ordinally. Cost–benefit analysis is usually conducted by surveying people about how much they are prepared to pay for public goods. And when voting people do take into account how they think different parties might tax and spend in government, but these calculations are all rather difficult to translate straightforwardly into utility (Boardman et al. 2017). When considering government intervention, even in ideal settings, our instruments for assessing welfare are blunter than those provided by market pricing in an ideal setting. We see in Chapter 4 some of the great difficulties we have with ordinal preference orderings in assessing general welfare. Pareto efficiency is a commonly used, but relatively crude criterion, which we explain in Chapter 2. The other important aspect is that the agents in economic models are not biological beings. They are abstract types. A type is an abstraction, a set composed of many token individuals. So we can think about an economic model which involves the behaviour of several firms trading with each

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other and with consumers; each firm and each consumer is a type. The rationality assumptions apply to these types. We place these agents in models. A model is an analytic construction that defines certain relationships between the agents contained within it. The models are useful, as they are taken to represent something else in the world. The agents represent their real entities, and the relationships in the model represent aspects of the real agents’ relationships in the world. So models in the social sciences are simplified representations of social processes and institutions. We can think of models as being more or less useful in helping us to understand the social world. The simplified representations of the world are designed to abstract (some) important features, so we may examine some of their causal effects in theory and try to examine them more closely in reality. Models become formal when we represent features of the descriptive model by symbols, which we are able to manipulate in order to deductively draw conclusions. When formalizing models, we face hard choices. We cannot include all the complexity of non-formal models, nor the complexity of full descriptions of reality, let alone the complexity of the world itself. We are forced to simplify and even to assume that relationships between aspects of the world are not as we know them really to be. We are forced to back our hunches and lay out, in ways that can be inspected, analysed and tested by others, the descriptive and causal inferences we think are important (note, not necessarily the most important, but perhaps in the past given less importance by others than we think they deserve). In doing so, we produce models with definite predictions, which we can then test in one way or another against data gathered from the actual world. These predictions can be true or false (in the same way as lessons about how real cars move along a road drawn from a toy car might be true or false). A formal model has a number of stated assumptions. These may be very difficult to empirically evaluate, or may be known to be false, but stating them at least allows for empirical evaluation of both the assumptions and what is supposed to occur were they true. The implications are deductively produced and hence, if the deduction is formally correct, are known to be valid. Thus, one element of debate or conflict is not open to issue. Another theorist may produce a rival model, with different assumptions and different implications. The derivation of the implications is clear in each case, and the two models may be pitted against each other in empirical tests. Of course, translating the formal model into a statistical test, or testing through the systematic collection of qualitative evidence, is not straightforward.

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Formal models are determinate in the sense that they produce predictions. Determinate here does not mean that they produce point ­predictions—many models are stochastic: that is, they produce predictions governed by some probability distribution. If a descriptive model is to explain anything, it must also produce some predictions. Appropriate statistical techniques may analyse the relationships between the variables to test the model’s predictions, but will always have unmeasurable, exogenous elements. Which model produces predictions most in accord with reality may be open to dispute. This may be because both models have captured some correct descriptive and causal aspects of reality. We may then attempt to capture the weight of the variables in the two models. This may be difficult, but we do have a clearer idea of what we are looking for. Sometimes models are just rivals. They produce different predictions from different assumptions. However, we can learn what we need to look for in a model that has false assumptions. Models of complete information tell us what we can expect to occur if individuals had complete information. Discovering what we can expect to occur if we relax this assumption in different ways tells us which direction we should take in order to find out more about what is happening in the real world. With formal models, the degree to which the assumptions are true, the degree to which the model displays descriptive and causal inference, may then, perhaps, be studied through quantitative analysis, or questions may be derived to give us a handle on the causal process through qualitative research. Non-formal models have many unstated assumptions; because they are unstated, they are impossible to empirically evaluate, and it is more difficult to draw out definite predictions. Thus, it is much more difficult to choose between competing non-formal models; indeed, it is often difficult to be sure they are competing. If two different models produce different predictions, then we know they are competing. But if we are not sure what the predictions are from two models, we do not even know if they are competing. They might be the same model. Hence, there are advantages to formalizing models. In this book, we use various types of model to understand political and organizational processes. Most of these models utilize the standard rationality assumptions of mainstream economics. However, in recent years, heterodox economists have taken on board some of the results from social psychology that show that biological agents do not conform to the rationality conditions. They do not have complete preferences, their behaviour is not transitive over choices and the continuity axiom simply does not seem to hold at the margins where it is defined.

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Behavioural economics, as we discuss in Chapter 3, assumes that humans use heuristics when making choices and are subject to framing effects. That is, how choices are described has a large bearing on the choices people make. Behavioural economics supplies an important corrective for normative arguments derived from the economic way of thinking, as we discuss in Chapter 3, but should also affect our positive explanatory models. However, most of the models we discuss in Chapters 4 and 5 utilize more mainstream assumptions, as it is these models which have been most extensively and effectively used.

Four Economic Concepts Building on this rational choice methodology, economists have formulated a more substantive, albeit still very general, approach to studying markets. We will consider various aspects of this approach in the coming chapters, but here we emphasize four key concepts which are central to the economic way of thinking: opportunity costs, incentives, thinking at the margin and voluntary trade. Opportunity costs. Because individuals have preferences over various things, all meaningful choices involve trade-offs. To get more of one thing we value, we need to give up something else. This results from the unfortunate fact of scarcity—our wants are potentially unlimited, but the resources we have to pursue them are limited, since we have only so many dollars in the bank, so many hours in a day, so many votes to cast. Without scarcity, there would be no need to choose between competing options and choices would not be choices at all. Scarcity is an inescapable fact of life. Increasing the resources at our disposal means we can satisfy more of our wants, but we can never satisfy all of them. Bill Gates doesn’t need to make tough choices between a new TV and a new car, but he does need to decide where to spend his resources on charity, for example. The Bill and Melinda Gates foundation would like to eradicate both malaria and HIV, but a dollar spent on malaria prevention is a dollar which cannot be spent on HIV research. Similarly, governments must make choices among competing policy priorities. Economists see the true cost of a choice as the value of what is given up in making that choice—that is, opportunity cost. Consider the full cost of a university degree to a student. Part of this cost is made up of clear, out-of-pocket or loan-funded expenses like tuition fees and textbook prices. A very significant portion of the cost, however, is the

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forgone opportunity to work full-time and earn an income. When deciding whether to attend university, focusing only on explicit expenses and ignoring forgone opportunities would lead to poor decisions. Incentives. As the costs and benefits of various options change, people will shift their behaviour. In other words, people respond to incentives. If the costs of university increase because fees go up while the benefits remain the same, we would expect fewer people to attend university, because some people who would find university worthwhile with lower fees now find it too expensive. If the full cost of university goes up because the wages of workers without tertiary education rise, we would similarly expect potential students to decide university isn’t worth forgoing these wages. In both cases, prospective students are rationally responding to incentives. Gans and Leigh (2009) provide a fascinating illustration of people responding to incentives. In 2004, the Australian government introduced a $3000 ‘baby bonus’ paid to parents of babies born on or after 1 July of that year, only seven weeks after the policy was announced. Since the announcement was made so close to the cut-off date, it was impossible for parents to delay pregnancy in order to take advantage of the policy and pocket an extra $3000. Those expecting to give birth around the time of the cut-off, however, had an incentive to make sure their baby was not born before 1 July. Birth timing cannot be perfectly controlled, but the fact that many babies are delivered by scheduled caesarean or are medically induced allows for some flexibility. If a mother with a caesarean scheduled on 30 June could safely wait another day, she had a $3000 incentive to do so. Gans and Leigh looked at the data and found that fewer babies were born just before the cut-off and more just after it. It seems that over 1000 births were moved to take advantage of the baby bonus; when it was increased two years later, a similar effect was seen. Looking at incentives allows economists to explain certain patterns of behaviour (e.g. why were Australian hospitals unusually busy on 1 July 2004?) and predict the outcome of various events (e.g. how would announcing a baby bonus effective immediately affect birth timing compared to announcing it ahead of time?). In Chapter 2, we will look at how prices act as incentives for buyers and sellers in ways which alter their behaviour. Thinking at the margin. A less obvious but equally important implication of the logic of rational choice theory is that rationality requires us to think at the margin. Economists say an action is rational if the benefits are equal to or greater than the costs. So if a can of soft drink costs

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$2 (the cost) and gives you $5 worth of satisfaction (the benefit), it would be rational to buy and drink it. But suppose that after finishing the first can you remain somewhat thirsty and need to decide whether to buy a second can for the same price of $2. If you value the second can at $1 and think about the costs and benefits of the two cans jointly, you might conclude that it is worthwhile buying the two cans, since the benefits ($5 for the first can and $1 for the second = $6) exceed the costs ($2 for each can = $4). However, by the time you are deciding whether to buy the second can, you have already enjoyed the benefits and paid the costs of the first. These are no longer relevant to your decision and you should focus only on whether the additional (i.e. marginal) benefit you receive is as large as the additional (i.e. marginal) cost. The extra cost of the second can is $2 and the extra benefit only $1. By thinking at the margin, we can see that this is not a rational choice and we should not buy the second can. People generally behave rationally in situations like this, but they do sometimes fail to think at the margin in ways which produce suboptimal choices. In particular, people tend to consider ‘sunk costs’ in their decisions when these should be ignored. Sunk costs are costs which have already been incurred (or have been committed to) and cannot be recovered. Suppose that you have purchased a non-refundable and non-transferrable $100 ticket to attend a concert, but catch the flu immediately beforehand. If you attend, you’ll feel miserable the whole time; but if you stay home, you will have wasted the $100 ticket price. In this situation, many people will force themselves to attend so as not to waste the $100. But since this is a sunk cost, it is not relevant to the decision whether or not to attend. You should consider only the marginal benefits of attending (the enjoyment of attending) and the marginal costs (the discomfort of dragging yourself to the concert while unwell) to know whether it is worthwhile attending. The $100 is gone either way and you should do whatever makes you happiest now, without the guilt of wasting resources. After all, making yourself miserable to avoid feeling you’ve wasted something benefits nobody. Voluntary trade. Markets are based on the idea of voluntary exchange—two parties both agreeing to exchange one thing for another. Since both the buyer and seller must agree to this exchange, revealed preference tells us both parties expect to benefit from it. If not, either party can refuse the transaction. This leads us to one of the central insights of economics: voluntary exchange is mutually beneficial. Here, we are moving beyond the value-free conception of preference as no more than a means of representing behaviour and entering the muddy

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waters of welfare economics, which does give preference-satisfaction positive value. It also assumes all trade is genuinely voluntary. We consider welfare economics and its application to public policy at some length in Chapter 2. We will see that, since voluntary trade is mutually beneficial, economists generally see markets as a desirable way of allocating resources. We must be careful not to conflate mutual benefit with common benefit, however. When the effects of a transaction are not limited to the transacting parties, we cannot guarantee that trade produces net gains in terms of preference satisfaction.

Public Choice Theory Many of the arguments we use in the book are derived from public choice theory. Public choice is the application of economic methodology to the study of politics. The name comes from the journal Public Choice, which was set up by Gordon Tullock in the 1960s. Its original title, tellingly, had been ‘Papers on Non-Market Decision-making’— public choice is simply snappier. We can look back further for the origins of modern social choice theory to Duncan Black and Kenneth Arrow, or longer ago still to the work of Jean-Charles de Borda and the Marquis de Condorcet on voting systems in the 1780s. However, it was the use of simple models to examine political processes such as party behaviour (Downs 1957), constitutional political economy (Buchanan and Tullock 1962) and collective action and interest groups (Olson 1965) that formed its initial basis. Several schools of thought developed. The Rochester school grew up around the teachings and work of William Riker. His graduate political science programme trained several generations of political scientists. The Rochester school is known for its mathematical modelling, use of social choice and game theory and, initially, for its largely abstract models from which institutional and empirical detail is missing (Riker 1982; Schofield 1978; McKelvey 1979; Austen-Smith and Banks 1999). Nevertheless, scholars learned from this approach the importance of institutional details in predicting the divergent course of politics in different countries and times. Partly normative, Rochester school studies examined the effects of strategic voting and agenda manipulation on democratic outcomes, the potential cycling of issues that can occur in n-dimensional issue space (Riker 1982) and how legislative procedures governing, for example, committee structure (Shepsle 1979; Shepsle and Weingast 1987), party system and coalitional

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behaviour reduce such potential cycling in practice (Laver and Shepsle 1996; Schofield 1995). The Virginia school is associated with Buchanan and Tullock, the former developing constitutional political economy through looking at foundational issues of the justification of state action and legal process (Buchanan 1975; Brennan and Buchanan 1985) and the latter concentrating more upon the problems of democratic systems through rent-seeking and log-rolling behaviour (Tullock 1967, 1990). We can trace its roots to the work of Frank Knight at Chicago in the 1920s. It set itself against mainstream economics and the dominant welfare economics of the 1960s. Here, the idea of welfare economics is that we can determine welfare-maximizing regulations and then expect politicians to turn these into law. The Virginia school argued that politicians themselves are maximizers of their own benefits, and these benefits include the power and pecuniary advantages of office. They will exploit their offices constrained only by their desire for re-election. Using Pareto optimality as their welfare criterion, the Virginia school largely argued for minimal state action. Chicago school political economists are more optimistic about the efficiency of democracy than either Rochester or Virginia (Wittman 1995). Their models tend to assume perfect information and that markets, including political markets, will produce efficient results (see Chapter 2); however, in studies analysing the nature of regulation, Chicago school scholars acknowledged the differential abilities of different actors to mobilize for their interests (Stigler 1971; Peltzman 1976). The school is best known for applying economic methods to new domains, such as the judicial system (Posner 2014), interest groups (Mitchell 1990) and various social problems (Becker 1974a, b, 1981). The Bloomington school is associated with the work of Vincent and Elinor Ostrom. Vincent Ostrom was instrumental in introducing the work of Charles Tiebout (1956) and fiscal federalism to mainstream political science; his mature work is somewhat in the mould of Buchanan’s constitutional political economy and federalism (Ostrom 1987). Elinor Ostrom’s early work was on public provision in the Tiebout mould, extending it to the idea of polycentricity (Ostrom 2001; Aligica and Tarko 2013). She became interested in collective action or common-pool problems, and was awarded the Nobel Prize for Economics for her work in this area. Using game theory, experimental methods and detailed empirical fieldwork, she argued that collective action was not best attained through single processes; different types of problems

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require different solutions, and path-dependent institutions and historical agreements pave the way for contemporary solutions (Ostrom 1990, 2005; Ostrom et al. 1994). More recently principal–agent models have been used to model many of the political relationships we are interested in, precisely to show how politics is often about regulation, and how we can most efficiently control those agents whose job is to carry out our wishes. These models have been applied to the relationships between voters and parties and government, between the legislature and the executive and between elected politicians and bureaucrats. We study these particularly in Chapter 5.

Outline of the Book Chapter 2 examines the role of the state. The standard economic justification for the state is market failure. This chapter describes the conditions under which markets are efficient and when those conditions are not met. It begins to look at irrational behaviour: that is, behaviour which does not conform to the axioms of rationality. Chapter 3 examines the behavioural economics challenge to mainstream approaches. It provides further justifications for the intervention of the state, suggesting a more active role for government. It examines the shaping of choice and how government can nudge citizens into welfare-enhancing behaviour or can use standard regulatory and taxation techniques. It teaches us that how issues are framed affects public attitudes, but once we are within a frame we can model using the principles of rational choice theory. Although the findings of behavioural economics suggest that behaviour is not always and everywhere consistent with rational choice theory, we argue that the latter remains a useful tool for studying human behaviour. Behavioural economics allows us to answer questions conventional economics is ill-suited for; but there remain many questions where good old-fashioned rational choice theory provides compelling insights with little theoretical overhead. Chapter 4 examines collective choice and bargaining. It briefly explains the problem of collective choice—the problems induced by Arrow’s theorem. Electoral competition provides a government, but bargaining still occurs within government and we provide some simple spatial models of bargaining of this. The chapter then turns to principal–agent problems, showing how many of the relationships that exist within government can be modelled in this way. We examine the manner in which principals provide incentives for their agents to act as the

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principal wishes, and how these relationships break down, viewing the cabinet and the relationship between the elected government and public servants through this lens. Chapter 5 continues by looking at the efficiency of bureaucracy using what we learned about collective choices from Chapter 4. While all large organizations have bureaucracies, we concentrate upon the incentives facing public servants. The chapter then turns to the pressures on government and the public service, using Virginia school models of rent-seeking and asymmetric information to show their effect on government efficiency. Finally, it examines how a process of fiscal federalism, or levels of government, might help efficiency within the state through competition between governments and a rationalized system of responsibilities, considering issues such as Tiebout’s competition, quasi-markets, polycentricity and fiscal federalism. Chapter 6 provides a short summary of what the book has taught us about the economic approach to politics and public administration.

References Aligica, P. D., & Tarko, V. (2013). Co-production, polycentricity, and value heterogeneity: The Ostroms’ public choice institutionalism revisited. American Political Science Review, 107, 726–741. Austen-Smith, D., & Banks, J. S. (1999). Positive political theory, I. Ann Arbor: University of Michigan Press. Becker, G. (1974a). A theory of social interactions. Journal of Political Economy, 82, 1063–1093. Becker, G. (1974b). Crime and punishment: An economic approach. In G. Becker & W. M. Landes (Eds.), Essays in the economics of crime and punishment. Washington, DC: National Bureau of Economic Research. Becker, G. (1981). A treatise on the family. Cambridge, MA: Harvard University Press. Binmore, K. (2009). Interpersonal comparison of utility. In D. Ross & H. Kincaid (Eds.), Oxford handbook of philosophy of economics. Oxford: Oxford University Press. Boardman, A. E., Greenberg, D. H., Vining, A. R., & Weimer, D. L. (2017). Cost-benefit analysis: Concepts and practice. Cambridge: Cambridge University Press. Brennan, G., & Buchanan, J. M. (1985). The reason of rules: Constitutional political economy. Cambridge: Cambridge University Press. Buchanan, J. M. (1975). The limits of liberty: Between anarchy and Leviathan. Chicago: University of Chicago Press.

14  K. DOWDING AND B. R. TAYLOR Buchanan, J. M., & Tullock, G. (1962). The calculus of consent. Ann Arbor: Michigan University Press. Dowding, K. (2009). What is welfare and how can we measure it? In D. Ross & H. Kincaid (Eds.), Oxford handbook of philosophy of economics. Oxford: Oxford University Press. Dowding, K., & Miller, C. (2019). On prediction in political science. European Journal of Political Research (forthcoming). https://doi.org/ 10.1111/1475-6765.12319. Downs, A. (1957). An economic theory of democracy. New York: Harper & Row. Gans, J. S., & Leigh, A. (2009). Born on the first of July: An (un)natural experiment in birth timing. Journal of Public Economics, 93, 246–263. Iannaccone, L. R. (1998). Introduction to the economics of religion. Journal of Economic Literature, 36, 1465–1495. Laver, M., & Shepsle, K. A. (1996). Making and breaking governments: Cabinets and legislatures in parliamentary democracies. Cambridge: Cambridge University Press. McKelvey, R. D. (1979). General conditions for global intransitivities in formal voting models. Econometrica: Journal of the Econometric Society, 47, 1085–1112. Mitchell, W. C. (1990). Interest groups: Economic perspectives and contributions. Journal of Theoretical Politics, 2, 85–108. Olson, M. (1965). The logic of collective action: Public goods and the theory of groups (2nd ed.). Cambridge, MA: Harvard University Press. Ostrom, E. (1990). Governing the commons: The evolution of institutions for collective action. Cambridge: Cambridge University Press. Ostrom, E. (2001). Decentralization and development: The new panacea. In K. Dowding, J. Hughes, & H. Margetts (Eds.), Challenges to democracy. Houndmills: Palgrave. Ostrom, E. (2005). Understanding institutional diversity. Princeton: Princeton University Press. Ostrom, E., Gardner, R., & Walker, J. (1994). Rules, games, and common-pool resources. Ann Arbor: Michigan University Press. Ostrom, V. (1987). The political theory of a compound republic: Designing the American experiment (2nd ed.). Lincoln: University of Nebraska Press. Peltzman, S. (1976). Toward a more general theory of regulation. Journal of Law and Economics, 19, 211–240. Phillips, P. J. (2011). Lone wolf terrorism. Peace Economics, Peace Science and Public Policy, 17. https://ssrn.com/abstract=1623573. Posner, R. A. (2014). Economic analysis of law (9th ed.). New York, NY: Wolters Kluwer Law & Business. Riker, W. H. (1982). Liberalism against populism: A confrontation between the theory of democracy and the theory of social choice. San Francisco: W. H. Freeman.

1 INTRODUCTION 

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Schofield, N. (1978). Instability of simple dynamic games. Review of Economic Studies, 45, 575–594. Schofield, N. (1995). Coalition politics: A formal model and empirical analysis. Journal of Theoretical Politics, 7, 245–281. Shepsle, K. A. (1979). Institutional arrangements and equilibrium in multidimensional voting models. American Journal of Political Science, 23, 27–59. Shepsle, K. A., & Weingast, B. R. (1987). The institutional foundations of committee power. American Political Science Review, 81, 86–108. Stigler, G. J. (1971). The theory of economic regulation. Bell Journal of Economics and Management Science, 2, 3–21. Tiebout, C. M. (1956). A pure theory of local expenditures. Journal of Political Economy, 64, 416–424. Tullock, G. (1967). The welfare costs of tariffs, monopolies and theft. Western Economic Journal, 5, 224–232. Tullock, G. (1990). The costs of special privilege. In J. E. Alt & K. A. Shepsle (Eds.), Perspectives on positive political economy (pp. 195–211). Cambridge: Cambridge University Press. Wittman, D. (1995). The myth of democratic failure: Why political institutions are efficient. Chicago: University of Chicago Press.

CHAPTER 2

Markets, Market Failure and the Role of Government

Abstract  This chapter introduces Pareto efficiency as the key normative concept of welfare economics and describes the conditions under which we expect efficiency or market failure. We pay particular attention to the existence of externalities and show how these can, but do not always, cause markets to fail. Whenever there is market failure it is conceptually possible for government to intervene in order to improve outcomes. Government failure also occurs, however, and so such intervention is not always practical. When considering imperfect alternatives, we must engage in comparative institutional analysis. Keywords  Pareto efficiency · Market competition · Market failure Externalities · Government failure · Coase theorem · Monopoly · Asymmetric information

·

The Invisible Hand and Market Efficiency A good deal of economic theory is positive—it attempts to explain and predict economic and social outcomes based on the rational choice assumptions outlined in the previous chapter. Economics also has a normative purpose, however, and economists have developed the concept of efficiency as a tool to consider the desirability of markets and to compare alternative policy options. © The Author(s) 2020 K. Dowding and B. R. Taylor, Economic Perspectives on Government, Foundations of Government and Public Administration, https://doi.org/10.1007/978-3-030-19707-0_2

17

18  K. DOWDING AND B. R. TAYLOR

In this chapter, we outline the assumptions and methods of welfare economics, with a focus on how these have been used to justify or oppose government intervention in the market. Although most mainstream economists agree on the basic evaluative method, the conclusions which can be drawn from this method about the role of government in a market economy are hotly disputed. We do not take a side on this question here; our intention is to lay out the basic method and to show how this has structured debates among economists over the proper role of government. The argument for markets is based on the idea expressed by Adam Smith (1776: Bk. 4, Ch. 2) that, with the right institutions, a selfish person can be ‘led by an invisible hand to promote an end which was no part of his intention’. The right institutions are, for Smith and mainstream economists today, private property and voluntary exchange. If people are rational, they will only agree to an exchange if they expect it to be of benefit to them, and since both parties must agree for a voluntary exchange to take place, both parties must expect to benefit from trade. If anyone expects to lose out from an exchange, they have a veto at their disposal. This idea of unanimous consent is operationalized in the concept of ‘Pareto efficiency’, named for the Italian economist and polymath Vilfredo Pareto. If all relevant costs and benefits are captured by the transacting parties, voluntary exchange results in a ‘Pareto improvement’, a redistribution of resources which benefits at least one person without harming anyone else (Pareto 1906). If one party expected to be harmed by the exchange, they would not agree to it. Individuals can thus trade with one another until all mutually beneficial exchanges are exhausted. At this point, there will be a ‘Pareto efficient’ or ‘Pareto optimal’ allocation of resources: nobody can be made better off without also making somebody else worse off. The major advantage of Pareto’s conception of efficiency is that it avoids the need to aggregate or compare the welfare of different individuals. Prior to this, economists used the term ‘utility’ to mean something akin to happiness or satisfaction. If we wanted to know whether some change in resources produces a net benefit or loss, we would need to weigh up the increased happiness of some against the losses of others. Such happiness was not measurable, but some influential economists hoped that advances in our understanding of the brain would eventually allow for the measurement of happiness (see Colander 2007). Pareto

2  MARKETS, MARKET FAILURE AND THE ROLE OF GOVERNMENT 

19



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&

Žď͛ƐhƚŝůŝƚLJ

Fig. 2.1  Pareto efficiency

allowed economists to make more limited welfare judgements on firmer methodological ground. The normative force of the Pareto efficiency analysis rests on a commitment to welfarism: that states of affairs are to be judged in terms of the welfare of individuals. The most basic normative commitment of welfare economics is that Pareto improvements are a good thing. Actions benefiting some and harming none are unobjectionable from the point of view of welfare economics. Since a voluntary trade with no spill-over effects must be a Pareto improvement, welfare economists insist that such trades be allowed to take place. Government intervention to prevent such trades is harmful to the individuals involved and produces no offsetting benefit in terms of welfare. Figure 2.1 shows the welfare of two people, Alice and Bob. Higher points in this two-dimensional space represent greater levels of utility for Alice; more rightward points represent greater levels of utility for Bob. Suppose that the current distribution of resources puts us at point A. Any change in resources which puts us higher in this space benefits Alice; any change in resources which puts us further to the right benefits Bob; and thus any movement up and to the right benefits both Alice and Bob. Leftward shifts harm Bob and downward shifts harm Alice. The movement from A to C benefits Alice without harming Bob, and the movement from A to E benefits Bob without harming Alice. We can thus say that the movement from A to C or from A to E is weak Pareto improvements; at least one person is better off and nobody is worse off. The move from A to D benefits both Alice and Bob. This is a strong Pareto

20  K. DOWDING AND B. R. TAYLOR

improvement; everybody is made better off as a result of the change. The movement from A to B, however, is not a Pareto improvement of any kind. Alice’s utility is increased, but Bob’s is decreased. Similarly, a move from A to F would benefit Bob, but harm Alice. The concept of a Pareto improvement provides a normative justification for preferring some states of affairs to others, but it should be noted that there will in practice be countless Pareto-efficient outcomes and this analysis provides no reason for preferring one to any other. In Fig. 2.1, points B–F are all Pareto efficient. Starting from any of these points, there is no way to benefit Alice or Bob without harming the other. Despite the fact that the Pareto criterion was capable of justifying a move from A to C, but not from A to B or A to F, once we find ourselves at point B there is no justification for a shift to point C since this would harm Alice. This logic lies behind the ‘first fundamental theorem’ of welfare economics. If people are left to themselves to trade in complete and competitive markets, they will reach an agreement which cannot be improved upon in Paretian terms. Exchange will continue until all gains from trade have been exhausted, so government intervention is not required to produce Pareto efficiency. This can be thought of as a formalization of Smith’s invisible hand: decentralized exchange produces optimal results. However, ‘optimal’ as it is used here does not mean ‘uniquely optimal’. The first theorem tells us that complete and competitive markets produce an efficient result, not the only efficient result. In Fig. 2.1, we can say that point D is superior to point A, but we cannot say anything at all about the relative merits of points B–F, since they are all equally Pareto optimal. The concept of Pareto efficiency allows us to say that some states of affairs are preferable to others, but does not provide a general tool for evaluating states of affairs against one another. Over the decades, welfare economists have celebrated Pareto’s avoidance of the problem of interpersonal comparisons of utility, while decrying the rigidity of Pareto efficiency as a normative standard. Virtually all changes to the status quo leave some people worse off; so some way of weighing up the losses of the few against the gains of the many would be a useful normative tool. Since this would involve interpersonal comparisons of utility, however, such a tool is scientifically dubious. The path forward for welfare economics came in 1939 when two economists, John R. Hicks and Nicholas Kaldor, arrived at a modification of Pareto efficiency which allowed for more general comparative

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evaluation of different states of affairs. Kaldor (1939) argued that economists could endorse on efficiency grounds policies which increase total real income, even if some people lose out as a result of these policies. This might seem to violate economists’ self-imposed ban on interpersonal comparisons of utility, but Kaldor pointed out that it would be possible to make everybody better off if the winners were required to compensate the losers. A requirement of actual compensation here would lead to a Pareto improvement which, as we have seen, does not require any interpersonal comparison of utility. For Kaldor, however, actual compensation is not required. If compensation is possible, the net benefit is positive and it is up to the political process to decide whether actual compensation should be paid. Building on Kaldor’s insight, Hicks (1939) was able to lay out the foundations of a ‘new welfare economics’. Not only is the equilibrium of perfectly competitive markets efficient, but also, as we will see in the next section, certain forms of government intervention can produce efficient results where markets cannot. The model of perfect competition is built on three general assumptions: 1. There are no externalities. The production and consumption of the good do not positively or negatively impact anyone other than the buyer and seller of the good. 2. The market is competitive. There are sufficiently many buyers and sellers in the market that no individual consumer or producer is capable of influencing the market price. Further, all firms sell products which consumers consider identical to one another, and firms are free to enter and exit the market. 3. There is perfect information. Consumers have all the relevant information about the prices and quality of products being sold and producers have all the relevant information about consumer demand and the prices charged by rivals. To build a model of perfect competition, we combine these assumptions with a general specification of consumer and producer preferences. These are represented in the demand and supply curves which are the subject of introductory microeconomics. Although this model is primarily used in a predictive way to analyse the effects of various events on the price at and quantity in which goods are sold, it also has important normative properties for those following the Kaldor–Hicks criterion of efficiency.

22  K. DOWDING AND B. R. TAYLOR

An individual demand curve for a particular good illustrates the quantity of a good a consumer is willing and able to buy at each possible price. Since consumers are rational and put their scarce purchasing power towards whatever bundle of goods best satisfies their preferences, higher prices will tend to discourage the purchase of any particular good. This can be seen in the demand curve of Fig. 2.2. The consumer is unwilling to buy any of the good for $5, but at a price of $4, she is willing to buy one unit of the good. If the price dropped to $3, she would be willing to buy two units and so on. The demand curve shows the maximum willingness to pay of the consumer for each unit of the good, and since the economic method works on the basis of revealed preferences, we can take this willingness to pay as representing the value attached by the consumer to each unit of the good. Assuming for the sake of simplicity that dollars are not divisible, we can conclude from this that the consumer values the first unit at $4, the second unit at $3, the third unit at $2 and the fourth unit at $1. The demand curve for an entire market, as opposed to an individual consumer, shows the quantity of a good demanded collectively by all consumers at each price level. If we knew everyone’s individual demand curve, we could add these up to derive the market demand curve, and it too will be downward-sloping. As the price of good increases, some consumers will buy less and others will choose not to buy any of the good at all. Ψϱ

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Fig. 2.2  Demand curve

ϰ

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23

To analyse the outcomes of a competitive market, we also need to consider the preferences of firms. In the perfect competition model, we assume that firms aim to maximize profit. In the real world, firms are organizations constituted by many individuals working together, rather than a single entity capable of making reasoned choices. To the extent that individual employees pursue their own goals, the firm will not be a perfect profit-maximizer (see Chapter 4 on principal–agent relationships), but in highly competitive markets there will be little scope for firms to deviate from profit maximization while remaining in business. Competitive pressure selects for firms able to direct individual incentives towards the common goal of profit maximization and limits the ability of managers and other employees to pursue other goals (Alchian 1950; Friedman 1953). The profit-maximizing firm decides what price to charge and what quantity to produce, and these objectives are represented by the firm’s supply curve. This shows how many units of the good a firm is willing to produce and sell at each price level. Other things equal, higher prices mean greater profits and so firms will be willing to supply more as the price rises. This means that the individual supply curve slopes upwards. Adding all of the individual firms’ supply curves together gives us the market supply curve, which represents the total quantity of a good supplied at each price level. This will be upward-sloping because each firm will be willing to supply more as the price rises, and at sufficiently high prices new firms will enter the market. Putting the market demand curve and the market supply curve on the same graph, as in Fig. 2.3, allow us to think about how these forces interact to determine the market outcome. Since the demand curve is downward-sloping and the supply curve is upward-sloping, they will intersect in any market where voluntary exchange is possible. At the point of intersection, at price PE and quantity QE, the quantity supplied by firms is equal to the quantity demanded by consumers: no firm willing to sell at this price is unable to find a buyer and no consumer wanting to buy at this price is unable to find a seller. This point is an equilibrium in the sense that it is a stable point towards which competitive markets gravitate. At any price higher than equilibrium, the quantity supplied is greater than the quantity demanded. Firms will be unable to sell as much as they’d like at this price and could increase profit by undercutting the market price to sell more. This puts downward pressure on the market price, pushing it towards equilibrium. At any price lower than equilibrium, the quantity demanded

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24  K. DOWDING AND B. R. TAYLOR

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Fig. 2.3  Market equilibrium

is greater than the quantity supplied. There will be consumers willing to pay the market price who are unable to find a seller. This forces the price up towards equilibrium. Only at the point of equilibrium do the forces of demand and supply balance each other in a way which creates no internal momentum for change. Of course, real-world markets may never be perfectly in equilibrium, since other events constantly shift the equilibrium and it takes time for markets to adjust, but we see a tendency for markets to move towards equilibrium. To show that this competitive equilibrium is uniquely efficient in the Kaldor–Hicks sense, we must consider the way in which demand and supply curves represent the preferences of consumers and firms. As we saw above, the market demand curve represents the marginal valuation placed by consumers on the consumption of each unit of the good. To focus on the normative properties of markets, then, we could rename the demand curve in Fig. 2.3 the ‘marginal private benefit curve’—a curve showing the marginal benefits of consumption to the consumers themselves. Since the competitive model further assumes that consumption of the good does not harm or benefit any third party, the marginal private benefit curve captures all the socially relevant benefits. We can thus further rename it the ‘marginal social benefit curve’.

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The market supply curve represents the quantity supplied by all firms at each market price. In a perfectly competitive market, each firm has so many competitors that it cannot control the market price and will be willing to produce and sell a unit of the good as long as doing so increases total profit. Producing an additional unit of the good will increase profit if and only if the additional revenue received (i.e. the market price) is greater than the additional costs of producing and selling that good. The supply curve therefore shows the additional cost of producing each unit of the good to the firm in question—the ‘marginal private cost’—and since we are assuming that there are no external costs, this will equal the ‘marginal social cost’. We can consider competitive equilibrium in efficiency terms. At the point where the marginal social benefit (the demand) curve and the ­marginal social cost (the supply) curve intersect, the marginal benefit to society of producing the last unit of the good is just equal to the marginal cost to society. It is at this point that the social surplus is maximized. At any lower level of production (i.e. any point to the left of equilibrium in Fig. 2.3), the additional benefits to consumers of one more unit are greater than the additional cost to firms (since the marginal social benefit curve is at this point higher than the marginal social cost curve). This unit is worthwhile producing, so if net benefits are to be maximized, production should be increased until the equilibrium quantity is reached. If, on the other hand, the quantity is greater than the equilibrium quantity (i.e. any point to the right of equilibrium), the marginal social costs exceed the marginal social benefits. Even though consumers derive value from consuming the additional unit of the good, greater value is lost in producing it. Net benefits would be maximized by reducing production back to equilibrium. The first theorem of welfare economics tells us that the competitive equilibrium is Pareto efficient, but not that it is uniquely Pareto efficient. Government cannot improve upon the outcome of perfect competition solely on Pareto grounds, but on these grounds there is equally no reason to think that various forms of government intervention are worse than perfect competition. The Pareto criterion is solidly grounded normatively, but does not provide much in the way of leverage when attempting to evaluate competing policies on efficiency grounds. The analysis above tells us that the competitive equilibrium maximizes net benefits in a more specific sense: that the competitive equilibrium is uniquely efficient and that any government intervention which disturbs

26  K. DOWDING AND B. R. TAYLOR

this equilibrium reduces net benefits. Such intervention will in general help some and harm others and so cannot be deemed Pareto inferior to competitive equilibrium; but since the net benefits defined in terms of willingness to pay are greatest at competitive equilibrium, we can say that this equilibrium is Kaldor–Hicks efficient.

Market Failure The demonstration of competitive market efficiency presented above made three key assumptions: no externalities, competitive markets and perfect information. If these assumptions are shown not to hold, and they often do not, we can no longer be certain that the market outcome is efficient in Pareto or Kaldor–Hicks terms. This raises the possibility of government intervention which increases net benefits or even results in a Pareto improvement. An inefficient market outcome like this is known as a market failure, and it is the main justification for government intervention generally accepted by economists. We should be careful to note, however, that the violation of one or more of these assumptions does not necessarily mean that market outcomes will be inefficient, much less that there is a feasible way for government to intervene in order to improve outcomes. If the assumptions above do not hold, there is a possibility of market failure; and if such a market failure occurs, there is a possibility for welfare-improving government intervention. This is important, because the assumptions are never perfectly met in reality. Consumers are never perfectly informed and rational, but they may often be sufficiently informed and rational for the efficient outcome to transpire anyway. In outlining these three sources of market failure we spend many more words on the issue of externalities and cover imperfections in information and competition only briefly. This is not because we see these as unimportant, but rather because spending more time on a single source of market failure allows us to interrogate the economic way of thinking in greater depth. Externalities A central assumption of the market-efficiency findings above is that all of the costs and benefits resulting from a transaction accrue to the transacting parties, each of whom is able to veto the transaction if it does not

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benefit them. In reality, however, many (all?) market transactions have spill-over effects on third parties with no voice in the negotiations. When external costs or benefits like this are present, we can no longer guarantee that market outcomes will be efficient in Pareto or Kaldor–Hicks terms. The classic example of a negative externality or external cost is pollution. When a consumer voluntarily buys a good from a company, we know that these two parties expect to benefit from the transaction. However, if the production of that good results in smoke or unpleasant smells in the area surrounding the factory, local residents are harmed but cannot normally veto the transaction. We can no longer be certain that the production and sale of the good are efficient. Since the buyer and seller benefit but some third party is harmed, the transaction no longer represents a Pareto improvement. If the externality is a serious one, it may mean that the transaction reduces aggregate welfare and the competitive market equilibrium will be Kaldor–Hicks inefficient. This pollution results in a departure of the marginal social costs of production from the marginal private costs. Since a profit-maximizing firm makes decisions on the basis of private costs, external costs can lead to overproduction of a good from an efficiency standpoint. This is shown in Fig. 2.4. Suppose that we have a market which meets all the conditions of perfect competition, except that whenever a unit of the good is produced an external cost is imposed on those living near the relevant factory. The supply curve represents the marginal private cost of producing additional units of the good, but the external costs push the marginal social cost (MSC) curve higher. Producing an additional unit of the good imposes some costs on the producing firm and some on those living nearby. Since consumers and firms make decisions based on their private costs and benefits, the equilibrium outcome in this market is an output level of QE, the intersection of the MPC (supply) and MPB (demand) curves. At this level of output, marginal social costs are higher than marginal social benefits. This means that the last unit of the good produced a net loss in welfare from a social standpoint. The efficient solution is to produce at Q*, where marginal social costs are equal to marginal social benefits. The negative externality results in an overproduction of the good relative to the social optimum. This way of thinking about externalities was developed by the English Economist A. C. Pigou (1920), who also suggested what has

28  K. DOWDING AND B. R. TAYLOR

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Fig. 2.4  Negative externality

become the textbook solution to negative externalities, a ‘Pigouvian tax’ which levies a per-unit tax on the production of the good equal to the marginal external cost. This has the effect of making the firm consider the full costs of their output, internalizing the externality.1 As shown in Fig. 2.5, this pushes the MPC (supply curve) upwards until it is equal to the MSC curve. Private and social costs are once again equal and the efficient outcome of Q*. Firms make fewer sales and consumers pay higher prices, but this is more than offset by the reduction in pollution to neighbours and the tax collected by the government. Here the market outcome was inefficient and government policy corrected this market failure.

1 In the standard analysis, the tax is levied on the production of the good itself. As Plott (1966) points out, the tax should instead be levied on the output of the externality (i.e. the pollution) or on the resource which causes the pollution. This provides the right incentives for firms to change their production process to remove externalities rather than simply reducing production. Since it does not alter the central points we wish to make in this chapter, we will use the simpler case of taxes imposed on the output of a good.

2  MARKETS, MARKET FAILURE AND THE ROLE OF GOVERNMENT 

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Fig. 2.5  Pigouvian tax

As we emphasize below, the theoretical possibility of a welfare-improving tax is not the same thing as its practical feasibility. A policy-maker wishing to set the Pigouvian tax at the correct level would need to know the magnitude of the marginal external cost. The marginal social benefit and cost curves as we have drawn them are abstractions and not visible to anyone in real-world markets. Policy-makers must instead rely on estimation. Even the best estimate will be imperfect and a poor estimate could well result in an intervention which decreases aggregate welfare. Inefficiency can also result from external benefits. If the production or consumption of some good benefits some third party with no say in whether the good is produced or consumed, the parties with decision-making power are not considering all relevant costs and benefits. For example, individuals vaccinating themselves against communicable diseases benefit others through herd immunity. If firms producing vaccines and consumers vaccinating themselves only consider their own private benefits and costs, we could end up with an inefficiently low number of vaccinations administered. Figure 2.6 represents this external benefit as an MSB curve which exceeds the MPB curve. The market equilibrium without government intervention will be at the intersection of the MPB and MPC cost curves, at quantity QE. The efficient outcome, however, is

30  K. DOWDING AND B. R. TAYLOR

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at the intersection of the MSC and MSB curves, at quantity Q*. By placing a Pigouvian subsidy on each unit of the good, MPB can be shifted up, in line with MSB, and output can be increased to the socially optimal level. In some cases, external benefits might be so significant relative to private benefits that none of the good is produced. This is the general prediction of economic theory when it comes to public goods: goods for which the consumption of one person does not diminish the available quantity to others (non-rival goods) and which producers cannot prevent people from enjoying, whether or not they pay for it (non-excludable goods). The classic example of a public good is national defence. A military force capable of defending against attack provides a valuable service to those living in a region. This service is non-rival because your use of the service does not reduce others’ enjoyment of it or use up any scarce resources. Once the good is produced, everyone can make use of it without any additional cost. National defence is also non-excludable, because it would be impossible to prevent a particular person from enjoying the benefits of national defence while living in the protected region.

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Any private company wishing to sell national defence would therefore have a very difficult time earning any revenue. It could ask for subscription fees, but each individual could attempt to ‘free-ride’ by enjoying the benefits without paying the costs. This represents a positive externality which can lead to under-provision of the good. If a sufficient number of consumers free-ride, the good will not be produced at all, even if the social benefits outweigh the social costs. The standard policy response to public goods is government provision. Since the government can force people to pay their share, the free-rider problem is avoided. Externalities are a major cause of market failure, but their mere existence is not enough to establish that market outcomes are in fact inefficient. This is an important point, because virtually all consumption and production (and, indeed, non-economic activity) affect third parties in some way, but this will not usually produce inefficiency. Only when there is some demonstrable Pareto improvement which could in theory be made can we conclude that there is market failure. Perhaps the most pervasive form of externality is a pecuniary externality: that is, one in which the costs and benefits fall on others via prices. When a firm decides to lower its price to attract customers, it is harming its competitors. Since firms are unable to veto transactions between their rivals and potential customers, even though they are financially harmed by such transactions, there exists a negative externality here. This does not lead to inefficiency, however, because the harm of lower prices or fewer sales made by one firm is fully compensated by the lower prices enjoyed by consumers or the increased sales of other firms. Purchasing power is redistributed, but there is no net loss. Similarly, increased demand for housing imposes a cost on potential buyers and an exactly equal monetary benefit on potential sellers. Another type of externality which does not cause inefficiency is an inframarginal externality: that is, a situation where external costs or benefits exist, but there is no difference between marginal private cost and marginal social cost in equilibrium (Buchanan and Stubblebine 1962). For example, suppose that a group of factories has polluted a river such that it is no longer suitable for swimming. However, the damage is caused at low levels of output, and any further increase in output will not cause any additional harm (see Fig. 2.7). Marginal social cost (the dotted line) is above marginal private cost at low levels of output, but the curves converge at an output less than equilibrium. At the relevant margin, social costs are equal to social benefits and imposing a tax to

WƌŝĐĞΘŽƐƚ

32  K. DOWDING AND B. R. TAYLOR

D^ džƚĞƌŶĂů ŽƐƚ

DW с D^

DW

Y

YƵĂŶƚŝƚLJ

Fig. 2.7  Inframarginal externality

decrease output would lead to inefficiency. In general, only marginal externalities—where external costs or benefits exist at the relevant margin—have the potential to cause inefficiency.2 Non-pecuniary and marginal externalities can also exist without causing inefficiency. To see why, it is important to recognize that externalities are inherently reciprocal (Coase 1960: 2; Buchanan and Stubblebine 1962: 381). Your neighbour playing loud music late at night imposes an externality on you because you are not in control of their volume switch. If you were able to control the volume of their music, through strict and responsive noise police, for example, then your preference for silence past 6 p.m. would impose a negative externality on your neighbour. Similarly, a factory which reduces the air quality for nearby residents imposes a negative externality if it has the right to pollute; but those same residents 2 Inframarginal externalities can in some cases be inefficient in the sense that net benefits would be increased by moving from equilibrium to a much smaller or greater level of output, even though marginal changes would cause inefficiency (Buchanan and Stubblebine 1962: 374).

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impose a negative externality on the factory if they are given the right to stop the pollution, since this would reduce the firm’s profit. We cannot get rid of all externalities; from an efficiency perspective, the aim is to avoid the greater harm. Consider the above example of a noisy neighbour. Suppose that you have a sleeping baby in the house and a job interview scheduled for the next morning. In such circumstances, you are likely to put a very high value on silence and might be willing to pay, say, $1000 for the music to stop. If your neighbour is listening to music while doing housework, they will probably be willing to accept much less than $1000 in exchange for switching it off, say $20. In this case, the negative externality of the loud music produces an inefficient result. There is a potential Pareto improvement to be made by putting control of your neighbour’s volume into your hands: the music stops and you pay your neighbour somewhere between $20 and $1000 in compensation. If such compensation is not in fact paid, there is no Pareto improvement, but the shift in control in more efficient in Kaldor–Hicks terms. The result above depends on the strength of your preference relative to your neighbour’s. Suppose instead that your neighbour is celebrating a major life event with many guests. In this case, they might value the ability to play loud music at $2000. This exceeds your preference for quiet and the efficient result is that the music continues. If you had the right to turn the music off there would be a potential Pareto improvement from this right reverting to your neighbour: the music plays on and your neighbour compensates you by between $1000 and $2000. If such compensation is not paid, the negative externality remains and you are likely to grumble about your neighbour, but the outcome is efficient in Kaldor–Hicks terms. In one of the most cited papers in economics, Ronald Coase (1960) argued that markets provide incentives to efficiently solve externality problems. This gave rise to what has come to be known as ‘the Coase theorem’, which states that if there are clear property rights and no excessive barriers to negotiation, the efficient outcome to an externality problem can be achieved through voluntary bargaining. Since an externality which produces inefficiency involves a potential Pareto improvement, the parties involved have reason to negotiate and find a mutually beneficial arrangement. In the noisy neighbour example above, you could knock on your neighbour’s door and offer them $50 to keep the noise down. As long as you value silence more than they value noise,

34  K. DOWDING AND B. R. TAYLOR

there will be some mutually agreeable figure you can pay them to turn the music off and the efficient outcome will prevail. If they value the music more than you value silence, no such agreement will be possible. Again, the efficient outcome prevails. If such bargaining is possible, how the rights are initially allocated should make no difference. Either way, the efficient result will occur. If you are given the legal right to stop your neighbour playing loud music whenever you please, your neighbour could offer you payment to waive this right. There will be a mutually agreeable side-payment if and only if the waiving of rights results in the efficient outcome. However, Coase did not think that the efficient solution would always be reached. The key barrier to agreement is the existence of ‘transaction costs’: the time and effort required to reach an agreement. If such costs are prohibitively high, agreements which are in principle mutually beneficial will not be reached and inefficient externalities can continue to exist. For many important externalities, bargaining costs are so high that Coase’s voluntary solution is impractical. Consider the case of climate change. Here there are countless individuals and businesses each imposing small costs on countless others. For this and many other externality problems, the bargaining costs are just too high for a voluntary solution to be feasible. A second problem is that the Coase solution assumes sincere preferences. If I know that you will pay me up to $50 to turn off my music, then I might play loud music even if it brings me disbenefit. I will get the $50 dollars for doing what I want to do anyway. However, sometimes bargaining can effectively internalize externalities without the need for outside intervention. Meade’s (1952) analysis of the interaction between beekeepers and apple growers became a standard example of how externalities can produce market failure. Because bees use apple blossom to produce honey, and at the same time fertilize the trees, there are positive externalities flowing in both directions. Dedicating greater resources to the production of honey will as a side-effect increase the production of apples and vice versa. Since neither the beekeeper nor the apple grower reaps the full reward of their work, output will be suboptimally low. Meade concluded that Pigouvian taxes or subsidies would be required for efficiency. Since the external benefits here are reasonably geographically contained and the number of transacting parties small, these are externalities which could potentially be internalized through Coasean bargaining. Steven Cheung (1973) looked at the actual arrangements between

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beekeepers and fruit growers and concluded that this is the case. Since beehives are mobile and trees are not, beekeepers can ‘rent’ hives to fruit farmers. This provides fertilization services for the grower as well as nectar for the beekeeper, and these services are openly advertised on a commercial basis. Depending on the relative magnitude of the externalities in each direction, the beekeeper might pay the farmer for access to the crops or the farmer might pay the beekeeper for pollination services. Externalities may also be internalized in more roundabout ways without direct bargaining and side-payments. One example of this is the provision of broadcast television and radio stations. Before the advent of encryption for such signals, these were pure public goods; anyone within range can enjoy the broadcasts whether or not they pay for them, and this does not reduce the strength of the signal for others. We might conclude on this basis that television and radio stations cannot be provided by the market, but of course they were. It was achieved by bundling the good of programming (which is costly for the station to produce) with the ‘bad’ of advertising (which earns the station money). Since viewers and listeners need to put up with the bad to get access to the good, stations are able to earn a profit on a good which is non-rival and nonexcludable (Friedman 1990: Ch. 18). In some cases, even if bargaining costs would be too high for bilateral agreements between affected parties, the organizational form in which production takes place can have an impact. In a paper written much earlier than his work on social cost, Coase (1937) argued that the entire purpose of the firm is to overcome transaction costs. If markets were frictionless, all production could be organized by discrete market transactions using prices. Because constantly negotiating such contracts would be overly burdensome, however, it makes sense to form teams in which production decisions are made on the basis of central planning rather than market exchange. In cases of positive or negative externalities flowing between different firms, a merger is a potential solution. Consider the example of beekeepers and apple growers above. If negotiating a mutually agreeable solution proved impossible, the apple grower could expand into the honey business. This would bring the spill-over benefits between beekeeping and apple growing within the scope of a single firm and allow for an all-things-considered decision about the production of apples and honey. Market failures caused by externalities can sometimes, but not always, be solved without government intervention. Coase (1992: 717) made it

36  K. DOWDING AND B. R. TAYLOR

clear in his Nobel prize lecture that his intention in showing that, absent transaction costs, efficient results would be reached was not to suggest that there were no transaction costs in reality, but rather to demonstrate their importance. Markets and governments are both imperfect institutions in reality and for Coase actual decisions can only be made by comparing these imperfections. External costs and benefits can and do produce market failure. It is possible then for government to step in and improve welfare. By making individuals or firms feel the full cost of their actions, Pigouvian taxes and subsidies can align individual incentives with the general welfare. However, the mere existence of external costs and benefits does not mean that markets have failed. Virtually everything we do affects others and any attempt to address all interdependency would quickly descend into absurdity. Outcomes will often be efficient even when people are imposing costs and benefits, on one another, and attempts to remove such externalities through policy can reduce efficiency. Monopoly and Imperfect Competition By assumption, each seller in a perfectly competitive market is faced with a large number of competitors selling identical goods. This means that customers will switch if price increases even slightly above the going rate, as determined by the intersection of market supply and market demand outlined above. Any firm could charge less than the market price, but would have no reason to do so since they are a small enough player in the market that they can sell as much as they choose at the market price. A firm under perfect competition takes the market price as given and decides only its level of output in order to maximize profit. Charging less will not increase sales and charging more will instantly drive sales down to zero. In order to decide how much to produce, a profit-maximizing firm will compare the marginal revenue (MR) and the marginal cost (MC) of each unit they could produce. Producing an additional unit of a good will increase profit as long as the extra revenue it brings in (MR) exceeds the additional cost of producing and selling that unit (MC). For a firm in a perfectly competitive market, the marginal revenue will always equal the market price, since this is the only price at which they will be willing and able to sell. Each firm faces a perfectly flat demand curve at the market price. The firm will earn this much for every sale it makes

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WƌŝĐĞΘŽƐƚ

D

сWсDZ

Y

YƵĂŶƚŝƚLJ Fig. 2.8  The perfectly competitive firm

regardless of how much it chooses to produce. In Fig. 2.8, this is shown as D = P = MR. The profit-maximizing level of output, QC, is found at the intersection of this curve and the MC curve. Since we are assuming that there are no externalities, in perfect competition MR equals the marginal social benefit of consumption (i.e. the valuation of the marginal consumer in the market) and MC equals the marginal social cost of production. By producing where MR = MC, the firm is promoting social efficiency. When there are not so many sellers or when goods are not identical, however, each firm can charge higher prices if they are willing to lose some customers or, conversely, can gain customers if they are willing to accept a lower price. When this is the case, there are meaningful choices to be made about price, and this can cause market failure. Imperfectly competitive markets vary on several dimensions, but here we consider the case of monopoly, a market with only one seller. The type of inefficiency caused by monopoly also applies to other forms of imperfect competition. Whereas a firm in a perfectly competitive market faces a perfectly flat demand curve at the market price, a monopolist has no competitors in the market and thus faces the entire market demand curve which, as

38  K. DOWDING AND B. R. TAYLOR

WƌŝĐĞΘŽƐƚ

explained, will be downward-sloping. This means that the firm must compare the benefits of selling more at lower prices against the benefits of earning more per sale at higher prices. Like the perfect competitor, it seeks to maximize profit and does so by producing such that MR = MC. Unlike the perfect competitor, however, the monopolist’s MR will not in general be equal to price. Assuming that the monopolist must charge the same price for each unit of a good it sells, an additional sale driven by a fall in price has two effects on revenue: the gain in revenue resulting from the extra sale and the loss in revenue resulting from the lower price charged on all units which would have been sold at the higher price. Except for the first unit sold, then, marginal revenue will be less than price. Graphically, the MR curve will be a steeper downward-sloping curve, as shown in Fig. 2.9. In Fig. 2.9, when setting MR = MC, the monopolist will choose an output of QM and will be able to charge a price of PM. This level of output is lower than is socially optimal (Q*). Too little of the good is produced from a social standpoint, because the firm has restricted output in order to charge a higher price. They could increase production and find consumers willing to pay for the extra production and distribution costs,

WD

D WΎ

сD^

YD

DZ с DW

YƵĂŶƚŝƚLJ

Fig. 2.9  Monopoly

YΎ

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but to do this would require dropping the price such that profit would decrease. The lost revenue from lower prices represents a private loss to the firm, but not a net social loss from an efficiency standpoint. The loss to the firm is fully compensated by the gain to consumers, but the firm does not fully take into account the welfare of consumers and so does not choose an efficient level of production. The same basic logic can be applied to other imperfect markets. If there are a few sellers (the market is an oligopoly) or there are many firms each selling slightly different products (monopolistic competition), each firm faces a downward-sloping demand curve for its product and has some price-setting power. This drives a wedge between the social and the private benefits of changing prices and can result in inefficiency. In perfectly competitive markets prices gravitate towards marginal cost. Firms would like to charge higher prices, but the existence of competition limits the extent to which they can do so. This way of thinking about competition has dominated the e­ conomic mainstream, but there is more to competition than this. Indeed, as Friedrich Hayek (1948) pointed out, the perfect competition model rules out much of the behaviour we consider essential to competitive markets in the real world. Firms sell identical products and cannot compete through product differentiation or advertising. Moreover, all of the knowledge about what consumers want and how best to produce is already assumed. In reality, competition can act as a discovery mechanism which allows diverse ideas to be tested against consumer preferences and commercial reality. Schumpeter (1934) argues further that perfect competition does not provide optimal incentives for innovation. Businesses strive to come up with new ideas in order to increase profits, and this is only possible when there are limits to the extent to which competitors can emulate successful innovations. Imperfect and Asymmetric Information The perfect competition model assumes that buyers and sellers know what options are available to them. In reality, even if many firms are selling identical products, customers may be unsure of what price each firm is charging or whether the products really are of uniform quality. Information is often costly to gather and rational consumers need to weigh up the benefits of better information against these costs (Stigler 1961). In this way, imperfect information adds friction to markets as a

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form of transaction cost. If the costs of finding information are prohibitively high, some mutually beneficial exchanges may not take place. Another sort of problem arises when there is asymmetric information—when one party to a potential transaction has more information than the other. Akerlof (1970) provides the canonical example and analysis of this in the economics literature, by considering the market for used cars. The seller of a used car has much better information about its quality than a potential buyer. The latter can take a test drive and kick the tyres, but many mechanical problems become apparent only with regular use. Buyers will therefore be unable to reliably tell the difference between good and bad cars. Moreover, those most motivated to sell will be those wanting to get rid of bad cars, meaning that there will be a preponderance of such cars available for sale. This is obviously bad news for buyers, but it also harms sellers of good cars. Unless they can find some way to credibly demonstrate the quality of their car, they will be lumped in with the sellers of bad cars and earn less than they otherwise could. This is an example of ‘adverse selection’—the tendency for undesirable types to be selected when there is asymmetric information. Another example of this is insurance. Those getting the most value out of insurance will be those facing the greatest risk—the unhealthy for health insurance and the reckless for car insurance. The expected payout for insurance companies will therefore be higher than for the general population, and to maintain profit premiums will be increased, further discouraging low-risk customers from buying insurance. This is bad for insurance companies as well as low-risk customers. It also creates inefficiency as mutually beneficial trades cannot be reached due to information asymmetry. Market failures of this sort provide incentives for participants to overcome them, however. Sellers of good cars and low-risk insurance customers may be able to find ways to signal their type to car buyers and insurance companies, or car buyers and insurance companies could screen sellers and customers (Spence 1973). Signalling and screening only work when they reliably reveal type, and as such require behaviour which is excessively costly or difficult for undesired types to imitate. The seller of a good car could offer a warranty. This gives the buyer peace of mind in the event of failure, but more importantly it also conveys the information that the seller is confident they are selling a good car, since offering a warranty on a bad car would be a poor financial decision. The credible offer of the warranty, rather than the warranty itself, is doing the work here.

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Markets rely on information to operate well, but so do governments. A plausible case can be made that the information requirements of markets are lower than those of government and the market does a good job of organizing dispersed information (Hayek 1945). Prices act as a signal of scarcity, with a built-in incentive to take that signal seriously. When we see that the price of a product has increased, self-interest compels us to consume less of it unless we value it very highly. This increase in price could be driven by an increase in demand, a decrease in supply or both. Either way, the socially optimal response is for low demanders to consume less of the good and leave what’s left to those with stronger preferences. A benevolent planner would find it a serious challenge to identify and enforce an efficient response, but markets achieve this without central direction and without anyone having complete information of exactly how it is working. Such coordination will almost always be imperfect; the impressive thing is that it happens at all.

The Role of Government in a Market Economy The market economy as it currently exists is built on a foundation of property rights defined and enforced by government. Beyond this, the main economic justification for government is to correct market failures. When markets do not live up to the standards of perfect competition outlined above, there is potential for government to intervene to increase net benefits or, in some cases, to produce genuine Pareto improvements. Indeed, the standards of perfect competition are never really attained. Even in their closest approximation—finance markets— insider trading, monopolistic practices by major traders and the use of supercomputing and fast communications processes allow some traders advantages over others. Market failure is the primary economic rationale for government intervention, but of course there are numerous other reasons for intervention which do not rest on market failure arguments. One obvious area of government action is redistribution. For reasons of fairness or welfare, most economists endorse some degree of redistribution from the rich to the poor, while emphasizing that such redistribution normally comes at a cost. If we tax income in order to fund unemployment benefits, we distort incentives in two ways. Workers paying tax on their earnings are discouraged from working and the unemployed are discouraged from taking low-paid jobs when benefits are available. Economists will thus often say that there is a trade-off between

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efficiency on the one hand and equity or equality on the other (Okun 2015). They view with suspicion many policies put forward in the name of fairness or equality, arguing that market mechanisms or simple redistribution would be preferable or that the policies simply do not have their desired effect. Most notably, economists are generally opposed to price controls. Where the public sees exploitation or price-gouging, economists see prices which emerge from the interaction of buyers and sellers. There may often be uneven bargaining power in such situations, entailing severe hardship, but legally mandating prices will disrupt equilibrium and produce inefficiency without solving the underlying problem. Consider the case of price-gouging for ice in an area left without electricity following a natural disaster (Munger 2011: 203–205). Since demand will dramatically increase, prices will soar if not legally controlled. However, legally keeping the price below equilibrium will cause other problems. The most immediate effect will be a shortage. The lucky, or the early in line, will benefit from low prices but many others will be left without. Higher prices would force people to economize on ice and leave it to those willing to pay the most. The rich will be willing to pay more on average since they have greater buying power, and we may find this troubling; but those who need to store medicine at cool temperatures, for example, will also be willing to pay more than someone who takes their whisky on the rocks. A secondary effect is to prevent entrepreneurs from profitably finding ways of meeting the excess demand. Supplies could be brought in from elsewhere, but this will often be expensive at short notice, and unless sellers can charge high prices they will have little incentive to do so. The economic way of thinking asks us to separate exchange from its background conditions for the purpose of evaluation. Many voluntary exchanges end with unfair distributions of resources because the participants differ greatly in bargaining power. As long as the exchange is voluntary, however, prohibition will harm those it means to protect. If voluntary exchange benefits both parties, preventing such exchange will harm both parties. This is not to say that issues of fairness are illusory, but we should instead look to differences in bargaining power or unfairness in the assignment of property rights and consider how these could be addressed rather than blaming the exchanges themselves (Munger 2011). Governments in the real-world act for many other reasons, such as preserving culture or protecting people from their own irrational

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behaviour. We consider the latter rationale in Chapter 3. Although the simplest version of the economic method has no room for irrationality, insights from behavioural economics and psychology are increasingly penetrating the mainstream and have been argued to justify significantly increasing the scope for government action. Markets often fail, but this does not necessarily imply that government can in practice do any better. Dealing with markets as they exist in the real world, warts and all, without considering the possibility that government itself can fail is a rather unhelpful comparison, but much economically informed policy analysis has implicitly taken this approach by assuming that policy advice is given to a benevolent despot (Demsetz 1969). In fact, it might be argued that there is no such thing as market failure, since all failures are caused by either government action or inaction. All failures are government failure (Keech and Munger 2015). It could be objected that perfection is an overly stringent standard against which to judge government performance, but this is exactly the standard we use to judge markets. Saying that markets fail because they fail to meet their theoretical optimum is like saying that a racing car fails because it is unable to reach its theoretical maximum speed, the speed of light (Booth 2008). In each case, the factors causing the deviation from perfection might be instructive, but ‘failure’ is perhaps the wrong label to apply.

Conclusions Welfare economics provides a set of evaluative tools useful for policy analysis. Markets produce optimal results when the assumptions of perfect competition are met. In markets with sufficiently many firms, no externalities and perfect information, the market produces outcomes which cannot be improved upon in welfarist terms. Attempting to benefit one person through government intervention would necessarily harm someone else and reduce the overall level of social surplus produced by the market. These assumptions seldom hold fully in reality. Externalities, imperfect competition and imperfect information each sever the link the private choice and social cost, opening up the possibility of market failure—that is, of a situation which can be improved by an appropriately designed and implemented policy intervention such as a tax, subsidy or regulation. Moving from economic analysis to policy is not a straightforward matter, however. If the assumptions of perfect markets are violated,

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markets can fail, but not every violation leads to market failure. When the assumptions are approximated, the market may continue to perform well. Moreover, as we will see in Chapters 4 and 5, government actions are not the decree of a benevolent despot, but rather the outcome of conflict and compromise among various actors pursuing their various ends. Governments can try to address market failure, but many problems emerge for them. The same problems that bedevil markets outside of perfect competition—externalities, a lack of competition, asymmetric and imperfect information—also bedevil governments. The private interests of political actors may lead political outcomes astray, or they may simply lack the information to make wise decisions. Governments as well as markets do not always provide what people want. Indeed, as we see in later chapters, deciding ‘what people want’ in a society is problematic, given a plurality of viewpoints. Faced with two imperfect alternatives, we need to consider the degree of imperfection of each.

References Akerlof, G. A. (1970). The market for ‘lemons’: Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84, 488–500. Alchian, A. A. (1950). Uncertainty, evolution, and economic theory. Journal of Political Economy, 58, 211–221. Booth, P. (2008). Market failure: A failed paradigm. Economic Affairs, 28, 72–74. Buchanan, J. M., & Stubblebine, W. C. (1962). Externality. Economica, 29, 371–384. Cheung, S. N. (1973). The fable of the bees: An economic investigation. Journal of Law and Economics, 16, 11–33. Coase, R. H. (1937). The nature of the firm. Economica, 4, 386–405. Coase, R. H. (1960). The problem of social cost. Journal of Law and Economics, 3, 1–44. Coase, R. H. (1992). The institutional structure of production. American Economic Review, 82, 713–719. Colander, D. (2007). Retrospectives: Edgeworth’s hedonimeter and the quest to measure utility. Journal of Economic Perspectives, 21, 215–226. Demsetz, H. (1969). Information and efficiency: Another viewpoint. Journal of Law and Economics, 12, 1–22. Friedman, D. D. (1990). Price theory: An intermediate text (2nd ed.). Cincinnati: South-Western University Press. Friedman, M. (1953). The methodology of positive economics. In Essays in positive economics (pp. 3–47). Chicago: University of Chicago Press.

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Hayek, F. A. (1945). The use of knowledge in society. American Economic Review, 35, 519–530. Hayek, F. A. (1948). The meaning of competition. In Individualism and economic order (pp. 92–106). Chicago: University of Chicago Press. Hicks, J. R. (1939). The foundations of welfare economics. Economic Journal, 49, 696–712. Kaldor, N. (1939). Welfare propositions of economics and interpersonal comparisons of utility. Economic Journal, 49, 549–552. Keech, W. R., & Munger, M. C. (2015). The anatomy of government failure. Public Choice, 164, 1–42. Meade, J. E. (1952). External economies and diseconomies in a competitive situation. Economic Journal, 62, 54–67. Munger, M. C. (2011). Euvoluntary or not, exchange is just. Social Philosophy and Policy, 28, 192–211. Okun, A. M. (2015). Equality and efficiency: The big tradeoff. Washington, DC: Brookings Institution Press. Pareto, V. (1906). Manuale di economia politica. Milan: Società Editrice Libraria. Pigou, A. (1920). The economics of welfare. London: Macmillan. Plott, C. R. (1966). Externalities and corrective taxes. Economica, 33, 84–87. Schumpeter, J. A. (1934). The theory of economic development: An inquiry into profits, capital, credit, interest, and the business cycle. Cambridge, MA: Harvard University Press. Smith, A. (1776). An inquiry into the nature and causes of the wealth of nation. Oxford: Clarendon Press. Spence, M. (1973). Job market signaling. Quarterly Journal of Economics, 87, 355–374. Stigler, G. J. (1961). The economics of information. Journal of Political Economy, 69, 213–225.

CHAPTER 3

Irrationality and Public Policy

Abstract  This chapter explains the critique of mainstream economics from behavioural economics. Research by economists and psychologists shows that people are irrational in ways which violate the basic assumptions of economic theory. Humans use heuristics which lead to biases, and decisions can be influenced by framing effects. Such irrationality widens the scope for government intervention, particularly through libertarian paternalist policies which nudge people in the right direction without explicit coercion. Keywords  Behavioural economics · Heuristics · Biases effects · Irrationality · Libertarian paternalism · Nudge

· Framing

Heuristics and Biases In the previous chapter, we followed the standard assumption in economics that decision-makers are individually rational. Although we saw that there are legitimate grounds for government intervention even if people are behaving rationally, the fact that people can be trusted to rationally pursue their own interests limits the scope of possible welfare-improving government action. Government can step in to protect people from each other, but rational actors do not need to be protected from themselves. If people systematically misjudge situations or make choices they predictably come to regret—if they are irrational—it may be © The Author(s) 2020 K. Dowding and B. R. Taylor, Economic Perspectives on Government, Foundations of Government and Public Administration, https://doi.org/10.1007/978-3-030-19707-0_3

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possible for government to improve welfare by influencing or restricting choices. This vastly increases the scope of legitimate government action. There has never been any shortage of criticism of the economic method in general and the assumption of rationality in particular from those outside or at the fringes of the discipline. Criticisms of the neoclassical approach are as old as the approach itself, but, for the most part, mainstream economists have ignored or quickly dismissed the complaints of disciplinary outsiders and heterodox economists. In the 1970s, however, a small group of economists and psychologists began testing the central assumptions of economic theory in a rigorous way which could not be ignored. ‘Behavioural economics’, as it is now known, has since grown into a major and perfectly respectable subfield of economics. In this chapter, we outline this subfield, focusing in particular on the implications of this research for the appropriate role of government. From an evolutionary standpoint, it would be quite surprising if humans made choices in the way posited by economic theory. Though most of us are capable of ends-orientated behaviour, it would be extremely costly in time and effort for an individual to rationally weigh up all of the costs and benefits of actions which don’t much matter. Instead of computing expected value for each action, we tend to rely on heuristics—rules of thumb which produce decisions which are good enough, often enough (Gigerenzer and Goldstein 1996). Indeed, the decision of how hard to think about something is in itself an economic decision involving trade-offs. If the expected value of a better decision exceeds the expected cost of coming to a better decision, it would be economically irrational to expend energy making the correct choice (Caplan 2007), just as it would be irrational to gather excessive information (Stigler 1961). This is not to say that humans never engage in deliberate and sustained thought. Behavioural economists tend to take a ‘dual process’ view of cognition, which conceptually separates an intuitive and automatic subsystem (‘system 1’) and a rational and deliberative subsystem (‘system 2’). System 1 is ‘a machine for jumping to conclusions’ (Kahneman 2011: 79). Rather than slowly and carefully thinking through a problem to reach the correct solution, it uses simple heuristics to quickly and effortlessly reach plausible conclusions. When someone asks ‘What is 2 × 2?’ or ‘Is Donald Trump a good president?’ you will probably be able to give an intuitive and confident answer without any mental effort. System 1 can quickly and tirelessly answer these questions using associations between concepts and simple heuristics. The role of

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system 2 is to step in with effortful thought when system 1 is unable to answer and to catch mistakes in intuitive judgements (Evans 2007; Kahneman 2011). The heuristics we use help us navigate the world in a practical way, but they do produce some systematic biases. Although many such heuristics and biases have been identified, here we outline the three identified by Tversky and Kahneman (1974): the representativeness heuristic, the availability heuristic and the anchoring and adjustment. The standard illustration of the availability heuristic is the ‘Linda’ problem (Tversky and Kahneman 1983). Experimental subjects were given a description of a fictional person: Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

They were then asked to judge the likelihood of various propositions about Linda. Included among other propositions were: Linda is active in the feminist movement. (F) Linda is a bank teller. (T) Linda is a bank teller and is active in the feminist movement. (T&F)

The description of Linda more neatly fits our idea of a feminist than a bank teller, so most people will judge F more likely than T. This is a plausible judgement. The description of Linda is also closer to what we imagine to be the background of a feminist bank teller than of a bank teller in general, so we might think that T&F is more likely than T, perhaps thinking that if Linda did end up as a bank teller, she would likely be politically active in progressive causes such as feminism. However, it is logically impossible for T&F to be more likely than T. Feminist bank tellers are a subset of bank tellers; all members of the group described in T&F are also members of the group described in T. Those rating T&F as more likely than T commit the conjunction fallacy, treating a subset of an event as more likely than its superset. The vast majority of subjects committed this error: 89% of subjects without statistical training, and 85% of statistically knowledgeable doctoral students in decision science, stated that Linda was more likely to be a feminist bank teller than a bank teller. The rates of error could be

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reduced by providing a stark choice between the two options and explaining why T had to be more likely,1 but even then the error rate remained at least 57%. It appears that the representativeness heuristic is at work here. Instead of answering the more difficult question about probability, the question ‘How representative of this group’s membership is Linda?’ is substituted. Indeed, there was an almost perfect correlation (0.98) between answers to the probability and representativeness questions. When people estimate frequency or likelihood based on the ease with which examples come to mind, they are using the availability heuristic (Tversky and Kahneman 1973). If a person is asked whether there are more words in the English language beginning with K or with X, they will tend to search for examples as an estimation technique, find countless ‘kitchens’ and ‘kayaks’ for every ‘xylophone’, and conclude that K words are more common than X words. In this case, the heuristic reaches the right answer, as will often be the case, since availability is often highly correlated with probability or frequency. However, when asked whether there are more words with K as a first letter or a third letter, we find it easier to think of words beginning with K than those with K as a third letter. If we follow the availability heuristic here, we end up with the wrong answer. There are more third-letter than first-letter K words, but most people answer that first-letter K words are more common (Tversky and Kahneman 1973: 211–212). Murders and motor accidents make the news more often than suicides and strokes, and as a result, people tend to falsely believe that they are more common (Kahneman 2011: Ch. 13). When making a numerical estimate, it is often difficult to know where to start. If asked how many grains of sand there are on a particular beach, it is difficult to know if we should be estimating in the millions or the quadrillions. A heuristic which people use is to start with some arbitrary value and adjust upwards or downwards from it. This adjustment tends to be insufficient, however, and so giving a person an arbitrary starting point can seriously influence their final estimate. This is known as anchoring and adjustment (Tversky and Kahneman 1974: 1128–1130). In one experiment, subjects were asked to estimate the number of African countries in the United Nations. Before making this estimate, however, a wheel was spun to generate a random number between 0 and 100. The subjects 1 ‘Linda is more likely to be a bank teller than she is to be a feminist bank teller, because every feminist bank teller is a bank teller, but some women bank tellers are not feminists, and Linda could be one of them’ (Tversky and Kahneman 1983: 299).

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saw the wheel being spun and thus knew that the number was completely irrelevant to their judgement, but the starting point nevertheless had a marked and consistent effect on the estimates given. When the wheel landed on 10, for example, the average response was 25. When it landed on 65, the average response was 45. (In case you’re wondering, there are 54 African UN member states as of 2018; 42 at the time of Tversky and Kahneman’s experiment.) Subjects adjusted away from the anchor towards a more plausible value, but they didn’t go far enough (Tversky and Kahneman 1974: 1128). Epley and Gilovich (2006) investigated the reason for insufficient adjustment and found that people will often only adjust from the anchor until a plausible value is reached. Since there is often a large range of plausible values, someone adjusting downwards from a high value will make an estimate at the top of this range, whereas someone adjusting upwards will make an estimate at the lower end. The more general point here is that the framing of questions and choices can have a big impact on the answer given or the option chosen. For example, prospect theory tells us that people treat gains and losses quite differently (Kahneman and Tversky 1979). This is illustrated by Tversky and Kahneman’s (1981: 453) ‘Asian disease’ problem. When asked to evaluate two alternative programmes as responses to the outbreak of a hypothetical exotic disease, people tend to favour the safer option when the question is framed in terms of lives saved. Most respondents (72%) preferred to save 200 people with certainty rather than saving all 600 with a 1/3 probability and saving nobody with a 2/3 probability. When exactly the same choice under the alternative frame of lives lost was posed to a different group, however, most (78%) chose the riskier programme of nobody dying with 1/3 probability and all 600 dying with 2/3 probability rather than the safer option of 400 people dying with certainty. Saving 200 of 600 people is the same as letting 400 of 600 people die, but they are treated very differently psychologically. Similar framing effects have been found for many questions with a similar structure (Tversky and Kahneman 1981, 1986). A real-world application of this idea is in the differing responses to a prompt payment discount or a late fee on a utility bill, which amount to the same thing. These framing effects come about because individuals break the ‘reflexivity’ of rational choice theory (see Chapter 1)—that is, they do not realize that two different descriptions are of the same object and so are not indifferent over the ordering of that object. They act as though they strictly prefer the same object over itself. (What they ‘really’ strictly prefer

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is one description of that object over another description of that object. But rational choice is ordinarily defined over alternatives, not descriptions of those alternatives.) This is irrational in some sense of the term, but we suggested in Chapter 1 that the rationality conditions of rational choice are there for predictive purposes. If we know that framing effects lead people to choose an object under one description and not another, we can still predict behaviour given the manner in which objects are described.

Preference Reversals Heuristics are useful tools which economize on cognitive costs, but they can at times produce biased judgements and ultimately biased decisions. And, indeed, it is not difficult to find examples of human behaviour which appear irrational. For example, many people both buy insurance and play the lottery. Since the former suggests an aversion to risk and the latter a preference for risk, it is difficult to square this with expected utility theory. One response to objections like this from advocates of the rationality assumption is that the observer is mis-specifying the preferences of actors involved. Friedman and Savage (1948) argue that it could be rational to buy both insurance and lottery tickets if we were riskaverse at low levels of wealth and risk-seeking at higher levels. Since we do not directly observe preferences, it is difficult to definitively conclude that behaviour is inconsistent with the rationality assumption. However, one definite prediction of standard economic theory is that rational actors will have coherent and consistent preferences, as described in Chapter 1. Behavioural economists have shown, however, that people can be made to act in an inconsistent manner. The most common and convincing way of demonstrating inconsistency is to show that preferences can be altered by factors which are irrelevant from the standpoint of economic theory—‘preference reversals’. If the framing of decision problems or other irrelevant factors can reverse the choices made by individuals, it is difficult to hold the view that these choices optimize on a coherent ranking of preferences. Changing the method through which preferences are elicited can induce preference reversal. Rational economic agents will choose their most preferred option when given a pairwise choice, and would also be willing to pay a higher monetary price to secure their most preferred of these two options. To prefer option A over option B in a pairwise choice, while at the same time being willing to pay more for option B than

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option A, shows an incoherent ranking of preferences. Through one elicitation method, we prefer A to B, but through another we prefer B to A. The preference ranking is intransitive. Slovic and Lichtenstein (1968) found that when subjects were asked to choose between pairs of gambles, they put stronger emphasis on the probability of winning, whereas when they were asked to express their willingness to pay for these gambles they were influenced more strongly by the dollar value of the potential prize. In a later paper (Lichtenstein and Slovic 1971), they would exploit this quirk of human choice to show experimentally that preferences can be reversed by altering the elicitation method. Risky bets with a lower probability of winning and a larger prize (‘$ bets’) were set against safe bets with a higher probability of winning a smaller prize (‘P bets’). For example, in one case a 75% chance of winning $1.20 and a 25% chance of losing $0.10 (the P bet) was put up against a 25% chance of winning $9.20 and a 75% chance of losing $2.00 (the $ bet). These bets have similar expected values; we cannot say that choosing one or the other is irrational, but the choice should be the same no matter how the question is asked. Subjects in these experiments tended to choose the safer P bets when given a pairwise choice, but would frequently set a higher reservation selling price on riskier $ bets. These results persisted when subjects were playing with real money on the line. This appears to be caused by scale compatibility issues. When asked to give the bets a monetary value, people start with the monetary value of the prize and then adjust upwards or downwards depending on the other desirable or undesirable aspects of the bet. When asked to choose between two bets, the monetary value of the prize does not present such a salient starting point (Lichtenstein and Slovic 1971: 54). However, preference reversals can exist without such scale compatibility effects. List (2002) conducted a field experiment at a sports trading card show, in which a self-selected group of knowledgeable and motivated subjects were asked to choose between different bundles of trading cards. When asked to choose between a bundle with ten high-quality cards and another bundle with ten high-quality cards and three low-quality cards, people predominantly chose the latter while valuing the former higher in monetary terms. Here, it seems that people are choosing on the basis of total value, but setting reservation prices on the basis of average value. Economists have been keen to dismiss these results as reflecting a lack of motivation or understanding among subjects, rather than a violation of the principles of rational choice theory. The results seem robust,

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however. Lichtenstein and Slovic (1973) found preference reversals using a field experiment in a Las Vegas casino, and others have continued to find preference reversals when monetary incentives have been increased and steps taken to ensure subjects understand the choices they face and the expected values of the bets (Grether and Plott 1979; Pommerehne et al. 1982; Reilly 1982). These findings pose a serious challenge to the economic method, in both positive and normative terms. If supposedly irrelevant factors can influence choice, then the predictions of economics, as well as the welfare analysis of the previous chapter, are brought into question. Without a coherent ranking of preferences which is independent of irrelevant contextual factors, we cannot fully specify a utility function, much less claim that individual actions optimize on this utility function.

Self-Control Another deviation from economic rationality is apparent when we think about the issue of willpower. The agent in economic models calculates the optimal course of action and then follows through without issue. As anyone who has struggled to stick to a diet or give up smoking knows all too well, however, this is not how humans operate. We are very often tempted to make decisions which we judge to be against our long-term interests. The issue here is not simply that we are impatient and prefer enjoyment now rather than later. The discounting of future enjoyment can easily be modelled in expected utility terms. Philosophers might claim that excessive impatience is irrational, but economists take individual preferences as they are. The consistent and coherent discounting of future enjoyment presents no particular problem for economic theory, and time preference has become a standard part of expected utility models. However, a rational economic actor making a short-term choice would face no internal conflict. If we choose to smoke a cigarette, it’s because that’s what we prefer; if we prefer not to smoke the cigarette, then we don’t. The fact that people systematically make decisions they know they will later regret presents a puzzle for standard economic theory. To solve this puzzle using economic theory with a behavioural twist, Thaler and Shefrin (1981) propose a model in which the problem of self-control is seen as a conflict between two distinct selves with distinct preferences. ‘The planner’ takes a long-term view and seeks to maximize lifetime utility. At any point in time, however, actions are taken by

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a myopic ‘doer’ maximizing short-term utility with no concern for future welfare. Following the logic of externalities (see Chapter 2), this myopia will prompt each doer to engage excessively in behaviour which imposes costs on future versions of themselves. They will borrow as much as possible to fund current consumption with no regard for the financial costs of the borrowing or the health costs of the consumption. Just as the self-interest of individuals and firms cause them to impose excessive costs and produce insufficient benefits for others (externalities), the myopia of individuals at any point in time causes them to impose excessive costs and produce insufficient benefits for future versions of themselves (internalities). The planner is aware of the problem of internalities and seeks to alter the behaviour of each doer by creating rules or altering incentives or preferences. The planner is in some sense in charge of decision-making but must rely on doers to follow through. The planner’s control over the doer is imperfect, however; this can be seen as a principal–agent problem much like that between the owner and the manager of a business. We consider principal–agent relationships in the context of government in much more depth in Chapter 4, but briefly a principal–agent relationship is one which involves one party (the agent) acting on behalf of another (the principal). The manager of a business (the agent) acts on behalf of the owner (the principal), but their preferences normally will not be perfectly aligned. The owner might want to maximize profit while the manager prefers a more pleasant workplace or higher wages even if this does not contribute to profitability. Unless the owner is able to perfectly monitor and discipline the manager, they will not be a perfect agent. Individuals as rational planners have a number of tools at their disposal to attempt to control their own behaviour as myopic doers (Thaler and Shefrin 1981: 396–398), but the most important for our purposes is pre-commitment—deliberately taking options off the table or increasing their cost in order to improve decisions. In standard economic theory, it is always better to have more options. An alcoholic should not be bothered by easy access to alcohol. If they really prefer not to drink, they will not; if they do drink, it is because this better satisfies their preferences. Either way, more options cannot be harmful to a rational economic actor. In the planner and doer model, however, the planner prefers to stay sober, but the myopic doer wants a drink and is not concerned with the long-term impact. To pre-commit to sobriety, an individual can take the drug Antabuse. This causes immediate sickness when even small quantities of alcohol are taken. This takes the option of an enjoyable night

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of drinking off the table and effectively limits the choices of the individual at any point in time. Similarly, those who prefer to spend less time on social media or other time-wasting websites can use software such as SelfControl and StayFocusd to limit their time on these sites, or even lock themselves out altogether. In standard economic theory, cutting off options can never improve welfare, but real human beings wary of their own weakness will often intentionally limit their own future choices.

Nudge The most influential application of behavioural economics has been Thaler and Sunstein’s (2008) book, Nudge: Improving Decisions About Health, Wealth, and Happiness. A New York Times bestseller, it inspired the 2010 creation of the Behavioural Insights Team in the UK cabinet office, known unofficially as the ‘Nudge Unit’. The goal of this unit was to apply insights from behavioural economics in order to improve public policy. It has since become a social purpose company and expanded to Australia, New Zealand, Singapore and the USA, in an attempt to influence policy in these countries. The central idea of Nudge is what Thaler and Sunstein call ‘libertarian paternalism’—actions aimed at changing behaviour without prohibiting any choices or significantly altering the incentives involved. The approach is paternalistic in the sense that it seeks to protect people from their own choices, with the considered preferences of the choosers themselves being the criteria on which choices are judged. It is libertarian in the sense that it seeks only to nudge people in the right direction while leaving them with the ability to choose otherwise if they prefer (Thaler and Sunstein 2008: 5–6). This is achieved by altering the factors which should be irrelevant, according to economic theory. As we have seen, judgements and decisions can be influenced by factors which should be irrelevant, such as the framing of the question and the default option. Since questions need to be framed in one way or another and there will normally be some default option, there is no entirely neutral choice situation (Thaler and Sunstein 2008: 10). Thaler and Sunstein give the example of a school cafeteria which serves both ice cream and fruit. If both options are clearly visible and students are rational, it doesn’t matter how the food options are physically laid out—which is earlier in the line, which is at eye level and so on—since students will choose whatever their preferences dictate. If the manager of the cafeteria believes that students are eating too much ice cream and not enough fruit, they might

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consider removing ice cream from sale or increasing its price. This would be the coercively paternalist solution, since it takes options away or makes some options costlier simply to change behaviour. If displaying fruit more prominently and making ice cream easier to ignore cause students to shift consumption from ice cream to fruit, on the other hand, the manager could alter the choice situation without taking away any options. This is the libertarian paternalist solution. The point here is not to increase the cost of some decisions without taking them off the table altogether. Increasing the price of ice cream would, like a tax on tobacco or sugary drinks, enable those with strong preferences and adequate purchasing power to maintain consumption, while encouraging those with weaker preferences to cut down. The changes in behaviour here, however, are caused by altering economic incentives, which is not libertarian by Thaler and Sunstein’s definition. Similarly, intentionally making ice cream difficult to find or to reach would impose costs on those actively choosing to buy ice cream and thereby fall foul of the libertarian requirement of a nudge. Ideally, it should be as easy and cheap as possible for people to make bad decisions if they really want to. Anyone laying out the options for another to choose is unavoidably a ‘choice architect’ who must pursue some objective or choose randomly. A salesperson is a choice architect, and they have the clear goal of making sales. Policy-makers and civil servants are also frequently choice architects, but often lack obvious and explicit goals. If these policy-makers are forced to pursue some objective, or else design choices randomly, they might as well explicitly pursue worthy objectives. By changing the context of choice, Thaler and Sunstein argue, individuals can be nudged to make choices which align with their long-term interests. All of our decisions are made at least partially on the basis of heuristics, but not all decisions will be significantly biased as a result. However, if choices are difficult, infrequently made, unfamiliar, lack meaningful feedback or involve delaying gratification, people often choose poorly (Thaler and Sunstein 2008: 75–78). Choices involving saving for retirement, for example, involve upfront costs and distant benefits for the young. There is a lack of meaningful feedback on saving decisions, because an individual will not feel the effects of insufficient saving until it is too late. Sunstein and Thaler (2008: Ch. 6) suggest a couple of nudges to increase the rate of saving. First, the setting of the default option for the employee contribution to a pension plan can have a dramatic effect on how much people save.

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From the perspective of standard economic theory, the default option will not matter unless transaction costs are very high. Since it is normally quite easy to alter contribution levels and there are strong, albeit distant, incentives to make a good choice, rational economic actors will switch to whatever plan best satisfies their preferences. Humans, however, tend to take the path of least resistance in many choice situations (Kahneman et al. 1991; Thaler and Sunstein 2008: 34–35), and so will not enrol themselves in savings programmes or switch from the default contribution level. Automatic enrolment in saving schemes and a default option which as closely as possible aligns with what individuals would choose for themselves can improve saving decisions (Benartzi and Thaler 2013). This does not deny anyone their freedom to choose a lower contribution rate or opt out altogether, but it does nudge people in the right direction by changing the context of choice. Secondly, since saving for retirement involves a conflict between the patient planner and the impatient doer, people will often struggle to muster the willpower to save today in order to improve their lives in the future. However, a quirk of human impatience is that we don’t just want things sooner, we want them now. If you are given the choice between taking one cookie now and two cookies in an hour’s time, impatience might well lead you to take the smaller reward now. Given the choice between one cookie at 10 a.m. tomorrow and two cookies at 11 a.m. tomorrow, on the other hand, you will be more willing and able to delay the gratification for a greater reward. The time differential in both cases is the same, so in standard economic theory there should be no difference—but this is not how humans behave. This general phenomenon is known as ‘hyperbolic discounting’ (Laibson 1997). Asking people to save more now in order to benefit themselves in the future runs up against the impatience of the doer, who would rather buy a new TV this week than fund important medical treatment in 30 years. As a solution, Thaler and Benartzi (2004) introduce an idea they call ‘Save More Tomorrow’. Rather than increasing contributions in the current period, people are given the option of pre-committing to increasing their contribution as their salary increases in the future. Whereas most saving decisions involve trading off the present against the future, Save More Tomorrow involves a choice between the future and the more distant future. Nudges are also suggested as a means of promoting pro-social behaviour rather than enlightened self-interest. These do not fit neatly into the category of libertarian paternalism, since they are not in any clear

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sense paternalist. One important case here is organ donation. In most countries, people may opt in to being an organ donor after their death; since the default option here is non-donor, organ donation rates are low. Replacing this with an opt-out system increases donation without denying anyone the ability to be a non-donor if they choose (Thaler and Sunstein 2008: Ch. 11). Similarly, Give More Tomorrow has been suggested as a way of increasing charitable giving (Breman 2011). As with pre-committing to escalated savings for their own benefit, individuals are asked to pre-commit to escalated altruism in order to benefit others without being influenced by forgone consumption in the short term.

Irrationality and Public Policy Many of the proposals made by Thaler and Sunstein are directed at private institutions, but nudge has had a major influence on public policy as well (Halpern and Sanders 2016). One obvious application is to government actions which already ask citizens to perform specific tasks, such as paying a fine, or make specific choices, such as choosing a retirement savings scheme. The justification for this sort of change is compelling— if policy-makers must frame questions or lay out options in one way or another, they ought to do so in the manner most likely to produce good decisions as judged by the choosers themselves. Going beyond improving extant government activities, government may be able to provide mechanisms of pre-commitment in order to overcome willpower and time-inconsistency problems. Le Grand (2008) suggests the introduction of smoking permits which are required to purchase tobacco. Rather than continuously making the choices of whether or not to smoke another cigarette or buy another pack, smokers would need to decide in advance whether they want to renew their smoking permit for another year. If the permits were cheap and easy to obtain, but needed to be applied for in advance, those wishing to quit could make smoking much more difficult for themselves in the future, while those who choose to continue smoking would be only mildly inconvenienced. Governments around the world have been experimenting with the idea of voluntary or mandatory pre-commitment on levels of gambling expenditure, particularly with respect to electronic gaming machines (EGMs, known variously as slot machines, fruit machines and pokies). EGMs have been subjected to various sorts of regulation, including maximum bets and limits on the number and location of machines. These regulations

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are not libertarian, since they take certain options off the table or at least inconvenience gamblers. It is also unclear how successful they have been in addressing the issue of problem gambling, since those strongly motivated to gamble are still able to do so. An alternative is to allow gamblers to set binding spending limits ahead of time (Blaszczynski et al. 2015). This more directly addresses problem gambling without imposing limits on non-problem gamblers. Casinos may offer voluntary pre-commitment to patrons as a way of attracting customers, of course, but if the option of gambling anonymously with cash remains open, problem gamblers will not credibly be able to pre-commit. A universal system in which everyone wishing to gamble is required to register for an account and set a spending limit appears the most effective way of providing credible pre-commitment devices. This is the approach taken in Sweden since 2014. All gamblers are required to set daily and monthly limits for both time and money spent on EGMs. This provides a binding commitment with only moderate inconvenience to non-problem gamblers and is thus commendable from a libertarian paternalist perspective. Norway has a similar system, but with universal maximum losses which apply to everyone (Rintoul and Thomas 2017). This is where we move from nudge to shove. Government may also take a more active role in protecting citizens from businesses seeking to exploit bias. Businesses are choice architects, and the choice contexts they design will not always be in the best interests of consumers. For example, Thaler and Sunstein (2008: 93–94) propose disclosure laws which ensure users of telecommunications services and other long-term contracts understand what they are paying for and what use they are making of the service. Such regulation is coercive in the sense that it forces firms to disclose information they would rather not, but as long as it does not significantly increase cost in a way which pushes up prices, it does not in general seriously restrict the freedom or welfare of consumers. In many cases, however, it seems that providing more information does not produce the expected behaviour change. Requiring fast-food restaurants to display the calorie count of menu items appears not to reduce caloric intake (Kiszko et al. 2014) and may even increase it slightly (Downs et al. 2013) because consumers use calorie labels to choose foods which are good value in terms of calories (and satiety) per dollar (Loewenstein 2011). Sunstein (2014) goes beyond simple information and endorses graphic warning labels on cigarettes on libertarian paternalist grounds. These labels show shocking pictures of diseased organs affected by

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tobacco use, with the aim of making smokers face the long-term consequences of their actions. Here, the waters are muddied for the libertarian paternalist. Although this can be seen as a benign attempt to make smokers think carefully about their choices, the labels also impose psychic costs on smokers. Someone who understands the risks of smoking but decides to smoke anyway is nevertheless confronted with unpleasant images and has no way of opting out of this situation. Insofar as nudges form part of a broader effort to de-normalize tobacco use, they also impose social costs on smokers as they come to be stigmatized (Chapman and Freeman 2008). From an economic point of view, this operates somewhat like a tax and may discourage consumption, but without the offsetting benefits of a tax in terms of government revenue. This may seem to radically expand the scope of legitimate government action, but Thaler and Sunstein (2008: 13–14) suggest that nudges can be used to replace coercive policies which more seriously restrict freedom. For example, with an effective system of smoking licences which overcame the myopia of those wishing to quit, the rationale for taxes on tobacco would be significantly weakened. Reducing tobacco taxes would reduce the coercion exercised on those smokers who do choose to renew their permits. Similarly, a well-functioning system of pre-commitment for gamblers would remove the need for other forms of regulation. More generally, if default rules are set wisely, there are good reasons to allow people to opt out of paternalistic regulations as long as we ensure they do so knowingly. Thaler and Sunstein (2008: Ch. 14) propose letting patients waive the right to sue their doctor in exchange for a discount, while Robin Hanson (2007) suggests a ‘would have banned store’ selling only products which are banned from sale elsewhere because regulators deem them too dangerous to users. If it is made clear that everything in the store would have been banned, and customers actively opt in to browsing such wares, the store would increase freedom while protecting people from being unknowingly harmed by dangerous products. Of course, there are many objections levelled against libertarian paternalism, some arguing that it is too libertarian and others that it is too paternalist. There are many non-libertarian paternalists, and the findings of behavioural economics have also emboldened them. O’Donoghue and Rabin (2006) consider the issue of internalities and find, by analogy to externalities, that ‘sin taxes’ on unhealthy items can be welfare improving. Conly (2013) uses the same behavioural findings motivating libertarian paternalism to argue for coercive paternalism. The economic argument against paternalism laid out in the previous chapter, and to

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a certain extent, the more general liberal one canonically expressed by J. S. Mill is based on the notion that individuals are rational and make good choices for themselves. If humans systematically and predictably err, however, the case for government stepping in to influence choice becomes much more plausible, whether or not coercion is involved. From the opposite side, critics have argued that empowering policy-makers to nudge citizens reduces freedom in various ways. First, the conception of paternalism advanced by Thaler and Sunstein—the advancement of individual self-interest defined by what the individual would choose on reflection—is problematic. It makes sense to speak of true preferences if our biases are simply masking a rational core with well-ordered preferences, but if the human mind is heuristics all the way down, it is unclear what exactly the notion of a true preference could mean. If choice is fundamentally and unavoidably context-sensitive, there is no such thing as a neutral choice situation. Instead, policy-makers nudging citizens to make certain choices must be making value judgements about what rational people ought to prefer and such judgements are paternalist in a stronger sense than Thaler and Sunstein are willing to admit. Value judgements on the part of those designing the nudge are unavoidable (Sugden 2009). Many nudge policies are aimed at making behaviour more future-orientated—reducing enjoyment now in order to improve financial or physical well-being in the future. While this seems like a noble goal, it is unclear how generally this can be defended as promoting individuals’ interests as judged by themselves. Some do surely struggle with weakness of will and would welcome a nudge, but others may simply value shortterm pleasure over long-term gain. We saw in Chapter 2 that externalities are fundamentally reciprocal. A live music venue imposes costs on neighbours if it is allowed to operate until the early hours of the morning, but neighbours impose a cost on the venue if they are able to force an early closing time. Since we logically cannot avoid both costs, policy should be focused on avoiding the greater cost and there is no a priori reason to think that this goes one way or the other. Thinking analogously of the costs imposed on our future selves as internalities, the same point can be made. Eating a doughnut now imposes a cost on your future self, but if this consumption is thwarted, a cost is imposed on your current self. Again, we cannot tell a priori which is the greater harm. It is easy to judge others’ actions as excessively shortsighted and the result of insufficient self-control, but it is unclear how many people see their own actions in the same way (though it seems obvious that some do). It is equally possible that some people exhibit

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excessive self-control. Saving money or living a healthy life, for example, could become such an obsession that the individual is unable to enjoy the present (Whitman 2006; Pennington 2016). Behavioural economists tend to focus on self-control, but we might also be worried about self-liberation (Cowen 1991). Some advocates of nudging policies go further and treat health as an overriding goal which cannot rationally be traded off against short-term enjoyment (see Crampton 2009; Crampton et al. 2011, 2012). Here, the basis of paternalistic judgement is not at all constrained by individual preferences. If policy-makers bring their own beliefs, preferences and value judgements to the table when designing policy, the degree to which they are willing and able to pursue citizens’ interests becomes an important consideration. As we argued in the previous chapter with respect to the policy response to market failure, we cannot assume that government is wise and benevolent. Since policy-makers are as human as anyone else, they are subject to the same cognitive biases (Schnellenbach and Schubert 2015) and may also pursue particular interests of their own or others (see Chapter 5 on rent-seeking). Thaler and Sunstein are aware of policy-maker imperfection and insist it counts as a point in favour of libertarian paternalism, since the libertarian constraint ensures an opt-out provision and thus mitigates the potential harm of policy-maker self-interest or irrationality (Thaler and Sunstein 2008: 10–11). However, a central premise of libertarian paternalism is that choice architecture has a real impact on welfare. If people cannot be seriously harmed by adverse choice contexts, there is little reason to nudge them; if they can, then presumably these adverse choice contexts may be the result of poorly designed or malicious nudges by government. Such harm could still be quite significant. To give an extreme example, a paternalist convinced that homosexuality is harmful to individuals could perhaps force gay bars or dating websites to display moral warnings, or perhaps even require individuals wishing to engage in homosexual conduct sign up for a homosexuality permit in order to demonstrate a considered choice. Such policies would be much more harmful than those suggested for, say, tobacco control under the guise of libertarian paternalism, but they are not inherently more coercive and require the same form of justification.2 If we worry about private 2 We emphasize that our point here is not to equate moral warnings against homosexuality with health warnings against smoking or to accuse public health advocates of bigotry. Our point is simply that policies can be non-coercive but still very harmful. Another

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nudges causing individuals to act against their best interests, we should also consider the possibility of public nudges doing the same. Critics coming from a free-market perspective have also claimed that nudges undermine the ability of individuals to learn from their own mistakes (Klick and Mitchell 2005) or set foot on a slippery slope leading to more coercive forms of paternalism (Rizzo and Whitman 2009). To say that libertarians and conservatives have been less than enthusiastic about libertarian paternalism would be a monumental understatement. The approach does not, it appears to us, represent ‘the real third way’ Thaler and Sunstein (2008: Ch. 18) hail it as. Those wanting less intrusive government need not accept the nudge project in its entirety, however, and there may be politically feasible policy improvements shifting from outright paternalist policies to those constrained by the requirements of libertarian paternalism. Thinking in terms of pre-commitment strategies or information provision directed at problem drinkers is likely to have a lesser effect on freedom than the blunt instruments of taxes or restrictions on sales. The main implication of behavioural economics for public policy and administration, however, is a better understanding of how citizens react to policies and public messages. Such insights can improve policy implementation and the day-to-day operations of government. Indeed, many of the successes of the Behavioural Insights Team have been of this sort—for example, increasing tax collection rates or improving the messaging already conducted by government. In this sense, behavioural insights are being used by governments in much the same way as they are being used in private institutions.

Conclusions It is clear that real, flesh-and-blood human beings do not behave exactly as economic theory says they must. Although we act in a goal-directed manner broadly speaking, the findings of behavioural economists show that we do not consistently make choices in order to maximize a coherent preference ranking. Our decisions are influenced by factors that ought to be irrelevant from a rational choice perspective, including the

difference is that there is strong evidence that smoking has deleterious health effects, whereas no such evidence exists that homosexuality is harmful.

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way in which choices are framed and the method by which preferences are elicited. Moreover, we suffer from weakness of will and make decisions we ourselves judge to be irrational. By loosening the connection between choice and preference, the findings of behavioural economics provide impetus for paternalistic intervention, particularly when profit-motivated businesses are able to exploit our behavioural quirks to further their own ends. Further justification for intervention is provided by Thaler and Sunstein’s the idea of libertarian paternalism. If people can be nudged towards choices aligning with their long-term interests without being coercively denied the final choice, liberal objections to paternalistic intervention lose much of their force. As we emphasized in the previous chapter, however, we must be careful when moving from analysis to policy. Government actors are as human as anyone else, and they are just as susceptible to the biases which lead people astray in their private decisions. Moreover, the very justification for libertarian paternalism depends on the notion that framing and other factors which are not coercive can nevertheless be harmful. Just as businesses frame decisions in order to increase profit, government frames decisions in order to pursue policy goals. The desirability of nudging as a policy tool, then, depends on the legitimacy of policy goals and the competence with which they are pursued.

References Benartzi, S., & Thaler, R. H. (2013). Behavioral economics and the retirement savings crisis. Science, 339, 1152–1153. Blaszczynski, A., Parke, A., Harris, A., Parkes, J., & Rigbye, J. (2015). Facilitating player control in gambling. Journal of Gambling Business and Economics, 8, 36–51. Breman, A. (2011). Give more tomorrow: Two field experiments on altruism and intertemporal choice. Journal of Public Economics, 95, 1349–1357. Caplan, B. (2007). The myth of the rational voter. Princeton: Princeton University Press. Chapman, S., & Freeman, B. (2008). Markers of the denormalisation of smoking and the tobacco industry. Tobacco Control, 17, 25–31. Conly, S. (2013). Against autonomy: Justifying coercive paternalism. Cambridge: Cambridge University Press. Cowen, T. (1991). Self-constraint versus self-liberation. Ethics, 101, 360–373. Crampton, E. (2009). Public health and the new paternalism. Policy: A Journal of Public Policy and Ideas, 25, 36–40.

66  K. DOWDING AND B. R. TAYLOR Crampton, E., Burgess, M., & Taylor, B. R. (2011). The cost of cost studies (Department of Economics and Finance Working Paper, No. 29). Christchurch: University of Canterbury. Crampton, E., Burgess, M., & Taylor, B. R. (2012). What’s in a cost? Comparing economic and public health measures of alcohol’s social costs. New Zealand Medical Journal, 125, 66–73. Downs, J. S., Wisdom, J., Wansink, B., & Loewenstein, G. (2013). Supplementing menu labeling with calorie recommendations to test for facilitation effects. American Journal of Public Health, 103, 1604–1609. Epley, N., & Gilovich, T. (2006). The anchoring-and-adjustment heuristic: Why the adjustments are insufficient. Psychological Science, 17, 311–318. Evans, J. S. (2007). Hypothetical thinking: Dual processes in reasoning and judgement. Hove: Psychology Press. Friedman, M., & Savage, L. J. (1948). The utility analysis of choices involving risk. Journal of Political Economy, 56, 279–304. Gigerenzer, G., & Goldstein, D. G. (1996). Reasoning the fast and frugal way: Models of bounded rationality. Psychological Review, 103, 650–669. Grether, D. M., & Plott, C. R. (1979). Economic theory of choice and the preference reversal phenomenon. American Economic Review, 69, 623–638. Halpern, D., & Sanders, M. (2016). Nudging by government: Progress, impact, and lessons learned. Behavioral Science and Policy, 2, 52–65. Hanson, R. (2007). Paternalism is about bias: Overcoming bias. Blogpost. http://www.overcomingbias.com/2007/03/paternalism_is_.html. Kahneman, D. (2011). Thinking, fast and slow. New York: Farrar, Straus & Giroux. Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1991). Anomalies: The endowment effect, loss aversion, and status quo bias. Journal of Economic Perspectives, 5, 193–206. Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 263–291. Kiszko, K. M., Martinez, O. D., Abrams, C., & Elbel, B. (2014). The influence of calorie labeling on food orders and consumption: A review of the literature. Journal of Community Health, 39, 1248–1269. Klick, J., & Mitchell, G. (2005). Government regulation of irrationality: Moral and cognitive hazards. Minnesota Law Review, 90, 1620–1663. Laibson, D. (1997). Golden eggs and hyperbolic discounting. Quarterly Journal of Economics, 112, 443–478. Le Grand, J. (2008). The giants of excess: A challenge to the nation’s health. Journal of the Royal Statistical Society: Series A (Statistics in Society), 171, 843–856. Lichtenstein, S., & Slovic, P. (1971). Reversals of preference between bids and choices in gambling decisions. Journal of Experimental Psychology, 89, 46–55.

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Lichtenstein, S., & Slovic, P. (1973). Response-induced reversals of preference in gambling: An extended replication in Las Vegas. Journal of Experimental Psychology, 101, 16–20. List, J. A. (2002). Preference reversals of a different kind: The ‘more is less’ phenomenon. American Economic Review, 92, 1636–1643. Loewenstein, G. (2011). Confronting reality: Pitfalls of calorie posting. American Journal of Clinical Nutrition, 93, 679–680. O’Donoghue, T., & Rabin, M. (2006). Optimal sin taxes. Journal of Public Economics, 90, 1825–1849. Pennington, M. (2016). Paternalism, behavioural economics, irrationality and state failure. European Journal of Political Theory. https://doi. org/10.1177/1474885116647853. Pommerehne, W. W., Schneider, F., & Zweifel, P. (1982). Economic theory of choice and the preference reversal phenomenon: A reexamination. American Economic Review, 72, 569–574. Reilly, R. J. (1982). Preference reversal: Further evidence and some suggested modifications in experimental design. American Economic Review, 72, 576–584. Rintoul, A., & Thomas, A. (2017). Pre-commitment systems for electronic gambling machines: Preventing harm and improving consumer protection (AGRC Discussion Paper No. 9). Canberra: Australian Institute of Family Studies. Rizzo, M. J., & Whitman, D. G. (2009). Little brother is watching you: New paternalism on the slippery slopes. Arizona Law Review, 51, 685–739. Schnellenbach, J., & Schubert, C. (2015). Behavioral political economy: A survey. European Journal of Political Economy, 40, 395–417. Slovic, P., & Lichtenstein, S. (1968). Relative importance of probabilities and payoffs in risk taking. Journal of Experimental Psychology, 78, 1–18. Stigler, G. J. (1961). The economics of information. Journal of Political Economy, 69, 213–225. Sugden, R. (2009). On nudging: A review of Nudge: Improving Decisions About Health, Wealth and Happiness by Richard H. Thaler and Cass R. Sunstein. International Journal of the Economics of Business, 16, 365–373. Sunstein, C. R. (2014). Nudging: A very short guide. Journal of Consumer Policy, 37, 583–588. Thaler, R. H., & Benartzi, S. (2004). Save more tomorrow™: Using behavioral economics to increase employee saving. Journal of Political Economy, 112, 164–187. Thaler, R. H., & Shefrin, H. M. (1981). An economic theory of self-control. Journal of Political Economy, 89, 392–406. Thaler, R. H., & Sunstein, C. R. (2008). Nudge: Improving decisions about health, wealth, and happiness. New Haven: Yale University Press.

68  K. DOWDING AND B. R. TAYLOR Tversky, A., & Kahneman, D. (1973). Availability: A heuristic for judging frequency and probability. Cognitive Psychology, 5, 207–232. Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science, 185, 1124–1131. Tversky, A., & Kahneman, D. (1981). The framing of decisions and the psychology of choice. Science, 211, 453–458. Tversky, A., & Kahneman, D. (1983). Extensional versus intuitive reasoning: The conjunction fallacy in probability judgment. Psychological Review, 90, 293–315. Tversky, A., & Kahneman, D. (1986). Rational choice and the framing of decisions. Journal of Business, 59, 251–278. Whitman, G. (2006). Against the new paternalism. Policy Analysis, 563, 1–16.

CHAPTER 4

Collective Choice and Bargaining

Abstract  This chapter examines collective choice and bargaining within the government. It explains the problems of collective choice described by Arrow’s theorem which suggest that no voting rule is able to simultaneously meet a number of conditions meant to describe a minimal normative standard for democracy. It outlines some simple spatial models of bargaining within governments. It then shows how many of the relationships that exist within government can be represented by principal–agent models, the problems caused by such relationships and how these can be mitigated. This approach is applied to the prime minister controlling her ministers and how much discretion a government will give to its civil servants. Keywords  Collective choice · Arrow’s theorem · Principal–agent models · Adverse selection · Agency rent · Moral hazard · Cabinets · Prime minister · Spatial models · Delegation and discretion · Parliamentary oversight

Bargaining Within Government We saw in Chapter 2 that although firms are not individuals capable of making choices, the discipline imposed by market competition makes the assumption of rational profit-maximizing useful in predicting market © The Author(s) 2020 K. Dowding and B. R. Taylor, Economic Perspectives on Government, Foundations of Government and Public Administration, https://doi.org/10.1007/978-3-030-19707-0_4

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outcomes. Likewise, we often think of government as a single entity, but here, the internal dynamics are even more important. We talk of the British government’s bargaining position with Europe. Or we talk about the government’s health or education policy. But a government is made up of countless actors. In a parliamentary democracy, such as the UK or Australia, there are members of the cabinet, other ministers outside it and members of the governing party who secure the parliamentary majority. There is also a host of other agents: politically appointed advisers and public servants—both senior civil servants who advise government and more junior ones who actually implement the policies that are enacted in parliament. All of these agents have their own preferences; they can work together in concert or against each other as rivals when government policy is formed and implemented. When we talk about the government’s position on any matter, that position is one that has been reached through explicit or implicit bargaining by all these actors. Some actors are more important than others, to be sure, but even the most important actor—the prime minister— might sometimes be marginalized. We first explain the basic problem of collective choice, and then we look at some simple bargaining models that show how ‘the government’s view’ can be realized. The most important result in political science is, perhaps, Arrow’s Impossibility Theorem. Kenneth Arrow was actually considering what it meant to think of the interests of a firm. Since firms are amalgams of owners, managers, and workers, it is unclear what constitutes the best welfare of the firm as a whole. He thought it might be relatively easy to construct a welfare function given the preferences of all the members of a firm—or of a country. That welfare function would then be the ‘best interests’ of the collective entity. In fact, he showed the opposite. He suggested some reasonable normative conditions that should be imposed on a social welfare function and proved that it was impossible to satisfy all of them simultaneously. More formally, Arrow showed that it was impossible to aggregate individual preferences into a coherent collective preference while satisfying his normative conditions (Arrow 1951). Arrow assumes a group G = {1, 2, …, n} where n is three or more. Each individual i is assumed to have a complete and consistent preference ordering over a set of alternatives A, where A = {1, 2, …, m} where m is three or more. (Completeness and consistency of preferences were defined in Chapter  1.)

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A consistent group preference must be complete and consistent in the same manner as individual preferences. Arrow’s minimal conditions are, then: Condition U (universal domain or universal admissibility of individual orderings): each individual i in G can have any possible ordering of the alternatives in A; Condition P (Pareto principle): if every individual in G prefers x to y, then the collective preference should be for x over y; Condition I (independence of irrelevant alternatives): the collective ranking of any pair of alternatives in A should depend only on the ranking of that pair and not be affected by individual rankings of either member of the pair against other alternatives in A; Condition D (non-dictatorship): there is no individual i whose preferences automatically determine the collective preference independent of the preferences of all other individuals in G. Arrow’s proof (which we do not present here; for an outline, see Binmore 2007: 547–548) shows that no aggregation procedure satisfies all these conditions. To give an indication of the result, think of three people (A, B and C) and three alternatives (x, y and z). Each individual has a strict preference over all three alternatives: A: x ≻ y ≻ z B: y ≻ z ≻ x C: z ≻ x ≻ y If we just consider first preferences, there is no winner; x, y and z each get one vote. Arrow’s theorem requires there be a winner. We could look at the alternatives pairwise, to see if any majority is preferred. Here, we find x beats y two votes to one; y beats z two votes to one; and z beats x two votes to one. This result is a Condorcet cycle (first shown by the Marquis de Condorcet). Although the preferences of each person are transitive, the pairwise majority ranking of all three considered together is intransitive (x ≻ y ≻ z ≻ x). If one were to exclude the loser of the first contest (say y), then z would win (it would beat x); but if we voted in a different order, any of the alternatives could win.

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Arrow’s theorem assumes that for any given profile, a reasonable system should always generate the same winner, and the Condorcet cycle shows that is problematic. Arrow’s theorem, in essence, demonstrates that, given certain preference profiles, different ways of counting the votes produce different results. One interpretation of this result is that there is no perfect preference-aggregation mechanism. There are no single ‘best interests’ for a collective. To be more precise, Arrow’s theorem states that there is no aggregation procedure that translates the preferences of rational individuals into a coherent group preference that simultaneously satisfies conditions U, P, I and D. The upshot is that any collective choice depends upon the decision mechanism as much as on the preferences of the individuals. For most democratic procedures, Arrow’s conditions seem minimally reasonable. U ensures that some preferences are not ruled out. Neither P nor D seems to need much justification. Condition I is more controversial (see, e.g., Mackie 2003: Ch. 6). While we are not going to engage in that debate here, we note that I is the condition that most social decision mechanisms break and, for that reason, they are subject to different forms of manipulation, particularly agenda setting and strategic voting. When we look (below) at some models of bargaining within government, we see how, for example, prime ministers can set agendas to help them get what they want, and we see some examples of strategic voting. These occur because there is no procedure (that is not dictatorial) we can adopt which can stop them. We can also note that there are many situations where we do not expect Arrow’s conditions to hold. The prime minister is considered more important than her ministers, and her preference might be given more weight than theirs. Indeed, generally speaking, the principle of cabinet responsibility suggests that an individual minister takes overall responsibility for his portfolio and thus his preferences in that issue domain ought to take precedence over those of other ministers. To be sure, the principle further demands that any decision made by the cabinet must be accepted and defended by every cabinet minister. Thus, any decision made by any cabinet minister within their own issue domain should be accepted by other cabinet ministers who, if they disagree, should try to overturn it within cabinet; if they cannot accept the final decision, they should resign. In practice, decisions that are made within departments are never achieved without bargaining with other government agents, largely through cabinet committees and meetings of public servants at various

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levels. The Treasury (or finance departments) will always have oversight, since all decisions have financial implications for the public purse. And the prime minister will be kept informed by her public servants and by her access to the minutes of all meetings. We now turn to some simple models of these sorts of decisions.

Principal–Agent Problems Political science standardly models many relationships within government as a principal–agent (or agency) relationship. A principal–agent relationship is a simple contractual one, one that everyone regularly engages in. If your plumbing system has problems, you call in a plumber to fix it. Maybe you could do it yourself if you had the time or skills; you employ the plumber because you think they could do a better job faster than you can. This is the basis of market exchange: we trade our specialities. Thus, in a trading group, we do better than we could if we simply operated as a collection of individuals. In our plumbing example, you are the principal and the plumber the agent. There are two major problems in any principal–agent relationship. The first we call the agency rent problem and the second adverse selection. Agency rent is a problem in that your plumber might not do a very good job. He might rush the job, use poor materials or do a good job but take three times longer than necessary and charge you for the extra time. We call it agency rent, since the agent takes a payment for not doing something. He takes a rent for just being your agent. He can get away with it, because you might not have the information to see that he rushed it, that he used substandard material or spent half the time in your house on the phone to his lover. You could stand over him, but then you are spending all that time you wanted to save by hiring him in the first place. Meanwhile, to gain knowledge of the right materials would turn you into a proto-plumber yourself. You can adopt defensive tactics: randomly popping in to confirm he is actually working, engaging him in conversation about his materials and processes, perhaps pretending more knowledge than you actually have. But the basic agency problem remains. Adverse selection occurs when the agent you most want is the person least likely to want to take the job. The best plumbers already have many customers who know they are good. They are already busy: they are less likely to be able to attend quickly or even answer the phone when you call. So, often, especially when you move to a new location, the first plumber you use is the one who can come out fastest and is not likely to

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be the best one around. If they do a shoddy job, you will try someone else next time and eventually find a better company who will appreciate your business. It is possible to overcome adverse selection problems by trial and error or by acquiring information—plumbers have professional associations and awards which it is in their interests to ensure go only to reputable firms; your friends and neighbours can advise you about whom to use or avoid. Nevertheless, adverse selection remains a problem. Both of these problems, as we have described them, arise through asymmetric information. The agent has knowledge that you do not. In the case of agency rent, the agent knows how hard they are working and, probably, how well they are performing, but the principal does not. In the case of adverse selection, the agent knows their agent type—they know their own skill set—but the principal does not. (The agent might themselves be unaware that their skill set is inadequate for the job, which is why they present themselves as they do.) Gaining information—either about an agent’s type or about how well they are performing—is a way to overcome the principal–agent problem, but it can be hard to identify the most efficient means of gaining that information. The principal–agent relationships within government form chains of accountability. The parliament is an agent of the electorate, the government an agent of the parliament, ministers agents of the prime minister, senior civil servants agents of ministers and more junior civil servants agents of more senior ones. We can see that individuals can be both principals and agents at the same time, and agents can pass on to their own agents at least some of the responsibilities they owe to their principals. Thus, people can be agents of a higher-level principal at several degrees of removal (Fig. 4.1). An agent might also have several principals. For example, in a coalition government, a minister might be in an agency relationship with both the prime minister and the leader of the minister’s party if the latter is not the prime minister. The leader of the minister’s party will expect him to carry out his duties and form policy in keeping with the policies and understandings of his party—that is, the leader will expect the minister to keep the interests of his party at the forefront of his thinking. The prime minister will expect the minister to carry out his duties and develop policy in keeping with the government’s priorities and perspectives. Of course, the coalition agreement ought to ensure that these two aims are not far apart; nevertheless, at times the interests of a coalition partner and of the prime minister might diverge. In that sense, the

4  COLLECTIVE CHOICE AND BARGAINING 

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Fig. 4.1  Principal–agent relationship in government

minister is a double agent (Andeweg 2000). Even in single-party governments, a similar situation might involve a minister and the leader of a faction within the party. Political parties are themselves coalitions of individuals and policy preferences that form for mutual benefit. There is a great deal of economic literature that deals with principal– agent relationships in market relationships, but most especially within the firm. Much of that literature discusses how incentive-compatible contracts can be written between principals and agents. An incentive-compatible contract is one which ensures that it becomes in the interests of the agent to carry out the wishes of the principal. For economists, incentive-compatibility is largely concerned with pecuniary benefits. It often involves awarding agents bonuses if what they do is to the competitive advantage of the firm. However, such financial incentives are rarely possible in the context of principal–agent relationships in government. For democratically elected politicians, competitive advantages occur through electoral processes. Moreover, the nature of the conflict between principals and agents might be very different from that in business: real-world constitutions are incomplete contracts: elected politicians are not offered an explicit incentive scheme associating well-defined payoffs with actions in all states of the world. Political constitutions only specify who has the right to make decisions, and according to which procedures for which circumstances. This makes it hard to tie specific rewards

76  K. DOWDING AND B. R. TAYLOR or sanctions to the content of those decisions. The mechanism to control a politician is to deny him the right to make those decisions in the future that is, to throw him out of office. In the terminology of Holmström [1982] and Tirole [1994], politicians can only be offered implicit incentive schemes. (Persson et al. 1997: 1165)

Agents not doing their job properly are usually described as shirking. Shirking is usually taken to mean not working hard enough, but in the context of principal–agent relationships can also mean simply not carrying out one’s duties efficiently, even if one is hard-working. In politics, furthermore, agents might be very efficient and hard-working, but not do what their principal wants because they have different policy preferences. Indeed, if a minister’s policy preferences differ from his principal’s, the latter might prefer him to shirk. When agents have different preferences from their principals and move policy away from the ideal point of the principal, we term this policy-shifting. In politics, then, there are two separate basic agency problems: agent shirking and policy-shifting. We can represent these sorts of shifting behaviour in spatial analysis. The idea of politics being represented in a spatial ideological dimension is a familiar one. We often talk about the left and the right in politics. That is to see politics in a single, left–right, dimension. We also often think of politics in two-dimensional terms, such as Eysenck’s (1954) left–right and tough–tender (authoritarian–libertarian) or Nolan’s (1971) chart of personal and economic components. However, although we often see clusterings of political beliefs which make simpler models useful, there is no logical reason why opinions on different policy areas—education, health, defence—need to be grouped together. We can model politics in n-dimensional policy space. Such models cannot be visualized as easily as the one-, two- or even three-dimensional models, but they can be analysed mathematically. We think of each dimension as being a given policy area— education, health, defence—and we can think of each in terms of left and right (or hawk and dove, progressive and conservative and so on). We will make use of spatial models when we look at policy-shifting behaviour. There is a third form of principal–agent problem that we term moral hazard. First used in banking in the eighteenth century, the term was reintroduced by Arrow (1963) discussing the economics of risk. Moral hazard occurs when the very act of making a contract creates perverse incentives. Arrow was considering insurance contracts. The very act of taking out insurance can affect one’s attitude to risk. The very act of insuring your car might lead you to drive differently. Arrow thought

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about this in terms of contracts for health care. Here, the problem is that the insurance company will pay out for the cost of one’s health care. However, the actual treatment is a decision taken by doctor and patient together. There might be two procedures, one very expensive and one relatively cheap. The expensive one might have only a slightly higher chance of success, but the doctor makes more money from it, and the patient does not have to pay. If the patient were footing the bill, she might decide that the slightly higher chance of success is not worth the extra money; if she is not paying, there is no incentive not to have the more expensive treatment. Moral hazard arises because the contract between the company and the patient leads the patient to behave differently. In an effort to mitigate these effects, insurance companies might cover only a percentage of the full costs of treatment, thus giving patients at least some incentive to consider the cost–benefit analysis. All three types of principal–agent relationship problems derive from asymmetric information. In classic examples of agency rent, the asymmetric information is due to hidden action. The agent observes exactly what he is doing, but the principal can only observe the outcome, and she might not be aware of all the problems with that outcome. In adverse selection, the agent knows how efficient or qualified they are for the job and will try to hide any deficiencies. Our use of the term ‘moral hazard’ is directly in line with Arrow’s usage. In more modern literature, moral hazard is often equated with what we call agency rent, because they both involve asymmetric information and hidden action. However, the hazard comes about precisely because the agent will change his behaviour as a result of the nature of contract he has with his principal. The moral element refers to the covert conspiracy between the agent and the third party (the doctor in Arrow’s original) against the principal, which is absent from agency rent. Adverse selection assumes that the population of potential agents is heterogenous that there are better and worse agents that could be hired. Adverse selection comes about because the least qualified for the position are those most desperate to gain it, who will go to greater lengths to attain it. Both agency rent and moral hazard, though, can occur even if the population of potential agents is homogenous. We shall first examine the principal–agent relationship between prime ministers and cabinet ministers. We will run through the tactics that prime ministers have traditionally used to overcome their principal–agent problems with their ministers. We will then utilize some simple spatial modelling to show how prime ministers can use their agenda-setting

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powers to overcome some of those problems, and how strategic voting can help ministers fight back against the prime minister. In the subsequent section, we will turn to the principal–agent problems experienced by politicians with regard to their bureaucrats.

Cabinet as a Principal–Agent Relationship We can apply our three types of principal–agent problem to a made-up example. Assume the public dislikes corruption, so, therefore, does the prime minister. Say that being a minister provides the opportunity for corrupt actions—doing favours for friends in consideration for payments. Agency rent occurs when the minister uses his time to engage in corruption behind the prime minister’s back—here, he literally gets rent from his job. Those who see and desire the opportunities to gain rent from a ministerial post will try hardest to get the job—adverse selection. In a moral hazard scenario, we imagine that the principal is the anti-corruption public and the agent is the minister. Here, if the prime minister discovers the corruption, she might conspire with the minister to hide it, because publicizing it will damage her and her government as well as the minister. (For more on these relationships, see Dowding and Dumont 2015.) Adverse Selection The first problem a prime minister faces when she constructs a cabinet is adverse selection. Adverse selection is a problem when there is heterogeneity in the population of candidates and those whose qualities the principal prefers less are more likely to shine at the selection stage. In the ministerial market, those who are the most ambitious for office will work hardest to attain it. We can identify two types of individuals who are most ambitious. The power-hungry want power for their own benefit. They are after the pecuniary rewards or the status of office. The policy-committed desire to change society and often have strong views about the way they want society to run. We tend to view the latter more favourably than the former—unless, that is, their views are diametrically opposed to our own, in which case we are likely to see them as dangerous. Prime ministers tend to take the same view. A prime minister will want to appoint the policy-committed if they are committed to the sorts of policies that she favours. Otherwise, she will tend to prefer the power-hungry, who will show loyalty to her as long as she can advance their

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careers. The prime minister will need to be wary once the power-­hungry become powerful enough to look after themselves, or if they hitch their career to one of her rivals. Hence, prime ministers are most likely to appoint as ministers people who are power-hungry, along with a few policy-committed ones. In parliamentary democracies, the way people put themselves forward is by making speeches or interventions on the floor of the house or in public or by acting decisively in committees. Such activities do not necessarily show that a minister will prove effective at managing a department, developing policy or demonstrating leadership if major issues blow up in their policy domain. The other problem for prime ministers is that they do not have a completely free hand when choosing ministers. Parties are made up of factions, often around ideological (policy) issues, but sometimes around personalities. The leaders of factions—big beasts—can rarely be sidelined, and prime ministers are forced to bring them into cabinet, often giving them important roles. It may be better to have a big beast in cabinet than on the backbenches, because they are constrained by individual and collective cabinet responsibility and so cannot openly act against the prime minister. We can note that adverse selection here does not necessarily involve asymmetric information. A prime minister can be well aware that she is choosing power-hungry ministers who might turn against her or a big beast who is working against her behind the scenes. Adverse selection is such a problem because it is difficult to solve. Indeed, sometimes a principal might choose perversely because of bargaining advantages that might accrue from choosing a corrupt or inefficient minister. In authoritarian regimes where the rule of law still operates, both dishonest and honest principals might promote corrupt people because they are corrupt. If the principal has knowledge of an inferior’s corruption, she can use that knowledge to better control him (Yaney 1973). Similarly, even in more democratic institutions, both the corrupt and the honest might support a corrupt colleague for promotion over them if they have knowledge that they can use to gain favours. While such trading is not so overt in democratic systems, private knowledge of colleagues’ problems and activities is often useful to both sides. Prime ministers might also offer jobs to rivals who are not ideally equipped for them. If they publicly fail, they are less likely to be in a position to threaten the prime minister. Again, perverse incentives can operate. Policy specialists are rarely appointed to ministries in the areas they specialize in. It is much harder for a prime minister to control a

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minister if he is an expert in the policy domain of his ministerial responsibility. So specialists are only appointed to ministries in which they are experts if the prime minister is assured that their policy preferences are close to her own. We have mentioned shirking and policy-shifting behaviour by agents. One dilemma for principals is that dealing with one problem might create the other. A principal might appoint to a given portfolio an agent she thinks efficient. However, if she then finds that the agent is guiding policy away from her ideal point in policy space, she might deal with that policy-shifting behaviour by replacing that minister with another who shares her views. But she cannot be assured that the new minister is as efficient as the previous one. She solves policy-shifting, but creates a problem of agent shirking (Bressler-Gonen and Dowding 2009). Agency Rent Shirking and shifting are the basic problems of agency rent. The agent either shirks and extracts some rent in the form of private benefits or extracts personal benefits in the form of policy preferences. An agent can extract this rent even if the set of ministrables (that is, people who are eligible to become ministers) is homogenous in quality, as long as there are some replacement costs. And there are always replacement costs when prime ministers reshuffle cabinets, especially if they do it too often. If the universe of ministrables is heterogenous, then the minister can extract rent equivalent to the difference between his talents and those of his nearest rivals. The extent of this rent extraction is his bargaining range. The rent extraction of big beasts can be very high indeed—in some cases demands for very large ministerial empires or great independence in the formation of policy. In parliamentary democracies, the executive dominates policy-making, giving the cabinet agenda-setting power. It is that power which makes the potential policy-shifting agency rent so great for ministers (Strøm 2003: 82). The discretion that ministers enjoy can translate into agency loss when the prime minister does not share the minister’s policy preferences, particularly if the minister enjoys independent support from a faction of backbenchers. Reshuffling or sacking might not be the prime minister’s optimal response. Shirking behaviour might cause lesser problems for prime ministers in parliamentary democracies, because the agenda-setting power of the cabinet and parliamentary oversight of

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ministers—who are forced to regularly face questions in the legislature— provide incentives not to shirk without the prime minister having to institute her own oversight procedures. Moral Hazard For a successful government, a prime minister wants a team of ministers who can offer a variety of different talents and skills. She will want some safe ministers whom she can rely upon to keep things quiet. She might want some who are adept at landing blows on the opposition, some who are entrepreneurial and risk-taking. The output of government policy is stochastic—it is often hard to judge what constitutes policy success or failure, especially at the time that policy is developed and legislation passed. Where ministers take risks and fail, it is in the interests of the prime minister—indeed, of the whole cabinet—for that failure to be concealed. The concept of collective cabinet responsibility is used to hide failure. This is a form of moral hazard created by the convergent interests of members of the government in maintaining the popularity of the government as a whole. How Prime Ministers Solve Principal–Agent Problems Prime ministers may use several tactics to try to overcome the principal– agent problems we have identified. Dewan and Hortala-Vallve (2011) discuss the three A’s of prime ministerial power: appointment, allocation and assignment. The prime minister chooses the cabinet (appointment), she places people in the portfolios she designates (allocation), and she has the power to reorganize departments (assignment). The last is not much discussed, but in Westminster systems, prime ministers can reorganize the government machine at any time (in presidential systems such as the USA, government agencies are set up by the legislature, and presidents cannot reorganize so easily). So a prime minister can assign a rival to a ministry and at the same time remove various responsibilities from that department and bestow them on another. In that way, she can maintain some control. The legislative timetable is also crowded. Not all ministers can get their legislative proposals to parliament in each session. One important bargaining chip the prime minister retains is whether or not any legislation will even be considered in parliament. Sometimes a prime minister is

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keen to enact legislation—Tony Blair, elected on the slogan ‘education, education, education’, was committed to early legislation on education. In such cases, prime ministers are likely to appoint ministers close to them in policy space or carefully (as we detail below) ensure that the legislation that emerges will be what they want. The prime minister can also shuffle ministers around before they get legislation in place, if she foresees it taking a direction she does not appreciate. In the UK, reshuffles tend to happen about mid-term, but if a minister resigns unexpectedly, opportunities arise for a limited reshuffle. The prime minister is the chair of a cabinet. In Westminster systems, which generally have single-party control, there are no set rules about how the business in cabinet is conducted. Most prime ministers dislike having formal votes in cabinet. Even though cabinet discussions are supposed to be secret, if a vote is taken, it is likely to emerge how the cabinet split and prime ministers do not like it to appear that their government is not united. Usually, therefore, if discussion reveals dissent over some policy put forward by a minister, he will be asked to go away and think again, rather than a formal vote being taken. However, we can represent such discussions as though there are votes; we will look at cabinet and cabinet committees as though they are voting bodies. A minister will not bring an issue to cabinet unless it has been discussed with the prime minister, her office and other affected ministers. In the UK, the prime minister exerts control over her ministers by oversight procedures largely operated through the Cabinet Office. The Cabinet Office is presided over by the cabinet secretary—the most powerful civil servant in the country—who often deals with issues that the prime minister does not want to handle directly. It has grown enormously over the past fifty years as prime ministers exert ever more control. The Cabinet Office also coordinates interdepartmental issues and services cabinet committees. While cabinet government is important in Westminster systems, it is rare today that decisions are made in full cabinet. Instead, they are taken in cabinet committees and then go upward to the full cabinet when the relevant interests have all been represented. Prime ministers might chair cabinet committees, but just as often they install people, they trust as chairs. The chairs, like the prime minister in full cabinet, have great powers, including the specific agenda of each meeting, how the discussion proceeds and over the final minutes. Minutes can be important. In 1986, Michael Heseltine famously resigned over a decision in cabinet for the reason that the minutes did not reflect the actual discussion (Heseltine 2000).

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Fig. 4.2  Appointing a conservative minister

We can illustrate how prime ministers control policy by using simple spatial models. In these models, we see two important roles, the agenda-setting role and the veto-player role. We can think of ministers as being agenda setters within their policy domains. We can think of the veto player as the median voter in cabinet (the ‘feeling’ of the cabinet) or, in some contexts, the prime minister herself. We represent policy space in these models in a single left–right dimension. We also assume that each person has simple left–right attitudes to the issue. We can mark their ideal point—where they would ideally like policy to be located. We assume Euclidean preferences in a single dimension: that is, we assume that preferences are continuous and closer points are preferred to more distant points. Furthermore, the actor is indifferent between two points (one to the left and one to the right) equally distant from their ideal point. In the figures, we mark where the policy currently is as the status quo (SQ), we mark the ideal point of the prime minister (PM), the ideal point of the minister (M) and the ideal point of the median ‘voter’ in the cabinet (CM): that is, what the cabinet wants. We refer to that as ‘the cabinet’ for short. We can see that by choosing ministers whose views may not correspond to her own, the prime minister can still set up the cabinet to ensure that she is more likely to get (close to) what she wants. In Fig. 4.2, we see the status quo (SQ) on the left. The prime minister (PM) is closer to SQ than the cabinet is. The minister (M) will propose a policy at his ideal point P. The cabinet prefers that to SQ, but would sooner the policy shifts further to their ideal point CM. M is indifferent between SQ and P* (the distance α is the same) and thus will agree to any radicalization of his policy up to point P*. P* is closer to the PM’s ideal point than any of SQ, M or CM. By playing off her ministers against each other, the prime minister achieves her policy goal. In fact, if she could appoint a minister whose distance (α) from SQ is precisely equal to that of his distance from the PM, then she would get her ideal policy.

84  K. DOWDING AND B. R. TAYLOR ^Y

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Fig. 4.4  Cabinet vetoes change

Imagine instead that the prime minister appointed a minister much closer to her in policy space than in Fig. 4.2, but closer also to the cabinet’s ideal point. In Fig. 4.3, we see that P is much closer to PM than it was in Fig. 4.2, but the cabinet can again bargain with the minister to move the point to P*. The prime minister, being powerful, might intervene and back the minister to maintain the policy position at his preferred point P. However, doing so will expend political capital to achieve a position that is further away from her ideal point than in Fig. 4.2. The judicious appointment of ministers with known policy preferences can allow the prime minister to achieve more of her aims while expending less political capital. In Fig. 4.4, the prime minister is close to SQ and therefore does not want change. Accordingly, she can appoint a minister who is close to SQ or herself and let the department have no new initiatives, or else appoint a minister who is on the other side of SQ from the cabinet. Here, any attempt by the minister to move away from SQ will be blocked by the cabinet, so policy P* remains at SQ. In Fig. 4.5, we see that the prime minister is closer to SQ than her cabinet is, and her minister is even further away from SQ. The cabinet would much prefer the minister’s policy at P than SQ. On their own, they could force the minister to shift policy to their ideal point at CM. However, the prime minister could use the fact that the cabinet is

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Fig. 4.5  PM expends capital

indifferent between the minister’s preferred policy P and point P* to shift policy to P*, closer to her ideal position than P or CM. Doing so would require having to expend her authority and political capital. The prime minister can also circumvent the full cabinet by setting up a cabinet committee that ensures the policy that emerges at full cabinet is closer to her preferences. She could pack it with members and ensure that it is chaired by a big beast whose views are close to her own. We represent this in Fig. 4.6. The top half of the figure reproduces Fig. 4.5. The lower half shows the cabinet committee preferring a point much closer to SQ and the prime minister’s own position. CCM is indifferent between P** and SQ, so the minister can bargain to take a policy to cabinet at P**. The cabinet would prefer to shift policy leftwards, and indeed, the minister would be happy for them to do. Nevertheless, he presents a policy M* in cabinet and might lose face were he not to defend it, despite his ideal point being closer to CM. The cabinet might try to move policy, but as it is presented at P**, the prime minister can expend her authority and political capital to ensure that no movement occurs. She has expended the same amount of capital in Fig. 4.6 as in Fig. 4.5, but has achieved a policy closer to her ideal point. Thus, prime ministers can use cabinet committees effectively for their ends. These models assume that each actor has definite ideal points that they and the others know. In reality, actors do not always have such clear policy preferences and might not have an accurate idea of the policy preferences of other actors—though in small groups, such as cabinets, they are likely to have a general sense of everyone’s policy preferences. However, government is secretive, and ministers do not like their policy proposals to leak out before they make announcements. The more people who know a policy proposal, the more the likely the press will hear about it. Prime ministers can make use of this asymmetric information.

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Policy preference is one thing, and power games another. Ministers might not want their colleagues to know how much they conceded in cabinet committee, which is why in Fig. 4.6 the minister and the prime minister can defend P** against the cabinet, even though the minister ‘ideally’ would prefer the cabinet’s ideal point to his proposed legislation. The bargaining powers of ministers and prime ministers are extensive and somewhat mysterious. Formal models of bargaining show that reputation is an important resource. For the prime minister, being seen to be strong and authoritative is a big bargaining chip. Paradoxically, a prime minister who gets what she wants without doing much might appear weaker than one who expends political capital. When an apparently weak prime minister does need to fight on some issue, she might find she is unable to command the respect of her cabinet colleagues. Two of the strongest-seeming prime ministers in recent years in the UK were Margaret Thatcher and Tony Blair, both right-wing outliers in their cabinet (less so for Thatcher as her premiership grew longer). Centrist prime ministers, such as John Major (especially) and David Cameron, were not regarded as so strong. Now, of course, to some extent the power of the prime minister is determined by her and her party’s standing in the polls and the support of her parliamentary party. But prime ministers can use their strength to get what they want against the wishes of (the median voter of) their cabinet. We illustrate this in Fig. 4.7, where we represent a three-person cabinet, with two ministers A and B and the prime minister.

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Fig. 4.7  PMs apparent strength

In Fig. 4.7a, the prime minister is an outlier in her own cabinet. Minister A is the median voter, and, with equality of voting, policy would be at point A. However, prime ministers rarely allow votes in cabinet and strive to achieve their aims through their authority and political nous. In Fig. 4.7b, the prime minister is the median voter; she never has to use her authority. But this might come over as weakness, as sometimes she might side with the left in her cabinet, sometimes with the right, depending on whether the legislative proposal comes from a minister on the right or one on the left. Then what seems to be the case sometimes becomes the case, when the resource that is being expended is reputation.

Moral Hazard: Parliamentary Oversight of the Executive The principal–agent model can also be applied to the relationship between the government as an elected body and its civil servants. Once again, we have asymmetric information—this time between the permanent civil service and their political superiors. Civil servants have experience and policy expertise, and they implement the policy that is formulated by politicians. Adverse selection was supposed to be solved by the professionalization of the civil service. Civil servants must pass examinations and then work their way up the hierarchy, and the general ‘Weberian’ idea is that they are neutral in the policy advice they offer. However, over the past fifty years politicians have increasingly come to

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believe that civil servants have their own interests. They tend to be conservative when it comes to policy change and to defend their positions (we look at some simple models of that behaviour in Chapter 5). The response to this form of adverse selection was to make the top civil service more competitive by bringing in people from outside—from industry—and by employing more political appointees. The agency rent problem appears most overtly in agent shirking and policy-shifting. The shirking problem emerged as it increasingly became the view that the civil service was inefficient and private-sector management practices would provide better results. It was thought civil servants lacked managerial skills. Secondly, it was thought that bringing a diverse group of people into the senior civil service would foster less conservative and more dynamic attitudes towards policy change. Government introduced more explicit oversight procedures, from a more active National Audit Office through to closer oversight of the civil service by the Treasury and breaking up line departments into smaller agencies with new heads. Further oversight of these agencies is provided by parliament, though in practice ministers often act in concert with their public servants to hide problems. Bureaucratic drift can occur when bureaucrats implement policies in a manner that diverges from the original intentions of the legislation. We distinguish two forms of bureaucratic drift. One we can liken to shirking—over time the bureau settles into habitual procedures that might depart from what was intended. The second is policy-shifting. Public servants have their own political views and are not the neutral agents of Weberian theory. The bureaucrats’ personal policy objectives, then, can lead them to implement legislation in ways that favour their own preferences rather than the legislators’. We examine these forms of principal– agent problems in Westminster-style parliamentary systems in Chapter 5. Here, we want to examine the moral hazard that emerges between parliament and the executive, as this type of agency problem is more extreme than in presidential legislative systems. Most of the literature on the principal–agent relationship between politicians and bureaucrats is based on presidential systems where the legislature provides the detailed oversight of the public service. It tends to concentrate upon three forms of legislative oversight: ‘police patrol’, ‘fire alarm’ (McCubbins and Schwartz 1984; McCubbins et al. 1987) and ‘fire extinguisher’ (Shepsle 2010: 432). ‘Police patrol’ oversight occurs where members of the legislature constantly monitor the

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bureaucracy to ensure that their intentions are carried out in policy implementation. ‘Fire alarm’ oversight is where the legislature waits until citizens or groups who are adversely affected by the way in which legislation is carried out bring it to their attention. ‘Fire extinguisher’ is when groups or citizens take agencies to the federal courts rather than the legislature. In centralized Westminster parliamentary systems, however, oversight of the bureaucracy is carried out more by the executive itself than by the legislature. We examine this in Chapter 5 where we look at parliamentary oversight, in the form of select committees in the House of Commons. Delegation and Discretion We have largely been concerned with how principals control their agents. We have seen that in the public sector, this is very different from how control is generally organized in the private sector, where pecuniary benefit—setting contracts so it is in the agent’s interests to do what the principal wants—is the main device. However, in the public sector, it might also be in the principal’s interest for the agent to have discretion over how they go about the tasks the principal has delegated. Political economy models assume that the major motivating factor for politicians in a democracy is their re-election. They do have policy preferences, but they also have an eye on how their policies will be viewed by the electorate. It is well known that the state of the economy is a major factor in the popularity of incumbent governments, and this is so even when world events outside the control of the government are the major causes of problems. For many policies, it will take some time, years not months, before we can judge their success. Often when a policy disaster occurs, the minister originally involved has long gone and a new one must face the consequences. To mitigate blame, ministers can adopt a hands-off strategy, allowing their agents a high level of autonomy in applying their policies. In some policy areas, the issues are largely technical and there is little that politicians can gain from them. Take transport. When traffic flows freely on motorways or in cities, do we give credit to the transport minister? When we sit in a massive tailback, do we blame the transport minister? The latter seems far more likely than the former. So success brings little reward, but failure breeds danger. Part of the problem might seem outside the minister’s immediate control. How many cars there are on the road today largely depends on how many there were yesterday, and

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the minister might only have been appointed yesterday. That is not to say that ministers have no control over traffic. An integrated transport policy, subsidized public transport, parking restrictions, tolls, higher tax on car registration and so on will all reduce traffic. But many of these will take some time to have effect, and many will be unpopular with car owners—and most voters are car owners. Another solution is to widen existing roads and build new ones. These might be popular in the long term—when they are finished—but deciding precisely where to build them brings local discontent. Hence, ministers try to leave many issues to public servants. While a minister will make the final decision on the route of a bypass, the initial recommendation will be made by public servants. Transport ministers were always blamed for poor service on the nationalized British Railways. Even though the private system is far less efficient in many ways, ministers can now blame the private operators and distance themselves from the problems. Christopher Hood (2011) describes three strategies for ministers to avoid blame. The first is presentational: they limit blame by presenting issues that lead the public to look to other actors. Second, they employ an agency strategy, delegating formal responsibilities and competencies to their agents. Third, they select policies that minimize risk to themselves. The three strategies are interrelated. Policies can be set that give more or less discretion to agents. The greater the perceived risks, the more discretion politicians will want to grant to agents. The further removed those agents are from the direct purview of the minister, the less likely it is that subsequent problems can be laid at the minister’s door. Indeed, setting up agencies with heads on fixed-term contracts enables ministers to fire their agents with greater ease than they can dismiss permanent civil servants, so they can gain credit for acting decisively if major problems emerge. These strategies enable ministers to present problems as being not their fault, yet present themselves as decisively addressing those problems. Of course, if a policy or agency is seen to be successful, the government can gain credit for setting it up. A win-win scenario. There is, however, often pressure on ministers to give public ­servants less discretion. Two processes lead to restricted autonomy. The first is where ‘police patrol’ procedures operate, such as social security payments, children’s welfare and health and safety. When agents make decisions, these can be challenged in the courts, constituents can take them up with their MPs and, most importantly, media campaigns can tell stories that outrage the public. The response is to write tighter regulations and guidelines for

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public servants, giving them less discretion. The second source of pressure comes from organized lobbies, such as industries that often want tighter regulations to keep out competition. We look at this in Chapter 5. The other aspect of discretion is how long a government thinks it will be in power. Giving discretionary powers to public servants enables governments to shift policy through instructions to civil servants. This has been dramatically illustrated by Teresa May’s ‘hostile environment’, which she introduced at the Home Office before the 2016 Immigration Act. It established more numerous and more difficult procedures for visa applications, as well as creating problems for British subjects who lacked the paperwork proving their rights (Warren 2016). Such changes within administration can be carried out quite easily—enacting legislation makes them harder to undo. But governments are aware that if they do pass controversial legislation, then an incoming government can amend or repeal it. Governments coming to the end of their term and foreseeing an election loss might pass less ideologically fraught legislation in the hope that it is less likely to be repealed.

Conclusions When considered as a collective agent, we usually treat firms, parties, governments or countries as rational agents with well-formed preferences. However, as collective agents they are governed in different ways. To the extent, a collective agent follows the dictates of a leader—a dictator—the assumption is plausible. However, Arrow’s theorem, originally created when Kenneth Arrow was considering how one might represent the interests of a firm, shows that collective decision mechanisms do not guarantee such rationality. Arrow’s theorem shows that no voting rule is able to simultaneously meet a number of conditions meant to describe a minimal normative standard for democracy. Within government institutions, such as voting rules and authoritative relationships combine to make decision-making more rational. We have looked at a series of simple spatial models of the process. These can be represented by principal– agent models. The basic problem demonstrated by such agency models is that the agents that work on behalf of the principal have their own interests, both to shirk, and in the political setting their own policy preferences. Asymmetric information compounds the problem. We examined the relationship between the prime minister and her ministers as a principal–agent relationship and looked at the formal and informal powers the

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prime minister has to control her ministers. We also looked at the incentives that governments have to control their agents and the amount of discretion they like to give dependent upon the risks and opportunities.

References Andeweg, R. B. (2000). Ministers as double agents? The delegation process between cabinet and ministers. European Journal of Political Research, 37, 377–395. Arrow, K. J. (1951). Social choice and individual values. New Haven: Yale University Press. Arrow, K. J. (1963). Uncertainty and the welfare economics of medical care. American Economic Review, 53, 941–973. Binmore, K. (2007). Playing for real: A text on game theory. Oxford: Oxford University Press. Bressler-Gonen, R., & Dowding, K. (2009). Shifting and shirking: Political appointments for contracting out services in Israeli local government. Urban Affairs Review, 44, 807–831. Dewan, T., & Hortala-Vallve, R. (2011). The three A’s of government formation: Appointment, allocation, and assignment. American Journal of Political Science, 55, 610–627. Dowding, K., & Dumont, P. (2015). Introduction: Agency rent, adverse selection and moral hazard. In K. Dowding & P. Dumont (Eds.), The selection of ministers around the world (pp. 1–24). London: Routledge. Eysenck, H. (1954). The psychology of politics. New York: Routledge. Heseltine, M. (2000). Life in the jungle: My autobiography. London: Methuen. Hölmstrom, B. (1982). Moral hazard in teams. Bell Journal of Economics and Management, 13, 324–340. Hood, C. (2011). The blame game: Spin, bureaucracy, and self-preservation in government. Princeton: Princeton University Press. Mackie, G. (2003). Democracy defended. Cambridge: Cambridge University Press. McCubbins, M., Noll, R., & Weingast, B. R. (1987). Administrative procedures as instruments of political control. Journal of Law Economics and Organization, 3, 177–243. McCubbins, M., & Schwartz, T. (1984). Congressional oversight overlooked: Police patrols versus fire alarms. American Journal of Political Science, 28, 165–179. Nolan, D. F. (1971, January). Classifying and analyzing political-economic systems. The Individualist, 5–11.

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Persson, T., Roland, G., & Tabellini, G. (1997). Separation of powers and political accountability. Quarterly Journal of Economics, 112, 1163–1202. Shepsle, K. A. (2010). Analyzing politics: Rationality, behavior, and institutions (2nd ed.). New York: W. W. Norton. Strøm, K. (2003). Parliamentary democracy and delegation. In K. Strøm, W. C. Muller, & T. Bergman (Eds.), Delegation and accountability in parliamentary democracies. Oxford: Oxford University Press. Tirole, J. (1994). The internal organization of government. Oxford Economic Papers, 46, 1–29. Warren, R. (2016). Even before Brexit, Theresa May’s laws made Britain a hostile place for migrants. The Conversation. http://theconversation.com/ even-before-brexit-theresa-mays-laws-made-britain-a-hostile-place-for-migrants-62467. Yaney, G. L. (1973). The systematization of Russian government: Social evolution in the domestic administration of Imperial Russia. Urbana: University of Illinois Press.

CHAPTER 5

Bureaucracy and Levels of Government

Abstract  This chapter considers the principal–agent problem with regard to public bureaus. It examines budget-maximizing, the related setter model, bureau-shaping and the effects of lobbies on government through rent-seeking activity. It finally examines the argument that different levels of government can help the public sector operate more efficiently through Tiebout competition, quasi-markets, polycentricity and fiscal federalism. Keywords  Bureaucracy · Budget-maximizing · Bureau-shaping · Rent-seeking · Romer-Rosenthal setter model · Tiebout competition Quasi-markets · Polycentricity · Fiscal federalism · Flypaper effect

·

Models of Bureaucracy Chapter 4 examined principal–agent problems between the prime minister and her ministers and between ministers and their bureaucrats, outlining the problems of asymmetric information, hidden action and adverse selection. In the nineteenth century, in order to improve the quality of civil servants, parliament introduced a competitive examination process. This was the start of the professional civil service, in which promotion was based upon performance and not family background or contacts. The civil servants were to provide professional neutral policy © The Author(s) 2020 K. Dowding and B. R. Taylor, Economic Perspectives on Government, Foundations of Government and Public Administration, https://doi.org/10.1007/978-3-030-19707-0_5

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advice to their political masters and then carry out legislative activity as the government wishes. They were supposed to be generalists rather than specialists, able to slot into any department. As time went by, governments again queried the quality of their civil servants. First, it was thought they were too risk-averse. Civil service careers have traditionally been very safe occupations. Government, unlike firms in the competitive market, does not ordinarily go out of business, so a career in the public service seemed guaranteed for life. Second, while the remuneration was not as high as the private sector, those who got to the top received a good enough salary. Third, a good pension scheme was provided. Hence, the civil service tended to attract the risk-averse. When radical governments arrived, following the major inflation and recession of the 1970s, they looked for a new breed of more entrepreneurial public servants. Risk-aversity was seen as a form of shirking, and so the competitive examination and job-safety aspect were creating adverse selection problems. The answer was to encourage people from the private sector to enter in senior positions, bypassing traditional routes. Salaries increased at the top end to attract them, but job security there was curtailed. Specialists were increasingly sought, first for scientific and agricultural roles, then economists and so on. Governments grew less likely to believe that civil servants were giving ideologically neutral advice; they began a process of politicizing the public service, not only by importing people from the private sector, but also through a new cadre of policy advisers who were officially outside the public service career structure, but who increasingly took on the role of instructing civil servants. One of the earliest and best-known proponents of the view that public servants both shirked and pursued their own agenda was William Niskanen (1971). He argued that, while managers in the private sector try to profit-maximize, bureaucrats attempt to budget-maximize, costing the public purse. They do so for the same reason that managers profit-maximize. By increasing profits, managers secure their jobs and are able to maximize their earnings. Through budget-maximizing, bureaucrats secure their position and maximize their influence over government. An important basis of Niskanen’s argument is that public bureaucracies supply public goods, the private sector private goods. As we saw in Chapter 2, while the market can provide good signals for the supply of private goods, it tends to undersupply public goods. This is a major

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justification for state activity, another being, as we saw, public desire for redistribution and transfers. Using a simple bargaining model, Niskanen argued that the public bureaucracy is in a strong position, as it translates public demands for public goods into pressure on ministers—but civil servants have an interest in inflating those public demands. In Fig. 5.1, we give a simple representation of the output decisions of profit-maximizing firms in a competitive market. The quantity of a private good is shown on the horizontal axis, and the price and cost on the vertical axis. The marginal benefit consumers derive from consuming the good gives us the demand curve, which declines as output increases. Marginal costs, from which we derive the supply curve, increase as production increases. Profit-maximizing firms produce additional units of a private good up to the point where the marginal benefits equal marginal costs, so the market will produce output QE at price PE. As we saw in Chapter 2, assuming that there are no externalities and no monopoly power, this is the socially optimal level of production. At lower levels of production, the marginal benefits of increasing production exceed the marginal costs; at higher levels, the marginal costs exceed the marginal benefits.

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Niskanen translates this basic representation to the situation of a public bureaucracy providing public goods or transfers, where there is no market signal of their marginal benefits and so no simple demand curve. Here, civil servants, taking signals from citizens and other interested parties (see below), inform politicians at what point the public good should be supplied. In Niskanen’s simple model, the public servants have a monopoly on information, so the politicians only know what their agents tell them. In Fig. 5.2, we reproduce the marginal costs and marginal benefits identically to those of Fig. 5.1, and QE remains the socially optimal level of production. In Niskanen’s model, the bureaucrats make a take-it-or-leave-it offer to the politicians. They can make that offer at the point at which society is indifferent between the point at which it would be offered QB and 0. This leads to an inefficiently high level of output. If politicians mostly prefer the optimal level of QE and have simple Euclidian preferences over the level of spending—that is, if they prefer values closer to their ideal point and treat each dollar of overspending as equally undesirable as each dollar of underspending—then the bureaucrat will be able to offer up to twice as much of the public good as would

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be provided by an efficient market, QB. At this level of output, marginal cost outstrips marginal benefit. We can take issue with Niskanen on several points. First, QE is entirely theoretical. As there is no market signal, we can have no idea precisely which point affords the efficient output of a public good. Niskanen and Gordon Tullock, as we see below, suggest that the signal bureaucrats receive comes from privileged interests that want government to produce more than it should. But it could equally be the case that interests lobby government to produce less, particularly if those interests press government to reduce taxation, which pays for public supply (see below). Second, principals do not just have to accept what their agents tell them. In parliamentary democracies, the Treasury or finance departments are the keepers of the public purse. Over the past fifty years, the Treasury has been increasingly involved in policy-making at the earliest stages, in the cabinet committees, as discussed in Chapter 4. This type of oversight can control the demands of budget-maximizers. Third, government provides incentives to public servants to make savings. Those who find ways to cut costs are rewarded. And fourth, government has privatized activities and created agencies at one remove in order to try to introduce competition. Thus, governments have developed means to overcome the principal– agent problem endemic in Niskanen’s simple model. Niskanen developed his ideas while working in the US Defense Department. Of all the bureaux in the world, this is the one the budget-maximizing hat might fit best. US government, both the executive and Congress, has been an easy target for weapons manufacturers, who have succeeded in increasing the budget well beyond the real needs of the nation. Few other examples are quite so pertinent. Thomas Romer and Howard Rosenthal (1979), however, provide an example of bureaucrats making take-it-or-leave-it offers—not to government, but directly to voters. In some school districts in the USA, the school board suggests a new budget for the next financial period. The citizens then vote in a referendum to accept or reject the budget. If the new budget is rejected, the budget reverts to that of the current year. In Romer and Rosenthal’s model, the lower the reversion budget, the higher the budget the school board can demand. This is illustrated in Fig. 5.3. On the horizontal axis, we have what the citizens are prepared to spend from public funds, and on the vertical axis how much from their own private expenditure. The line B–B is the budget constraint, representing the maximum attainable combination of the two

100  K. DOWDING AND B. R. TAYLOR

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goods. Any point within the budget constraint (i.e. to the left and below the line) is an attainable combination. Any point outside the budget constraint (i.e. to the right and above the line) is unattainable. Points on the budget constraint line are attainable, and since we assume that agents will spend their budget in full, we expect them to choose some point on this line. We also have three indifference curves (I1, I2 and I3) representing preference orderings. All points on a single indifference curve are ranked equally (i.e. the agent is indifferent among them), but any point on a higher indifference curve is strictly preferred to any point on a lower one. The shape of these indifference curves tells us that each good is positively valued and that averages are preferred to extremes. A reasonable quantity of both public and private expenditure is preferred over a somewhat greater quantity of only one or the other. The highest indifference curve, I3, just touches the budget constraint at S, which would be the optimal supply. No other points on this or any higher indifference curve are attainable. We have two reversionary budgets, R1 and R2. The public is indifferent between R2 and output at Q1 (because they are both on the same indifference curve I2), which means that the school board could

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increase the budget up to Q1 before voters object. At the lower reversionary budget of R1, the budget could be pushed even higher to Q2. We can see that the lower the reversionary budget, the higher the school board can push the increases. Niskanen’s model suggests that bureaucrats want to maximize their total budget. However, a large part of budgets such as the education or health budget is beyond the control of public servants. All they do is to pass the budget on to other state agents—hospital administrators, GPs, schools and so on. Jean-Luc Migue and Gerard Belanger (1974) suggest that bureaucrats maximize their discretionary budget; Niskanen (1994) agrees. Patrick Dunleavy (1985, 1991) extends this argument to suggest that we can break a bureau’s budget into several different categories. We simplify his account in Fig. 5.4 to show three types: the core budget, the bureau budget and the programme budget. The core budget is money spent by the bureau on its own operations: staffing costs, accommodation, equipment, day-to-day activities and so on. The bureau budget comprises those parts of the overall expenditure for which the department is directly responsible to the government, that for which it has to report on directly. The programme budget is all of the money over which the department exercises some supervision or control.

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Fig. 5.4  Dunleavy’s three budgets

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If there are problems with the non-bureau elements of the programme budget, blame will attach to those who are directly responsible. In fact, we can see that there might be slack-seeking bureaucrats who want to maximize their surplus through underprovision of a public good, and then siphon off surplus through higher salaries, wasteful office expenditure and other shirking behaviours. The surplus maximized in Fig. 5.5 where output equals QS, meaning both underprovision of the public good and wasteful production of it. Bureaucrats produce wastefully when they maximize their surplus at higher cost (CS) and lower output (QS). Dunleavy argues that bureaucrats only have a direct interest in maximizing the core budget and may respond to incentives to cut the bureau and, especially, the programme budgets. Or they may want to

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shift responsibility for these budgets to other agents. For some types of bureau (e.g. taxing offices), the core budget constitutes most of the budget, with the small bureau budget comprising the programme budget. For other departments, such as education, the core budget is relatively small in relation to the bureau and, in particular, the programme budget. When under pressure to reduce public expenditure, bureaucrats will defend their core and bureau budgets and cut the programme budget. This is likely to lead to undersupply of public goods, and certainly to inefficiency, and the core budget will increase as a proportion of the overall budget. Dunleavy argues, furthermore, that senior civil servants desire innovative policy work, not routine policy implementation. So they seek to change the nature of their bureau, maximizing its core budget and hiving off responsibilities for implementing policies to separate agencies that they will deal with at one remove. He calls this bureau-shaping. Applied to the remodelling of government that has occurred over the past thirty years, his bureau-shaping account has many merits. The agencification process has led to more complex chains of service delivery than was once the case. These can lead to ‘accountability conspiracies’, a form of moral hazard, as it becomes in the interest of each lower-level principal to hide their agent’s failures from their own higher-level principal. We illustrate this in Fig. 5.6, with five principal–agent relationships between different sets of actors. At the top, we have the parliament, which oversees the minister. The minister has agents in his department, and they have a contractual relationship with an agency— for example, in the UK health service, with a hospital trust. The trust runs several hospitals and the managers there have a contractual relationship with a private firm for cleaning the hospital. The hospital is dirty because the company bid too low to get the contract and can’t fulfil its terms at that price. The hospital managers are not happy, but cannot sack the firm and replace it with another without spending more money. They do not want to have to renegotiate their budget with the hospital trust after boasting about the advantageous contract they had signed with the current company. The hospital trust also knows the hospital is dirty, but tries to hide this from the Health Department officials. These public servants also suspect there is a problem with cleaning services in hospitals up and down the country, but would sooner get on top of the issue before bringing it to the attention of the minister. By hiding the extent of these problems, the minister does not have to report

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on them to parliament. This accountability conspiracy requires no secret meetings in darkened rooms, just a set of principal–agent relationships which complicate the incentive for principals to enforce their preferred behaviour on their agents. No agent is directly conspiring with another, but there are problems at the bottom and, as we go up the hierarchy, knowledge of the problems reduces and continues to be hidden from those at the very top. It is a conspiracy of silence. Such conspiracies are dealt with by oversight. In Chapter 4, we outlined three forms of oversight: ‘police patrol’, ‘fire alarm’ (McCubbins and Schwartz 1984; McCubbins et al. 1987) and ‘fire extinguisher’ (Shepsle 2010: 432). In Westminster systems, ‘police patrol’ oversight is provided by parliament’s select committees, although they lack the resources and the regularized procedures of many committees in the US Congress. We see ‘fire alarm’ oversight when constituents or the mass media bring the issue of, say, dirty hospitals to parliamentarians’ attention. MPs can then question ministers on the floor of the house at regular question time or call ministers and civil servants (including in our example health trust and hospital managers) to answer questions in committee. ‘Fire extinguisher’ oversight tends to be less utilized in parliamentary systems, certainly by the public but also corporately, since the legal system is less open to litigation unless lower-level agents are clearly breaking statutes of some kind.

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Interest Groups and Rent-Seeking One reason why public servants might advise the government to overproduce public goods or to over-regulate is because they are subject to intense pressures from interested groups or firms. Gordon Tullock (1967, 1990) argues that because government is uniquely placed to provide benefits to groups or firms, they will spend resources to secure privileges or ‘rents’. He suggests that firms would like to be able to enjoy the benefits of monopoly, charging higher prices and making bigger profits than in competitive markets, and will therefore spend money persuading government to produce regulations deterring other firms from entering the market (see also Stigler 1971; Peltzman 1976). In Fig. 5.7, once again we have the familiar downward-sloping market demand curve D we encountered in Chapter 2. For simplicity, we assume that marginal costs are constant at PC, meaning that it costs PC to produce each unit of the good, regardless of which firm is doing the producing. In perfect competition, this flat marginal cost curve will represent the supply curve and the competitive equilibrium will thus be at price PC and quantity QC. This equilibrium is Kaldor–Hicks efficient, because

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all and only those units for which marginal social benefits are at least as large as marginal social costs are produced. A lower level of production would mean that worthwhile units are not being produced and a higher level of production that units not worth the cost are being produced. As we can see, many consumers would be willing to pay far more than the competitive price for the good. The difference between the maximum a consumer would be willing to pay for a good and what they actually do pay is known as ‘consumer surplus’. In Fig. 5.7, the large triangle consisting of areas A, B and C is consumer surplus. This represents the net benefit to consumers of the good after the price they pay is taken into account. Those consumers valuing the good highly at the top of the demand curve derive a large amount of consumer surplus, while the marginal consumer at QC is indifferent between buying the good or not and thus derives no surplus. There is no producer surplus or economic profit in this competitive market, because each unit costs PC to produce and also sells for PC. Firms are just able to cover their costs (including the opportunity costs of time and resources, so they will nevertheless be making a profit in accounting terms).1 As we saw in Chapter 2, a monopolist will not charge the market price, instead charging a higher price and producing a lesser quantity in order to maximize profit. In Fig. 5.7, this is shown as price PM and quantity QM. We know that this level of output is not efficient, since it does not exhaust the possibilities for worthwhile production (where MSB ≥ MSC). We can also see this inefficiency as a loss of surplus. Under perfect competition, the large triangle A + B + C is consumer surplus, but under monopoly the price is higher and only QM is produced. The higher price reduces the consumer surplus for those units which are still produced under monopoly, but these losses are compensated by the profit earned by the monopoly firm. The rectangle B is transformed from consumer surplus to monopoly rent, and since the loss to consumers could, in theory, be fully compensated, there is no efficiency loss (or gain). High demanders of the good retain the smaller triangle of consumer surplus A. The triangle C which is consumer surplus under perfect competition, however, disappears under monopoly. The production which gave rise to this surplus no longer occurs, and the loss of C is not 1 If some units were cheaper to produce than others (resulting in an upward-sloping supply curve), we would see producer surplus under perfect competition, represented by the vertical distance between the supply curve and the market price.

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balanced by a gain to producers or anyone else. C is a deadweight loss, a net loss of social surplus indicating an inefficient outcome. This welfare loss, known as the Harberger triangle, is the standard economic reckoning of the social cost of monopoly. However, Tullock argues that many monopolies are created by government regulation and that firms will go to some effort in order to convince government to grant them this privilege. Since this will in most cases be wasteful spending which produces little or no social benefit, this spending can also be considered as part of the social cost of government-granted monopoly. Tullock argues that the rectangle of monopoly rent B will be dissipated as firms expend resources to secure government support. The full social cost is therefore the trapezoid B + C, consisting of the Harberger triangle and the Tullock rectangle. How will rent be fully dissipated? Imagine a lottery with n firms, each of which ceteris paribus has an equal chance of gaining the rent (R). Further imagine that these firms are all risk-neutral and each equally values R. The lottery is not free, and the more you spend, the better your chance of winning. Under these conditions, each firm will invest in the lottery an equal amount, xi, hoping to gain the rent R. The expected utility of winning is R/n, so xi = R/n and the total amount of rent-seeking will be nx = R. The winning firm gains the contract which, for that firm, makes the investment in entering the lottery worthwhile, but the industry as a whole has spent on the lottery an amount equivalent to the entire rent. These arguments are somewhat simplistic, and we cannot really expect full dissipation of rents. If firms are not risk-neutral, there will be positive gain to the industry; if they are risk-averse and rents are small, then there would be a net loss. If there is equality between the firms and entering the lottery costs money, then again there should be gains to the industry. All things considered though, there is inefficiency in the rent-seeking activity. In offering special privileges, government encourages wasteful spending by firms seeking to secure that privilege.

Policy-Seeking Bureaucrats Most of the literature on policy drift examines presidential systems, where there are several actors with different preferences—in the USA, for example, the president, the median voter in the Senate, the median voter in the House of Representatives and the agency. Many models show how

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the agency can play off the interests of the other three political actors against each other to attain a policy which is closer to its ideal point. In an interesting article, Bertelli and Feldmann (2007) argue that government agencies are subject to pressures from advocacy groups and that presidents might make strategic appointments that are different from their own preferences, so that compromise between the advocacy groups that the agency wants to keep on its side to stop too much scrutiny from Congress will result in an outcome close to the president’s own ideal point. These sorts of models have little application in parliamentary systems, since the executive controls the bureaucracy in a top-down manner with little opportunity for bureau chiefs to play off parliamentarians against the executive (and party discipline is much greater too). In parliamentary systems, rather, the issue is one of asymmetric information. Ministers have dealt with this by bypassing senior civil servants in policy formation. When legislation is being drafted, where once in the UK everything was filtered through the permanent secretary (the most senior civil servant in the department), ministers now often deal directly with lower-level civil servants (Page 2010, 2012).

Levels of Government The underlying difference between a public bureaucracy and a firm in a competitive market in the relationship with their clients is that the former produces public goods or direct transfers and the latter produces private goods. One response to the lack of competitiveness in the public sector is to involve private firms, but if these hold monopoly contracts with the public service, the issue is not solved, and accountability conspiracies can occur. Another way of dealing with the lack of competition was proposed by Charles Tiebout (1956; see also Ostrom et al. 1961). He suggested that a system of local governments in urban areas could provide different mixes of public goods and taxes (we will term these ‘fiscal packages’). Citizens of large cities could then ‘vote with their feet’ and move to districts providing the fiscal package they desired. This would mirror the competitive market we saw in Chapter 2. Local governments would be constrained by the preferences of citizens, much as firms are constrained by the preferences of consumers. This idea has been applied more broadly than Tiebout originally intended, and extended as technical change enables different forms of provision.

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Fig. 5.8  Spatial Tiebout representation

The basic idea behind Tiebout’s model can, once more, be explained spatially. Imagine there are two public goods, say health care and education. These can be provided in different mixes and at different levels of taxation. For ease of presentation, we will assume that the tax rate is exogenously set. Say the preferences of the citizens line up as in Fig. 5.8. Here, those on the left want more money spent on health care and less on education. Those on the right want more on education and less on health care. Perhaps those on the left are older and have no children, and those on the right have children of school age. Those in the middle want a more even spread of resources. If we assume the median voter prevails in votes over these potential packages, then the fiscal package for these two public goods will be located at B2. However, we can split the nine voters in the figure into three distinct groups marked as A, B and C. If we can split the provision of the goods (and assuming no loss in economies of scale), then we can have three communities whose median voter will prevail, giving fiscal packages at A2, B2 and C2. At these points, a greater number of people will be satisfied as the fiscal package is closer to their preferred mix. If Tiebout competition can occur, then homogenous communities will develop which have similar needs and preferences over local collective goods. Just as market competition allows different firms to cater to diverse consumer tastes, Tiebout competition allows different local governments to cater to diverse fiscal preferences and results in greater allocative efficiency. It will also encourage competition between local governments to lead to greater productive efficiency in the provision of such goods. These ideas were developed by the Bloomington school associated with Vincent and Elinor Ostrom, who promoted ‘polycentricity’ (Ostrom 1972; Ostrom et al. 1988; Oakerson 1999; McGinnis 1999; Aligica 2013). The idea is that the optimum scale of production varies across different types of public good, so variation in urban areas, while apparently messy, is efficient. Having overlapping, interacting

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and competitive agencies is not inefficient, even if some of them duplicate the functions of others. Elinor Ostrom’s study of police functions in Indianapolis provided empirical justification (Ostrom 1972). A third form of competition is de-localized membership. Technical advances now mean that many goods that once needed a single provider can now be supplied by competitors. For example, electricity and telephone provision once required a single entity which owned the wires through which the service was provided. Now, one can switch providers without needing any new infrastructure. These private-sector developments could, according to some (Frey and Eichenberger 1996, 1999), provide a model of local public-good provision. A remarkable book by Alexandra Reifschneider (2006) shows that such decentralized allocation mechanisms can be efficient. Crucially, though, they depend on knife-edge factors, which include the presence of sunk costs in local public goods, a pricing policy that is clear to all and the presence of real competition—meaning multiple providers, not just three or four. Richard Feiock has also shown that, importantly, polycentric-type systems require cooperation across units as much as competition (Feiock 2004, 2009; Carr and Feiock 2004; Dowding and Feiock 2012). This does suggest that, in theory, complex systems can overcome some of the difficulties associated with principal–agent relationships. However, we have to remember that the basic problems in principal–agent relationships are hidden action and asymmetric information. Complexity tends to augment informational problems, not solve them. It is well known that, in practice, firms in competitive markets do not always present their customers with easily understandable facts about their charges, entitlements to special offers (which tend to be offered to those who are not yet clients rather than existing customers), nor with information to which consumers are entitled about the costs of switching providers. Worse, they have been known to illegally charge those who switch providers. The issue of sunk costs is an important one. Rival electricity companies can use the same transmission wires, but these have to be owned and maintained by someone. Monopoly still exists somewhere in the system. Furthermore, for some transfers, such as welfare payments, the recipient who wants a good service and might want to switch providers is not the payer. Some government department is paying, and its interests in driving down costs are not the same as those of the clients who want a first-class service. The room for an accountability conspiracy here is real.

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The same issue arises for Tiebout’s exit model. It assumes that households have good information about the fiscal packages of the local jurisdictions. John et al. (1995) show that households will take notice of fiscal packages in their moving decisions when they are clearly distinguished and advertised, but also empirically demonstrate, in another context, that these movements are too small to affect providers (Dowding and John 2012; Dowding and Mergoupis 2003). Outside of specialist provision, such as schooling, fiscal household movement is too small in relation to other factors that affect moving decisions—job location, neighbourhood amenities, shopping facilities and personal factors— to give proper market signals. Even when household moves do have an impact, the advantages of moving are at least partially capitalized into housing costs (Dowding et al. 1994). Dowding and Mergoupis (2003) also show that fiscal mobility only works within large metropolitan communities where households can learn about fiscal packages; citizen satisfaction with local services is highest (at least in the UK) in jurisdictions which are considerably bigger than the average size, suggesting larger is preferable, at least to households. James Buchanan (1965) modelled Tiebout effects as club goods. A club good is something that is excludable but jointly supplied. Specialist provision in education, health care and other facilities might indeed resolve into such club effects. A school can exclude some children, and a health centre can cater for the needs of people with specific problems. The idea is that groups such as A, B and C in Fig. 5.8 could form their own clubs. Specialist provision in education, health care and other facilities can then be efficient. Club goods are themselves subject to principal–agent problems. The issue is that the providers of the goods ought to be agents of those requiring the services. However, the providers often have the authority to decide whom to exclude. Schools can choose to exclude on the basis of merit, which might seem to be advantageous—but if educational provision is universal, some supplier must be forced to take the children other schools reject. Competition between schools, represented in league tables, has led some to try to temporarily or permanently exclude disruptive and low-performing pupils to boost their results. Similarly, with GPs receiving fixed fees for patients, there are incentives to recruit a healthy clientele and to be slow to remove deceased patients from the roll. We learn that many processes that appear to bring efficiency gains are subject to gaming.

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Another issue was pointed out by Albert Hirschman (1970; see Dowding and John 2012). Hirschman argues that making exit easier for people will mean that those most able to utilize the exit option will do so. This will then have knock-on effects for politics, reducing the effectiveness of ‘fire alarm’ accountability. The traditional means for signals to government about the desired fiscal packages for the community as a whole is through the voting system. Despite its flaws, representative democracy is a system where political parties in competition for votes set out what they see as the best fiscal package for the community as a whole. This is so at both the national and local levels. Hirschman sees voting as a ‘voice’ mechanism. He also sees that problems with provision of goods can lead people to voice their complaints directly to their providers—teachers, doctors and so on—as well as to their political representatives (‘fire alarm’ accountability). Those most able to exit from bad schools, poor health service providers, or indeed move location, are likely to be the richer and better educated, and also those who are more likely to voice (Dowding and John 2012). Exit options, according to this argument, make people less likely to exercise their voice, but they may also provide incentives for citizens to become more informed about the relevant policy issues and thus cast better votes or otherwise promote better policies. Exit options could decrease the quantity of voice, but increase its quality (Taylor 2016). A complicating factor in our discussion of the provision of public goods is redistribution. While even the very rich might have use for some public goods such as defence and law and order, they are able to provide themselves with many others. As we saw in Chapter 2, while public-good provision is a reason to collect ourselves into states, much state activity is to provide transfers—that is, to redistribute from the better off to the worse off. Universal education, health care and state pension schemes are redistributive in this manner. We also provide welfare packages which are directly redistributive. One way of attempting to provide the plurality of fiscal packages in a Tiebout or polycentric manner while enabling the state to make such transfers is through fiscal federalism. The idea behind fiscal federalism is one shared with polycentrism: the belief that different sorts of goods and services are most efficiently provided by different levels of government. The difference is that fiscal federalism envisages a series of tiers of government, rather than many competing and overlapping governments. In that sense, it is a more rationalized system of government (though we can mix the two, and have

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tiers of government with lower tiers overlapping). An important aspect of fiscal federalism is how transfer payments or grants will be directed by upper tiers across lower tiers. It envisages both local and national taxation, with local taxation directed at providing services and national taxation providing transfers from richer to poorer regions and jurisdictions (Oates 1972, 1977; Brennan and Buchanan 1980; King 1984; Persson and Tabellini 1996). Transfers from higher to lower tiers can come in the form of unconditional grants allowing local governments to spend money as they wish, or of matching grants which are given to the lower tiers to spend on specific items. Higher-tier governments tend to use matching grants when they want to direct lower-tier governments into specific areas. They give the lower-tier governments less discretion. In fact, matching grants depart from the idea underlying fiscal federalism, which is that the tiers can provide goods and services which meet local demands. We graph this in Figs. 5.9 and 5.10. In Fig. 5.9, a budget constraint BB would lead, in the absence of a grant, to public-good expenditure and provision at G0. This expenditure would, of course, come from local taxation, leaving the public with private expenditure at X0. The matching grant assumes local expenditure remains the same, so the money from the higher-tier government

Public Expenditure

B′

GMG

B

I2

G0

I1

X0

Fig. 5.9  Matching grants

B

Private Expenditure

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Public Expenditure

B′

B

G UG G0

I2 I1

X0

X UG

B

B′

Private Expenditure

Fig. 5.10  Unconditional grants

produces a higher budget constraint at B´B and puts the public on a higher indifference curve, with total public-good expenditure and provision at GMG. The matching grant allows higher expenditure on a higher indifference curve, and thus a greater benefit to the public. In fact, of course, the grant has to be paid for, so the public does contribute and that will affect private expenditure; but we are assuming that if the grant was not directed to the lower-tier government, the higher-tier government would spend it elsewhere and the tax rate would be unaffected. Otherwise, it might be due to fiscal illusion (see below). Figure 5.10 shows the situation with an unconditional grant. Again, we see a higher level of provision of the public good on a higher indifference curve. However, the unconditional nature of the grant allows a higher level of private expenditure, as the local government can reduce the amount it spends while providing a higher amount of the public good (higher spending overall) and still leaving the public on a higher indifference curve. This gives local government more control over what it spends to match what its citizens want. However, it has been suggested that in fact local governments spend more on a public good than they would otherwise do, despite the unconditional nature of the grant (Courant et al. 1979). That is, with a grant, a local government spends

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more overall on the public good than it would if the same amount of money came to the community in the form of private income. Known as the ‘flypaper effect’ (Gramlich 1977; Hines and Thaler 1995)—the analogy being that money sticks to what it hits—this is thought to arise since governments find it harder to raise taxes than not to cut them. Oates (1979) explains the flypaper effect by the idea of fiscal illusion. Voters do not clearly see the relationship between the tax they pay and the benefits of that tax. They might have an idea of the average tax rate—what their taxes cost them—but not a clear idea of how they benefit. If a local government provides a service, they make judgements based on the taxes that level of government charges given the benefits they receive; but they do not factor grants from a higher-tier government into their attitude to the tax they pay to that higher tier. Their judgements there are founded solely on their overall tax rate. (For a critique, see Becker 1996.)

Conclusions Chapter 4 introduced principal–agent problems and applied them to the relationship between prime ministers and their ministers and looked at the incentives that governments have to give more or less discretion to their public servants. This chapter extends the application of principal– agent model to public bureaus. The most famous example of such an analysis is Niskanen’s budget-maximizing model. This model is problematic in application but has some application in the Romer and Rosenthal setter model. We can multiply the effects of moral hazard through levels of government where the incentives of contracting-out encourage accountability conspiracies where principals lose the incentive to punish recalcitrant agents lest their own principals discover the failure in those lower-order contracts. The Tiebout and polycentric arguments of the Ostroms suggest that competition between sets of agents might be able to reduce these informational asymmetries and provide more efficient output for some types of public good. However, there are still issues with levels of government where higher levels that enjoy greater tax-raising powers provide grants to lower-level agents. Fiscal federalism seems to be a clear idea with regard to efficiently sorting levels of government and government provision, but changing economic conditions and the fact that governments at different levels face different electorates and have differing incentives creates problems for efficiency and equity.

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References Aligica, P. D. (2013). Institutional diversity and political economy: The Ostroms and beyond. New York: Oxford University Press. Becker, E. (1996). The illusion of fiscal illusion: Unsticking the flypaper effect. Public Choice, 86, 85–102. Bertelli, A. M., & Feldmann, S. E. (2007). Strategic appointments. Journal of Public Administration Research and Theory, 17, 19–38. Brennan, G., & Buchanan, J. M. (1980). The power to tax: Analytical foundations of a fiscal constitution. Cambridge: Cambridge University Press. Buchanan, J. M. (1965). An economic theory of clubs. Economica, 32, 1–14. Carr, J. B., & Feiock, R. C. (2004). City-county consolidation and its alternatives. Armonk, NY: M. E. Sharpe. Courant, P. N., Gramlich, E. M., & Rubinfeld, D. L. (1979). The stimulative effects of intergovernmental grants or why money sticks where it hits. In P. Mieszkowski & W. H. Oakland (Eds.), Fiscal federalism and grants-in-aid. Washington, DC: Urban Institute. Dowding, K., & Feiock, R. C. (2012). Intra-local competition and cooperation. In K. Mossberger, K. E. Clarke, & P. John (Eds.), Oxford handbook of urban politics (pp. 29–50). Oxford: Oxford University Press. Dowding, K., & John, P. (2012). Exits, voices and social investment: Citizens’ reactions to public services. Cambridge: Cambridge University Press. Dowding, K., John, P., & Biggs, S. (1994). Tiebout: A survey of the empirical literature. Urban Studies, 31, 767–797. Dowding, K., & Mergoupis, T. (2003). Fragmentation, fiscal mobility and efficiency. Journal of Politics, 65, 1190–1207. Dunleavy, P. (1985). Bureaucrats, budgets and the growth of the state: Reconstructing an instrumental model. British Journal of Political Science, 15, 299–328. Dunleavy, P. (1991). Democracy, bureaucracy and public choice. Hemel Hempstead: Harvester Wheatsheaf. Feiock, R. C. (Ed.). (2004). Metropolitan governance: Conflict, competition, and cooperation. Washington, DC: Georgetown University Press. Feiock, R. C. (2009). Metropolitan governance and collective action. Urban Affairs Review, 44, 356–377. Frey, B. S., & Eichenberger, R. (1996). FOCJ: Competitive governments for Europe. International Review of Law and Economics, 16, 315–327. Frey, B. S., & Eichenberger, R. (1999). The new democratic federalism for Europe: Functional, overlapping and competing jurisdictions. Cheltenham: Edward Elgar.

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Gramlich, E. M. (1977). A review of the theory of intergovernmental grants. In W. E. Oates (Ed.), The political economy of fiscal federalism. Lexington: Lexington Books. Hines, J. H., & Thaler, R. H. (1995). Anomalies: The flypaper effect. Journal of Economic Perspectives, 9, 217–226. Hirschman, A. O. (1970). Exit, voice and loyalty: Responses to decline in firms, organizations and states. Cambridge, MA: Harvard University Press. John, P., Dowding, K., & Biggs, S. (1995). Residential mobility in London: A micro-level test of the behavioural assumptions of the Tiebout model. British Journal of Political Science, 25, 379–397. King, D. (1984). Fiscal tiers: The economics of multi-level government. London: George Allen & Unwin. McCubbins, M., Noll, R., & Weingast, B. R. (1987). Administrative procedures as instruments of political control. Journal of Law Economics and Organization, 3, 177–243. McCubbins, M., & Schwartz, T. (1984). Congressional oversight overlooked: Police patrols versus fire alarms. American Journal of Political Science, 28, 165–179. McGinnis, M. D. (1999). Polycentricity and local public economies: Readings from the workshop in political theory and policy analysis. Ann Arbor: Michigan University Press. Migue, J.-L., & Belanger, G. (1974). Towards a general theory of managerial discretion. Public Choice, 17, 27–43. Niskanen, W. A. (1971). Bureaucracy and representative government. Chicago: Aldine Press. Niskanen, W. A. (1994). Bureaucracy and public economics. Aldershot: Edward Elgar. Oakerson, R. J. (1999). Governing local public economies: Creating the civic metropolis. Oakland, CA: ICS Press. Oates, W. E. (1972). Fiscal federalism. New York: Harcourt Brace. Oates, W. E. (1977). The political economy of fiscal federalism. Lexington: Lexington Books. Oates, W. E. (1979). Lump-sum grants have price effects. In P. Mieszkowski & W. H. Oakland (Eds.), Fiscal federalism and grants-in-aid. Washington, DC: Urban Institute. Ostrom, E. (1972). Metropolitan reform: Propositions derived from two traditions. Social Science Quarterly, 53, 475–493. Ostrom, V., Bish, R., & Ostrom, E. (1988). Local government in the United States. San Francisco: ICS Press. Ostrom, V., Tiebout, C. M., & Warren, R. (1961). The organisation of government in metropolitan areas—A theoretical enquiry. American Political Science Review, 55, 831–842.

118  K. DOWDING AND B. R. TAYLOR Page, E. C. (2010). Has the Whitehall model survived? International Review of Administrative Sciences, 73, 407–423. Page, E. C. (2012). Policy without politicians: Bureaucratic influence in comparative perspective. Oxford: Oxford University Press. Peltzman, S. (1976). Toward a more general theory of regulation. Journal of Law and Economics, 29, 211–240. Persson, T., & Tabellini, G. (1996). Fiscal federal constitutions: Risk sharing and redistribution. Journal of Political Economy, 104, 979–1009. Reifschneider, A. P. (2006). Competition in the provision of local public goods. Cheltenham: Edward Elgar. Romer, T., & Rosenthal, H. (1979). Bureaucrats versus voters: On the political economy of resource allocation by direct democracy. Quarterly Journal of Economics, 93, 563–587. Shepsle, K. A. (2010). Analyzing politics: Rationality, behavior, and institutions (2nd ed.). New York: W. W. Norton. Stigler, G. J. (1971). The theory of economic regulation. Bell Journal of Economics and Management Science, 2, 3–21. Taylor, B. R. (2016). Exit and the epistemic quality of voice. Economic Affairs, 36, 133–144. Tiebout, C. M. (1956). A pure theory of local expenditures. Journal of Political Economy, 64, 416–424. Tullock, G. (1967). The welfare costs of tariffs, monopolies and theft. Western Economic Journal, 5, 224–232. Tullock, G. (1990). The costs of special privilege. In J. E. Alt & K. A. Shepsle (Eds.), Perspectives on positive political economy. Cambridge: Cambridge University Press.

CHAPTER 6

Conclusion

Abstract  This concluding chapter brings together the major lessons of the book to consider some major criticisms of economics as a discipline and its application to government. Although such criticisms are not without merit, the economic method remains a useful tool for the positive and normative analysis of government. Keywords  Critique of economics · Political bias economics · Populism · Democracy

· Abstractness of

Economics and Government This short book offers an insight into how the economic approach offers perspectives on the foundations of government and public administration. It is by no means a comprehensive account of what the economic approach offers to the study of politics and public administration. We have covered only a few aspects of government activity. In Chapter 2, we looked at the standard normative approach to analysing markets and government intervention therein. In Chapter 3, we considered the findings of behavioural economics and examined the implication of these for public policy. Chapters 4 and 5 examined government activity more directly and illustrated how the economic approach can illuminate various government activities. Chapter 4 briefly explained Arrow’s © The Author(s) 2020 K. Dowding and B. R. Taylor, Economic Perspectives on Government, Foundations of Government and Public Administration, https://doi.org/10.1007/978-3-030-19707-0_6

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theorem and then described one of the workhorse models of political economics: the principal–agent model. Chapter 5 examined the relationships between politicians, bureaucrats, interest groups and levels of government. There is, of course, much we have left out. When considering the role of government, we passed over macroeconomic issues (the operation of economies as a whole, including issues of inflation, unemployment and economic growth) in order to focus on the microeconomic analysis of individual and corporate choice and its aggregation to the level of individual markets. Large areas of government action are focused on macroeconomic variables, and a full accounting of the interface between economics and government would need to spend a great deal of time on this. This omission reflects the interests and expertise of the authors, as well as a reluctance to spread the analysis too thinly. The assumptions and tools of macroeconomics are quite different from those of the microeconomic models we have considered in this book and require a good deal of more technical elaboration. Our analysis of public choice theory has been framed around the operation of government itself at the expense of other political processes and actors. For example, we have not considered the choices facing voters. On simple rational choice grounds, it is rather puzzling that people choose to vote at all (Dowding 2005). Voters do not choose candidates like consumers choose products; voting one way or another has only the slightest chance of altering the outcome of an election, but takes scarce time and energy. Significant numbers of people do vote, however, and the explanation of why they vote has implications for how they vote. If voters are motivated mainly by a desire to express values or group allegiance rather than instrumentally bringing about certain policy outcomes, for example, the implications for electoral competition are profound (Brennan and Lomasky 1993). The low chance of individual pivotality in an election may also prompt voters to remain ‘rationally ignorant’, and this in turn might give politicians and bureaucrats greater scope to pursue their own interests or pander to special interests (see Hindmoor and Taylor 2015: Ch. 8, for an overview of the rational choice literature on voter choice). We have also focused largely on the mainstream ‘neoclassical’ version of economics and paid scant attention to heterodox approaches, with the major exception of behavioural economics in Chapter 3. Although neoclassical economics is undoubtedly the dominant approach, interesting

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and important work is being done in a variety of heterodox schools of thought. For example, Austrian and evolutionary economists eschew the optimizing equilibrium approach and instead view the market as an open-ended process of entrepreneurial discovery and innovation (Boettke et al. 1986; Buchanan and Vanberg 1991; Potts 2001). We saw such arguments briefly in Chapter 2 when considering the dynamic nature of competition, but we have otherwise restricted our attention to orthodox and behavioural economics. Despite these omissions, we hope to have convinced you that the tools of economic analysis are useful to both the administration and the rigorous study of government. There are, of course, many critiques of economics as a discipline and its application to government. We will now briefly consider two of these: the claim that economics is inherently biased towards free-market policies and the claim that the unrealism of its assumptions renders it worthless as a guide to reality. Such criticisms come from outside economics as well as from heterodox members of the profession.

Is Economics Politically Biased? As we saw in Chapter 2, economists spend a lot of time thinking about markets and generally view them favourably. Some critics have taken this as a sign of right-wing bias in the very foundations of the approach. Peter Self (1993, 2000), for example, sees economics and public choice theory as promoting ‘market dogmas’ which have been used to justify extensive, and undesirable, free-market reforms. First, it must be noted that the efficiency of markets is a finding of economics rather than an assumption. Economists do not simply assume that the invisible hand of the market channels self-interest towards generally beneficial ends, but have drawn this conclusion from theoretical analysis and empirical observation. If we reach free-market conclusions, the appropriate interpretation may be, to paraphrase Stephen Colbert, that reality has a free-market bias. This analysis is grounded in the basic assumptions of rational choice theory and welfare economics, however, and observation is always theory-laden. If the assumptions are inappropriate, the normative conclusions of economics will be suspect. Before examining these assumptions, however, we must make sure not to overstate the extent to which economic analysis prescribes freemarket institutions. Economists generally see markets as an efficient way

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of distributing resources, but most also recognize an important role for government in setting the conditions which enable efficient markets to emerge. In even the most free-market economies in the real world, the property rights and contract law which enable voluntary exchange are defined and enforced by government. Although it is possible that law and order could be provided in a pure market economy (Friedman 1989; Stringham 2015), most economists endorse the view of Polanyi (1944) that competitive markets are not a free-floating entity but rather built on the foundation provided by government. We saw in Chapter 1 that rational choice theory, considered narrowly, is simply a framework for studying human behaviour. The preferences of individuals are not given any particular normative status; they are simply a representation of behaviour and there is no moral or political imperative to satisfy them. The methods of welfare economics considered in Chapter 2, on the other hand, do give preferences normative significance. It is here that we find arguments that competitive markets maximize the satisfaction of preferences. The first theorem of welfare economics shows that competitive markets cannot be unambiguously improved upon in Pareto terms. That is, if the market is in competitive equilibrium, any move away from this equilibrium that benefits one person must necessarily harm another. If we take the Kaldor–Hicks or potential Pareto conception of efficiency, we get the stronger result that competitive equilibrium maximizes welfare and that the harms of moving away from equilibrium must exceed the benefits in terms of preference satisfaction. These certainly sound like bold defences of the market, and for many economists they are. It needs to be emphasized, however, that no serious economist believes that assumptions of perfect competition accurately represent most markets, and very few believe most markets come anywhere close to this ideal. The presence of externalities, public goods, market power and information problems means that markets in the real world are not always efficient. Economic theory tells us that violation of one or more of the assumptions of perfect competition introduces the possibility of market failure, an equilibrium which can be improved upon in Pareto or Kaldor–Hicks terms by appropriate government action. Economists spend a good deal of their time identifying market failures and prescribing government remedies in the form of taxes, subsidies, regulation or government provision. Such analysis of market failure and

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the corrective role of government also takes a prominent place in most introductory economics textbooks and university courses. Violation of the assumptions of perfect competition does not guarantee market failure, however, as we showed in Chapter 2 with the analysis of inframarginal externalities. This is an important point, since the assumptions are extremely strong and implausible as a description of most real-world markets. Small deviations from perfect information or perfectly private goods will not normally be a cause for concern on efficiency grounds, but larger deviations will. Moreover, as we will emphasize shortly, the existence of a market failure does not imply that effective government correction is feasible. Economics textbooks, however, tend to ignore these complications and suggest more straightforwardly that deviations from perfect competition justify government intervention. Free-market economists have taken this to demonstrate something of an anti-market or pro-government bias on the part of their colleagues (McClure and Watts 2016). Many people believe that the state should go beyond this narrow role of setting the conditions for and correcting the failings of competitive markets; it should promote broader conceptions of social welfare, including access to basic goods such as education and redistributing resources in the name of fairness. Those claims are not part of the economic justification for the state and, indeed, go beyond efficiency arguments, but nor are they in conflict with economic method. We have not considered issues of distributional justice in this book, but important work in this area by economists such as Thomas Piketty (2014) and Joseph Stiglitz (2012) shows that the economic method has much to offer here. It is inaccurate to say that economists are in general opposed to government intervention, but they are in general suspicious of particular kinds of intervention, such as price controls. Economics tells us that prices emerge from the interaction of supply and demand. Any attempt to alter them by decree without changing their determinants will prevent the market from reaching equilibrium, resulting in shortages or surpluses. But even here economists are willing to make exceptions, with many endorsing minimum-wage legislation as a corrective to employer power, despite the possibility of unemployment effects (that is, a surplus of labour resulting from a price above the market-clearing level). Economists show greater unity in their opposition to protectionist policies. Since Adam Smith, they have recognized that the benefits

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of markets increase with size. A global market allows greater specialization and gains from trade than a series of isolated national economies, and economists tend to insist that direct redistribution is the best way of addressing issues of distributional justice (on economists’ policy views, see Klein and Stern 2007). We think it is fair to say that economists have a generally favourable view of markets as a mechanism for allocating resources, but this by no means implies that economists are in favour of unregulated markets. Economics in general can plausibly be described as pro-market and opposed to central planning, but not as anti-government within the narrower range of democratic capitalist institutions and policies. Public choice theory, however, might seem on the face of things to be more anti-government. The Virginia school, led by Buchanan and Tullock in particular, has defined itself in opposition to the benevolent despot model of government and emphasized the existence of government failure. Buchanan (1984) describes public choice theory as ­‘politics without romance’—that is, without the presumption that politicians and bureaucrats are perfectly willing and able to rationally pursue the democratic will of the people. Moreover, Arrow’s theorem shows (see Chapter 4) that a neutral aggregation of individual preferences into collective choices runs into problems and the choice of democratic institutions will often strongly influence the decisions eventually reached. Insofar as public choice theory draws attention to the difficulties of preference aggregation and the possibility of government failure, it is a useful reminder that government is imperfect. If government were omnipotent and infallible, we would presumably want it to do a lot more than it currently does. Governments, like markets, clearly operate imperfectly and it is not a sign of political bias to admit this (Demsetz 1969). Public choice scholars may in fact tend to exaggerate the degree of government failure relative to market failure, but this is not inherent to the approach itself (Dowding and Hindmoor 1997: 451–458). One way in which Virginia school public choice theorists have in fact stacked the deck in favour of markets and the status quo is in their emphasis on unanimous consent as a normative standard (Dowding and Hindmoor 1997: 458–460). This is related to the concept of Pareto efficiency introduced in Chapter 2. A situation is Pareto optimal if there is no way to benefit anyone without harming someone else. Pareto optimality thus requires only that there is no change that every single individual either prefers or is indifferent to. A change is only

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justified as a Pareto improvement if it benefits at least one person and harms nobody; in the real world, of course, few genuine Pareto improvements are left on the table after individuals are allowed to trade with one another. This means that changes to the status quo, or whatever hypothetical scenario we use as a benchmark, can very seldom be justified on Pareto grounds. Saying that a change is not justified is not the same as saying that the status quo is justified, however. When an intervention would benefit some and harm others, the alternatives are simply not comparable on Pareto grounds. James Buchanan, in particular, is interested in examining what sort of government can be justified on Pareto grounds from the starting point of anarchy, and he finds support for only a rather limited one (see Buchanan 1975; Kliemt 2004; Hindmoor and Taylor 2015: Ch. 2). If Buchanan’s analysis is correct, then we can conclude on Pareto grounds that the minimal state is superior to anarchy, but not that the minimal state is superior to a more extensive state. The latter claim requires much stronger liberal individualist commitments. In fact, Buchanan and many other Virginia school public choice theorists seem to hold such views, but these are by no means part of public choice theory proper.

Has Economics Become Detached from Reality? Many critics accuse economists of making unrealistic assumptions. Simply pointing out that the assumptions are unrealistic is not compelling, however, since all meaningful analysis involves making assumptions in order to simplify reality. The social world is just too complex for us to understand in its entirety. To get any traction, we have no option but to leave some things out of our account and focus on simplified versions of others. The question is whether the assumptions we make assist our ability to explain and predict real-world phenomena. We cannot reasonably expect economics to explain everything in the social world, of course. Economics concerns itself with ends-driven behaviour and its aspirations are to explain such behaviour. We humans do pursue various ends, but habit, social pressure and psychology also influence our behaviour. The latter influences mask and interact with the former, but they do not remove goal-directed behaviour altogether. Economics, we contend, helps us understand the goal-directed aspects of human behaviour. As we saw in Chapter 3, behavioural economists have conclusively found that humans do not behave exactly as rational choice theory

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assumes they must. The problem is not simply that people make avoidable mistakes, but rather that framing effects can produce violations of the reflexivity and transitivity conditions of rational choice. Grether and Plott (1979: 623) state the problem starkly when they argue that preference reversals suggest that ‘no optimization principles of any sort lie behind the simplest of human choices and that the uniformities in human choice behavior … may result from principles which are of a completely different sort from those generally accepted’. It must be emphasized here that the findings of behavioural economics are now generally accepted in the profession, as evidenced by Nobel Prize winners, publications in leading journals and chairs at top universities. Behavioural economics is by no means on the academic fringe, but its insights have been integrated into mainstream economic analysis only selectively. The core of the economic approach remains grounded in rational choice theory and this is in tension with the findings of behavioural economics. Accepting that real humans do not in general have well-formed preferences need not rob the rational choice approach of all value, however. One line of response is best articulated by Elinor Ostrom (2010), when she suggests that calculative rational choice should be seen as a limiting case which is approximated when people face strong incentives and have strong opportunities to learn from feedback. In such environments, behaviour will be consistent with rational choice theory; but with weaker incentives or inadequate feedback, framing effects are likely to have a larger impact (see also Smith 2008). Economic theory can also help us identify the conditions under which humans will deviate from instrumental rationality. The literature on voting choice mentioned above, for example, was the result of public choice theorists looking at the strange characteristics of the voting decision and thinking through its implications in rational choice terms. In arguing that people vote in order to express their values or allegiances (Brennan and Lomasky 1993), or to indulge their biases (Caplan 2007), economists have rejected the idea of an instrumental choice among rival candidates while retaining a broader rational choice model of human motivation. We can then compare the situation facing voters to that facing interest groups or politicians. Since these actors experience strong incentives, we expect them to behave in a more instrumental manner. We also saw in Chapter 3 that behavioural economics provides justification for state activity beyond that offered by standard economic theory. If individuals make different choices depending upon how their

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choice situation is framed, then framing in welfare-enhancing ways can bring overall social benefit. Making pension-plans ‘opt-out’ rather than ‘opt-in’ increases the numbers of people in a pension plan and is less coercive than making such plans compulsory (Thaler and Sunstein 2008). If we see people as guided by irrational impulses, however, there is no obvious reason on welfare grounds to limit paternalistic interventions to those involving minimal coercion. If people choose badly, coercing them into choosing well can make them better off (Conly 2013). Those accepting liberal values for other reasons will not find this convincing, of course, and we must remain aware that those designing paternalist policies are also humans subject to bias. William H. Riker (1982) interprets Arrow’s theorem as ruling out the populist conception of democracy in which elected rulers are tasked with faithfully executing the will of the people. This is impossible, since a coherent collective will does not exist. Democratic institutions remain valuable, however, insofar as they allow citizens to control politicians. Although we cannot neatly aggregate preferences into a definite social choice, citizens are in virtually unanimous agreement that tyranny and kleptocracy are undesirable. Electoral competition thus constrains the power of rulers. A similar point can be made about the value of individual choice. Even if our choices are routinely manipulated by frames and our preferences thus violate the conditions of reflexivity and transitivity, it remains the case that most of us would not under any frame voluntarily choose slavery over freedom or suffering over happiness. If you enjoy tea but hate the taste of coffee, you will refuse to knowingly order coffee for yourself regardless of the frame. Even if individual choice does not guarantee we land on the uniquely best option, it allows us to avoid particularly bad ones. The mainstream approach does not explain everything, but nor does it explain nothing. By focusing our attention on instrumental rationality under conditions of scarcity, economics provides useful predictions of some events and insight into social processes more generally. The profession of economics has slowly integrated insights from heterodox approaches, and criticisms of a behavioural unrealism and a focus on static equilibrium are no longer as cogent as they once were (Colander et al. 2004). Similarly, the evaluative tools of welfare economics are useful in thinking about welfare as long as we keep the axiological assumptions underpinning efficiency concepts in mind as we move from theory to evaluation to policy prescription.

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References Boettke, P. J., Horwitz, S., & Prychitko, D. L. (1986). Beyond equilibrium economics: Reflections on the uniqueness of the Austrian tradition. Market Process, 4, 6–25. Brennan, G., & Lomasky, L. E. (1993). Democracy and decision: The pure theory of electoral preference. Cambridge: Cambridge University Press. Buchanan, J. M. (1975). The limits of liberty: Between anarchy and Leviathan. Chicago: University of Chicago Press. Buchanan, J. M. (1984). Politics without romance: A sketch of positive public choice theory and its normative implications. In J. M. Buchanan & R. D. Tollison (Eds.), The theory of public choice II (pp. 11–22). Ann Arbor: University of Michigan Press. Buchanan, J. M., & Vanberg, V. (1991). The market as a creative process. Economics and Philosophy, 7, 167–186. Caplan, B. (2007). The myth of the rational voter. Princeton: Princeton University Press. Colander, D., Holt, R., & Rosser, B. (2004). The changing face of mainstream economics. Review of Political Economy, 16, 485–499. Conly, S. (2013). Against autonomy: Justifying coercive paternalism. Cambridge: Cambridge University Press. Demsetz, H. (1969). Information and efficiency: Another viewpoint. Journal of Law and Economics, 12, 1–22. Dowding, K. (2005). Is it rational to vote? Five types of answer and a suggestion. British Journal of Politics and International Relations, 7, 442–459. Dowding, K., & Hindmoor, A. (1997). The usual suspects: Rational choice, socialism and political theory. New Political Economy, 2, 451–463. Friedman, D. D. (1989). The machinery of freedom: Guide to a radical capitalism (2nd ed.). La Salle: Open Court Publishing. Grether, D. M., & Plott, C. R. (1979). Economic theory of choice and the preference reversal phenomenon. American Economic Review, 69, 623–638. Hindmoor, A. M., & Taylor, B. R. (2015). Rational choice (2nd ed.). Basingstoke: Palgrave Macmillan. Klein, D. B., & Stern, C. (2007). Is there a free-market economist in the house? The policy views of American Economic Association members. American Journal of Economics and Sociology, 66, 309–334. Kliemt, H. (2004). Contractarianism as liberal conservatism: Buchanan’s unfinished philosophical agenda. Constitutional Political Economy, 15, 171–185. McClure, J., & Watts, T. (2016). The greatest externality story (n)ever told. American Economist, 61, 157–177. Ostrom, E. (2010). Beyond markets and states: Polycentric governance of complex economic systems. American Economic Review, 100, 641–672.

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Piketty, T. (2014). Capital in the twenty-first century. Cambridge, MA: Harvard University Press. Polanyi, K. (1944). The great transformation. New York: Farrar & Rhinehart. Potts, J. (2001). Knowledge and markets. Journal of Evolutionary Economics, 11, 413–431. Riker, W. H. (1982). Liberalism against populism: A confrontation between the theory of democracy and the theory of social choice. San Francisco: W. H. Freeman. Self, P. (1993). Government by the market? The politics of public choice. London: Macmillan. Self, P. (2000). Rolling back the market: Economic dogma and political choice. London: Macmillan. Smith, V. L. (2008). Rationality in economics: Constructivist and ecological forms. Cambridge: Cambridge University Press. Stiglitz, J. E. (2012). The price of inequality: How today’s divided society endangers our future. New York: W. W. Norton. Stringham, E. P. (2015). Private governance: Creating order in economic and social life. New York: Oxford University Press. Thaler, R. H., & Sunstein, C. R. (2008). Nudge: Improving decisions about health, wealth, and happiness. New Haven: Yale University Press.

Index

A Accountability, 74, 112 Accountability conspiracies, 103, 104, 108, 110, 115 Adverse selection, 40, 73, 74, 77–79, 87, 88, 95, 96 Agenda-setting, 77, 80, 83 Arrow, Kenneth, 10, 70, 71, 76, 91 Arrow’s Impossibility Theorem, 70 “Asian disease problem, the”, 51 Assumptions of perfect competition model, 23, 39 rationality, 2, 3, 5, 6, 48, 52 realism of, 125–127 stated and unstated, 5, 6 Austrian economics, 121 B Baby bonus, 8 Bargaining power, 42, 86 Becker, Gary, 1, 11

Beekeepers, 34, 35 Behavioural economics, 7, 12, 43, 48, 56, 61, 64, 65, 119–121, 126 Benevolent despot assumption, 43, 44 Black, Duncan, 10 Blair, Tony, 82, 86 Bloomington school, 11, 109 Brennan, Geoffrey, 11, 113, 120, 126 Buchanan, James M., 10, 11, 31, 32, 111, 113, 121, 124, 125 Budget constraint, 99, 100, 113, 114 Budget maximising bureaucracy, 96, 102, 103 Bureau-shaping, 103 C Cabinet, 13, 56, 70, 72, 77–87 Cabinet committee, 72, 82, 85, 86, 99 Cabinet Median (CM), 83–85, 87 Calorie labels, 60 Cameron, David, 86 Cardinal utility, 3

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG, part of Springer Nature 2020 K. Dowding and B. R. Taylor, Economic Perspectives on Government, Foundations of Government and Public Administration, https://doi.org/10.1007/978-3-030-19707-0

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132  Index Chicago school, 11 Choice architecture, 57, 60 Civil service, 13, 87–89, 95–98, 108 Climate change, 34 Club goods, 111 Coalition government, 74 Coase, Ronald, 32–35 Coase theorem, 33 Colbert, Stephen, 121 Comparative institutional analysis, 17 Competition as a discovery mechanism, 39 imperfect competition, 37, 43 perfect competition, 21, 25, 27, 36, 37, 39, 41, 43, 44, 105, 106, 122, 123 Tiebout, 13, 109 Competitive equilibrium, 24–26, 105, 122 Completeness, 3, 70 Condorcet cycle, 71, 72 Condorcet, Marquis de, 10, 71 Constitutional political economy, 10, 11 Consumer surplus, 106 Continuity, 3, 6 D Deadweight loss, 39, 107 De Borda, Jean-Charles, 10 Default options, 56–59 Demand curve, 22–24, 36, 37, 39, 97, 98, 105, 106 Demsetz, Harold, 43, 124 Disclosure laws, 60 Downs, Anthony, 10 Dual process theory, 48 Dunleavy, Patrick, 101–103 E Efficiency, 13, 25, 34, 36, 37, 39, 42, 106, 109, 111, 115, 121, 123, 127

efficiency, Kaldor-Hicks, 21, 24, 26, 27, 33, 105, 122 efficiency, Pareto, 4, 11, 18–21, 25–27, 31, 122, 124, 125 Electronic Gaming Machines (EGMs), 59, 60 Evolutionary economics, 121 Externalities inframarginal, 31, 32, 123 negative, 21, 27, 28, 31–33, 35, 37, 43 pecuniary, 31 positive, 21, 30, 31, 34, 35 reciprocal nature of, 32 F Federalism, 11 First fundamental theorem of welfare economics, 20 Fiscal federalism, 11, 13, 112, 113, 115 Fiscal illusion, 114, 115 Flypaper effect, 115 Framing, 7, 51, 52, 56, 65, 126, 127 Fruit growers, 35 G Give More Tomorrow, 59 Government failure, 43, 124 H Harberger triangle, 107 Hayek, F.A., 39, 41 Heseltine, Michael, 82 Heterodox economics, 2, 6, 48 Heuristics anchoring and adjustment, 49, 50 availability heuristic, 49, 50 representativeness heuristic, 49, 50 Hicks, John R., 20, 21

Index

Hidden action, 77, 95, 110 Hirschman, Albert, 112 Hyperbolic discounting, 58 I Incentives, 7, 8, 12, 13, 23, 28, 33, 36, 39–42, 54–58, 75–77, 79, 81, 92, 99, 102, 104, 111, 112, 115, 126 Indifference, 3 indifference curves, 100, 114 Information asymmetric, 13, 40, 74, 77, 79, 85, 87, 91, 95, 108, 110 imperfect, 39, 43, 44 Interest groups, 10, 11, 120, 126 Internalities, 55, 61, 62 Interpersonal comparisons of utility, 4, 20, 21 Invisible hand, the, 121 Irrationality, 43, 63 K Kahneman, Daniel, 48–51, 58 Kaldor, Nicholas, 20, 21 Knight, Frank, 11 L Left-right dimension, 76, 83 Lichtenstein, Sarah, 53, 54 “Linda problem, the”, 49 Local government, 108, 109, 113–115 M Macroeconomics, 120 Major, John, 86 Market failure, 12, 26, 28, 31, 34–37, 40, 41, 43, 44, 63, 122–124

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May, Theresa, 91 Median voter, 83, 86, 87, 107, 109 Mill, J.S., 62 Ministers, 70, 72, 74–92, 95, 97, 103, 104, 108 Models competing and non-competing, 6 economic, 4, 54 formal and non-formal, 5, 6, 86 Monopoly, 36–38, 97, 98, 105–108, 110 Moral hazard, 76–78, 81, 88, 103, 104, 115 Munger, Michael, 42, 43 N Niskanen, William, 96–99, 101, 115 Nolan chart, 76 Nudge, 12, 56–65 Nudge unit, 56, 64 O Opportunity cost, 7, 48, 106 Organ donation, 59 Ostrom, Elinor, 11, 12, 109, 110, 126 Ostrom, Vincent, 11, 109 Oversight fire alarm, 88, 89, 104 fire extinguisher, 88, 89, 104 police patrol, 88, 104 P Pareto, Vilfredo, 18 Parliament, 70, 74, 79–81, 86, 88, 89, 95, 99, 103, 104, 108 Paternalism, coercive, 61, 64 Pigou, A.C., 27 Pigouvian subsidy, 30 Pigouvian tax, 28, 29, 34, 36 Policy shifting, 76

134  Index Political bias of economics, 121 Political bias of public choice theory, 121 Political capital, 84–86 Political parties, 4, 75, 112 Polycentricity, 11, 13, 109 Pre-commitment, 55, 59–61, 64 Prediction, scientific, 2, 4 Preference aggregation of, 72, 124, 127 Euclidian, 98 revealed, 2, 3, 9, 22 strong ordering, 2, 4, 41, 57 weak, 2 Preference reversal, 52–54, 126 Price controls, 42, 123 Price gouging, 42 Prime ministers, 72, 77–83, 85–87, 92, 115 Principal-agent problems, 76, 115 Producer surplus, 106 Public choice theory, 10, 120, 124, 125 Public goods, 4, 30, 31, 35, 96–98, 103, 105, 108–110, 112, 122 R Rational ignorance, 120 Rationality instrumental, 2, 126, 127 rationality assumptions, 2, 3, 5, 6 Redistribution, 18, 41, 42, 97, 112, 124 Reflexivity, 3, 51, 126, 127 Rent, 35, 73, 78, 80, 107 dissipation of, 107 rent, agency, 73, 74, 77, 78, 80, 88 rent, monopoly, 106, 107 Rent-seeking, 11, 13, 63, 107 Retirement saving, 57, 59, 96, 112, 127 Riker, William, 10, 127 Risk preference, 52 Rochester school, 10

Romer, Thomas, 99, 100, 115 Rosenthal, Howard, 99, 100, 115 S Save More Tomorrow, 58 Scarcity, 7, 41, 127 Self-control, 54, 58, 59, 62, 63 Self, Peter, 121 Setter model, 100, 115 Shirking, 76, 80, 88, 96, 102 Signalling, 40 Sin tax, 61 Slovic, Paul, 53, 54 Smith, Adam, 18, 123 Smoking permits, 59 Spatial models, 12, 76, 83, 91 Stigler, George, 11, 39, 48, 105 Sunk cost fallacy, 9, 110 Sunstein, Cass, 56–65, 127 Supply curve, 21, 23–25, 27, 28, 97, 105, 106 T Thaler, Richard, 54–65, 115, 127 Thatcher, Margaret, 86 Thinking at the margin, 7–9 Tiebout, Charles, 11, 13, 108, 109, 111, 112, 115 Tiebout competition, 109 Time inconsistency, 59 Time preference, 54 Tobacco use, 54, 59, 61, 63, 64 Tough-tender dimension, 76 Transaction costs, 34–36, 58 Transitivity, 3, 126, 127 Trump, Donald, 48 Tullock, Gordon, 10, 11, 99, 105, 107, 124 Tullock rectangle, 107 Tversky, Amos, 49–51 Types and tokens, 4

Index

U UK health service, 103 Unhealthy food, 61 V Virginia school, 11, 13, 124, 125 Voluntary exchange, 9, 18, 23, 42, 122 Voting, 2, 4, 10, 72, 78, 82, 87, 91, 112, 120, 126

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W Warning labels, 60 Welfare economics, 10, 11, 18–21, 25, 43, 121, 122, 127