Seat of government, the Michigan State Capitol

12 Governments and markets in a democratic society

12.1 Introduction

The Social Science 125 course at Harvard University was oversubscribed; more students had signed up for it than could be enrolled, given the 95-student limit placed on class size. Students who crowded into the lecture hall on the first day of the semester were surprised when the professor announced that admission to the course would go to the 95 highest bidders. The sums collected, he explained, would help to pay for the cost of extra materials to be circulated to students. He then asked students to write down their student ID numbers and the amount of US dollars they were willing to pay for admission to the course.

Who was this professor? Samuel Bowles, one of our authors.

‘Why should I pay to get into a class?’ one of the students asked politely. The professor replied that limiting the class size was regrettable but necessary. In the circumstances, he said, the best way to allocate the scarce places was to identify the students most willing to pay for a place.

What other methods could he have considered?

As an economist, the professor proposed to allocate places in the class in a similar manner to the way in which access to most goods and services is allocated in a capitalist economy, that is, by means of a market. Students could bid for their places. Imagine that you had been there, hoping to enrol in the class that day. Would you have accepted his logic? Most of the students did not. And when he tried the same thing in another class, some students shouted insults at him and walked out!

The professor wasn’t really going to auction places in his class to the highest bidders; his experiment was simply a first lesson in economics for the students. Nevertheless, every day school administrators, healthcare providers, managers of food banks, and many others face the problem of allocating scarce resources among individuals with differing needs. Their decisions are real.

How to allocate kidneys for transplant

Here is one of those real-life dilemmas. You must decide who will receive an organ transplant, say, a kidney:

Kidneys can be allocated using a combination of medical need and generosity. We know that many people waiting for kidney transplants die every day, because there are too few donors to save everyone who needs a transplant. So, might it be feasible to let people buy a kidney instead? If so, we can add a third option:

But letting kidneys be allocated by markets like any other good that is sold—like clothes or cars—has been criticized on the grounds that, under this arrangement, only rich people would get transplants. You might object to this system, reasoning: ‘The difference between the people who get replacement kidneys and the people who don’t, is not that one group values life more than the other; it is that only one group can afford it.’ In this case, ‘willingness to pay’ is simply ‘ability to pay’.

There is yet another way to improve the way in which kidney transplants can be organized:

A network of exactly this kind is providing replacement kidneys in the US under the New England Program for Kidney Exchange (NEPKE), which you can hear more about in our ‘Economist in action’ video featuring Alvin Roth, a Nobel Laureate in economics and former president of the American Economic Association. NEPKE is like a market in that it allows exchanges to take place among total strangers who are matched by what they need or can provide. But unlike a market, who gets what is not based on the willingness to pay. The key to getting a replacement kidney is not being wealthy enough to afford one, but instead having some friend or family member (or even a stranger) who is willing to contribute a kidney to the pool so that the person needing the replacement gets a kidney matching his type.

Markets sometimes seem to be everywhere in the economy, but this is not so.

Why are some goods and services allocated in markets, while firms, families, and governments allocate others? This is an old question, and one that is hotly debated. But the main reason is that some kinds of activities are better organized if they are regulated by the rules of the game that characterize families, or governments, or firms, instead of by markets. It is hard to see, for example, how conceiving and raising children could be effectively carried out by firms or markets. A combination of families and governments (schooling) does the job in most societies.

People disagree about the appropriate extent of the market. Some think that things that are now to some extent for sale—like sex, or influence over political decisions—should be allocated by other means. Others think that markets should take a larger role in the economy. These disagreements are about matters of fact (for example, do public schools or home schooling do a better job?) and matters of value (is the sale of sexual services or bodily organs immoral, even if these transactions are well regulated?).

In this unit, we consider why some economic activities are organized primarily by markets and some are organized in other ways, by firms, families and governments. Family is the main institution that organizes how we give birth to children and raise them in their first few years of life. In the rules of the game characteristic of families, parents teach and set limits for children, and these rules differ from the way markets determine outcomes. Similarly, as you learned in Unit 6, firms organize the process of production through a top–down structure of command, from owners to managers at various levels, down to production workers. Here, we explore how governments work, and how they interact with firms, families, markets and other institutions.

We have seen in the previous units that markets often fail to implement efficient and fair outcomes, and we have shown how governments can address market failures and unfairness. In this unit, we will also explain why governments often fail to address the problems of market failures and unfairness, and how these government failures can themselves be addressed.

In the previous unit, we explained that market failures—large and small—are the rule, not the exception, and result in Pareto-inefficient outcomes. So why do we use markets at all?

Firms, governments, and the extent of the market

In many cases, we do not use markets. The structure of our economy, taken as a whole, shows that markets are not the chosen way to organize many aspects of the production and distribution of goods and services.

If you think of the economy as a territory, as Herbert Simon’s imaginary Martians did in Unit 6, then even setting aside families, vast areas are not organized by markets.

Ronald Coase explained that, as a result, the boundaries of this divide between the firm and the market are set by the relative costs of the ‘make it’ and ‘buy it’ options. Thus, the extent of the market is determined by the firm’s decision about which components of a product to produce and which ones to buy.

His explanation underlines an important fact that is often lost in heated debates about the merits of decentralized systems of organization-like markets, as opposed to more centralized ones like governments. There are some things that centralized systems (like the firm) are better at, and others that are better handled by the market.

The beauty of this demonstration is that it is not a judgement by some, possibly biased, observer; it is the verdict of the market itself. Competition among firms ultimately punishes firms that overdo the ‘make it’ option by overextending the boundaries of the centralized system through internal expansion. And market competition equally punishes the firms that fail to take advantage of centralized decision making by overly opting for the ‘buy it’ option.

The answer is that, just as there are market failures, there are also failures of centralized and top–down organization. And there are limits too, to what families can do. Markets are important parts of all modern economies and have been important in most economies in human history.

12.2 The limits of markets: Repugnant markets and merit goods

Seeing prices as both message and motivation teaches us the following: markets work well when prices are informative about the real scarcity of goods and services, and when people can change their behaviour to take account of changes in this information. When this is the case, we have ‘the magic of the market’; when it is not the case, we have market failures.

But even when markets work well in this sense, many (probably most) people think that there are reasons to organize the production and distribution of some particular goods and services by other means.

repugnant market
Buying or selling something that people believe ought not to be exchanged on a market.
merit goods
Goods and services that should be available to everyone, independently of their ability to pay.

Repugnant markets

In most countries, there are well-established institutions that allow parents to voluntarily give up a baby for adoption, but laws typically prevent parents from selling their infants.

The research done by Alvin Roth, the economist whose video you watched when we discussed kidney transplants, has identified many of these repugnant markets.1

Why do most countries ban the buying and selling of babies? Is it not true that a market for infants would provide opportunities for mutual gains from exchange between parents wishing to sell and would-be parents wishing to buy?

Michael Walzer and Michael Sandel, two philosophers, have discussed the moral limits of markets. Some market transactions conflict with the way we value humanity, such as buying and selling people as slaves; others conflict with principles of democracy, such as allowing people to sell their votes.

Michael Sandel. 2009. Justice. London: Penguin.

Michael Walzer. 1983. Spheres of Justice: A Defense of Pluralism and Equality. New York, NY: Basic Books.

Sandel investigates the moral limits of his audience (students around the world) in a talk called ‘Why we shouldn’t trust markets with our civic life’ and in a series of videos called ‘What money can’t buy’.

A common response is that some goods and services are different from the shirts, haircuts, and other goods that we routinely buy and sell on markets. Virtually all countries ban the sale of human organs for transplant. Commercial surrogacy—a woman becoming pregnant and giving birth to a baby for another couple for pay—is not legal in most countries (although it is legal in some states in the US, Thailand, and Russia).

Some economists might reason that it is wrong to prevent these transactions if both parties engage in them voluntarily—preventing those exchanges would be Pareto inefficient. But economic reasoning of this kind does not apply to just any transaction, and most economists now recognize that not everything should be put up for sale.

democracy
A political system, that ideally gives equal political power to all citizens, defined by individual rights such as freedom of speech, assembly, and the press; fair elections in which virtually all adults are eligible to vote; and in which the government leaves office if it loses.

Regarding the final bullet point, recall (from Section 3.10) that this seems to have occurred when parents were fined for coming late to pick up their children at daycare centres in Israel (more parents picked their kids up later after the fine was imposed).

Merit goods

Economists recognize that there are some goods and services that are considered special in that they should be made available to all people, even those who lack the ability or willingness to pay for them. These are called merit goods; they are provided by governments rather than allocated by a market governed by the willingness to pay.

In most countries, primary education is provided free to all children and financed by taxation. Basic healthcare—at least emergency care—is also often available to all, irrespective of the ability to pay. The same holds for legal representation at trial in many countries—a person unable to pay for a lawyer should be assigned legal representation without charge. Personal security—protection from criminal assault or home fires, for example—is typically ensured in part by publicly provided police protection and fire-fighting services.

Why should merit goods be provided to people free of charge? People of limited income do not have access to a great many things. They typically live in substandard and often unhealthy housing and have very limited opportunities for recreational travel. Why are basic healthcare and schooling, legal representation, and police and fire protection different? The answer is that in many countries, these goods and services are considered the right of every citizen.

Exercise 12.1 Capitalism among consenting adults

Should all voluntary contractual exchanges be allowed among consenting adults?

State what you think about the following (hypothetical) exchanges. You may assume in each case that the people involved are sane, rational adults who have thought about the alternatives and consequences of what they are doing. In each case, decide whether you approve, and if you do not approve, whether you think the transaction should be prohibited. In each case explain why the transaction described produces mutual benefits (that is, it is a Pareto improvement over not allowing the exchange).

  1. A complicated medical procedure has been discovered that cures a rare form of cancer in patients who will otherwise certainly die. Staff shortages make it impossible to treat all those who could benefit, and the hospital has established a policy of first come, first served. Ben, a wealthy patient who is at the bottom of the list, offers to pay Aisha, a poor person on the top of the list, $1 million to exchange places. If Aisha dies (which is very likely), then her children will inherit the money. Aisha agrees.
  2. Melissa is 18. She has been admitted to a good university but does not have any financial aid, and cannot get any. She signs a four-year contract to be a stripper on the Internet and will begin work when she is 19. The company will pay her tuition fees.
  3. You are waiting in line to buy tickets for a movie that is almost sold out. Someone from the back of the line approaches the woman in front of you and offers her $25 to exchange positions in the line (he takes her position in front of you and she takes his at the back of the line).
  4. A politically apathetic person, who never votes, agrees to vote in an election for the candidate who pays him the highest amount.
  5. William and Elizabeth are a wealthy couple who give birth to a baby with a minor birth defect. They sell this baby to their (equally wealthy) neighbours and buy a child without any birth defects from a family that needs the money.
  6. An individual with an adequate income decides that he would like to sell himself to become the slave of another person. He finds a buyer willing to pay his asking price. The aspiring slave will use the money to further his children’s education.

12.3 The government as an economic actor

The reasons why institutions other than markets play an important part in production and distribution include market failures, the status of some goods or services as merit goods, and the morally repugnant nature of some exchanges. This helps to explain why governments are major economic actors. Government spending, taxation, laws, wars, and other activities are as much a part of economic life as the working, investment, saving, buying, and selling activities of families and firms.

When we say that governments are economic actors (as we did in calling firms economic actors), we refer to those making the key decisions—policymakers, military leaders, and top judicial authorities in a government.

In earlier units, especially the previous one, we identified many cases in which government policies could be introduced to address problems of either inefficiency or unfairness. But in Unit 3, we also showed how governments (like firms and individuals) are limited in what they can do, not only because they have limited resources to accomplish their objectives, but also because, in most economic matters, even a powerful government cannot dictate what citizens do.

The government can require that a minimum wage be paid to all workers, but it cannot require workers to work hard instead of shirking on the job. The government can require the owners of a business to pay taxes, but it cannot require them to invest in building new productive capacity instead of purchasing a second home. In many cases, the most it can do is to alter the circumstances under which people decide what to do. Here we return to the question of government policies, stressing not what governments might do to address market failures, unfairness, and other problems, but instead what they actually do and why that sometimes falls short of what we would like.

A government allows people to do things together that they could not do individually. An example is going to war. Governments also engage in activities that vastly improve living standards and the quality of life of their citizens. Examples include:

More about the economics of poverty reduction: Angus Deaton. 2013. The Great Escape: health, wealth, and the origins of inequality. Princeton: Princeton University Press.

Coercion and providing public services

Governments are actors on a scale unparalleled by families and most firms. The US government—federal, state and local—employs almost 10 times as many people as the country’s largest firm, Walmart. However, governments were not always economic actors on this large a scale. In Figure 12.1 we show the total tax revenues collected by the government of the UK as a fraction of gross domestic product—a measure of the size of the government relative to the size of the economy—over more than 500 years. The figure rises from about 3% in the period prior to 1650 to 10 times that amount after the Second World War.2 3

Even when tax revenues were only 3% of gross domestic product, the government of the UK was an immensely important actor. It is not the size of governments that make them unique, or uniquely important as actors.

Within a given territory, only a government has the authority to use force and restraints on an individual’s freedom to achieve its objectives. Because citizens generally see the use of the government’s coercive powers to maintain order, regulate the economy and deliver services as legitimate—meaning that they accept the government’s authority—most citizens comply with government-made laws. One application of government’s coercive power is the collection of taxes, which can be used to fund its operations.

government
Within a given territory, the only body that can dictate what people must do or not do, and can legitimately use force and restraints on an individual’s freedom to achieve that end. Also known as: state.

To distinguish governments from private economic actors like firms, families, individuals, trade unions, and professional organizations, we define the government as the only body in a geographical territory (the nation) that can legitimately use force and the threat of force to pursue its ends. Governments routinely do things—locking people up, for example—which, if done by a private individual, are considered wrong and illegal.

Beyond its legitimate use of coercive powers, a second feature of the government is that it has obligations to its citizens based on civil and human rights; this feature also distinguishes the government from firms and other private economic entities. To advance and protect these rights, governments use tax funds to provide services such as national defence, police protection, and schooling. These services are often available to citizens without restrictions to those who use them, and without charging a price.

The growth of government in the UK (1500–2015).

Figure 12.1 The growth of government in the UK (1500–2015).

UK Public Revenue; Patrick K. O’Brien and Philip A. Hunt. 1993. ‘The rise of a fiscal state in England, 1485–1815’. Historical Research 66 (160): pp.129–76. Note: Pax Britannica refers to the century between the end of the Napoleonic Wars and the beginning of the First World War, in which (compared to earlier or subsequent periods) Europe and most of the world was relatively peaceful, with the UK the militarily dominant nation. The Glorious Revolution deposed King James II in 1688 and increased the independent power of parliament.

People differ greatly in their income and wealth and, therefore, in the taxes they pay; however, as citizens, they are equally entitled to many government-provided services. This simple fact is at the root of many debates about the appropriate ‘size’ of the government; people with less income and wealth benefit from many government services, but people with more wealth and income pay more (in absolute terms) of the taxes that finance these services. The tax, transfer, and expenditure systems of democratic governments typically redistribute income from those with higher incomes to those with lower incomes (See Figures 5.20 and 5.21 in Unit 5).

Part of the solution

Jean Tirole, an economist who specializes in the role of intervention and regulation, describes the way that governments can intervene in his Nobel prize lecture.

Governments may adopt the twin objectives that we have used in this course:

Examples of policies commonly adopted by governments to address market failures and unfairness include:

Governments pursue these objectives by some combination of four means:

Part of the problem

To accomplish these valuable objectives, governments must have extraordinary powers to acquire information and to compel compliance. This creates a dilemma. For the government to be a successful problem solver, it must also be powerful enough to potentially be a problem itself. Examples from history, and today’s news, show governments using their monopoly on the use of force to silence opposition and to acquire huge personal wealth for their officials and leaders.

Before the French Revolution, Louis XIV of France constructed a luxurious palace and grounds for himself at the Palace of Versailles, which is now one of the top tourist attractions in the world. He was called the Sun King by his subjects and claimed, ‘L’etat, c’est moi’ (‘I am the state’). The word ‘state’ is sometimes used—as the Sun King did here—to mean ‘government in general’, distinguishing it from any particular body, such as the government of France. In neighbouring Britain, at almost the same time, William Pitt had a different view of his King, declaring that ‘The poorest man may in his cottage bid defiance to all the forces of the Crown,’ as we saw in Unit 1, Exercise 1.5.

Well-governed societies have devised ways to limit the damage that the use of government powers can inflict, without undermining the government’s capacity to solve society’s problems. These have generally included a combination of:

The second point is why Pitt could observe that, while the farmer may have difficulty keeping rain out of his cottage, he could confidently exclude the King of England.

In a capitalist economy, aside from the obligation to pay taxes, other than in exceptional circumstances, the government cannot seize what you own. This limits the government’s capacity to enrich itself at your expense. This is an essential limit on arbitrary government powers.

An example of an exceptional case would be if you owned a piece of land that was the only possible site for a bridge needed to solve a traffic problem. Most governments have the right to acquire the land at what is independently judged to be a fair price, even if you are unwilling to sell. This power to take private property for public use has many names. For example, it is known as the ‘right of eminent domain’ in the US or a ‘compulsory purchase order’ in the UK. Even with well-designed limits on government powers and provision for exceptions allowing governments to better serve the public, we will see that governments, like markets, sometimes fail.

Question 12.1 Choose the correct answer(s)

Which of the following statements are correct?

  • A government should not be able to seize private property.
  • A government should not be the monopoly supplier of a service.
  • A government should not be allowed to use force against its citizens.
  • A government should not collect information about its citizens.
  • Generally speaking, this is correct. Even in the exceptional case of ‘right of eminent domain’ (discussed in this section), the government still has to pay individuals to acquire their private property. Some individuals might regard taxation as the seizure of a certain category of private property, but it is done with the consent of the society as a whole, according to rules that society has approved; taxation is accepted as payment for services provided by the state.
  • There are some services that must be provided by a monopoly in order to ensure standardization and benefit from economies of scale. An electricity grid is one example. If a monopoly is required, it may be better that the monopolist is the state and subject to democratic control, rather than a private firm.
  • A degree of force may be legitimate, provided it is reasonable, exercised against individuals committing serious misdemeanours (terrorism, insurrection), and is exercised within a framework of rules (law) that has the prior approval of its citizens.
  • We accept that the state has to hold some information about its citizens in order to function properly. For example, in order to accurately estimate the amount of money needed for programs such as pensions for the retired or unemployment benefits, it needs to know the size of the population, gender, age, and other demographic information. For security reasons, it needs to know who is entering and leaving the country. However, the extent of this collection (and holding) of information is subject to rules approved by its citizens, and citizens may object to sharing some of their private information with the government. When the UK tax authorities announced plans to collect financial information previously considered private, this was controversial and led to some criticism.

Government failure

natural monopoly
A production process in which the long-run average cost curve is sufficiently downward-sloping to make it impossible to sustain competition among firms in this market.

To understand why neither markets nor governments may provide ideal solutions to economic problems, think about the case of a natural monopoly. An example would be the provision of tap water in a city, or electricity transmission over a national network. In these cases, as a result of economies of scale, the most efficient solution is to have a single entity provide the service. This could be a private firm, an economic monopoly, or the government, which is a political monopoly.

If the firm were privately owned as a monopoly, we know from Unit 7 that it would face a downward-sloping demand curve, which would limit the price at which it could sell its goods. In order to maximize the profits of the firm, and hence the value of the owners’ assets, the monopoly firm would both seek to reduce costs and restrict output so that it could charge a higher price. The result would be a price above the marginal cost of production, which would mean that some consumers who value the service at more than its marginal cost would not consume it. Private ownership of the monopoly would result in a market failure.

Would the government do a better job?

government failure
A failure of political accountability. (This term is widely used in a variety of ways, none of them strictly analogous to market failure, for which the criterion is simply Pareto inefficiency). See also: political accountability.
economic accountability
Accountability achieved by economic processes, notably competition among firms or other entities in which failure to take account of those affected will result in losses in profits or in business failure. See also: accountability, political accountability.
political accountability
Accountability achieved by political processes such as elections, oversight by an elected government, or consultation with affected citizens. See also: accountability, economic accountability.
market failure
When markets allocate resources in a Pareto-inefficient way.

Ideally, a government-owned natural monopoly would set the price equal to the marginal cost and finance the fixed costs through taxation. But the government may have little incentive to reduce costs. The publicly owned water- or electricity-supply company may be under pressure to overstaff the company with well-paying jobs for politically connected individuals. As a result, the costs may be higher. Wealthy individuals or firms may lobby the government-owned monopoly to provide its services on favourable terms to special-interest groups. These outcomes of public ownership would be a government failure.

This case illustrates both the similarities and differences between the economic accountability provided by the market and the political accountability provided by a democratic form of government. Both the owners of the monopoly firm and the government decision-makers may act to further their own interests at the expense of the consumer or citizen, but they would both operate within constraints. The monopoly firm would not be free to charge whatever price it wished; its profits are limited by the demand curve. The government would not be entirely free to inflate the costs of provision by hiring or catering only to ‘friends of the government’, because it may suffer an election defeat.

These two cases—private or government ownership of a natural monopoly—illustrate the problem of market failure (the monopoly charging more than the marginal cost) and what is sometimes called government failure (the failure to minimize the cost of providing the service).

Which works better? There is no general answer to this question. And there are many choices besides private ownership or government ownership, including private ownership under public regulation, or public ownership with competition among private firms for the time-limited right to produce and price the service.4

Viewing the government as an economic actor that pursues its objectives but is constrained by what is feasible, helps us clarify which factors can influence a government to be more of a problem solver, and less of a problem.

Exercise 12.2 Building self-control into government

James Madison, a leading figure in the debates about the US Constitution after the formerly British colonies in the United States of America won its war of independence, wrote in 1788:

In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself.5

How does democracy (including the rule of law) address Madison’s concerns to oblige the government to ‘control itself’?

Exercise 12.3 The relationship between economic development and size of government

Use Figure 12.1 to help you answer the following questions:

  1. Why was Pax Britannica a period of smaller government?
  2. Compare Figure 12.1 with Figure 1.6. Why do you think the growth of the size of government coincides with both the emergence of capitalism as an economic system in the seventeenth and eighteenth centuries, and the increase in output per capita?
  3. Compare two ‘peacetime’ periods—Pax Britannica and the period since the end of the Second World War. Why do you think the size of government was so much larger in the second period?

Question 12.2 Choose the correct answer(s)

In order to be able to deal effectively with cases of market failure and unfairness, and to discharge its other obligations, the state needs to be sufficiently large and powerful. This means that the problem solver is also big enough to be a potential problem. How is this paradox usually resolved?

  • the rule of law
  • constitutional restrictions
  • international pressure
  • democratic elections that give citizens the power to dismiss the government
  • Most countries have a framework of laws that apply to all citizens, without exception. These laws must be interpreted and enforced by a judicial system. How effective the rule of law is in constraining government behaviour usually depends on how independently (of government) the judiciary can function.
  • A constitution is a set of rules that is more permanent than the laws that individual governments can make and unmake. Some countries have written constitutions. To give a constitution a special status, laws are usually in place that make it difficult to change. For example, an amendment to a constitution may require a vote of 66% rather than a simple majority, and this vote may have to be widely replicated amongst different groups.
  • Most governments are probably sensitive to international pressure, but that does not mean that they feel bound to accept it. There are plenty of examples of governments that behaved for years with complete disregard for international opinion, even in face of sanctions. South Africa during the apartheid regime was one example; more recently Zimbabwe and North Korea have shown how an authoritarian government can ignore international pressure.
  • This is perhaps the ultimate constraint. Provided the elections are ‘free and fair’ (requiring secret ballots and other conditions), a democratically-elected government must ultimately accept the will of the people.

12.4 The government as a rent-seeking monopolist

Governments, as we have seen, have the power to solve problems, but also to cause them. Heads of governments and their associates often misuse their power for personal gain. Other governments, even undemocratic ones like those just mentioned, sometimes provide valuable public services and rule without extravagant personal gain.

Political rents

Our analogy between firms and governments suggests a similarity between a dictator and a monopolist—neither faces much competition. But there are other similarities. Think about what a dictator can do. The examples above from Russia, Ivory Coast, France and Romania show that the lack of competition allows the ruler to gain substantial income that would not be possible were it not for his political position.

political rent
A payment or other benefit in excess of the individual’s next best alternative (reservation position) that exists as a result of the individual’s political position. The reservation position in this case refers to the individual’s situation were they to lack a privileged political position. See also: economic rent.

This income is called a political rent. It is political because it is associated with a political position or connections. It is a rent in the sense already used many times in this course—a payment above and beyond what the actor can get from their next best alternative.

This is similar, for example, to the employment rents received by an employed worker. In the case of the worker, the next best alternative is considered to be unemployment; for a member of the political elite, the next best alternative is what the person would receive without a political position or connections. In the case of Russian oligarchs, their political rents are the income they have received above and beyond what they would have had in the absence of any privileged connection to the Russian government.

Unlike the stationary rents that encourage workers to work hard and well, or the dynamic rents received by successful innovators, these rents do not play a useful role in the economy. They are simply a reward for having power.

Objectives and constraints

To understand why governments do what they do, we begin by modelling the government as a single individual, and use the usual concepts:

To begin, we model the government as a ‘political monopolist’, which means there is no competition from elections that could remove it from power. We call this the ‘government as monopolist’ model, and we would usually call a government like this a dictatorship. Even in the absence of elections, the dictator faces a feasibility constraint: his powers are not unlimited, because if he takes too much from the population, he may be removed from office by an uprising of citizens.

Depending on his preferences and the constraints he faces, the dictator (that is the political monopolist) may use the tax revenues the government collects for purposes that may include:

A rent-seeking dictator

As with all models, we simplify greatly so we can focus on the most important aspects of the problem. We assume that:

While simple, this model captures some key realities:

Rent-seeking by the dictator (activities to enlarge or to perpetuate these high incomes) often involves using the economy’s resources to police the population. This is to keep the dictator in power, rather than to produce goods and services. These are similar to some of the rent-seeking activities of a profit-maximizing firm—advertising or lobbying the government to gain a tax break, for example—but are different from rent-seeking activities such as innovation that create substantial economic benefits.

To simplify the dictator’s decision-making problem, we assume that the dictator does not choose the public service to supply—the public service is taken as given. The dictator only chooses how much to collect in taxes.

Even a dictator faces constraints on what he can do

As in Unit 5, when Bruno was using his coercive powers to exploit Angela, the dictator will not want to collect so much in taxes that the citizens would lack the strength and ability to produce. But the dictator will face the possibility of a revolution, an additional constraint.

We assume there are two reasons for removing the dictator:

The dictator wants to maximize the total political rent that he can expect to get over his period in office, not the rent he can get in any particular year. So, he has to think about how long he is likely to last. Of course, this is impossible to predict, but he will reasonably expect that if he is providing a given amount of the public service, then the lower the taxes he imposes, the longer his duration in office will be.

Figure 12.2 illustrates how a forward-looking dictator would evaluate two possible levels of taxation. With the higher tax, the dictator gets a larger rent per year, but for a shorter time in office (the likelihood of being removed is greater).

The forward-looking dictator contemplates the total political rent he will get with two different levels of annual taxation.

Figure 12.2 The forward-looking dictator contemplates the total political rent he will get with two different levels of annual taxation.

Higher tax

If the dictator collects T2 in taxes, he anticipates that he will remain in office for D2. His total political rent is (T2 − C)D2, where C is the cost of supplying the public good.

Figure 12.2a If the dictator collects T2 in taxes, he anticipates that he will remain in office for D2. His total political rent is (T2 − C)D2, where C is the cost of supplying the public good.

Lower tax

If he collects less in taxes, he will expect to remain in office longer. His total political rent is (T1C)D1. You can see from the figure that he does better by imposing a higher tax (the light blue rectangle, Rent2, is larger than the light red rectangle, Rent1).

Figure 12.2b If he collects less in taxes, he will expect to remain in office longer. His total political rent is (T1C)D1. You can see from the figure that he does better by imposing a higher tax (the light blue rectangle, Rent2, is larger than the light red rectangle, Rent1).

Assuming the private sector does not also provide this service to the public, you can think about the government as a monopolist providing the public service at a price (the tax) that citizens are legally obliged to pay. The dictator faces a constraint similar to a demand curve. Just as the amount a monopolistic firm is able to sell is inversely related to the price that it sets, the duration of the government’s time in office is inversely related to the tax rate it sets.

Figure 12.3 shows how the tax rate imposed by the dictator affects the expected duration of the government, defined as the number of years he may expect to stay in office following this year.

The duration curve: The dictator sets the tax given the cost of the public service.

Figure 12.3 The duration curve: The dictator sets the tax given the cost of the public service.

What is the longest time (Dmax) that the dictator could expect to remain in office? To figure this out, imagine that our dictator suddenly lost interest in money and simply wanted to remain in office as long as possible. What would he do?

He cannot reduce the probability that he will be removed for reasons unrelated to his performance. But he can reduce the ‘performance-related’ probability of being removed by only collecting enough taxes to meet the production costs of the public service. In Figure 12.3, Dmax is therefore where the duration curve meets the cost line. It is the expected duration when only considering factors unrelated to the dictator’s performance. Any tax rate above the cost of production will reduce the expected duration below Dmax, as shown by the downward slope of the duration curve.

The duration curve goes through points X and Y in Figure 12.2 and does not go below the cost line because if it did, the dictator would be paying out of his own pocket toward the cost of the public service. A dictator in a country with a stronger rule of law—and therefore a lower likelihood of a coup unrelated to performance—would face a duration curve that meets the cost line to the right of the one shown.

The duration curve is the feasible frontier for the dictator. Points in the feasible set above the cost curve result in positive rents for him. The curve represents a familiar trade-off:

The dictator chooses a tax to maximize his total rents

How does a dictator facing a duration curve decide the tax rate to impose on the citizens? The answer is similar to the way that a monopolistic firm decides on the price to charge for its product. Like the owner of a monopoly, the dictator faces a trade-off: he would like to extract a large amount of total taxes from the citizenry, and remain in office for a long time. But the duration curve tells him that he cannot have both. So, he has to evaluate differing combinations of tax revenue (T) and duration (D).

The dictator’s isorent curves.

Figure 12.4 The dictator’s isorent curves.

Isorent curves

Some of the dictator’s isorent curves are shown, with Isorent2 indicating a higher political rent than Isorent1. Here we assume the cost per year of supplying public services is 1.

Figure 12.4a Some of the dictator’s isorent curves are shown, with Isorent2 indicating a higher political rent than Isorent1. Here we assume the cost per year of supplying public services is 1.

Relatively high tax revenue, relatively short duration

Point V corresponds to a duration of 3 years, and a yearly tax revenue of 4.5. The rent at V is (4.5 − 1) × 3 = 10.5 (the green shaded area).

Figure 12.4b Point V corresponds to a duration of 3 years, and a yearly tax revenue of 4.5. The rent at V is (4.5 − 1) × 3 = 10.5 (the green shaded area).

Another point on the same isorent curve

Point Z corresponds to a duration of 7 years, and a yearly tax revenue of 2.5, giving a rent of (2.5 − 1) × 7 = 10.5 (an identically-sized area to that enclosed by point V). Note that rents are calculated by subtracting the cost per year of supplying the public service from the yearly tax revenue.

Figure 12.4c Point Z corresponds to a duration of 7 years, and a yearly tax revenue of 2.5, giving a rent of (2.5 − 1) × 7 = 10.5 (an identically-sized area to that enclosed by point V). Note that rents are calculated by subtracting the cost per year of supplying the public service from the yearly tax revenue.

He does this using a set of isorent curves (similar to the monopolist’s iso-profit curves), shown in Figure 12.4. Points V and Z on Isorent2 in the figure, are two different combinations of total taxes per year and duration in office that yield the dictator the same level of rent. High taxes and a short duration in office (point V) yield him the same total rent as lower taxes and a longer term in office (point Z). The points on the blue curve (Isorent2) all yield the same level of total rent, and this is greater than the total rent possible by the points on Isorent1.

The shape of the isorent curves is similar to the isoprofit curves of a monopolist:

Using these isorent curves, the monopolist can determine which point on the duration curve—the frontier of his feasible set—yields him the highest total rent. This can be seen in Figure 12.5.

The dictator chooses a tax level to maximize his political rents.

Figure 12.5 The dictator chooses a tax level to maximize his political rents.

The dictator will find the tax that maximizes his total expected political rent, which is the quantity (TC)D. The dictator reasons in a way that is analogous to the profit-maximizing firm that chooses the price to get the highest expected profits equal to (PC)Q, where P is the price charged by the firm and Q is the quantity sold.

Just as we used the firm’s isoprofit curves to determine the price it would charge in order to maximize profits, we can now use the dictator’s isorent curves to determine the tax rate it will impose on the citizens.

Suppose the dictator is considering setting a modest tax and expecting a long tenure in office, indicated by point A. Because the isorent curve is flatter than the duration curve at this point, we can see that he would do better by raising the tax and bearing the opportunity cost associated with doing so (a shorter expected stay in office).

Continuing this reasoning, we can see that the tax rate indicated by point F on the duration curve earns the dictator a large surplus per year, but not enough to offset the short duration of his government. A lower tax rate would increase his expected rent.

To maximize his political rent, the dictator will select point B, imposing the tax T* and expecting to stay in office for D* years, making a total rent of (T* − C)D*. At this point, the slope of the highest isorent curve is equal to the slope of the feasible frontier (the duration curve):

Question 12.3 Choose the correct answer(s)

Consider Figure 12.5. Which of the following statements is true?

  • A self-interested dictator will maximize the annual tax revenue they collect.
  • Moving from A to B in the diagram is a Pareto improvement, improving outcomes for both citizens and the dictator.
  • At T*, an increase in the tax rate will increase total expected rent.
  • Dictators use some tax revenues to provide essential public services.
  • Dictators will maximize total expected rent, which will require taxes to be below the maximum level (as at T* in the diagram above).
  • It improves outcomes for the dictator. However, outcomes will be worse for the citizens, who will have to pay higher taxes with no improvement in public services or increase in public service provision.
  • T* is the optimal taxation rate. Further increases in tax rates will decrease total expected rent because the decrease in expected duration will outweigh the increase in annual rent.
  • Dictators cannot appropriate all of the tax revenue as rent, but must spend at least C to provide essential public services (rule of law, defence etc.) to avoid being overthrown.

12.5 Competition can limit political rent-seeking

Competition disciplines firms in the economy by limiting the profits they can get by setting too high a price, or producing goods of low quality. Competition to win elections is the way that a democracy disciplines its politicians to provide the services desired by the public at a reasonable cost (in terms of taxes). Below we give some evidence of this from the US.

There is also evidence from other countries that the prospect of being removed from office affects how politicians act.

Even in undemocratic settings, the threat of losing office can discipline politicians. In China, provincial governors and Communist Party secretaries are not subject to review by voters but instead by higher officials in the central government. Governors and party secretaries are frequently promoted and almost as frequently fired. The records of all terminations between 1975 and 1998 show that those whose provinces experienced rapid economic growth were promoted, while those whose provinces lagged behind were dismissed. The introduction of village-level elections in China led to increased provision of local public services such as health services and schooling, and arguably a reduction in corruption.6

How economists learn from data Does electoral competition affect policy?

Think of a politician as wanting to stay in office and knowing that she must satisfy a majority of voters when seeking re-election. But she also has her own objectives: to advance a particular project that she favours, or to maintain good relations with wealthy individuals who would support her political campaigns or employ her when her political career was over. Does the threat of ‘give the voters what they want or get thrown out’ lead her to emphasize the public’s interests, instead of her own?

Comparing the policies adopted by politicians in districts that are non-competitive (for example, there will be no other candidate for the seat) with those who face electoral competition will not answer the question. The reason is that competitive and non-competitive political districts, and the politicians who represent them, are different in so many ways that the comparison would mix the effects of political competition with the effects of other differences.

Economists Tim Besley and Anne Case devised an ingenious way to answer the question. Some state governors in the US are limited to two four-year terms of office. This means that at the end of their first term they will face electoral competition when they ask voters to re-elect them. During their second term, the prospect of political competition does not affect them, because they are not allowed to stand for re-election.

natural experiment
An empirical study exploiting naturally occurring statistical controls in which researchers do not have the ability to assign participants to treatment and control groups, as is the case in conventional experiments. Instead, differences in law, policy, weather, or other events can offer the opportunity to analyse populations as if they had been part of an experiment. The validity of such studies depends on the premise that the assignment of subjects to the naturally occurring treatment and control groups can be plausibly argued to be random.

This is a natural experiment. The ‘treatment’ is the prospect of electoral competition, and so governors in the first term are the ‘treatment group’. The same governors in the second term are the ‘control group’. As in any good experiment, other important influences are held constant. We are measuring the same individuals, in the same districts, under a treatment and a control condition.

They found that during their first terms (the treatment period), Republican and Democratic governors implemented virtually identical levels of total taxation per capita. But during their second terms (the control period), Democratic Party governors, who tend to favour more public expenditures and taxation, implemented much higher levels of taxation than Republicans did. And Republican governors, when not facing political competition, implemented much lower levels of the state minimum wage.

Whether Democrat or Republican, governors faced with electoral competition in their first term implemented very similar policies to those favoured by ‘swing’ voters. These are voters who tend to change who they vote for, and so tend to decide many elections. The common policies were lower taxes and higher minimum wages. But they diverged according to their own political preferences or economic interests when electoral competition was removed.

Political competition as a constraint

governing elite
Top government officials such as the president, cabinet officials, and legislative leaders, unified by a common interest such as membership in a particular party.

Because it affects what governments do, now we introduce political competition to the model to see how it affects the government’s choice of tax level. The government leadership is no longer represented by a dictator, but instead by what we call a governing elite, that is the top government officials and legislative leaders, unified by a common interest such as membership in a particular party. Unlike a dictator, the elite can only be removed from office by losing an election, and not by a citizen uprising or some other non-electoral means.

When we speak of the elite’s ‘removal from power’ or the duration of its ‘time in office’, we do not mean the removal or duration in office of an individual (as might have been the case with a dictator), but rather the removal from power of the entire group and its affiliation with a political party. In the US, for example, the Republican Party governing elite was removed from office in 2008, when President Obama was elected. The Democratic Party governing elite associated with President Obama was removed from office when President Trump was elected eight years later.

Figure 12.6 illustrates a few of examples of governing elites’ duration in office and the reasons that they eventually left office. The longest continuous rule by a governing elite was the government of the Mexican Institutional Revolutionary Party (PRI). It governed Mexico from the time of the Mexican revolution in the early twentieth century right into the twenty-first century. The longest rule by an individual at the head of a governing elite was by Fidel Castro (49 years) in Cuba, who was then succeeded by his brother Raul. The shortest period in office in this table is the elected government of Gough Whitlam in Australia, which was removed by the Governor General (not an elected official) following a parliamentary impasse over the budget.

Governing elite Country Rule Came to power by Left power by
Congress Party India 1947–1977 Election (end of colonial rule ) Election
Communist Party Cuba 1959– Revolution Still in power as of 2019
Social Democratic Party Sweden 1932–1976 Election Election
Second Republic Spain 1931–1939 Election Military coup civil war
Francisco Franco Spain 1939–1975 Military coup, civil war Natural death; return to democracy
Institutional Revolutionary Party Mexico 1929–2000 Election Election
Democratic Party US 1933–1953 Election Election
Sandinista Party Nicaragua 1979–1990 Armed revolution Election
African National Congress South Africa 1994– Non-violent revolution & election Still in power as of 2019
Australian Labor Party Australia 1972–1975 Election Dismissed by (unelected) executive

Examples of governing elites, their period of rule, and reasons for their end (where applicable).

Figure 12.6 Examples of governing elites, their period of rule, and reasons for their end (where applicable).

The key idea in our model is that political competition makes the likelihood of losing an election more dependent on the government’s performance. This means that it makes the duration curve flatter. In other words, an increase in taxes by the government will have a larger effect on the elite’s expected duration in office than it would if there was no political competition.

The flatter, more competitive, duration curve that you see in Figure 12.7 shows a situation in which raising taxes above the cost of providing the public services is associated with a reduction in the current governing elite’s period in power.

The feasible set for taxes and government duration in a relatively uncompetitive and competitive political system.

Figure 12.7 The feasible set for taxes and government duration in a relatively uncompetitive and competitive political system.

A dictatorship

In a dictatorship, the duration curve is steep.

Figure 12.7a In a dictatorship, the duration curve is steep.

A flatter curve

The more competitive duration curve (darker) is flatter.

Figure 12.7b The more competitive duration curve (darker) is flatter.

A rise in taxes

Raising taxes to T′ above the cost of providing the public services is associated with a more substantial reduction in the current government’s expected lifetime when political competition is stronger.

Figure 12.7c Raising taxes to T′ above the cost of providing the public services is associated with a more substantial reduction in the current government’s expected lifetime when political competition is stronger.

The model helps show why governing elites, and the wealthy and powerful members of society who are allied to these elites, have so often resisted democracy, and attempted to limit the political rights of the less well off. In Figure 12.8, voting is initially restricted to the wealthy and as a result, the elite faces little political competition (the duration curve is steep), and maximizes its rents at point B. But now suppose that everyone has the right to vote and that opposition political parties are allowed to challenge the elite. This increase in political competition is represented by the flatter duration curve, indicating that the feasible set of the elite has shrunk. It now chooses point G, and collects lower taxes per year.

Choice of taxes under less and more competitive conditions.

Figure 12.8 Choice of taxes under less and more competitive conditions.

Notice that, in the figure, the governing elite in a more competitive political system implements lower taxes but has the same expected duration as the elite in the less competitive system (with higher taxes). But this need not be the case. Generally, the duration could be longer or shorter if conditions become more competitive. But the tax rate will definitely be lower.

12.6 Political monopoly and competition compared

In the model the ‘government’ is a single person—the dictator—or a ‘political elite’ which we have treated as if it were a single person. In both cases their actions are constrained by nothing other than the fact that if they collect too much in taxation, this may result in them being removed from office. But governments are large bodies of people, regulated by complex rules of the game.

political institution
The rules of the game that determine who has power and how it is exercised in a society.

In Unit 6 we explained that the firm is not only an actor, it is also a stage on which the various groups making up the firm also act, sometimes in conflict, sometimes in cooperation. The same can be said of governments. On the stage of government, politicians, political parties, soldiers, judges, citizens, and bureaucrats interact according to their particular preferences and the informal and formal rules that make up political institutions.

The political institutions of a country are the rules of the game that determine who has power and how it is exercised in a society. Democracy is a political institution, which means it is a set of rules that determine

Political institutions differ from country to country and over time. Major categories of political institutions include democracy and dictatorship. Recall that in Unit 1 we defined democracy as ‘A political system, that ideally gives equal political power to all citizens, defined by individual rights such as freedom of speech, assembly, and the press; fair elections in which virtually all adults are eligible to vote; and in which the government leaves office if it loses.’

The key value motivating democracy is political equality. Citizens should have substantially equal opportunities to be able to express their views in ways that can shape the policies and other activities of the government. Recall that in Unit 1 we explained that we use the term ‘democracy’ to refer to a form of government characterized by the rule of law, civil liberties, and inclusive, fair, and decisive elections. Inclusive means that no major group—for example, women, ethnic minorities, those without property—can be excluded from the right to vote.

In Figure 12.9 we illustrate political institutions by contrasting the effects of competition and the lack of competition in the economy and in government.

Varieties of political and economic competition Source of rents or reasons for their absence Controls on political elites and firm owners Power of the non-elite (citizens and consumers) Profits/rents
The extreme case of limited political competition (a dictator) The dictator uses tax and other government revenues as a source of personal income above what he would receive as an ordinary citizen. Limited threat of removal from office, e.g. revolutionary overthrow Little Political rents > 0
The extreme case of limited economic competition (a monopolist) The monopolist restricts sales, charges prices above the average cost of production and receives a profit greater than the opportunity cost of capital. Limited threat of market entry by competing firms Little Economic profits > 0
‘Ideal democracy’ Rents are eliminated by competition among political parties and other freedoms such as a free press Electoral loss is certain if significant political rents are extracted. Exercised mainly through ‘Voice’—vote for someone else Political rents = 0
‘Perfect competition’ among firms Rents are eliminated by competition among firms Zero sales (and firm failure) if sets a price higher than average cost. Exercised mainly through ‘Exit’—buy from someone else Economic profits = 0

Political and economic rents under competition and monopoly.

Figure 12.9 Political and economic rents under competition and monopoly.

Question 12.4 Choose the correct answer(s)

Why is the term ‘political rent’ used to describe the increases in personal wealth often enjoyed by dictators?

  • The income is derived from hiring out public property to private individuals.
  • These are ‘excessive’ earnings resulting from the dictator’s political position.
  • Political rent is income that dictators earn from confiscating private property and letting it to friends at preferable rates.
  • ‘Rent’ is a term used to describe any excessive level of income.
  • The answer confuses the economist’s use of the term ‘rent’ with the everyday use of the term to describe income from hiring out property, usually (but not always) buildings.
  • Economists use the term ‘rent’ to describe any earnings over and above what the resources could earn in their next best use (in other words, abnormal profit). Rents here are ‘political’ because they are the result of political institutions.
  • While this kind of behaviour is characteristic of some dictatorships, it does not capture the economic meaning of the term ‘rent’.
  • It is true that ‘rent’ implies a strict definition of ‘excess’; it is the return in excess of that which could be earned in the next best use. However, the answer needs to describe why these rents are considered ‘political’.

Question 12.5 Choose the correct answer(s)

The magnificent chateaux in France’s Loire Valley, built between 1550 and 1780, are a major tourist attraction. Many of them were commissioned and built by finance ministers serving French kings of the period. How might this be explained in the context of this unit?

  • There was a lack of accountability.
  • The king’s ministers were drawn from aristocratic French families who were generally very wealthy.
  • Building a magnificent chateau was a way of confirming one’s status.
  • The Loire valley was well provided with the essential materials for building.
  • French kings of this period (Francois I to Louis XIV) and earlier were autocratic, effectively dictators, although as the unit explains they always had to ensure the loyalty of their armed forces. This meant they could dispense favours to anyone they liked and were accountable to no one. Favours inevitably went to those on whom they relied. Ministers of finance were key individuals in this respect, since the lavish lifestyles of autocratic monarchs depended on their success.
  • Inevitably, the king’s court was dominated by aristocratic families, but ministers of finance often came from high income backgrounds, perhaps because the ministerial role required some knowledge of trade and commerce. What is striking is how quickly these people amassed personal fortunes once they had been introduced to the court.
  • This may well have been part of the motivation, but the means to do it came from the ability to amass a private fortune out of public funds.
  • As it happens, it wasn’t. Much of the stone was transported over long distances. Caen in Normandy was one major source. But even if it had been abundant in building materials, this would not explain the strange coincidence between the chateaux being built by people who had influential positions at the French court.

Question 12.6 Choose the correct answer(s)

The role of the dictator can perhaps be compared to that of the monopolist, in that both earn rents that they try to protect, either by spending on police and security services (dictator) or by creating barriers to entry (monopolist). In what important respects do these rent seekers differ?

  • The dictator is looking to maximize benefits for himself, and possibly for his family and various interest groups.
  • The monopolist is a private firm and subject to government regulation, whereas the dictator is the government. The state is always more powerful than an individual firm.
  • Unlike the monopolist, the dictator seeks to maximize long-run rents by staying in office for as long as possible.
  • Some of the barriers to entry used to protect monopoly rents (for example, economies of scale, innovation) yield some economic benefits. This not true for the dictatorship.
  • The monopolist is assumed to be maximising profit for the shareholders, while the dictator is maximising rents for himself (and some others, perhaps), but this is not a major difference.
  • The monopolist faces the constraint that the government possesses numerous powers, which it can legitimately use to terminate the monopoly if it acts too far outside the public interest. The dictator, however, is the government and is only constrained by the possible use of force.
  • This behaviour is similar to that of a monopolist, who tries to protect supernormal profits for as long as possible.
  • In a dictatorship, rents are often protected by high levels of spending on police, armed forces, and security services. It is difficult to see much social benefit in this.

12.7 Spending by democratic governments: Priorities of a nation

Joseph Schumpeter once wrote that the public budget is the ‘skeleton of the state stripped of all misleading ideologies’. He argued that the way in which a government spends its money reveals its true priorities, much in the way that an individual’s spending pattern is a lens through which to study their preferences.7

As we have seen, before the twentieth century a major activity of governments was defence (in some cases, predation on other nations), and raising the taxation to support it. But well before that time, some ruling institutions came to understand that they would benefit from providing conditions for the growth of the economy—building canals, roads and schools in the nineteenth century, for example. Economic development could be an asset by creating a larger tax base, educating a more scientifically oriented cadre of citizens, or by building financial institutions that could loan money to the government.

During the twentieth century, large-scale production in firms was easy for the government to see and it happened in one place. This made taxation and regulation of firms easier, and governments could also use the accounting books and payroll records of firms to find out who was paid what. This meant that taxing individuals became easier, too. Governments in many countries deducted tax directly from the pay of their citizens, and many workers were taxed explicitly for ‘social security’, that is, to fund pensions and sometimes healthcare.

Many governments are currently investigating whether their systems of taxation are efficient and fair. An example is the 2010 Mirrlees Review, which offered proposals for a comprehensive reform of the UK’s tax and transfer system, establishing the scope for better addressing market failures and unfairness.

Changes in the structure of the economy also made it easier for governments to levy taxes, not only on a specific good, such as salt or imports, but also on consumption in general and ultimately on value added in production. These broad-based taxes play an important role in the public finances of advanced economies. With the extension of voting rights to virtually all adults, governments became accountable to their citizens for delivering services.

The historical processes of transition from political monopoly to political competition have produced most of the modern governments in the world, with their distinctive patterns of spending.

Figure 12.10 shows how the democratic governments of the US, South Korea, and Finland spent their money in 2016.

Patterns of public expenditure in Finland, the US, and South Korea (2016) measured as a percentage of total spending by government.

Figure 12.10 Patterns of public expenditure in Finland, the US, and South Korea (2016) measured as a percentage of total spending by government.

The size of the government spending in Finland is 55.9% of its GDP, which is the largest of the three countries. For the US, it is 38.2%. Note: this does not mean that the US spends less than Finland in absolute terms, just that government expenditure is a smaller fraction of the country’s GDP. Expenditure by South Korea’s government is 32.3% of its GDP.

This is what the categories mean:

social insurance
Expenditure by the government, financed by taxation, which provides protection against various economic risks (for example, loss of income due to sickness, or unemployment) and enables people to smooth incomes throughout their lifetime. See also: co-insurance.

There are many reasons why governments differ in their spending patterns. One reason is that political institutions differ, even among democracies.

Exercise 12.4 Past influences on current government spending patterns

  1. Looking at Figure 12.10, how would you characterize the two biggest differences in the spending patterns among the three pairs of countries (the US vs South Korea, the US vs Finland, and Finland vs South Korea)?
  2. Can you think of factors in the countries and their histories that might account for these differences? You need to do some research to support your claims.

Exercise 12.5 Using Excel: Comparing government expenditures

Go to the source of Figure 12.10, OECD statistics, and see if you can find different countries for each of the criteria below (for the year 2016, or the most recent year available). For each of your chosen countries, plot a stacked column chart similar to Figure 12.10.

  • General government expenditure (as a percentage of GDP) is greater than South Korea’s, but less than Finland’s.
  • Government expenditure on health (as a percentage of GDP) is greater than the US’s.
  • Government expenditure on social protection (as a percentage of GDP) is greater than Finland’s.
  • Government expenditure on defence (as a percentage of GDP) is greater than South Korea’s.

A puzzle: Persistence of unfairness and market failures

It is clear that even governments considered to be ‘small’ in spending relative to their economy—South Korea and the US in the above figure—control vast economic resources that could be used in pursuit of both efficiency and fairness. But previous units have revealed many cases in which economic outcomes are Pareto inefficient, so potential mutual gains remain unrealized. These seem like potentially ‘win–win’ situations that those engaged in political competition—aspiring electoral candidates or political parties, for example—would energetically exploit. Yet the problems persist.

We know that citizens in many countries think the distribution of wealth or income is unfair. In 2005 in the US, for example, both Republicans and Democrats, both rich and poor, when asked said that the poorest 80% of the wealth distribution should receive at least three times the wealth that they then had received. More recently, changes in US tax policy have favoured the wealthy, not the bottom 80%. This is a puzzle.

12.8 The feasibility of economic policies

To make sense of this puzzle, we must think about the feasibility of the policies that a government might adopt. Fixing some problem of Pareto inefficiency or perceived unfairness will happen only if:

economically feasible
Policies for which the desired outcomes are a Nash equilibrium, so that once implemented private economic actors will not undo the desired effects.
politically feasible
Capable of being implemented given the existing political institutions.
administratively feasible
Policies for which the government has sufficient information and staff for implementation.

We take up these three problems in turn, starting with economic feasibility.

Given people’s preferences and the information available to private economic actors, there may not be a feasible set of policies that would sustain an efficient and fair outcome. For a policy to have economic feasibility, it must be a Nash equilibrium, which means no actor can improve its position by changing its behaviour.

In Section 3.9 we showed that a government’s policy to raise the tax rate for the rich to be able better to provide needed services to low-income families might be less effective than expected if the high tax rates make it cost effective for the wealthy to engage in tax evasion.

To take another example, a government that tries to enforce perfect competition in every industry will fail. Since firms are free to advertise, and to differentiate their products, it is impossible for the policymaker to legislate that demand curves be horizontal.

We have also seen that no macroeconomic policy can entirely eliminate unemployment, given that the threat of unemployment motivates people to work hard and well.

Economic feasibility: An example from Chile

The model of tax evasion in Unit 3 is a simplification, but it helps us understand real economic forces operating in the world. The experience of Chile provides such an example.

In 1970, the socialist Salvador Allende was democratically elected president of Chile in a surprise victory, on a platform promising greater public services and nationalization of many of the privately held firms in the country.

Stock market prices in Chile: The election of a socialist president, 1970.

Figure 12.11 Stock market prices in Chile: The election of a socialist president, 1970.

Proprietary data from the Santiago stock market. Time zero is the first trading day on the Santiago stock market following the election. Daniele Girardi and Samuel Bowles. 2017. ‘Institutional Shocks and Economic Outcomes: Allende’s Election, Pinochet’s Coup and the Santiago Stock Market’, Journal of Development Economics.

To interpret the data in Figure 12.11, notice the vertical line that marks the day before the election. The series for share prices dropped dramatically the next day. The fall in share prices indicates a major sell-off of shares in Chilean companies as soon as the news arrived. This tells us that the victory of Allende was a surprise. Had his victory been anticipated, the stock market would have fallen before the election.

A stock (or share) is a share in the ownership of a company; its price measures how much it is worth to own part of that company and as a result receive a share of its profits, and benefit in the future from selling it to another person.

Share prices rise when, taking everything into account, owners or potential buyers of shares think that the company will be more profitable in the future. When a socialist president was elected in Chile, wealthy people were worried about:

In turn, these worries created a limit to the policies that would prove economically feasible for the Allende government. If the wealthy thought that the firms they owned would be less profitable in the future, they would have no incentive to invest in increasing the assets of the firm. Rather than invest in these firms, these people might instead invest in another country (known as capital flight), in housing, or in other Chilean assets more likely to be valuable in the future.

The result was poor economic performance of the Chilean economy. We will return to the Chile story a bit later, when we will see that political interests, as well as economic infeasibility, can limit what a democratically elected government can do.

Question 12.7 Choose the correct answer(s)

What is meant by economic feasibility?

  • Policies that solve the problem must be possible to implement in practice.
  • For a policy to have economic feasibility, it must produce a Nash equilibrium and sustain a fair and efficient outcome.
  • Policies that would solve the problem and are politically acceptable.
  • Must be able to make someone better off without making anyone else worse off.
  • This description refers to administrative feasibility (see the next section), which some policies can lack. Economic infeasibility refers to policies that can be implemented but do not have the desired outcomes.
  • This may be impossible given the information available to the policymaker and/or people’s preferences, or there may be unintended consequences.
  • Some policies may be able to solve the problem and could be introduced in practice, but political pressures may prevent their adoption. For example, between 1815 and 1846, the UK parliament maintained a series of ‘Corn Laws’ that kept food prices high. As a means of lowering food prices, their abolition would have been economically and administratively feasible. But the Corn Laws benefited landowners who dominated parliament at the time and resisted giving up the benefit for many years.
  • This is the definition of a Pareto improvement.

12.9 Administrative feasibility: Information and capacities

Even if there exists an economically feasible set of policies that would address market failures, in order to design and implement these policies, the government needs:

fiscal capacity
The ability of a government to impose and collect substantial taxes from a population at low administrative and other costs. One measure of this is the amount collected divided by the cost of administering the tax system.

As we have seen, the magic of the market means that, as long as prices reflect social marginal costs, the information required to direct resources to more highly valued rather than less highly valued uses arises as a by-product of people’s everyday transactions.

Contrast this with the case of a citizen attempting to get a remedy through the courts for an environmental market failure. If the citizen suffering from a respiratory illness could bring a lawsuit against the polluting firm that caused it, and secure compensation for the costs of his illness, then this might ‘internalize’ the external costs of the polluter’s actions, leading to more effective abatement efforts. But in most cases, this cannot be done because the citizen does not have the necessary information about who is polluting, or cannot afford the legal and other costs of pursuing the case.

Governments have limited information

Market failures arise because essential information is not available to buyers, sellers, and other private economic actors. But this information is not likely to be available to the government either, limiting its ability to design policies that address environmental market failures. Governments often do not know how much citizens value environmental quality, or how effective environmental policies will be in ensuring a sustainable environment. If prices are sending the wrong messages, and if the government is to correct them through the implementation of taxes, subsidies, or regulation, it must find ways of collecting the necessary information to design those interventions.

administratively feasible
Policies for which the government has sufficient information and staff for implementation.

Limited information is not the only factor limiting the administrative feasibility of policies to remedy market failures.

Limited fiscal capacities

To levy taxes effectively and collect the revenue, governments need revenue officers who are competent, not corrupt, with sufficient resources to find and punish tax evaders, and with enough legitimacy to ensure that most people pay their taxes.

Administrative capacity is required for many different kinds of taxes, from trade tariffs enforced at the border, to payroll taxes levied on wages, and to corporate income taxes charged on legally incorporated economic entities. The use of accounting books in large firms makes it easier to audit firms and accurately assess their tax bill. But this also depends on the technology and institutions available. International flows of difficult-to-track financial obligations make illegal tax evasion, and legal tax avoidance (for example, by moving profits to international tax havens), a problem for governments who want to collect tax. This lowers their fiscal capacity.8

Lack of administrative capacity affects all aspects of government, not just taxes. An educational reform, for example, requiring teachers to abandon rote-learning methods and engage in more active student-centred learning may simply be impossible to implement, given the skills of the current teaching force.

How economists learn from data Administrative infeasibility: An application from Nigeria

A lack of information about the progress of infrastructure projects funded by the government, and a poorly functioning and corrupt administration, resulted in poor outcomes in Nigeria.

In 2006–2007, the public sector was given funding and made responsible for implementing 4,700 small-scale infrastructure projects like installing water wells, constructing dams, and building health centres. Just 31% of the projects were completed and 38% were not even started. For example, the funding was paid for 1,348 water wells, but 846 were never completed, leaving hundreds of thousands of people without improved access to water.

Economists Imran Rasul and Daniel Rogger wanted to find out why some organizations succeeded in completing projects on schedule and budget, while others did not. They could do their research because the Nigerian government had collected information from independent teams of engineers about the quantity and quality of completed projects. Accurate information of this kind from independent observers is very rare for a low-income country.9

Rasul and Rogger found that ‘getting things done’ by public sector organizations is affected by how the organizations are managed. They were surprised to discover that using performance incentives, with which managers were rewarded for good performance as measured by the organization (not by independent assessors), was correlated with lower completion rates. In organizations where officials had greater autonomy in making decisions—not in response to performance incentives—outcomes were better.

While financial incentives can play a positive role in motivating government officials, the Nigerian case shows that, if it is difficult to collect and verify information, trying to attach simple performance incentives to complex tasks may backfire. If there is poor information, then it may be better to give organizations greater autonomy. In this case, officials given autonomy observed social norms of responsibility, and completion rates were higher.

12.10 Political feasibility

In a democracy, it is often said that ideally the government is the servant of the people. In economic terms, government officials are the agents and the citizens are the principals. But this immediately raises two questions:

principal–agent relationship
This is an asymmetrical relationship in which one party (the principal) benefits from some action or attribute of the other party (the agent) about which the principal’s information is not sufficient to enforce in a complete contract. See also: incomplete contract. Also known as: principal–agent problem.

Think about the first problem—motivating the elected official to do what the citizens prefer—as a principal–agent problem, like the employer trying to motivate a worker to contribute to the profits of the firm. What are the possible solutions when the manager tries to motivate workers? The manager could:

In a democracy, elected officials are held accountable to the electorate by a similar set of strategies:

But these methods—while essential components of a democratic society—sometimes work imperfectly, if at all. There are many reasons. But one is that citizens or groups that can amass substantial wealth for the purposes of influencing the government have extraordinary political influence even in a democracy.

How economists (and political scientists) learn from data Does money talk?

Elites and organized groups seem to have much more influence on policy than average citizens: Martin Gilens and Benjamin I. Page. 2014. ‘Testing theories of American politics: Elites, interest groups, and average citizens’. Perspectives on Politics 12 (03): pp. 564–81.

In the US, people often say ‘money talks’. Many are concerned that it talks particularly loudly when it comes to politics.

To some, it is obvious that, when a candidate for political office receives a large contribution for his electoral campaign from a business or a trade union, the candidate is more likely to use political power to influence policy in favour of the contributor.

Research by Joshua Kalla and David Broockman, two political scientists, shows that election campaigns for the US congress in 2012 spent on average $8.5 million per congressional seat. But did the winners provide favours for the donors that would not have occurred without the donors’ contributions? We might ask if the members of congress who received contributions from those with investments in the oil industry tended to favour the interests of those firms afterwards. Or did those receiving funds from trade union members support an agenda that favoured the union’s interests? The answer in both cases would be that they did.10

But this does not demonstrate that donor contributions purchased influence over the legislator. Remember, causation can work both ways; those with oil wealth are likely to donate to candidates who already favour that industry’s interests; trade union members will donate money to those who already support the interests of trade unions. Simply showing a correlation between the source of the funding and the policies supported by the legislator does not show that the contributions caused the legislator to act differently.

Kalla and Broockman designed a clever experiment to see if the donation caused the congress member to behave in the donor’s interest. They reasoned that citizens could influence legislators by meeting with them and expressing their views. Members of congress are busy people, so gaining access to them for a meeting is something that groups compete for.

It seems that democracy alone cannot reverse rising inequality: Adam Bonica, Nolan McCarty, Keith T. Poole, and Howard Rosenthal. 2013. ‘Why hasn’t democracy slowed rising inequality?’ The Journal of Economic Perspectives 27 (3): pp. 103–23.

Kalla and Broockman wanted to find out if those who gave money to a congress member were more likely to be granted a meeting. With the cooperation of a (real) interest group Credo Action, they contacted 191 members of congress to ask for a meeting. All the constituents making this request had contributed some funds to the member’s campaign. The control group, randomly chosen, and half of the total sample, said only that they were residents of the member’s district. The treatment group also identified themselves as donors. All callers in both groups read from a script, so the requests for a meeting were otherwise identical.

Among those not identified as donors, 2.4% gained a meeting with either the congress member or the chief of staff. For those identified as donors, 12.5% got a meeting.

The authors concluded: ‘The vast majority of Americans who cannot afford to contribute to campaigns in meaningful amounts are at a disadvantage when attempting to express their concerns to policy makers.’

Political feasibility: The story of Chile continued

What happened after the election of Allende in Chile in 1970 tells a story not only of economic limits to feasible policies, but also of political limits.

Amid faltering economic performance, due in part to potential investors holding back on investment in Chile, opposition to President Allende’s government mounted, some of it supported in secret by the US government. In 1973, the Chilean armed forces attacked the presidential palace, defeating troops loyal to Allende. They took over the government, ending democracy and replacing Allende with General Augusto Pinochet, who ruled as a dictator—without the democratic constraints of elections and individual political rights—for the next 17 years.

Stock market prices in Chile: The military overthrow of the socialist government, 1973.

Figure 12.12 Stock market prices in Chile: The military overthrow of the socialist government, 1973.

Proprietary data from the Santiago stock market. Time zero is the first trading day on the Santiago stock market following the election. Daniele Girardi and Samuel Bowles. 2017. ‘Institutional Shocks and Economic Outcomes: Allende’s Election, Pinochet’s Coup and the Santiago Stock Market’. Journal of Development Economics.

The wealthy anticipated that Pinochet would introduce pro-business policies, so stock prices rose again (Figure 12.12). The Pinochet dictatorship would remain until a constitutional referendum in 1988 demanded a return to democracy, which the armed forces respected.

Allende’s economic program was infeasible for two reasons:

12.11 Policy matters

In this unit, you have learned that for a policy to improve an outcome, it must change the current Nash equilibrium to a different and preferable one (economic feasibility). And it also must be favoured by a governing elite with the authority and capacity to implement it (political and administrative feasibility).

The limits posed by special interests, as well as economic and administrative feasibility, explain why governments often do not successfully address the problems of market failure and unfairness that we have encountered throughout this course. Looking at the different economies of the world, however, you see substantial differences in the extent to which these problems are effectively addressed. As a result, the limits posed by economic, political, and administrative feasibility differ substantially among countries.

Policies differ across countries

To see this, we return to the problem of climate change introduced in Section 2.13. In Figure 12.13 we can see that Germany, Australia and the US have roughly the same per capita income. If they all faced similar constraints of economic, administrative, and political feasibility in adopting policies to limit greenhouse gas impacts on climate, then we might expect to see their similarity in income matched by similarity in CO2 emissions per capita.

But this is not at all what we see in the figure. The US and Australia emit about two times as much per capita as Germany. It seems likely that what is economically feasible may not differ very much in these three countries, as all share the same knowledge about technologies, and their citizens are likely to respond in similar ways to incentives to adopt cleaner energy sources. The government information and capacities in the three countries are also similar—all have well-informed and capable governments.

Carbon dioxide emissions are greater in richer countries, but countries of the same level of income differ greatly in how much they emit.

Figure 12.13 Carbon dioxide emissions are greater in richer countries, but countries of the same level of income differ greatly in how much they emit.

The World Bank. 2018. ‘World Development Indicators.’; Maddison Project Database, version 2018. Bolt, Jutta, Robert Inklaar, Herman de Jong, and Jan Luiten van Zanden (2018), “Rebasing ‘Maddison’: new income comparisons and the shape of long-run economic development”, Maddison Project Working paper 10.

Although carbon dioxide emissions are affected by industrial structure and trade specialization, they are also affected by what is desired by the elites, who have political influence. Policies to address climate change are more likely to have political support in Germany than in Australia and the US. One reason for this difference is the importance in US and Australian politics of lobbies representing the natural resource industries, including the gas, oil, and coal producers.

A similar contrast appears when we look at inequality, shown in Figure 12.14. Germany and the US have both experienced about the same rate of growth in GDP per capita over the past four decades, but they differ markedly in inequality of living standards, as can be seen by the much higher Gini coefficient for disposable income in the US. The comparison for the measure of intergenerational inequality is similar. Denmark, Sweden, and Finland are more equal by this measure than even Germany.

Many things could account for these differences. They are, at least in part, due to the greater political influence in Germany than in the US, of those who value sustaining a higher living standard for the least well off.

Greater equality in disposable income is not associated with slower growth in average income.

Figure 12.14 Greater equality in disposable income is not associated with slower growth in average income.

Chen Wang and Koen Caminada. 2011. ‘Leiden Budget Incidence Fiscal Redistribution Dataset’. Version 1. Leiden Department of Economics Research.

What can we learn from the comparisons in Figure 12.14 showing that high income countries with a similar growth in GDP per capita do not necessarily have similar levels of inequality.

Lessons from the experiences of different countries

One lesson, if we wish to address problems like climate change and unfair inequalities in living standards, is that for most countries it is possible to do a lot more than is currently being done. The fundamental forces contributing to inequality in the high-income countries—new technologies and growing imports (from China, for example) that make the skills of low-paid workers redundant—do not differ much among the high-income countries in Figure 12.14. The differences appear to be a matter of choices among the similar set of policies that are economically and administratively feasible, some countries opting for policies that sustain high levels of inequality, and others pursuing the goal of greater equality.

We also have a lot to learn from the top performers in these and similar figures, by studying the policies and institutions that appear to account for their success in addressing market failures and unfairness and in delivering public services.

For example, some countries have school systems that teach much more effectively than others. Because educational policies differ greatly among countries, we can get some idea of the importance of good policy by looking at differences among nations in performance on a mathematics test administered to 15-year-old students around the world.

You can access the data from a test at the OECD’s Programme for International Student Assessment.

Using the OECD data, let’s compare two countries that are ethnically diverse and have about the same per capita income: the US and Singapore. The average maths score in Singapore was 20% higher than in the US. Even more striking, the student whose score placed them in the middle of the US students (the student with the median score) would have been in the bottom quarter of Singapore’s students. A similar comparison would place the median American student in the bottom quarter of Japanese students, and just above the bottom quarter of Finland’s students.

Not all policies and institutions that are effective in one country can be transferred to another. For example, a comparison between the innovation systems in Silicon Valley and in Germany in Section 21.2 of The Economy shows how different combinations of innovating firms, government policies, financial institutions, and social norms in these two regions produce effective solutions to the market failures associated with knowledge production. Neither would be easily adopted in the other country.

12.12 The distributional impact of public policies: Early childhood education

Harold Lasswell, a prominent mid-twentieth-century American political scientist, is best known for his book, Politics: Who gets what, when and how. The title captures a basic point of this unit. Politics is all about:

The reason is that political processes determine the rules of the game—the basic institutions that govern how we interact in the economy and other arenas of our society.11

But politics is not simply about dividing up a pie, with the powerful getting the larger slice and the struggle for power sometimes resulting in a smaller pie. Well-designed government policies are also able to increase the size of the pie, improving living standards for the vast majority of people. Examples that you have already seen include the economic policies of the government of China, which since the 1980s resulted in the most rapid eradication of large-scale poverty ever witnessed in human history. Another example was the clean water and sanitation policies that were behind the global reduction in child mortality.

Schooling and inequality

Economic research has explored the question of how schooling and preschool experience affects inequality. In our ‘Economist in action’ video, James Heckman shows how economists can learn from experiments and other data about how to level the playing field for children growing up poor. You may also want to read his book Giving kids a fair chance.12

His book begins by noting that: ‘The accident of birth is a principal source of inequality in America today. American society is dividing into skilled and unskilled … birth is becoming fate.’

Heckman’s ‘strategy that works’ to address this problem is based on the following logic: ‘Both cognitive and socio-emotional skills develop in early childhood and their development depends on family environment.’ Growing up poor deprives children of opportunities to develop these skills, and ‘family environments in the US have deteriorated’.

In response, Heckman advocates ‘early interventions’, such as enriched preschool environments and home visits by professionals to assist parents, which his research shows can ‘produce positive and lasting effects on children in disadvantaged families’.

Policies of the kind advocated by Heckman are being implemented in several countries, including Colombia, Jamaica, Chile, and in the state of Orissa in India. Teams of economists and experts in child development are rigorously evaluating them for their longer-term effects and to assess the feasibility of scaling them up from small pilot interventions.

We know that the kids of poor parents often grow up to be poor. We now also know that this has little to do with genetics, and more to do with the socio-emotional situation that poor parents and children experience. We now know of, and governments can implement, effective policy remedies to break this cycle of poverty.

Question 12.8 Choose the correct answer(s)

Watch the ‘Economist in action’ video of James Heckman. According to Heckman, which of the following individual attributes are NOT among the reasons for persistent poverty in a family from generation to generation?

  • inherited IQ
  • limited schooling
  • race
  • social behaviour
  • Inherited IQ could contribute to persistent poverty, but it is not mentioned in the video.
  • Heckman argues that this is among the reasons for persistent poverty.
  • Heckman argues that this is among the reasons for persistent poverty.
  • Heckman argues that this is among the reasons for persistent poverty.

12.13 Free tuition in higher education: Can it be fair to non-students?

endowment
The facts about an individual that may affect his or her income, such as the physical wealth a person has, either land, housing, or a portfolio of shares (stocks). Also includes level and quality of schooling, special training, the computer languages in which the individual can work, work experience in internships, citizenship, whether the individual has a visa (or green card) allowing employment in a particular labour market, the nationality and gender of the individual, and even the person’s race or social class background. See also: human capital.

As a person enters the labour force, education—its quality, amount and content—is an endowment that affects both their wage and the kinds of goods and services and possible innovations that the citizens of a nation can enjoy. Governments set aside tax revenues to fund higher education for both efficiency and fairness reasons.

Taking efficiency first, without government support people would have to pay for the costs of their own (or their children’s) studies, and this would result in less higher education than economists think would be desirable for two efficiency-related reasons:

Exercise 12.6 Solutions to the credit constraints problem

The ‘asset’ acquired by attending a university is a person’s knowledge, problem-solving abilities, contacts, gained as a result of higher education. Two ways to turn this asset into collateral (as with a car loan or home mortgage) are described below. Compare and evaluate these solutions to the credit constraints problem from the standpoint of efficiency and fairness.

  1. One proposed solution to the credit constraints problem is that a company or other organization could select promising secondary school students and offer to pay their entire cost of higher education (the student’s degree program chosen by the company) in return for the student’s agreement to work for the company for ten years, on terms determined by the company.
  2. During the nineteenth century many Europeans wishing to move to North America and lacking the funds and unable to borrow to pay for the trans-Atlantic voyage agreed to what is known as an indentured servitude contract. Their prospective North American employer would pay for the voyage, and in return the person would be obligated to work for the employer, perhaps for many years.

Questions of fairness arise because many people consider education to be a merit good, namely one that should be available to all irrespective of their ability to pay.

In response to the fact that meeting two objectives—fairness and efficiency—requires some kind of government support, methods of funding higher education vary greatly around the world. For example:

Where student fees are high, some families are able to pay. Students from other families take out loans for this purpose.

Let’s think about these five ways of financing higher education from the standpoint of efficiency and fairness (summarized in Figure 12.15 below).

  1. The entirely private funding of higher education by the families of students: This is now considered unfair. It violates elementary principles of equality of opportunity and education as a merit good. Because as a result, the children of the high-paid and well-educated also then tend to be highly paid and well educated, it contributes to the perpetuation of income differences across families from generation to generation. It is inefficient because it restricts high-quality education to a small group, not all of whom are capable of benefiting, while denying higher education to the talented children of the less well off.
  2. The no-fees option: This addresses the ‘too little education’ inefficiency of the entirely private funding option by removing the private costs of attendance. But it goes to the other extreme: motivating even those who expect to benefit very little from higher education to attend, at considerable cost to taxpayers. Also, many consider this option to be unfair because the students enrolled in higher education tend to come from families with much higher incomes than those without children in university, so the no-fees option is a free government service that is used disproportionately by well-off people.
  3. Private-credit-financed higher education: This is an option, but this has never been a major source of funding. The reason is that unlike borrowing to purchase a home or a car, the borrower does not acquire an asset that can be used as collateral (insuring the lender against losses if the borrower cannot repay). The asset acquired are the skills embodied in the person herself, and (because slavery is illegal) that person cannot sign over ownership of herself to the lender (see Exercise 12.6 for more details).
  4. A government-backed student loan option with repayment contingent on income: By making loans available to families who otherwise would be excluded from borrowing sufficient funds, this increases educational opportunity for the less well off. Because repayment depends (is ‘contingent’) on the income the student later earns, it also addresses two shortcomings of student loans. The first is that the income of a former student may vary from year to year, making repayment difficult during periods of low income (or unemployment).

CORE author Antonio Cabrales investigates with colleagues how an income-contingent loan system would work in Spain, where the labour market for young university graduates functions poorly.

The second shortcoming is that the obligation to repay a fixed amount unconditionally also leads students to major in subjects they think will allow a reliable high income, rather than studying subjects they like, or in which they are most talented. This results in a mismatch between the educational resources devoted to, say, an engineering education, and the students signing up for engineering studies, who might have been a better fit for the study of subjects associated with less well-paying jobs such as language or primary school teaching.

Those who take out income-contingent loans are shielded from the worst income shocks since there is a maximum proportion of a debtor’s income required to be repaid in any year. In Australia and England, for example, this is 8% and 9%, so there is insurance against hardship and default. And because the amount repaid depends on your income, the student is not biased to major in high-income-earning subjects. In practice, neither kind of loan system covers the full cost of higher education and the gap is filled by a combination of general taxation and income from private university endowments.

  1. Free tuition with an income-contingent tax for graduates: This is a proposal under which attending university would be free, but students would incur a tax obligation (later in life), the total revenues of which would fund higher education (either fully or more plausibly partially). As with income-contingent loans, the amount of tax paid would depend on the income earned. An effect would be to reduce the pressure that students feel to study ‘high-earning subjects’ so as to be able to pay off their loans (low-earning subjects would lead to jobs with lower graduate taxes).
Policy Efficiency Fairness
Private universities funded by fees paid by the families of students Too little education Perpetuates unfair inequality (inheritance from parents)
Free universities funded by general taxation Too much education Unfair: it provides a free public service to rich families
Private universities as above but with students (and families) borrowing to pay Too little education (credit constraints) Unfair: parents or students who lack wealth cannot borrow.
Income contingent government loans to students Depends on design Depends on design
Free tuition with an income contingent graduates tax Depends on design Depends on design

Financing higher education.

Figure 12.15 Financing higher education.

Either income-contingent loans or free tuition with an income-contingent tax obligation are capable of addressing most of the shortcomings of the other systems, depending on how they are designed. For example, suppose policymakers or the electorate wanted to aggressively promote equal access to higher education without expanding the amount of public resources used. They could implement the free tuition option with a steeply graduated income contingent graduate tax. Those who receive high incomes following graduation pay more than their education cost, while those with low incomes pay very little.

12.14 The distributional impact of public policies: Rent control

Another policy that is frequently advocated on grounds of fairness is rent control. Rent control is a legally binding limitation on the rents that landlords can charge tenants. Landlords (owners of housing that is rented out) are typically much wealthier than the people they rent to. Rent control is advocated as a way to redistribute income from the landlords to the tenants. Adequate housing is also considered by many to be a merit good, available to all irrespective of their income, providing a second reason commonly proposed in support of rent control.

Rent control laws are common in some major cities in the US, including Los Angeles, San Francisco, New York and Washington DC. Rent control is typically bundled with restrictions on the conditions under which a landlord can evict a tenant.

In its economic logic, rent control is similar to the minimum wage: it seeks to improve the economic conditions of less well-off people (renters, low-wage workers) by imposing a price (a lower rent, a higher wage) that is favourable to their interests.

You can find an analysis of the minimum wage, along with an ‘Economist in action’ video by one of the leading researchers in this area in Unit 19 of The Economy.

The rental housing market: Renters’ surplus and landlords’ surplus

We can use the model of supply and demand to study the impact of rent control. Recall that in Unit 7 the model of the bread market allowed us to identify two components of the gains from trade:

Here we adapt those concepts to the rental market, giving us:

Figure 12.16 illustrates these concepts at the equilibrium of a hypothetical rental market. To make sense of the model assume that there are two classes of people in a city: landlords and renters. The latter considerably outnumber the former, which in a democracy gives them the possibility of passing legislation limiting the rents that landlords can charge, much like the way that Angela and her colleagues in Unit 5 voted to reduce the hours of work.

The rental market after rent control.

Figure 12.16 The rental market after rent control.

The rental market before rent control

The market is in equilibrium (point G), with X0 apartments each rented at a price of p0.

Figure 12.16a The market is in equilibrium (point G), with X0 apartments each rented at a price of p0.

Renter surplus and landlord surplus before rent control

The light red area shows renter surplus, and the light blue area shows landlord surplus.

Figure 12.16b The light red area shows renter surplus, and the light blue area shows landlord surplus.

Rent control affects the equilibrium price and quantity

Rent control lowers the price of an apartment to pR and reduces the number of units supplied to XR.

Figure 12.16c Rent control lowers the price of an apartment to pR and reduces the number of units supplied to XR.

Renter surplus and landlord surplus after rent control

Renter surplus is now the sum of the light red and green areas (FBDpR), and landlord surplus is now the (smaller) light blue area (pRDE).

Figure 12.16d Renter surplus is now the sum of the light red and green areas (FBDpR), and landlord surplus is now the (smaller) light blue area (pRDE).

Winners and losers from rent control

Rent control results in a redistribution of surplus from landlords to renters (the area p0CDpR), and deadweight losses for both renters and landlords (the areas BCG and CDG respectively).

Figure 12.16e Rent control results in a redistribution of surplus from landlords to renters (the area p0CDpR), and deadweight losses for both renters and landlords (the areas BCG and CDG respectively).

The horizontal axis is the number of units of housing. To simplify, we assume they are all identical in quality and that landlords are unable to charge different rents to different people so there will be just a single rent, which is measured on the vertical axis. The supply curve tells you, for any given rent, how many units of housing will be offered. A higher price will bring more units onto the market, even in the short run, as landlords find ways of converting unused space into apartments. And in the long run, of course, higher rentals will raise the profitability of owning rental apartments and stimulate new construction.

The demand curve provides the answer to the question: if the rental price is p, how many units of housing will be demanded? At a lower rent, more units are demanded, as more people choose to live in the city, or not to live with their parents or roommates.

In the figure you can see that prior to the introduction of rent control, the rent was p0 and the number of units rented was X0, and the renters’ surplus and the landlords’ surplus are as shown by the shaded areas.

Rent control reduces the total surplus and rearranges who gets it

The introduction of the rent control reduces the rental price to pR and the landlords respond by supplying fewer units, reducing the number available to XR. With fewer units being rented, notice, the willingness to pay of the ‘least willing’ renter (the height of the demand curve at XR), exceeds the marginal cost of putting additional units on the market. This being the case, there are people who would have been willing to rent units beyond the XR, being offered at a price exceeding the marginal cost. So the demand for rent controlled housing exceeds the supply.

This has two effects:

The net effect of these two changes is that landlords definitely lost. Their surplus is less than before for two reasons: first, they experienced some of the deadweight loss and second, they transferred some of what was before their surplus to the renters.

The effect on the renters is more complicated to evaluate. Like the landlords, they experienced some deadweight loss, but they also gained some of what was previously landlords’ surplus. Their net gain is the green rectangle p0CDpR minus the orange triangle BCG.

In the figure the surplus gained at the expense of the landlords is greater than the deadweight loss experienced by the renters. So, the policy benefited them, as intended, even though it reduced the supply of housing. Rent control is a way of dividing up a smaller pie, with a larger slice going to the renters.

Because the pie is smaller as a result of the deadweight loss, the surplus lost by the renters must be greater than the surplus gained by the renters. To see this:

So:

Is there a better way to help the less well off?

It is also the case that rent control could hurt the less well off, rather than helping them as was the case in this example. The costs inflicted on the renters in the form of deadweight loss could have exceeded the gains they made by capturing some of what previously had been the landlords’ surplus.

Exercise 12.7 Distribution of surplus under rent control.

Using a diagram similar to Figure 12.16, sketch supply and demand curves such that the costs experienced by renters (deadweight loss) will exceed their gains through gaining a larger share of the surplus.

Is there a better way to help the less well off? What can we learn from the experience of Angela and Bruno in Unit 5? Recall that Angela and her friends exploited their newly-won voting rights to impose legislation that resulted in an outcome that they preferred, but which was Pareto inef­ficient. From the new position of greater bargaining power that democracy had granted them, they had the idea that they might reach some agreement with Bruno (and the other members of Bruno’s class) that compared to the new status quo would make all of them better off.

Let’s modernize Angela and Bruno. They are now living in San Francisco and Bruno, a manager at Apple, is a landlord. Angela, a driver for Uber, is a renter. Both have learned a lot of economics, too, since Unit 5. So, when Angela goes to Bruno with Figure 12.16 she does not have to explain much. Angela has lost none of her assertiveness.

Angela
Look, Bruno, we are willing to vote to rescind the rent control if you and your landlord pals will simply transfer some money to us so that we are as well off or better than we are under rent control.
Bruno
How much would you need?

Angela shows Bruno Figure 12.17.

  Landlord (LL) and Renter (R) surplus gained or lost. Area in Figure 12.16 Calculated area ($) Amount ($ ‘000s)
1 Previously LL surplus, now R surplus Rectangle p0CDpR 350,000 × 500 175,000
2 LL’s share of deadweight loss Triangle CDG 150,000 × 500 × 1/2 37,500
3 R’s share of deadweight loss Triangle BCG 150,000 × 500 × 1/2 37,500
4 LL surplus lost (net) p0CDpR + CDG Line 1 plus Line 2 212,500
5 R net surplus gained p0CDpR − BCG Line 1 minus Line 3 137,500

Monthly gains and losses compared to the no rent control market equilibrium. (Entries in the table are based on Figure 12.16, with p0 = $1,500, pR = $1,000, X0 = 500,000, XR = 350,000, and the price at A = $2,000.)

Figure 12.17 Monthly gains and losses compared to the no rent control market equilibrium. (Entries in the table are based on Figure 12.16, with p0 = $1,500, pR = $1,000, X0 = 500,000, XR = 350,000, and the price at A = $2,000.)

From the table you can see that if the landlords transferred $137.5 million per month to the renters, the renters would be as well off as they would be under rent control, and the landlords would be much better off (paying $137.5 million directly to the renters is better than losing a total of $212.5 million in lower rents and deadweight losses). This would strike Bruno as a bargain.

Of course, Angela would be quick to point out that, were the landlords to transfer $212.5 million to the renters, then the landlords would be no worse off than they were under the rent control, and the renters much better off (getting a transfer of $212.5 million beats the net benefits to the renters from lower rents but on a reduced number of apartments rented).

The two might then bargain and agree on some intermediate amount, under which both landlords and renters would be better off.

This episode in the story of Angela and Bruno, like the others, is fanciful. It is difficult of think of ways that the kinds of transfers from landlords to renters could take place in any practical way. But it underlines an important objective: if possible, policies to grant a larger slice of the pie to the less well off should be designed to make the pie larger. Or, at least, not smaller.

The data in Figure 12.14 shows that many countries have found ways to give a larger slice to the less well off while also growing the pie. By comparison to the US, France, and Italy, for example, Germany, Norway and Finland, have enjoyed both more rapid growth in average incomes and a larger share of income going to the less well off.

Weighing the gains and losses to different groups in society

What these countries have accomplished—granting a larger slice of a larger pie to the less well off—is impressive. But we do not conclude that policies that redistribute the pie, even while shrinking it should be ruled out. The fact that in the case of rent control, the surplus lost to landlords must exceed the surplus gained by renters is not a reason to oppose the policy: remember, it was intended to help the renters, and it did.

Policies to redistribute income are often advocated on the grounds that providing additional income to one group (typically less well off) is more highly valued than the incomes lost by some other (typically higher income). The basic idea here is that the utility of people can be compared, and the needs that will be met by the poor family—more adequate housing, for example—are more important than the reduction in spending—perhaps on a second home—that the well off will experience.

Returning to Figure 12.17 you can see that if we placed a value on the gains by the renters that is twice the value placed on the costs to the landlords then the former (2 × 137.5 million) greatly outweigh the latter (212.5 million).

Exercise 12.8 Implementing rent control

Imagine you are a policymaker considering imposing the rent control whose distributional effects are shown in Figure 12.17. You place a higher value on the gains to the renters than on the losses to the landlords, because you wish to raise the living standards of the less well off (the renters) even at a cost to those who are better off (the landlords). You just saw that if your value on the gains to the renters is twice your value on the losses to the landlords, then the benefits of the policy exceed the cost.

What is the smallest value placed on the gains of the renters that would make the benefits of the policy exceed the costs?

12.15 Conclusion

Governments and markets are two major economic institutions today. Like other important economic institutions, such as families and firms, each has particular advantages and shortcomings in organizing economic activities.

Markets can allow large numbers of people to interact in mutually beneficial trades, relying on prices to convey information rather than centralized planning or coordination. However, markets are not ideal in the cases of repugnant markets or merit goods, and even for goods where markets are acceptable, market failures are common. Therefore, we need governments to produce and distribute some types of goods and to help address unfairness or inefficiencies resulting from market failure.

A government is distinct from other economic actors because it has the authority to act on behalf of all people within a given territory and to require citizens to abide by its decisions. These powers allow the government to be a successful problem solver, but also to become a problem itself. There are many examples in which governments were more concerned with earning political rents than serving the interests of their citizens.

In well-governed societies, democracy is a political institution that gives citizens the power to dismiss the government. This political accountability constrains what governments can do to further their private interests. Still, the principal–agent relationship between government officials and the citizens that exists because of differences in objectives means that some policies are not politically feasible.

Besides political feasibility, governments may fail to adopt policies that solve society’s problems for two reasons. First, the policy may not be economically feasible, meaning that an efficient and fair outcome is not a Nash equilibrium. Second, the policy may not be administratively feasible, meaning that it is impossible for the government to implement it in practice, given the information available and its fiscal capacity. The extent to which governments can address problems of unfairness and inefficiency depends on the limits posed by economic, political, and administrative feasibility.

12.16 Doing Economics: Government policies and popularity: Hong Kong cash handout

In Sections 12.7–12.11, we looked at government spending priorities in different countries, and discussed how economic, administrative, and political feasibility influence government policy decisions.

An important role of the government is to use tax funds to provide goods and services for its citizens. When governments have a budget surplus (taxes exceed government spending), they may choose to increase spending on public programs or improve the goods and services provided to their citizens.

In Doing Economics Empirical Project 12, we will look at an unconventional policy adopted by the Hong Kong Government in 2011, which was to simply give a lump sum to every citizen aged 18 or above. We will assess the effects that this policy could have on inequality, and discuss some reasons why governments may choose this policy over other redistributive policies.

Go to Doing Economics Empirical Project 12 to work on this project.

Learning objectives

In this project you will:

  • draw Lorenz curves
  • assess the effect of a policy on income inequality
  • convert cells from text to number format
  • convert nominal values to real values (extension).

12.17 References

  1. Alvin E. Roth. 2007. ‘Repugnance as a Constraint on Markets’. Journal of Economic Perspectives 21 (3): pp. 37–58. 

  2. Peter Lindert. 2004. Growing Public: Social Spending and Economic Growth since the Eighteenth Century. Cambridge: Cambridge University Press. 

  3. Jon Bakija, Lane Kenworthy, Peter Lindert, and Jeff Madrick. 2016. How Big Should Our Government Be? Berkeley: University of California Press. 

  4. Andrei Shleifer. 1998. ‘State versus private ownership’. Journal of Economic Perspectives 12 (4): pp. 133–50. 

  5. Alexander Hamilton, James Madison, and John Jay (1961). The Federalist. Middletown, Ct., Wesleyan University Press. 

  6. Monica Martinez-Bravo, Gerard P. I. Miquel, Nancy Qian, and Yang Yao. 2014. ‘Political reform in China: The effect of local elections’. NBER working paper 18101. 

  7. Joseph Schumpeter. 1918. ‘The crisis of the tax state.’ Reproduced in Swedberg R. (ed.) 1991. Joseph A. Schumpeter, The Economics and Sociology of Capitalism. Princeton University Press. 

  8. Timothy Besley and Torsten Persson. 2014. ‘Why do developing countries tax so little?’ The Journal of Economic Perspectives 28 (4): pp. 99–120. 

  9. Imran Rasul and Daniel Rogger. 2016. ‘Management of bureaucrats and public service delivery: Evidence from the Nigerian civil service’. The Economic Journal 128 (608): pp. 413–46. 

  10. Joshua L. Kalla and David E. Broockman. (2015). ‘Campaign contributions facilitate access to congressional officials: A randomized field experiment’. American Journal of Political Science 60 (3): pp. 1–14. 

  11. Harold D. Lasswell. 1936. Politics; who gets what, when and how. New York: Whittlesey House. 

  12. James J. Heckman. 2013. Giving Kids a Fair Chance. Cambridge, MA: MIT Press.