Chapter 25

POLITICAL ECONOMICS
Copyright 2002 by South-Western, a division of Thomson Learning. All rights reserved.
MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS
EIGHTH EDITION
WALTER NICHOLSON
Social Welfare Criteria
Analyzing the choice among feasible
allocations of resources is difficult
it involves making choices about the utility
levels of different individuals
in choosing between two allocations (A and
B) the problem arises that some individuals
prefer A while others prefer B
Social Welfare Criteria
We can use the Edgeworth box diagram
to show the problems involved in
establishing social welfare criteria
only points on the contract curve are
considered as possible candidates for a
social optimum
along the contract curve, the utilities of the
two individuals vary, and these utilities are
directly competitive
Social Welfare Criteria
O
J

O
S

U
J
4

U
J
3

U
J
2

U
J
1

U
S
4

U
S
3

U
S
2

U
S
1

Contract curve
Social Welfare Criteria
If we are willing to assume that utility
can be compared among individuals, we
can use the contract curve to construct
the utility possibility frontier
Social Welfare Criteria
Smiths utility
Joness utility
O
J

O
S

The utility possibility frontier shows those utility
levels for Smith and Jones that are obtainable
from the fixed quantity of goods available
Any point inside the curve is
Pareto-inefficient
-
C
Equality Criterion
Smiths utility
Joness utility
O
J

O
S

One possible criterion could
require complete equity giving
Smith and Jones the same level
of welfare
45
Utility is equal in this
case, but the quantities of
X and Y may not be
This occurs at U
J
A
and U
S
A

U
S
A

U
J
A

-
A
Contract curve
Equality Criterion
O
J

O
S

U
J
2

U
J
A

U
J
1

U
S
2

U
S
A

U
S
1

A
-
X
S
A

X
J
A

Y
S
A

Y
S
A

Utilitarian Criterion
A similar criterion would be to choose
the allocation on the utility possibility
frontier so that the sum of Smiths and
Joness utilities is the greatest
this point would imply a certain allocation
of X and Y between Smith and Jones
The Rawls Criterion
This was first posed by philosopher
John Rawls
Suppose that each individual begins in
an initial position in which no one knows
what his final position will be
individuals are risk averse
society will only move away from perfect
equality when the worst off person would
be better off under inequality than equality
The Rawls Criterion
Smiths utility
Joness utility
O
J

O
S

Unequal distributions such as B
would be permitted when the
only attainable equal distributions
are below D
45
D
B
A
Equal distributions that lie
between D and A are
superior to B because the
worse-off individual is better
off there than at B
-
-
-
Social Welfare Functions
A social welfare function may depend
on Smiths and Joness utility levels
such as
social welfare = W(U
S
,U
J
)
The social problem is to allocate X and
Y between Smith and Jones as to
maximize W
The optimal point of social
welfare is where W is
maximized given the utility
possibility frontier
W
1

W
2

Social Welfare Functions
Smiths utility
Joness utility
O
J

O
S

E
This occurs at U
J
E
and U
S
E

U
S
E

U
J
E

-
W
1

W
2

Social Welfare Functions
Smiths utility
Joness utility
O
J

O
S

Even though point F is
Pareto-inefficient, it is still
preferred to point D
Note the tradeoff between
equity and efficiency
D
-
-
F
Equitable Sharing
A father arrives home with an 8-piece
pizza and must decide how to share it
between his two sons
Teen 1 has a utility function of the form
1 1
2 X U =
Teen 2 has a utility function of the form
2 2
X U =
Equitable Sharing
The least resistance option would be to
give each teen 4 slices
U
1
= 4, U
2
= 2
The father may want to make sure the
teens have equal utility
X
1
= 1.6, X
2
= 6.4, U
1
= U
2
= 2.53
The father may want to maximize the
sum of his sons utility
X
1
= 6.4, X
2
= 1.6, U
1
= 5.06, U
2
= 1.26
Equitable Sharing
Suppose the father suggests that he will
flip a coin to determine who gets which
portion listed under the three allocations
The expected utilities of the two teens
from a coin flip that yields either 1.6 or
6.4 slices is
E(U
1
) = 0.5(2.53) + 0.5(5.06) = 3.80
E(U
2
) = 0.5(2.53) + 0.5(1.26) = 1.90
Equitable Sharing
Given this choice, the teens will opt for
the equal distribution because each
gets higher expected utility from it than
from the coin flip
Equitable Sharing
If the father could subject the teens to a
veil of ignorance so that neither would
know his identity until the pizza is
served, the voting might still be different
if each teen focuses on a worst-case
scenario, he will opt for the equal utility
allocation
insures that utility will not fall below 2.53

Equitable Sharing
Suppose that each teen believes that he has
a 50-50 chance of being labeled as teen 1
or teen 2
Expected utilities are
X
1
= X
2
= 4 E(U
1
) = 0.5(4) + 0.5(2) = 3
X
1
= 1.6, X
2
= 6.4 E(U
1
) = 0.5(2.53) + 0.5(2.53) = 2.53
X
1
= 6.4, X
2
= 1.6 E(U
1
) = 0.5(5.06) + 0.5(1.26) = 3.16
The teens will opt for the utilitarian solution
The Arrow Impossibility
Theorem
Arrow views the general social welfare
problem as one of choosing among
several feasible social states
it is assumed that each individual can rank
these states according to their desirability
Arrow raises the following question:
does there exist a ranking on a societywide
scale that fairly records these preferences?
The Arrow Impossibility
Theorem
Assume that there are 3 social states
(A, B, and C) and 2 individuals (Smith
and Jones)
Smith prefers A to B and B to C
A P
S
B and B P
S
C and A P
S
C
Jones prefers C to A and A to B
C P
J
A and A P
J
B and C P
J
B
The Arrow Impossibility
Theorem
Arrows impossibility theorem consists of
showing that a reasonable social ranking
of these three states cannot exist
Arrow assumes that any social ranking
should obey six seemingly
unobjectionable axioms
P should be read is socially preferred to
The Arrow Axioms
It must rank all social states
either A P B, B P A, or A and B are equally
desirable (A I B) for any two states A and B
The ranking must be transitive
if A P B and B P C (or B I C), then A P C
The ranking must be positively related
to individual preferences
if A is unanimously preferred by Smith and
Jones, then A P B
The Arrow Axioms
If new social states become feasible, this
fact should not affect the ranking of the
original states
If A P B, then this will remain true if some
new state (D) becomes feasible
The social preference function should
not be imposed by custom
it should not be the case that A P B
regardless of the tastes of individuals in
society
The Arrow Axioms
The relationship should be
nondictatorial
one persons preferences should not
determine societys preferences
Arrows Proof
Arrow was able to show that these six
conditions are not compatible with one
another
because B P
S
C and C P
J
B, it must be the
case that B I C
one persons preferences cannot dominate
both A P
S
B and A P
J
B, so A P B
transitivity implies that A P C
this cannot be true because A P
S
C but C P
J
A
Significance of the
Arrow Theorem
In general, Arrows result appears to be
robust to even modest changes in the set
of basic postulates
Thus, economists have moved away
from the normative question of how
choices can be made in a socially optimal
way and have focused on the positive
analysis of how social choices are
actually made
Direct Voting
Voting is used as a decision process in
many social institutions
direct voting is used in many cases from
statewide referenda to smaller groups and
clubs
in other cases, societies have found it
more convenient to use a representative
form of government
Majority Rule
Throughout our discussion of voting, we
will assume that decisions will be made
by majority rule
Keep in mind though, that there is nothing
particularly sacred about a rule requiring
that a policy obtain 50 percent of the vote
to be adopted
The Paradox of Voting
In the 1780s, social theorist M. de
Condorcet noted that majority rule
voting systems may not arrive at an
equilibrium
instead, they may cycle among alternative
options
The Paradox of Voting
Suppose there are three voters (Smith,
Jones, and Fudd) choosing among
three policy options
we can assume that these policy options
represent three levels of spending on a
particular public good [(A) low, (B) medium,
and (C) high]
Condorcets paradox would arise without
this ordering
The Paradox of Voting
Smith Jones Fudd
A B C
B C A
C A B


Preferences among the three policy
options for the three voters are:
The Paradox of Voting
Consider a vote between A and B
A would win
In a vote between A and C
C would win
In a vote between B and C
B would win
No equilibrium will ever be reached
Single-Peaked Preferences
Equilibrium voting outcomes always
occur in cases where the issue being
voted upon is one-dimensional and
where voter preferences are single-
peaked
Single-Peaked Preferences
Quantity of
public good
Utility
A B C
-
-
-
Smith
We can show each voters preferences in
terms of utility levels
-
-
-
Jones
-
-
-
Fudd
For Smith and Jones,
preferences are single-
peaked
Fudds preferences have
two local maxima
Single-Peaked Preferences
Quantity of
public good
Utility
A B C
-
-
-
Smith
-
-
-
Jones
Option B will be chosen
because it will defeat
both A and C by votes 2
to 1
If Fudd had alternative preferences with a
single peak, there would be no paradox
-
-
-
Fudd
The Median Voter Theorem
With the altered preferences of Fudd, B
will be chosen because it is the
preferred choice of the median voter
(Jones)
Joness preferences are between the
preferences of Smith and the revised
preferences of Fudd
The Median Voter Theorem
If choices are unidimensional and
preferences are single-peaked, majority
rule will result in the selection of the
project that is most favored by the
median voter
that voters preferences will determine
what public choices are made
A Simple Political Model
Suppose a community is characterized
by a large number of voters (n) each
with income of Y
i

The utility of each voter depends on his
consumption of a private good (C
i
) and
of a public good (G) according to
utility of person i = U
i
= C
i
+ f(G)
where f
G
> 0 and f
GG
< 0
A Simple Political Model
Each voter must pay taxes to finance G
Taxes are proportional to income and
are imposed at a rate of t
Each persons budget constraint is
C
i
= (1-t)Y
i

The government also faces a budget
constraint
A
n
i
i
tnY tY G = =

=1
A Simple Political Model
Given these constraints, the utility
function of individual i is
U
i
(G) = [Y
A
- (G/n)]Y
i
/Y
A
+ f(G)
Utility maximization occurs when
dU
i
/dG = -Y
i
/(nY
A
)

+ f
G
(G) = 0
G = f
G
-1
[Y
i
/(nY
A
)]
Desired spending on G is inversely
related to income
A Simple Political Model
If G is determined through majority rule,
its level will be that level favored by the
median voter
since voters preferences are determined
solely by income, G will be set at the level
preferred by the voter with the median level
of income (Y
m
)
G* = f
G
-1
[Y
m
/(nY
A
)] = f
G
-1
[(1/n)(Y
m
/Y
A
)]
A Simple Political Model
Under a utilitarian social welfare
criterion, G would be chosen so as to
maximize the sum of utilities:

=
+ = + = =
n
i
A A
i
A
i
G nf G nY G f Y Y n G Y U SW
1
) ( )] ( / ) / [(
The optimal choice for G then is
G* = f
G
-1
(1/n) = f
G
-1
[(1/n)(Y
A
/Y
A
)]
the level of G favored by the voter with
average income
Voting for Redistributive
Taxation
Suppose voters are considering a lump-
sum transfer to be paid to every person
and financed through proportional
taxation
If we denote the per-person transfer g,
each individuals utility is now given by
U
i
= C
i
+ g
Voting for Redistributive
Taxation
The governments budget constraint is
ng = tnY
A

g = tY
A

For a voter with Y
i
> Y
A
, utility is
maximized by choosing g = 0
Any voter with Y
i
< Y
A
will choose t = 1
and g = Y
A

would fully equalize incomes

Voting for Redistributive
Taxation
Note that a 100 percent tax rate would
lower average income
Assume that each individuals income
has two components, one responsive to
tax rates [Y
i
(t)] and one not responsive
(N
i
)
also assume that the average of N
i
is zero,
but its distribution is skewed right so N
m
< 0

Voting for Redistributive
Taxation
Now, utility is given by
U
i
= (1-t)[Y
i
(t) + N
i
] + g
The individuals first-order condition for a
maximum in his choice of t and g is now
dU
i
/dt = -N
i
+ t(dY
A
/dt) = 0
t
i
= N
i
/(dY
A
/dt)
Under majority rule, the equilibrium
condition will be
t* = N
m
/(dY
A
/dt)

Representative Government
In representative governments, people
vote for candidates, not policies
Politicians policy preferences are
affected by a variety of factors
their perceptions of what their constituents
want
their view of the public good
the forcefulness of special interests
their desire for reelection

Probabilistic Voting
Assume there are only two candidates
for a political office
each candidiate announces his platform (u
1

and u
2
)
also assume that the candidate, once
elected, will actually seek to implement the
platform he has stated
Each of the n voters observe the two
platforms and choose how to vote
Probabilistic Voting
The probability that voter i will vote for
candidate 1 is
t
i
= f
i
[U
i
(u
1
) - U
i
(u
2
)]
where f > 0 and f< 0
The probability that voter i will vote for
candidate 1 is 1 - t
i

The Candidate Game
Candidate 1 chooses u
1
so as to
maximize the probability of his election

= =
u u = t = =
n
i
n
i
i i i i
U U f EV
1 1
2 1 1
)] ( ) ( [ vote expected
Candidate 2 chooses u
2
so as to
maximize his expected votes

=
= t = =
n
i
i
EV n EV
1
1 2
) 1 ( vote expected
The Candidate Game
Our voting game is a zero-sum game
with continuous strategies (u
1
and u
2
)
Thus, this game will have a Nash
equilibrium set of strategies for which
EV
1
(u
1
,u
2
*) s EV
1
(u
1
*,u
2
*) s EV
1
(u
1
*,u
2
)
Candidate 1 does best against u
2
* by
choosing u
1
*
Candidate 2 does best against u
1
* by
choosing u
2
*

Net Value Platforms
A net value platform is one in which a
candidate promises a unique dollar
benefit to each voter
Suppose candidate 1 promises a net
dollar benefit of u
1
to each voter
The candidate is bound by a government
budget constraint:

=
= u
n
i
i
1
1
0
Net Value Platforms
The candidates goal is to choose u
1
that
maximizes EV
1
against u
2
*
Setting up the Lagrangian yields

|
|
.
|

\
|
u + =

=
n
i
i
EV
1
1 1
L
|
|
.
|

\
|
u + u u =

=
n
i
i i i
U U f
1
1 2 1
)]
*
( ) ( [ L
Net Value Platforms
The first-order condition for the net
benefit promised to voter i is given by
cL/cu
1i
= f
i
U
i
+ = 0
If the function f
i
is the same for all voters,
this means that the candidate should
choose u
1i
so that U
i
is the same for all
voters
a utilitarian outcome

Rent-Seeking Behavior
Elected politicians perform the role of
agents
choose policies favored by principals
(voters)
A perfect agent would choose policies
that the fully informed median voter
would choose
are politicians so selfless?
Rent-Seeking Behavior
Politicians might engage in rent-seeking
activities
activities that seek to enhance their own
welfare
This would create an implicit tax wedge
between the value of public goods
received by voters and taxes paid
Rent-Seeking Behavior
Extraction of political rent r would
require that the government budget
constraint be rewritten as
G = tnY
A
- r
Voters would take such rent-seeking
activities into account when deciding on
public policies
would likely reduce G and t
Rent-Seeking Behavior
Whether political rents can exist in an
environment of open electoral
competition is questionable
Candidate A announces policy (G,t)
A

Candidate B can always choose a policy
(G,t)
B
that is more attractive to the median
voter by accepting a smaller rent
Only with barriers to entry or imperfect
information can positive rents persist
Rent-Seeking Behavior
Private citizens may also seek rents for
themselves by asking politicians to grant
them favors
Thus, economic agents engage in rent-
seeking activities when they use the
political process to generate economic
rents that would not ordinarily occur in
market transactions
Rent Dissipation
If a number of actors compete in the
same rent-seeking activity, it is possible
that all available rent will be dissipated
into rent seekers costs
Suppose a monopoly might earn profits
of t
m
and a franchise for the monopoly
can be obtained from the government
for a bribe of B
Rent Dissipation
Risk-neutral entrepreneurs will offer
bribes as long as the expected net gain
is positive
If each rent seeker has the same
chance of winning the franchise, the
number of bribers (n) will expand to the
point at which
B = t
m
/n
Important Points to Note:
Choosing equitable allocations of
resources is an ambiguous process
because many potential welfare
criteria might be used
in some cases, achieving equity
(appropriately defined) may require
some efficiency sacrifices
Important Points to Note:
Arrows impossibility theorem shows
that, given fairly general
assumptions, there is no completely
satisfactory social choice mechanism
the problem of social choice theory is
therefore to assess the performance of
relatively imperfect mechanisms
Important Points to Note:
Direct voting and majority rule may
not always yield an equilibrium
if preferences are single-peaked,
however, majority rule voting on one-
dimensional public questions will result
in choosing policies most favored by the
median voter
such policies are not necessarily efficient
Important Points to Note:
Voting in representative governments
may be analyzed using the tools of
game theory
in some cases, candidates choices of
strategies will yield Nash equilibria that
have desirable normative consequences
Politicians may engage in opportunistic
rent seeking, but this will be constrained
by electoral competition