Read Chapter 6 in the textbook to accompany this lesson.
In the first section of the course, we found that the best way to allocate resources was through a competitive market. More specifically, we said that perfectly competitive markets produce the best outcome, and by "best" we mean the wealth maximizing outcome. We also talked about how deviations from, or interferences with, the functioning of the perfectly competitive market decreased total wealth accruing to society. We talked about ways in which markets can fail to provide the optimal, social-wealth maximizing outcome, which we called market failures.
Some of the market failure mechanisms we described:
- Market power (i.e., monopolies and oligopolies)
- Imperfect information
- Common Pool Resources
- Public Goods
We also examined some of the solutions to market failure:
- Market power issues are typically alleviated by reducing barriers to entry and, thus, allowing competition to occur.
- Externalities are corrected by assigning property rights.
- Common Pool Resources are corrected by assigning property rights to the government, which limits the quantity to the social optimum.
- Public Goods are corrected by having a centrally controlled agency provide the good (usually the government).
- Information failures are corrected by providing those at risk means to punish potential cheaters.
Most of the solutions require government intervention or permanent government control of the failed market. In each case, the government enters into a market in order to solve a problem of wealth not being maximized. When governments intervene in markets, they are exercising power, and exercises of power tend to have a lot of results and consequences that are neither expected nor optimal.
This is a point in the class where we veer dangerously close to politics, as government choices to intervene in market processes are typically "policy" decisions that are outcomes of election processes. I wish to avoid discussion of politics and talking about which policies might be "good" or "bad." Those are normative and not positive questions.
What we are striving to look at here is the actual results of certain policy decisions, and whether those end results are what the policy-makers intended, and whether the policy in question tends to help or hurt the economic "size of the pie."
Not all regulation is "bad" in this sense. It is broadly, if not universally, held that workplace safety rules or bans on child labor or food safety laws are net beneficial to a society, even if they represent impingements on the behavior of either private firms or individuals.
The problem of regulation is that, like all other economic processes, it suffers from diminishing returns. The first bit of regulation, which corrects major distortions or market power exercises, is generally very beneficial. We then move on to addressing the next worst distortion, which gives us a smaller benefit. And so on. We are now at a point in our history where we begin regulating smaller and smaller distortions, and we often find ourselves causing more harm to the economy than benefit by our government action. These are the types of issues we are talking about here - not fundamental discussions about the appropriate role and size of government, but whether, "at the margin," some set of government actions actually solves the problems they strive to address, and whether, in the process, they end up hurting the size of the economy more than if the government did nothing.
Reiterating, we are talking about diminishing marginal return to regulation, not whether some regulation is "good " or "bad" policy.
We will now examine some of the ways in which governmental entities behave in these situations.
Before we move on, I wish to introduce a new term, or a new paradigm. remember that the word "paradigm", which has been greatly ridiculed as a horrible piece of biz-speak jargon, has an actual meaning: a paradigm is a "way of thinking" or a way of looking at the world. So now, I wish to introduce the concept of "methodological individualism." A good description of this concept can be found at the Wikipedia page: Methodological individualism.
However, I will briefly sum things up this way: methodological individualism is a way of looking at the world and a way of explaining outcomes that views institutions not as "things" in their entirety, but merely as collections of individuals. Thus, a government, a firm, a university, or some other grouping of people is merely a large collection of individuals and individual decisions. It boils down to this: only people can make decisions, and only people can perform actions. A firm does not make decisions; the managers inside it make decisions. Governments do not make decisions or take actions; the people who constitute the government, such as politicians and bureaucrats decide things and do things. Societies do not do things; people do things.
Thus, every action taken by some collective entity, be it a government, a company, a school, a team, a society, or a family, is actually an action undertaken by a person, or multiple persons.
I have found this to be a useful way of thinking when examining actions taken by such collective entities. It is helpful because, in a microeconomics framework, we like to look at the aggregate results of millions of separate, independent decisions and actions performed by consumers. Thinking of markets as aggregates of all of the decisions and actions of the individual economic actors is the accepted and well-practiced framework of microeconomics - it works well to explain and predict market outcomes. We look at these individuals as rational, self-interested, utility maximizers operating in an environment of imperfect information and scarce resources.
It turns out that examining and predicting the actions of non-market aggregations, such as government bodies or companies by looking at the incentives faced by the individuals that make up those entities works well. Note that when I say a company is a non-market entity, I don't mean that it does not participate in markets, but that, internally, a firm is not a market, but an authority based hierarchical structure.
So, putting this as simply as I can, if we want to figure out why governments and schools and companies do what they do, we should look at the incentives faced by the people who make decisions inside those structures, and how those individuals would act if they were rational utility maximizers, which, of course, they are.
The Positive Theory of Government
We spoke earlier in the course of the notion of "normative" and "positive' questions. Normative analyses examine what outcome "should" occur (what happens in the best of all possible worlds), assuming that we have some notion of what "should" and "best" mean. Positive analyses determine what actually is happening, and why. We have already determined how the government "should" act when it intervenes in a market place to correct market failure: it "should" strive to correct the market failure in a way that maximizes wealth in the society that is being affected by the market failure. Unfortunately, that seldom, if ever, is what happens. Now, we want to examine how the government actually acts - thus the usage of the term “The Positive Theory of Government." This is a study of what government does in real life, and why.
We assume that greed motivates consumers and firms, and it is logical to assume this, since we all prefer more to less, and this assumption has been shown over time to be a reliable predictor of market actions and outcomes. We now know how government should behave (as summarized above), but we want to know how governments operate, i.e., we want a positive (rather than normative) answer.
Within economics, this field of study is known as "Public Choice." It attempts to explain what factors determine how governments make decisions. Government is composed of government officials - elected politicians and civil servants. Remembering the framework of methodological individualism, we need to ask: What do government officials want? What motivates government officials? What incentives do they face?
Politicians have one great goal, the one thing that defines them as successful politicians, which is the ability to get elected and then re-elected. A politician who cannot win an election is a poor politician indeed. Civil servants, on the other hand, are motivated by their desire to get promoted to positions of higher pay and higher authority.
Using the simplest terms and most convenient definitions, GREED motivates both politicians and civil servants.
Since government agencies are controlled by individuals motivated by greed, it is easy to imagine that these agencies are not always run in a manner consistent with society’s best interest. Let us take a look at a basic civics lesson, from an economist's point of view.
How does a politician get/keep her job? He or she gets elected by the voting public. Thus, we can say that voting is the first input to the political process (i.e., all power comes from the majority’s mandate). Generally, in a representative democracy, we vote for a candidate who will represent us on all issues. However, it is unlikely that one candidate will mirror our desires completely. As a result, we must make compromises when we cast our votes. Most people tend to choose the candidate with a platform that, on average, matches ours better than any other candidate. However, there are a couple of other selection criteria that are also commonly employed by large shares of the electorate: choosing the candidate with the position closest to ours on the most important issue, and choosing the candidate who will do the least damage.
Representative democracy has the advantage of allowing someone to specialize in making decisions. It is far better to have someone thoroughly trained in making decisions, someone who has the best information on the issues actually making the decisions. For example, it would make little sense to have national referendums on how to design military aircraft. Representative democracy also gives substantial powers to elected officials who can then use it, often for a period of several years (for example, the term of office for a US Senator is 6 years), without going back to the voters. It is possible to have direct votes (referenda) on various issues; this is an alternative to electing people for extended terms. They are commonly employed in some countries, Switzerland being the most frequently cited example. However, the frequent use of direct referenda has its problems. In California, voters typically vote on over 100 items on a ballot, and one has to wonder if they really know what they are voting for. Also, when voting on a single issue, it is often being examined without any sort of context.
So, when we vote, economic theory suggests we pick the candidate who will improve our welfare. But in some sense, it can be very difficult to tell just who is the best candidate. Individuals have little incentive to seek the necessary and costly information on politicians and policy to determine which candidate will most likely improve our welfare. Thus, voters are rationally ignorant; they are not properly informed on all the issues and candidates. We say rationally ignorant because your equilibrium behavior is to be uninformed. The cost of discovering all you need to know about all of your electoral options is greater than the benefit of doing so - it is actually rational to be ignorant! (by ignorant, we mean "not in possession of all possible information").
A short (one-page) paper from Clemson University explains rational ignorance in a little more depth:
"The Theory of Rational Ignorance". The Community Leader's Letter, Economic Brief No. 29, Clemson University.
The vote of one person is seldom decisive in a democracy - it is extremely rare for an election to be decided by one vote, outside of a very small society. The lack of impact of one vote ultimately means that your vote does not count. Since you cannot directly affect the outcome, you have no incentives to acquire all the necessary information for you to act rationally (as opposed to acting ignorantly). To illustrate, compare the incentives of a consumer buying a house and a voter "buying" a politician (spending valuable, and limited, resources to choose the “right” politician). A typical consumer will generally will take great care in acquiring information about which house he buys, because if he makes a bad choice, he’ll suffer. However, voting generates a public good, in the sense that a vote for the "best" candidate benefits others. Therefore, we can say that “correct” votes will be under-supplied, and there are thus no incentives for voting efficiently.
So, as a consequence, we look for shortcuts when it comes to ways of educating ourselves about how we should vote. This is where labels, such as "Republican," "Democrat," “liberal,” or “conservative” come into play. These are ways of conveying a large bundle of information in a shorthand way. They are attempts by politicians to overcome rational ignorance. Since we expect that politicians will seek to retain office, just like car manufacturers will seek to stay in business, and since politicians are driven by rationally ignorant voters, we see a lot of image advertising which costs a lot of money – and may not properly represent the politician.
The phenomena, taken together, are part of what we call the theory of public choice, which is a study of how the public makes collective decisions with respect to choosing government. One of the founders of this field, a Nobel Prize winner called James Buchanan, referred to this as the study of "politics without romance", by which he meant that it is a study of political behavior devoid of the romantic notions of "doing the right thing for society." For a little more background in this area, please read the below article from the Concise Encyclopedia of Economics, which is a document put together by a libertarian organization called Liberty Fund.
Shughart II, William. "Public Choice". The Concise Encyclopedia of Economics.