Schools Associated with

Economic Analysis of Public

Goods
A Damodaran
PPTs
 Why do we have this Module?
• Understand how and why (political economic
reasons) public choice is frustrated and public
goods are not supplied optimally in quantities
and in terms of prices
• How and why unbridled State control can be
harmful and what needs to be done to improve
State control
• Can Institutions, Trust, social capital, collective
goods and voluntary action promote better
provisioning of public goods and remove the
perils of State control?
 Scope
• What is Political Economy
• What are the origins of Public Choice
School and Rent Seeking
• Institutional Economics, Corruption and
Lobbying
• Collective Goods Analysis
• Economic Growth Schools
• Social Capital
 Political Economy
• PE combines behavioral assumption from
economics and the market place with the political
(non market) arena
• That is it brings the economic human being into
the political arena and analyses the situation of
economically rational group action.
• In the abstract it postulates that the study of
market and the study of political decision making
may be based on the utility maximizing behavioral
assumption of economics.
 Public Choice School: Origins
• 1957 : An Economic Theory of Democracy
by Anthony Downs - self interest axiom or
that political behavior is directed primarily
towards selfish interest/ends :
• Thus politicians act solely in order to attain
income, prestige and power which come
from being in office.
• 1962: The Calculus of Consent by
Buchanan and Tullock
The Public Choice School: Rent
Seeking
• The average individual acts on the basis of the same
overall value scale when he participates in a market
activity and political activity.(Kelman)
• Tullock(1967) introduced the concept of rent seeking and
defined it as ‘the use of resources in lobbying and other
activities directed at securing protective legislation’.
• Rent means economic rent created by government
intervention in the market economy.
• Governments create rent by issuing permits to local
producers or by taxing imports.
• Government restrictions give rise to rent for which
people compete which may be legal ,e.g.lobbyism.
 Tariff and Quota
• Consumers lose surplus and domestic
producers experience an increase in
producer surplus of size G. The producers
prefer this situation than the free trade
situation.
• Identifying winners and losers of a
proposed regulation is important when
parties have lobbying power in order to fully
understand the choice of regulation.
(Brandt and Svendsen)
• Producers may rationally spend gain of producer
surplus to promote a license system.(Tollison,
2000)
• Producers may spend enough of their rent to make
deregulation socially unprofitable.
• Individual industrial groups may face loss and
oppose free trade.
• The social cost of rent- seeking may be avoided by
reallocating resources from lawyers and lobbyists
towards more productive uses.
• But the ability of rent seeking agents to resist any
reallocation is yet another reason not to waste
resources attempting to do so. (Tollison and
Wagner,1991)
• The rent seeker takes the regulator out to
dinner , the value that the regulator places
on the dinner must be subtracted from the
social costs of rent seeking.
(Tollison,2000)
• It pays some interest groups to rent seek
by reducing free trade and price
liberalization.
•
Institutional Economics
Formal and Informal Institutions
1. This approach is employed to study economic
interaction in a world where economic agents do not
have full information.
2. The inability of societies to develop effective, low cost ,
enforcement of contracts is the most important source
of historical stagnation and contemporary
underdevelopment in the third world. (North, 1990).
3. The transaction cost will be positive when agents do
not possess full information and to support exchange of
goods and services in a world with incomplete
information, Besides this leads to rent seeking
4. In such a situation agents need to construct the ‘rules
of the game’.
• Behavioral norms enforced decentrally by agents save
monitoring and third party enforcement costs.
• Many gains cannot be realized in primitive trade without
institutions.
• Here, transactions take place when you give with one hand
and take with another.
• Formal institutions sanctioned by the state are crucial in
determining whether a society can accomplish economic
growth in the long run.
• ‘Law Merchants’ and ‘Champagne fairs’ gave trading parties
information on other countries.
• Capability of state to formulate and enforce formal
institutions is decisive.
• British development of a well functioning capital market is
due to the parliamentary system which deprived the king to
influence economic policies.
 Lobbyism
• Institutional economists tend to focus on the
circumstances that facilitate successful lobbyism and the
achievement of rent amongst organized interest groups
and seek to rectify them through new institutional
measures.
• The new institutional set up has a beneficial impact on
policy outcome and economic growth.
– Private property rights become more secure because
it is now more difficult to undermine them as more
actors had to accept such action.
– Power sharing and parliamentary supremacy mitigated
rent-seeking activities by raising the price of favorable
regulation.
– Institutional arrangement ‘significantly limited publicly
supplied private benefits’.
 Corruption
• Corruption is derived from Latin, rumpere and means ‘to
break’ .
• Everyone is not equal to the law and corruption may be
defined as intentional non compliance with the Arms
length principle.
• Arms length principle means personal relationships
should not play any role in economic decisions, all
agents must be treated equally.
• Laws are only as good as the institutions that enforce
them and high quality formal organizations are required
needed for predictability in a modern market economy.
• Arms length principle requires that a rule is precise and
transparent, to curb monopoly power which is the
source of corruption.
• The definition of corruption includes
acceptance of money or other rewards for
granting of contracts, ranging from
violation of procedures to advance
personal interests, including kickbacks
from development programmes or
multinational corporations, pay offs for
legislative support, the diversion of public
resource for private use to overlook illegal
activities.
 Key Question to ponder
• How do you see the Cash transfer scheme
as an institutional measure to prevent rent
seeking and reduce corruption????
 The Collective Good Analysis
• Group Action
– Any collective action will fundamentally provide
an inseparable benefit for any member of the
group.
– Collective action is to be found whenever
grouping of two or more individuals is needed
for accomplishing a goal.
– Group size is important when groups strive to
mobilize for ‘collective good’ provisions
typically concerning redistribution of national
income and wealth rather than production of
additional output.(Olson,1965)
• Interest groups fighting over the national income
pie are like people people fighting over porcelain
‘in a china shop’ and accumulation of interest
group related organizations slow down economic
growth over time. (Olson, 1982)
• Great Britain experienced economic stagnation
after World War II because of burden of groups,
‘British Disease’.
• Redistribution at the EU level will take place
because rational interest groups will try to
redistribute as much money from EU taxpayers to
themselves.(Olson’s logic of collective
Action,1965)
.
• The ‘collective good’ of full market
liberalization or, in contrast, of preventing
any further market liberalization is
provided by lobbyism.
 Full market Liberalization
• Consider an example where one million
identical consumers will be affected in the
EU.
• The numerous small entities are not yet
organized in a large group but are all
potential economic winners by the
‘collective good’ policy.
• Competition from eastern Europe will
reduce prices on agricultural products.
 Decision of an individual when alone as compared to his decision
when member of a group is depicted. The individual demand curve
for collective good Q is drawn as Di. The supply curve for producing
any amount of Q at price of Pi is depicted as S. In this case no single
consumer will provide the collective good without organization. The
total cost area C is much higher than the individual gain below Di
curve. Thus the net benefit to the individual is clearly negative
 Status Quo
• ‘Winners’ of a policy of preventing market
liberalization belong to a small sized
group.
 Here it is the case of one individual farmer to lobby on her own for preventing a free
market economy. Her WTP for preventing liberalization is the area under the demand
curve and above price or supply cost ie PS. An individual’s net gain is Ai if alone. This is
the cost of lobbying. This can be bought down to zero if she groups herself. Indeed the
larger the group , the gain could go upto Ai +C
Asymmetrical Political Pressure
• Asymmetrical political pressure against full
market liberalization is common in States
• The large and non organized group will not
act to promote full market liberalization
 Economic Growth
• Modern Economic Growth theories
– The state as benevolent leader of the
developmental process, an omniscient social
welfare maximizer’. (Rodrik,2001)
– The state as major obstacle to economic
growth as it acts on behalf of narrow interest
groups, politicians and bureaucrats.
• The recent trend is towards privatilization
and minimalist government.
• International dependence models tried to explain
failure of economic growth in developing
countries by –neoclassical dependence models,
false paradigm model and dualistic development
thesis.
• Neoclassical dependence model said that rich
nations exploit the poor and unequal power
relationship exists between the centre of rich
countries and periphery of poor countries.
• False paradigm means lack of economic growth.
• Dualistic development means dualism represents
the existence and persistence of increasing
divergences between rich and poor, in poor
countries.
• Markets alone are efficient and free trade and
price signals will be effective as cartel busters
that eliminate privileged elites.
• Politicians', bureaucrats, states and interest
groups act solely from a interested perspective
and chase capital benefits called rent.
• The state may fail to protect its citizens and
could use its power to confiscate private
property from individual.
• Hence minimal government is the best
government.
• There is an optimal balance between state intervention
and free market forces.
• Arguments for state intervention(Meier and Rauch, 2000)
– Market failure
– Income distribution
– Rights to goods such as education
– Paternalism
– Rights of future generation.
• Environmental regulation would be classified under
market failure because the market cannot on its own
provide optimal level of environmental quality.
• Minimalist governments have a key role in facilitating well
functioning markets and can provide collective goods
such as infrastructure, security, health care, education
etc.
 Production Factors
• Traditional production factors such as technology,
land, physical capital and human capital.
• Firms should invest in developing countries where
wage is low.
• Culture, skills, education influences per capita
income.
• Rich countries have vast larger leads over poor
countries in per capita incomes than can possibly
be explained by differences in marketable human
capital of their population.
• Great difference in wealth is due to indifferent
quality of institutions and economic policies.
 Free Trade
• The Olsonian solution to cope with cartels
and accumulation of interest groups is
Free trade which is the essential cartel
buster .
 Critics
• Societal Norms
– Role of public spirit also plays a role in
motivating individual behavior and economic
growth.(Kelman)
– Economic analysis can’t be just applied to
politics because people do not necessarily act
everywhere as they would act in marketplace.
Excess Co-operation
It is to be wondered why people tend to co-
operate more than they should
E.g. Prisoners dilemma game
 Social Capital
• Adam Smith observed that there is noticeable difference in
trust across nations and found that Dutch ‘are most faithful
in their word’. John Stuart Mill wrote that, ‘There are
countries in Europe… where the most serious impediment
to conducting business on a large scale is rarity of persons
who are supposed to fit to be trusted with the receipt of
expenditure of large sums of money.
• The level of trust is used as the most preferred measure
for the sociological concept called social capital.
• Social Capital is ability of organizations to work together
for common purposes.
• The key cultural element in social capital is trust. Shared
norms and the social glue of culture link people together
and establish social networks.
•
Why social capital/ Trust
In presence of trust, few will commit crime, free ride or ignore rules in
contract.
• Olliver Williamson has emphasized the role of formal institutions in
reducing transaction costs.
• Kenneth Arrow said that every commercial transaction has a element
of trust.
• In traditional approach of political economy , the key cultural element
in social capital is the element of trust.
• Trust is important to economic growth because trust may reduce the
number of transactions that need to be enforced by a third party.
• Social Capital could be a new production factor which must be added
to the conventional concept of human and physical capital.
• A new social capital production factor may be the missing link in
neoclassical growth.
• When citizens cannot trust institutions in
society and when everyone is not equal to
the law, this unpredictability blocks the
building of social capital.
• An agent’s trust about the quality of formal
institutions will affect the level of positive
social capital beneficial to economic
growth.
 Measurement and other isues
• The simple way to measure trust level is to ask people
directly as to what level of corruption is likely to affect the
level of social capital.

• Putnam’s Instrument is also used to measure social

capital. Putnam proposed simple operational proxy: the
density of voluntary organization of any type e.g.
neighbourhood associations, choral societies, co-
operatives, sports clubs, mass based parties, tower
societies, mutual aid societies, literary societies, guilds,
unions.
 Building Social Capital
• The state must withdraw and minimize its role in
the economy, make use of markets and promote
free trade , rather than have a centrally planned
economy that leaves little room for the existence
of beneficial voluntary organizations and
entrepreneurship.
• State withdrawal should be combined with efforts
to increase economic growth.
• The setting of effective social sanction
mechanisms must be maintained in voluntary
groups to prevent them from becoming harmful
rent-seeking groups.