Political Economy

Question 1

Arrow’s impossibility theorem

Answer 1

If there are at least 3 different options, there is no such voting mechanism that meets all the following requirements:
-Unrestricted domain
-Sovereignty of decision makers
-Pareto principle
-Independence from irrelevant alternatives
-No dictatorship
In summary, there is no perfect way of aggregating individual preferences.
If there is only 2 options, the majority rule system meets the requirements.

Question 2

How to determine the optimal level of public goods?

The government can use Lindahl pricing. What is it?

Answer 2

An approach to financing public goods in which individuals honestly reveal their willingness to pay, and and the government charges them that amount to finance the public good.

Question 3

Lindahl pricing corresponds to the concept of benefit taxation. What is it?

Answer 3

Taxation in which individuals are taxed for a public good according to their valuation of the benefit they receive from that good

Question 4

Explain the 3 problems of Lindahl pricing

Answer 4

Preference Revelation Problem
-Individuals have incentive to lie about their willingness to pay. This rises from the concept of free rider problem.
Preference knowledge problem
-Individuals may not know their willingness to pay. For example, how would you value firework or national defense
Preference Aggregation problem

Question 5

Voting mechanism helps to aggregate individual demands.

What is referendum?

Answer 5

A measure placed on the ballot by the government allowing citizens to vote on state laws or constitutional amendments that have already been passed by the state legislature

Question 6

Median voter model

Answer 6

The median voter may apply to representative democracies
Key assumptions:
-Single dimension: the median voter models assumes that voters are basing their votes on a single issue
-No ideology: all politicians care about is maximizing the number of votes they get.
-Only 2 candidates (plurality voting system). e.g., Republicans and Democrats

Politicians strategically position themselves to get the most votes.
-End up enacting the median voter’s preferences.

Question 7

What is voter initiative?

Answer 7

The placement of legislation on the ballot by citizens

Question 8

What is majority voting?

Answer 8

individual policy options are put to a vote, and the option that receives the majority of votes in chosen

Question 9

Success means being able to consistently aggregate individual preferences into a social decision.
To be consistent the aggregation mechanism must satisfy 3 goals:

Answer 9

Dominance
-if 1 choice is preferred by all voters, the aggregation mechanism must be such that this choice is made by society
Transitivity
-if a>b>c then a>c must be true
Independence of irrelevant alternatives
-if a>b , then introduction of c shouldn’t change this preference

Question 10

The problems with Median voter model

Answer 10

Since all politicians are trying to represent the interest of the median voter,

• No differences among the proposals of political parties and candidates
• Not properly representing the preferences of the whole society

Question 11

Why the median voter theorem does not necessarily work?

Answer 11

-Politicians have to maintain the voting activity of their core constituencies
-New political alternatives may arise
-Politicians may not have the full information about the preferences of the median voter
Social left
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-More than 1 relevant dimension. ( economic lefteconomic right )
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Social right

Question 12

Constraints government can face:

Answer 12

Constitution

• Redistribution of wealth, problems with the 2nd welfare theorem
• International treaties

Government decisions affect incentives, with unintended consequences.

• reaction of capital markets
• taxation(Laffer curve, Tax evasion, costs of tac collection)
• Lack of Information(such as preferences of consumers, exact cost structure(cost function) of firms, external costs)

Question 13

What is natural monopoly?

Answer 13

When there is a huge fixed cost and low MC, then the average cost decreases as more products are produced. In this sense, due to this cost structure, it is better if only 1 company produces the good.

Question 14

Reasons for inefficiencies of public companies

Answer 14

Soft budget, low competition, on average less salary.
Bureaucracy: difficulty in measuring performance
-How to measure
-Different objectives

Pursuing self-interest

• Principal agent problem(different objectives, the principal is not able to monitor the agent’s performance)
• Incentives to exhaust the yearly budget.(if they send the leftover money back, less funding might arrive next term)

Risk aversion

• Routines and rules-lack of flexibility
• inefficiency

Adverse selection
If the problem is solved then the agency is no longer needed so the agency has less incentive to solve the problem. Therefore, the more long-lasting agencies are the less productive.

Paternalism
If government provides a wide set of goods and services, then the expectations of citizens will adjust.
-Moral hazard (since government offers certain service, such as insurance, citizens are more likely to be risky. Such as building houses on flood plains. )

Question 15

Arrow’s theorem states that

Answer 15

There is no social decision(voting) rule that converts individual preferences into a consistent aggregate decision w/o either

1. restricting preferences or
2. imposing a dictatorship

Question 16

Median Voter Theorem

Answer 16

Majority voting will yield the outcome preferred by median voter if preferences are single-peaked.