Lecture 7

1. Lecture 7 Government failure Readings: T. Besley, Principled Agents?, chapter 2

2. Government intervention • Scope for government intervention in the economy exists when individuals fail to reach a good outcome on their own (when there is a market failure) • We analyzed mechanism of collective decision making

3. Government intervention • Mechanisms of collective decision making • the government can take an action maximising some social welfare function (i.e. a function that gives a precise weight to each individual in the society • political mechanism, like majority voting to decide

4. Government intervention and efficiency • Do governments solve market failures? • Government failures? • Some welfare criteria to judge government intervention • Pareto-inefficiency • Distributional failures • Wicksellian failures

5. Pareto-inefficiency • Remember that market failure is defined as situation where the market fails to achieve an outcome on the utility possibility frontier • In an analogous way, we will say that there is a government failure when the government fail to achieve policies resulting in outcomes on the utility possibility frontier • Criticism: a very unequal outcome chosen by a dictator would satisfy Pareto-efficiency

6. Distributional failures • Distributional concerns may be very important when we consider public policies • Example of policies raising distributional concerns: • subsidies to particular sectors • Provision of goods targeted to particular regions • Policies favouring some particular lobby group or region may be Pareto-efficient, yet they may result in very unequal distribution of resources

7. Distributional failures • How can we judge government intervention on distributional grounds and assess whether there is a case of “distributional failure”? • We need some kind of distributional metric: Social Welfare Function • Does the government maximise a Social Welfare Function? • Problem: the choice of the function is arbitrary and any allocation might be affected by distributional failure or might be considered distributionally efficient depending on the Social Welfare Function used as benchmark!

8. Distributional failures • Alternative criterion: if utility is transferable (ex: utility linear in money) so that there is a way to redistribute resources from winners to losers, then social surplus maximisation could be an alternative criterion. • Hence, if a policy maximises Social Surplus there is not policy change in which the gainers can compensate the losers • On the other hand, if a policy does not maximise social surplus, than moving toward social surplus maximization will guarantee that gainers from the policy change can compensate losers

9. Wicksellian failures • Policy outcomes and political decisions should lead to outcome that Pareto dominate what would have been achieved without government intervention • Hence, whenever the government does not achieve an outcome that Pareto dominate the status quo (i.e. what would have been achieved without government – this could be for example the market outcome) the government intervention is affected by a Wickesellian failure

10. Utility possibility frontier (UPF) UB Social preferences A= social welfare function maximisation point (distributional and Pareto efficient) B= Pareto efficient but not distributionally efficient A • • B UA

11. Utility possibility frontier (UPF) UB M=status quo Pareto-inefficient A= Pareto and Wickesell efficient B= Pareto-efficient but Wickesell- inefficient C= Wicksell-efficient but Pareto-inefficient • A • C • M • B UA

12. Majority voting and efficiency • Does majority voting deliver outcomes satisfying any of the above criteria of efficiency? • Example: Public Good Provision • Public good g can be provided at a cost C(g) that is equally shared among N individuals (N odd) • Each individual indexed by j derives from the public good provision the following utility

13. Majority voting and efficiency • The most preferred level of public good for each individual is obtained equating the marginal benefit to the marginal cost • Assume that the utility and cost associated to the public good provision are such that if there is no government intervention, individuals would not voluntarily contribute to the public good provision and therefore g=0 • If the government intervenes, the provision of g depends on the mechanism of collective decision making • Suppose that government chooses the quantity of public good that is preferred by the majority. • Given that preferences are single peaked the median voter results applies. Therefore, among the possible g, the most preferred outcome of the median voter is selected and let’s denote it by

14. Majority voting and efficiency • Is the median voter outcome Pareto-efficient? • Suppose that the outcome preferred by the median voter (that is a Condorcet winner), is not Pareto-efficient. In this case there must be another outcome that must be preferred by everybody. But if this is the case, the outcome preferred by the median voter cannot be a Condorcet winner (because it could not beat any other outcome in any pair wise comparison)

15. Majority voting and efficiency • Wicksell efficiency? • Status quo policy g=0 • Government policy g*m • For the median voter clearly • However, for individuals with preferences sufficiently distant from the median voter, the status quo, although Pareto-inefficient, may be preferred to the median voter most preferred policy:

16. Ranking of most preferred outcomes g*j • Individuals whose most preferred policy is closer to the status quo policy g=0 than to the outcome implemented by majority voting g*m are worse off if the government intervenes • Hence, majority voting does not satisfy Wicksell efficiency • Similar concerns can be raised if we judge majority voting according to distributional efficiency (tyranny of the majority) • Hence, public policies chosen by majority voting satisfy Pareto- efficiency only g=0 status quo g*m

17. Questions • Explain the difference between Pareto efficiency, Wicksell-efficiency and distributional efficiency • Do governments choosing policies preferred by the majority of the population achieve efficient outcomes? Explain carefully your answer specifying the notion of efficiency you are using • Consider the example of public good provision provided in the lecture. Does majority voting deliver the same outcome of the Samuelson rule (remember public good provision of lecture 3)?