PE: Institutions and Economic principles

The main reference for today will be Mueller’s Public Choice III Chapter 1 and 2 (Mueller, 2003)as well as Acemoglu’s Political Economy Lecture Notes Chapter 1 (Acemoglu, 2009). Additional readings are Acemoglu’s Chapter 2 and work by Ostrom (Ostrom, 1998) and Schnellenbach (Schnellenbach & Schubert, 2015).

Political Economy joins the fields of Political Science and Economics. To illustrate the case, we can consider the Trump administration: Politics affects the economy and the choice of policy areas benefits some sectors or others. So far, the stock markets reacted positively to the Trump administration in expectation of reduced “red tape”. But upon closer inspection specific sectors benefit whereas others linger or decline. The political decisions will influence which sectors flourish.


As always, the term is widely different defined. We will rely on the definition of “rules of the game” provided by Acemoglu (p.5ff). This includes political institutions (constitution electoral rules, separation of powers, chacks and balances, etc.) and economic institutions (property rights, commercial law, contract law, etc.). It also differs between formal (de jure) and informal (de facto) institutions.

Four different views on institutions compete according to Acemoglu (in no particular order):

  1. Efficient institutions view: maximising total surplus or compensation (Coase theorem), should have no impact on output (not proven empirically) and  troubled by commitment problems (imperfect contracts about compensation).
  2. Social Conflict view: Institutions are chooses by political power (rent maximisation).
  3. Ideology/belief view: Different view on what is best for society.
  4. Incidental institutions view: By-product of other social interactions (taxation implies representation and ultimately leads to parliamentary representation).

This views on their own are often not 100% explanatory. Inefficient institutions can be explained by hold-ups (current elites usually cannot respect future elites), political losers (parliaments usually cannot shrink) or economic losers (reforms benefit some more than others, which may have political power). Consequences from these limitations are 1) that constraints on political power and broad distribution of political power make secure property rights more likely, 2) stable economic institutions are more likely if rents are limited and 3) institutional reforms are more likely to be successful if they do not threaten incumbents.

Economic Principles

Homo Oeconomicus assumes rationality and utility maximisation, but is undermined by findings in Behavioural Economic (Schnellenbach & Schubert, 2015).

Trade and markets are usually a good way to organise economic activity.

Perfect competition/markets assumes well-defined property rights, large number of buyers and sellers, perfect information, homogeneous products, no barriers to entry and exit, all participants are price-takers (no market power), participants are homo oeconomici (and firms are profit-maximising), no externalities, no transaction costs and a constant returns to scale. In other words, a pareto-optimal allocation.

Pareto-efficient/optimal implies that no improvement can be made for some people without making anyone else worse off.

Kaldor-Hicks-optimality is a relaxation of the Pareto-optimality, where the benefiting side hypothetically could compensate the worse-off side.

Market failures occur with public goods, externalities, monopolies, unequal distribution of resources, etc.

Types of Goods:

RivalrousPrivate Goods
clothing, car
Common-pool resources
fish stock, timber, coal
Non-rivalrousClub goods
cinemas, satellite TV
Public goods
national defense
The four types of economic goods.

The Freerider Problem arises with public goods where an individual does not have to contribute to receive the public good, but consequently the public good is underprovided.

Externalities are unintended impacts on another individual or firm. The social costs is not covered by the private cost. Pareto-optimality can be achieved by a Pigouvian tax or Coase bargaining.

The Coase Theorem states that if an externality is tradable and has sufficiently low transaction costs, bargaining between involved parties will lead to a pareto-optimal solution regardless of initial allocation of property. However, assignment of property rights and large numbers of individuals undermine the Coase Theorem.

The Tragedy of the Commons is that the individual, ration self-interest is contrary to the common good.

The n-person social dilemma (Ostrom, 1998) stipulates that the more persons cooperate the higher the benefit, but for a given number of cooperating players, a single defecting player will benefit more. This induces non-cooperation that lowers the overall benefit achievable. To overcome non-cooperation, social conventions can be applied from adaptive learning over reputation to social sanctions (in contrast to the homo oeconomicus).

In a Game of Chicken the best outcome would be to cooperate, but for each individual the outcome is better to defect, the ultimate state is the worst for all.

(G,D)Contributes to fence-buildingDoes not contribute
Contributes to fence-building(3,3)(2,3.5)
Does not contribute(3.5,2)(1,1)
The Game Theory discrition of the Chicken game

Conceptions of the state

Often states are normatively justified: from survival (better than the state of natural anarchy) over efficiency (e.g. distribution of public goods) to equity (e.g. social fairness).

According to Acemoglu (Acemoglu, 2009) the state is often conceptualised as:

  1. State without agency: no interests of its own, rectifies market failures
  2. State as nexus of cooperation: Hobbesian/Rousseau’s view of the state (as compared to anarchy)
  3. State as agent of a social group: Capitalists, financial sector, ethnic group, men, etc.
  4. State as grabbing hand: Members of the state look after their own interest
  5. State as autonomous bureaucracy: Represents interests beyond their members interst


Acemoglu, D. (2009). Political Economy Lecture Notes. Retrieved from
Mueller, D. C. (2003). Public Choice III (3rd ed.). Cambridge, UK: Cambridge University Press.
Ostrom, E. (1998). A Behavioral Approach to the Rational Choice Theory of Collective Action. American Political Science Review, 92(1), 1–22.
Schnellenbach, J., & Schubert, C. (2015). Behavioral Political Economy: A Survey. European Journal of Political Economy, 40, 395–417.


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