# PE: Redistribution

The focus of today’s lecture will be on redistribution as discussed in Chapter 3(Mueller, 2003). Additionally, we will discuss papers quantitatively assessing the situation (De Haan & Sturm , 2017; Sturm & de Haan, 2015).

A justification for the state can be redistribution. But redistribution itself can be argued for based on different reasons. In this post, we will illuminate the main arguments. First three voluntary redistribution arguments will be covered, then we will have a look at involuntarily redistribution.

Redistribution as insurance

If one assumes Rawls’ veil of ignorance (Rawls, 2009), redistribution can be seen as an insurance against the uncertainties of what kind of role one will assume in society. Insurance can be covered privately, so at first state intervention may seem inadequate. However, since people can assess their risk, high-risk individuals would select the insurance whereas low-risk individuals would shun the insurance. To overcome the issue of adverse selection, public insurance is introduced. The issue of adverse selection has been introduced by Akerlof (Akerlof, 1970) and shows that information asymmetry can break markets. The public insurance overcomes this issue by forcing a pareto-optimum on a societal level. Typical cases for this are health care insurance, unemployment insurance, and retirement insurance.

Redistribution as public good

Another justification comes from altruism or empathy (“warm glow”). The utility equation is expanded to $max U_m + \alphaU_o$ where $0\leq\alpha\leq1$.

Redistribution as fairness norm

The assumption that fairness is an important norm, is the basis for this redistribution argument. The classical example is the dictator game, where anonymous individuals are paired and one gets an amount of money and may share it with the other. Usually, any individual share around 30% with the other despite being able to keep everything and not knowing anything about the other. So far, the assumption is that the random element of the game let people share their gain because they also could have ended up on the other side.

Redistribution as allocative efficiency

If two individuals ($P$ and $U$) work a fixed amount of land. The productivity of $P$ is 100 whereas $U$’ productivity is 50. The connecting curve describes the production possibility frontier. Any initial allocation (e.g. $A$ may not be optimal on a societal level (i.e. $A$ is not tangential on a $45°$ line), the societal optimum would be in $B$, which is however unacceptable for $U$. The inefficient allocation would end up at $A'$. The state could either redistribute land to reach $B$ or production to reach $C$. Note that C in the graph should amount to a value above 100. Alternatively, private contracting could reach the same result given that the state enforces property rights and contracts.

The example is based on (Bös & Kolmar, 2003).

Redistribution as taking

Groups can lobby to increase their utility $U$ by increasing their income $Y$ based on their political resources $R$ available. However, if two antagonistic groups lobby their policies may cancel each other leaving them only with the additional cost of lobbying without any gains.

Measuring redistribution

To measure redistribution, inequality needs to be measured first. A typical measure of inequality is done via the Lorenz curves and the Gini coefficient (Gini, 1912). The Gini coeffcient is the ratio of areas under two curves. The Gini market coefficient (before taxes) and the Gini net coefficient (after taxes and subsidies) are subdivisions that taken at ratio help to assess redistribution.

The causation of inequality is difficult to assess. Some argue for politics (Stiglitz, 2014), whereas others argue for the market-based economies (Muller, 2013). A new line of inquiry attributes inequality to ethno-linguistic fractionalisation reducing the interest in redistribution (Desmet, Ortuño-Ortín, & Wacziarg, 2012).

Sturm  and de Haan (Sturm & de Haan, 2015) follow up on the argument and examine the relationship between capitalism and income inequality. A large sample of countries is analysed using an adjusted economic freedom (EF) index as proxy for capitalism and Gini coefficients as proxy for income inequality. Additionally, they analyse the relation between income inequality and fractionalistion given similar capitalist systems. For the first analysis, there is no conclusive evidence that capitalism and income inequality are linked. However, if fractionalisation is taken into account, than inequality can be explained based on the level of fractionalisation. The more fractionalised a society is, the less redistribution takes place and consequently inequality remains high.

In a second paper de Haan and Sturm (De Haan & Sturm , 2017) analyse how the financial development impacts income inequality. Previous research on financial development, financial liberalisation and banking crises (theoretical and empirical) has been ambiguous. TBC.

## References

Akerlof, G. A. (1970). “The market for” lemons”: Quality uncertainty and the market mechanism. The Quarterly Journal of Economics, 488–500.
Bös, D., & Kolmar, M. (2003). Anarchy, efficiency, and redistribution. Journal of Public Economics, 87(11), 2431–2457.
De Haan, J., & Sturm , J.-E. (2017). Finance and Income Inequality: A review and new evidence. European Journal of Political Economy, Forthcoming.
Desmet, K., Ortuño-Ortín, I., & Wacziarg, R. (2012). The  Political Economy of Linguistic Cleavages. Journal of Development Economics, 97(2), 322–338.
Gini, C. (1912). Variabilità e mutabilità. In E. Pizetti & T. Salvemini (Eds.), Memorie di metodologica statistica (p. 1). Rome: Libreria Eredi Virgilio Veschi.
Mueller, D. C. (2003). Public Choice III. Cambridge, UK: Cambridge University Press.
Muller, J. Z. (2013). Capitalism and inequality: What the right and the left get wrong. Foreign Affairs, 92(2), 30–51.
Rawls, J. (2009). A theory of justice. Harvard university press.
Stiglitz, J. (2014). Inequality is not inevitable. New York Times, pp. 1–2.
Sturm, S., Jan-Egbert, & de Haan, J. (2015). Income Inequality, Capitalism and Ethno- Linguistic Fractionalization. American Economic Review: Papers and Proceedings, 105(5), 593–597.

# PE: Public Good Game

Public Good Game

Each subject secretly chooses how much of their initial endowment to put into a public pot. The joint value in this pot is multiplied by a factor ($1 < factor < N$) and evenly paid out across all $N$ subjects. All unspent endowments is kept by the respective subject. In one-shot games a non-cooperative strategy is usually applied. In infinitely repeated games, subjects eventually cooperate.

However, experimental results are not in line with predictions of rational choice theory. Even in one-shot, two person prisoners’ dilemma games half the participants cooperate. Voluntary contributions to public goods fall if the game repeats and therefore participants have been called “adaptive egoists” (Mueller, 2003) or “conditionally cooperative”(Gächter, 2006).

People seem to be contributing for “warm glow” preference (utility from contributing) (Palfrey & Prisbrey, 1997), altruistic preferences (want to increase other’s utility) or due to error and learning (testing the best approach).

Gächter found that voluntary cooperation is fragile, that there exists social interaction effects in voluntary cooperation, group composition matters (likemindedness), and that management of believes matters. Also, path dependency has been observed where the first round is the most important.

In other field experiments, students were informed how many others contributed to social funds (64% versus 46%) and were influenced by the numbers (Frey & Meier, 2004).

The cooperative environment (Ostrom, 1998)

Models of complete rationality do not work well in non-competitive situations. Verbal communication can improve trust and allow groups to reciprocate. There is also some capacity to solve second-order social dilemma that change the structure of the first-order dilemma (e.g. institute punishment). Ostrom proposed a model of bounded rationality where individuals use heuristics, norms and rules to improve outcomes of non-competitive, not frequently repeated situations.

According to Ostrom, reciprocity, reputation, and trust can overcome strong temptations of short-run self-interest. Consequently, a self-reinforceing process can be created that increases the level of cooperation and leads to higher net benefits for all, but it is very fragile.

The system is stable if it has a small size, symmetry of assets and resources, long time horizon, and a low-cost production function. As the group size increases, marginal gains from contributing falls and it is more difficult to identify and punish defectors. As the stakes increase, cooperation is reduced. Other issues that may arise are: monitoring becomes more costly, economies of scale may not apply and marginalisation behaviour within the group may be questions (is it fair punishment?).

Current Research (Lanz, Wurlod, Panzone, & Swanson, 2017)

A field experiment in supermarkets in greater London area to compare quantitative impact of three measures to reduce footprint of consumption (welfare analysis). The experiment tested conditions on four types of goods: soda, milk, spreads, and meat. Three conditions were used:

1. Information label
2. Pigouvian tax based on relatively higher footprint of “dirty-type” product alternative
3. Neutrally framed price change.

The main findings includes effectiveness of all policy interventions is higher if substitutability is higher and the motivation crowding out due to taxation relevant only for low effort products.

Critiques were raised since it was a “one-shot” game testing “warm glow” and it required a state-solution.

Cognitive biases

Way of thinking that can lead to systematic deviations from the benchmark of rationality. The concept originates from psychology and behavioural economics. Classic biases include availability heuristics (remembered events seem more likely), confirmation bias (consume new information as complementing preconceptions), endowment effect (ownerships changes value perception), and framing effect (the presentation affects the conclusion).

Preference Aggregation

The problem with the state without agency and the state as a nexus of cooperation (Acemoglu, 2009) is that the government is treated as a black box into which takes as input individual preferences and provides as output a collective choice. Arrow’s Impossibility Theorem  (Arrow, 1963) shows that “the only voting method that is not flawed is a dictatorship.” Arrow stipulates that even under reasonable requirements there can’t exist a ranked voting system  (i.e. social welfare function or preference aggregation rule) that transforms the set of preferences into a single global societal order for two or more participants with three or more option. Arrow specifies reasonable requirements as:

1. Non-dictatorship
2. Universality (unique and complete ranking)
3. Independence of irrelevant alternatives
4. Pareto efficient (unanimity)

Pairwise voting alternatives do not lead to a complete ordering. Only through violation of reasonable requirements (dictatorship, Kaldor-Hicks efficiency, non-universality) can preference aggregation be performed. Cox  (Cox & McCubbins, 2000) showed that voting rules shape policy outcomes even if the voter preference is fixed.

Nudges or “Libertarian paternalism”

A nudge can be understood as a change in the choice context (that would be irrelevant to the homo oeconomicus) to intentionally steer real-world agents’ behaviour in the direction of the homo oeconomicus benchmark (see organ donor debate). Critiques of such “behavioural welfare economics” are again that no global social preference exists and that without appropriate information manipulation could occur. It also implies a benevolent paternalist state, which is debatable.

Endogenous versus exogenous institutions

The difference between whether on asses how institutions arose (endogenous) or how institutions impact policy (exogenous). This course focuses on the latter.

## References

Acemoglu, D. (2009). Political economy lecture notes. Retrieved February 27, 2017, from http://citeseerx.ist.psu.edu/viewdoc/summary?doi=10.1.1.682.3171
Arrow, K. J. (1963). Social Choice and Individual Values. New York: Wiley.
Cox, G. W., & McCubbins, M. D. (2000). Political structure and economic policy: The institutional determinants of policy outcomes. In Presidents, Parliaments and Policy (pp. 21–96). Cambridge University Press.
Frey, B. S., & Meier, S. (2004). Social comparisons and pro-social behavior: Testing “conditional cooperation” in a field experiment. The American Economic Review, 94(5), 1717–1722.
Gächter, S. (2006). Conditional cooperation: Behavioral regularities from the lab and the field and their policy implications. CeDEX Discussion Paper, 3.
Lanz, B., Wurlod, J.-D., Panzone, L., & Swanson, T. (2017). The behavioural effect of Pigovian regulation: Evidence from a field experiment. IRENE Working Paper.
Mueller, D. C. (2003). Public Choice. Springer.
Ostrom, E. (1998). A behavioral approach to the rational choice theory of collective action: Presidential address, American Political Science Association. American Political Science Review, 1, 1–22.
Palfrey, T. R., & Prisbrey, J. E. (1997). Anomalous behavior in public goods experiments: How much and why? The American Economic Review, 829–846.

# 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.

Institutions

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: [table id=7 /]

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.

[table id=8 /]

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