Microeconomics for MBAs 55

CHAPTER 16 Public Choice: Politics in Government And the Workplace I have no fear, but that the result of our experiment will be, that men may be trusted to govern themselves without a

Chapter 15 Competitive and Monopsonistic

Labor Markets

52

offers Their firms may also be subject to takeover, given that bright investors can buy

the firm, replace the existing management team with a more competent team, and then

sell the firm at a higher price The poor performance of one management team can

represent a profitable opportunity for their competitors in the market for firms and

management talent

Concluding Comments

In a competitive labor market, wage rates are determined by the interaction of willing

suppliers of labor (employees) and demanders of labor (employers) Suppliers are

influenced significantly by the nonmonetary benefits of employment, as well as by the

value they place on their next-best alternative employment Thus differences in money

wage rates may not reflect true differences in full wage rates Demand is influenced by

the laborer’s productivity and the price of the laborer’s product

In a competitive labor market, any attempt to change workers’ incomes through

minimum standards for wages or working conditions can benefit some workers only at

the expense of others As the economist Milton Friedman complains, “The old saying is

that Quakers went to the New World to do good and ended up doing well Today, well-meaning reformers go to Washington to do good and end up doing harm.”62 Can the

mixed results of minimum wage legislation be construed as a clear-cut improvement in

social welfare? Economic analysis cannot address that highly subjective question The

best we can do is present the deductions drawn from theory and evidence Unfortunately, both are conflicting, as evident in the theoretical implications of minimum-wage hikes

under competitive and monopsonistic conditions and as evident in the differing empirical

findings

We have also shown that while it is nice to suggest that workers be paid according

to performance, the issues of providing the “right” pay for the “right” performance are

thorny ones for managers Regrettably, the reality of managing can be tricky, as evident

in our discussion of executive pay, or, rather, “excessive” pay There are good economic explanations for executives to be paid more than they are “worth.”

Review Questions

1 The government requires employers to pay time-and-a-half for labor in excess of forty hours a week How should managers be expected to react to that law? What effect should such a law have on the quantity of labor demanded? Why?

2 Does union support of laws outlawing child labor square with the private interests

of union members? Should society protect some of its members from some kinds

of employment regardless of monetary considerations? Why?

62

Milton Friedman, “Migrant Workers,” Newsweek (July 27, 1970): 60

Chapter 15 Competitive and Monopsonistic

Labor Markets

53

3 How could the minimum wage rate and migrant housing standards be expected to affect the prices of consumer goods? Explain, using supply and demand graphs

4 Suppose government requires employers to pay a minimum wage of $10 per hour

to workers over twenty-two years of age What effect should such a law have on the employment opportunities and wage rates of persons under twenty-two?

5 Average real wages have increased steadily over the last 100 years What do you think is the main cause of the increase?

6 Suppose there were a cap put on executive pay by the government Suppose that

“excessive wages” of executives were “excessively” taxed What would be the

effects on wages of workers down the corporate ladder?

CHAPTER 16

Public Choice: Politics in Government

And the Workplace

I have no fear, but that the result of our experiment will be, that men may be trusted to govern themselves without a master Could the contrary be proved, I should conclude, either that there is no God, or that he is a malevolent being

Thomas Jefferson

revious chapters have discussed the effects of various government policies on the market system in general and the firm in particular We looked at government

efforts to control the external costs of pollution We considered the economic

impact of price controls and consumer protection laws, for example, on the market for final goods and services Throughout the analysis we have focused on assessing the

economic efficiency of government policy We said little about how government policy

is determined or why government prefers one policy to another

In this chapter, we will shift our focus to the functioning of government itself Using

economic principles, we will examine the process through which government decisions are made and carried out in a two-party democratic system, and consider its

consequences Today, when government production accounts for a substantial portion of the nation’s goods and services, no student of economics can afford to ignore these

issues

A study of the political process is especially important for many MBA students, mainly because a non-trivial amount of your time will be involved with seeking to change one governmental policy or another Moreover, politics is also endemic to many

businesses Our discussion of the “economics of politics” has various implications for

how businesses can be expected to operate, especially those that rely on “participatory management” processes (which are necessarily democratic to one extent or another)

The Central Tendency of a Two -Party System

In a two-party democratic system, elected officials typically take middle-of-the road

positions Winning candidates tend to represent the moderate views of many voters who are neither liberals nor conservatives For this reason there is generally little difference between Republican and Democratic candidates Even when the major parties’

candidates differ strongly, as Ronald Reagan and Walter Mondale did at the start of their

1984 presidential campaign, they tend to move closer together as the campaign

progresses

P

Chapter 16 Public Choice: Politics in

Government and the Workplace

2

Figure 16.1 illustrates politicians’ incentives to move toward the center The bell-shaped curve shows the approximate distribution of voters along the political spectrum

A few voters have views that place them in the wings of the distribution, but most cluster

near the center Assuming that citizens will vote for the candidate who most closely

approximates their own political position, a politician who wants to win the election will

not choose a position in the wings of the distribution

Suppose, for instance, that the Republican candidate chooses a position at R 1 The Democratic candidate can easily win the election by taking a position slightly to the left,

at D 1 Although the Republican will take all the votes to the right of R 1 and roughly half

the votes between R 1 and D 1, the Democrat will take all the votes to the left Clearly the Democrat will win an overwhelming majority

_

FIGURE 16.1 The Political Spectrum

A political candidate who takes a position in the

wings of a voter distribution, such as D 1 or R 1,

will win fewer votes than a candidate who moves

toward the middle of the distribution In a

two-party election, therefore, both candidates will take

middle-of-the-road positions, such as D and R

The smart politician, therefore, will choose a position near the middle Then the

opposing candidate must also move to the middle, or accept certain defeat Suppose, for

instance, that the Republican candidate chooses position R, but the Democrat remains at

D 1 The Republican will take all the votes to the left of R and roughly half the votes

between R and D 1 She will have more than the simple majority needed to beat her

Democratic opponent In short, both candidates will choose political positions in the

middle of the distribution

Politicians can misinterpret the political climate, of course Even with polls, no

one can be certain of the distribution of votes before an election Just as producers find

the optimum production level through trial and error, politicians may suffer several

defeats before finding the true center of public opinion Inevitably, however, political

competition will drive them toward the middle of the distribution, where the median voter

group resides The median voter is in the middle of the political distribution

The recent history of presidential elections illustrates how politicians play to the

views of the median voter After an election in which the successful candidate won by a

wide margin, the losing party as moved toward the position of the winning party After

Barry Goldwater lost by a wide margin to Lyndon Johnson in 1964, the Republican Party made a deliberate effort to pick a more moderate candidate As a result, the contest

Chapter 16 Public Choice: Politics in

Government and the Workplace

3

between Richard Nixon and Hubert Humphrey in 1968 was practically a dead heat After George McGovern was defeated by Richard Nixon in 1972, Democrats realized they too needed a less extreme candidate Their choices in 1976 and 1984, Jimmy Carter and

Walter Mondale, were more moderate

In more recent times, after Ronald Reagan soundly defeated Jimmy Carter and

Walter Mondale and George Bush beat Michael Dukakis in 1988, the Democrats began what appeared to be a move back toward the center, picking Bill Clinton, a centrist

candidate whose policies, in many ways, have been more conservative than were George Bush’s

The Economics of the Voting Rule

So far we have been assuming that a winning candidate must receive more than 50

percent of the vote Although most issues that confront civic bodies are determined by

simple-majority rule, not all collective decisions are made on that basis, nor should they

be Some decisions are too trivial for group consideration The cost of a bad decision is

so small that it is uneconomical to put the question up for debate Other decisions are too important to be decided by a simple majority Richard Nixon was elected president with only 43 percent of the popular vote in 1968 (when a third-party candidate, George

Wallace, took almost 14 percent), but Nixon’s impeachment would have required more

than a majority of the Senate and the House of Representatives In murder cases, juries

are required to reach unanimous agreement In such instances, the cost of a misguided

decision is high enough to justify the extra time and trouble required to achieve more

than a simple majority

The voting rule that government follows helps determine the size and scope of

government activities If only a few people need to agree on budgetary proposals, for

example, the effect can be to foster big government Under such an arrangement, small

groups can easily pass their proposals, expanding the scope of government activity each

time they do so However, under a voting rule that requires unanimous agreement among

voters—a unanimity rule—very few proposals will be agreed to or implemented by

government There are very few issues on which everyone can agree, particularly when

many people are involved

A unanimity rule can be exploited by small groups of voters If everyone’s vote is critically important, as it is with a unanimous voting rule, then everyone is in a strategic

bargaining position Anyone can threaten to veto the proposed legislation unless he is

given special treatment Such tactics increase the cost of decision-making

Government represents the people’s collective interest, but the type of voting rule used determines the particular interests it represents and the extent to which it represents them

Chapter 16 Public Choice: Politics in

Government and the Workplace

4

The Inefficiencies of Democracy

As a form of government, democracy has some important advantages It disperses the

power of decision making among a large number of people, reducing the influence of

individual whim and personal interest Thus it provides some protection for individual

liberties Democracy also gives political candidates an incentive to seek out and

represent voters’ interests Competition for votes forces candidates to reveal what they

are willing to do for various interest groups Like the market system, however, the

democratic system has some drawbacks as well In particular, democracy is less than

efficient as a producer of some goods and services

The fact that the democratic form of government is inefficient in some respects

does not mean that we should replace it with another decision-making process, any more than we should replace the market system, which is also plagued by inefficiencies

Instead, we must measure the costs of one type of production against the other, and

choose the more efficient means of production in each particular case We must weigh

the cost of externalities in the private market against the cost of inefficiencies in the

public sector Neither system is perfect, so we must choose carefully between them

Median Voter Preferences

When you buy a good like ice cream in the marketplace, you can decide how much you

want You can adjust the quantity you consume to your individual preferences and your

ability to pay If you join with your neighbors to purchase some public service, however, you must accept whatever quantity of service the collective decision-making process

yields How much of a public good government buys depends not only on citizens’

preferences, but also on the voting rule that is used

Consider police protection, for instance Perhaps you would prefer to pay higher taxes in return for a larger police force and lower crime rate Your neighbors might

prefer a lower tax rate, a smaller police force, and a higher crime rate, but public goods

must be purchased collectively, no matter how the government is organized If

preferences differ, you cannot each have your own way Under a democracy, the

preferences of the median voter group will tend to determine the types and quantities of

public goods produced If you are not a member of that group, the compromise that is

necessary to a democracy inflicts a cost on you You probably will not receive the

amount of police protection you want

The Simple-Majority Voting Rule

Any decision that is made less than unanimously can benefit some people at the expense

of others Because government expenses are shared by all taxpayers, the majority that

votes for a project imposes an external cost on the minority that votes against it

Consider a democratic community composed of only five people, each of whom would

benefit to some degree from a proposed public park If the cost of the park, $500, is

divided evenly among the five, each will pay a tax of $100 The costs and benefits to

Chapter 16 Public Choice: Politics in

Government and the Workplace

5

each taxpayer are shown in Table 16.1 Because the total benefits of the project ($550) exceed its total cost ($500), the measure will pass by a vote of three to two, but the

majority of three imposes net costs of $50 and $75 on taxpayers D and E

Table 16.1 Costs and Benefits of a Public Park for Five People

Individuals

(1)

Dollar Value of Benefits to Each Person

(2)

Tax Levied on Each Person (3)

Net Benefit (+)

or Net Cost (-) [(2) - (3)]

(4)

Vote For or Against (5)

When total benefits exceed total costs, as in this example, decision by majority

rule is fairly easy to live with, but sometimes a project passes even though its cost

exceeds its benefits Table 16.2 illustrates such a situation Again, the $500 cost of a

proposed park is shared equally by five people Total benefits are only $430, but again

they are unevenly distributed Taxpayers A, B, and C each receive benefits that outweigh

a $100 tax cost Thus A, B, and C will pass the project, even though it cannot be justified

on economic grounds

Table 16.2 Costs and Benefits of a Public Park for Five People

Alternative Schedule

Individuals

(1)

Dollar Value of Benefits to Each Person

(2)

Tax Levied on Each Person (3)

Net Benefit (+)

or Net Cost (-) [(2) - (3)]

(4)

Vote For or Against (5)

It is conceivable that many different measures, each of whose costs exceed its

benefits, could be passed by separate votes under such a system If all the measures were considered together, however, the package could be defeated Consider the costs and

benefits of three proposed projects—a park, a road, and a school—shown in Table 16.3

If the park is put to a vote by itself, it will receive the majority support from A, B and C Similarly, the road will pass with the support of A, C, and E, and the school will pass

Chapter 16 Public Choice: Politics in

Government and the Workplace

6

with the support of C, D, and E If all three projects are considered together, however,

they will be defeated Voters A, B, and D will reject the package (see column 4)

Table 16.3 Costs and Benefits of a Park, a Road, and a School

Individuals Benefit Cost Vote Benefit Cost Vote Benefit Cost Vote Benefit Cost Vote

E 50 100 Against 250 200 For 500 400 For 800 700 For

Many if not most measures that come up for a vote in a democratic government

benefit society more than they burden it Moreover, voters in the minority camp can use

“logrolling” (vote trading) to defeat some projects that might otherwise pass For

instance, voter A can agree to vote against the park if voter D will vote against the

school Our purpose is simply to demonstrate that, in some instances, the democratic

process can be less than cost efficient

Political Ignorance

In some ways, the lack of an informed citizenry is the most severe problem in a

democratic system The typical voter is not well informed about political issues and

candidates In fact, the average individual’s welfare is not perceptibly improved by

knowledge of public issues

A simple experiment will illustrate this point Ask everyone in your class to write

down the name of his or her congressional representative Then ask them for the name of the opposing candidate in the last election You may be surprised by the results In one

survey, college juniors and seniors, most of whom had taken several courses in

economics, political science, and sociology, were asked how their U.S senators had

voted on some major bills The students score no better than they would have done by

guessing.1 In the United States, most voters do not even know which party controls

Congress,2 and public opinion polls indicate that most voters greatly underestimate the

cost of programs like Social Security.3

1

Richard B McKenzie, “Political Ignorance: An Empirical Assessment of Educational Remedies,”

Frontiers of Economics (Blacksburg, VA.: University Publications, 1977)

2

Donald E Stokes and Warren E Miller, “Party Government and the Saliency of Congress.” Public

Opinion Quarterly 26 (Winter 1962): 531-546

3

Edgar Browning, “Why the Social Insurance Budget Is Too Large in a Democracy,” Economic Inquiry 13

(September 1974): 373-388

Chapter 16 Public Choice: Politics in

Government and the Workplace

7

If voters were better informed on legislative proposals and their implications,

government might make better decisions In that sense, political information is a public

good that benefits everyone Nevertheless, as we have seen before, in large groups

people have little incentive to contribute anything toward the production of a public good Their individual contributions simply have little effect on the outcome

To remain politically free, people must exercise their right to determine who will

represent them The result is that they often cast their votes on the basis of impressions

received from newspaper headlines or television commercials—impressions carefully

created by advertisers and press secretaries

Special Interests

The problem of political ignorance is especially acute when the benefits of government

programs are spread more or less evenly, so that the benefits to each person are relatively small Benefits are not always spread evenly: subgroups of voters—farmers, labor

unions, or civil servants—often receive more than their proportional share Members of

such groups thus have a special incentive to acquire information on legislative proposals Farmers can be expected to know more about farm programs than the average voter

Civil servants will keep abreast of proposed pay increases and fringe benefits for

government workers, and defense contractors will take a private interest in the military

budget

Congressional representatives, knowing they are being watched by

special-interest groups, will tend to cater to their wishes As a result, government programs will

be designed to serve the interest of groups with political clout, not the public as a whole

Cyclical Majorities

In their personal lives, most people tend to act consistently on the basis of rational goals

If an individual prefers good A to good B, and good B to good C, the rational individual

will choose A over C repeatedly Collective decisions made by majority rule are not

always consistent Consider a community of three people, whose preferences for goods

A, B, and C are as follows:

Individual Order of Preference

Supposed these three voters are presented with a choice between successive pairs

of goods, A, B, and C If the choice is between good A and good B, which will be

preferred collectively? The answer is A, because individuals I and III both prefer it to B

If A is pitted against C, which will be preferred? The answer is C, because individuals II and III both prefer it to A Since the group prefers A to B and C to A, one might think it

Chapter 16 Public Choice: Politics in

Government and the Workplace

8

would prefer C to B, but note that if C and B are put up to a vote, B will win A cyclical,

or revolving majority has developed in this group situation This phenomenon can lead

to continual changes in policy in a government based on collective decision-making

Although there is no stable majority, the individuals involved are not acting

irrationally People with perfectly consistent personal preferences can make inconsistent

collective choices when acting as a group Fortunately, the larger the number of voters

and issues at stake, the less likely a cyclical majority is to develop Still, citizens of a

democratic state should recognize that the political process may generate a series of

inconsistent or even contradictory policies

The Efficiencies of Competition

Among Governments

In the private sector, competition among producers keeps prices down and productivity

up A producer who is just one of many knows that any independent attempt to raise

prices or lower quality will fail Customers will switch to other products or buy from

other producers, and sales will fall sharply To avoid being undersold, therefore, the

individual producer must minimize its production costs Only a producer who has no

competition—that is a monopolist—can afford to raise the price of a product without fear

of losing profits

These points apply to the public as well as the private sector The framers of the Constitution, in fact, bore them in mind when they set up the federal government

Recognizing the benefits of competition, they established a system of competing state

governments loosely joined in federation As James Madison Described in The

Federalist papers, “In a single republic, all the power surrendered by the people is

submitted to the administration of a single government: and the usurpations are guarded

against by a division of the government into distinct and separate departments.”4

Under the federal system, the power of local governments is checked not just by citizens’ ability to vote, but also by their ability to move somewhere else If a city

government raises its taxes or lowers the quality of its services, residents can go

elsewhere, taking with them part of the city’s tax base Of course, many people are

reluctant to move, and so government has a measure of monopoly power, but competition among governments affords at least some protection against the abuses of power

Local competition in government has its drawbacks Just as in private industry,

large governments realize economies of scale in the production of services Garbage,

road, and sewage service can be provided at lower cost on a larger scale For this reason,

it is frequently argued that local governments, especially in metropolitan areas, should

consolidate Moreover, many of the benefits offered by local governments spill over into surrounding areas For example, people who live just outside San Francisco may benefit from its services, without helping pay for them One large metropolitan government,

4

Alexander Hamilton, John Jay, and James Madison, The Federalist: A Commentary on the Constitution of

the United States, no 51 (New York: Random House, Modern Library edition, 1964), pp 338-339