Prof. Bryan Caplan

bcaplan@gmu.edu

http://www3.gmu.edu/departments/economics/bcaplan

Econ 816

Spring, 2000

I.                 The Logic (?) of Efficiency

A.                With Pareto efficiency, you can plausibly say"Taking all costs into account, the fact that a trade isn't made showsthat one person wouldn't be better off as a result." 

B.                The same does not hold for Kaldor-Hicks efficiency,the efficiency standard economists typically use.  Individual maximizing behavior is perfectly consistent with thecontinuing existence of surplus-increasing uncompensated changes.

C.               Still, many economists have seen general tendenciestowards Kaldor-Hicks efficiency.

D.               This tendency is strongest in the work of DonaldWittman, most notably in his "Why Democracy is Efficient" and The Myth ofDemocratic Failure.  Wittmanargues that Kaldor-Hicks efficiency is not merely a tendency but is in fact a reality,at least in democracies.

E.                Wittman's basic claim:  All theories of political failure are mistaken because theyimplausibly assume one or more of the following:

1.                 Extreme voter stupidity (violation of RE)

2.                 Serious lack of competition

3.                 Excessively high negotiation/transfer costs

II.              How to Think Like Wittman

A.                Principle #1: Voter ignorance is not a serious problem.  Voters can simply ask their preferredexperts for information, and they appropriately discount biased information.(Moreover, asymmetric info makes government too small, not too large!)

B.                Application: Just as I don't need to know anythingabout heart surgery to get a first-rate bypass operation, I don't need to knowanything about current gun control proposals to vote intelligently about guncontrol.  If I like guns, I just votethe NRA line; if I don't like guns, I follow the advice of Citizens for GunControl. 

C.               Principle #2: Politics, like the market, is competitive.  If one politician carries out policies thatharm the majority, a competing politician (a "politicalentrepreneur") will happily campaign on a platform to abolish that policy.  Over the longer run, politicians need tomaintain their reputation in order to win future elections and advance theircareers.

D.               Application: sugar tariffs.  If the current crop of politicians isharming the majority of the public by raising the price of sugar, then this isan obvious opportunity for competing candidates, who will offer the electoratea better deal in order to win.

E.                Principle #3: Political bargaining can eliminate any remainingsignificant inefficiencies. Majority voting merely assigns initial property rights; the Coasetheorem tells us to expect parties to bargain to the efficient solution.  (Also note that transactions costs are lowerunder majority rule than with unanimity).

F.                Application: If a 1000 tenants get a $1 benefit eachfrom rent control, but 20 landlords lose $100 each, democracy apparently yieldsan inefficient outcome.  But this leavesobvious gains from trade on the table. It is extremely likely that the landlords' representatives will bargainwith the tenants' representatives for an efficient transfer of, say, $1.50 pertenant in exchange for repealing rent control.

G.               Macro applications: Proponents of major macro policychanges are probably wrong.  People whowant more government are wrong because the political system already providesthe efficient level.  People who wantless government are wrong for the same reason. In general, any macro model where policy is a net cost is wrong.

III.           Reality vs. Optimality: Some Evidence on FreeLunches

A.                Is there any aspect of Wittman that would not applyfully to dictatorships?  After all, asWittman states, "[I]nequality of political power is no more an argumentagainst efficiency than inequality of economic power."

B.                Why then are some countries rich and otherspoor?  (Olson 1996)

1.                 Answer #1: Explanations consistent with efficiency: "National borders markdifferences in the scarcity of productive resources per capita."

2.                 Answer #2: Explanation inconsistent with efficiency: The institutions in somecountries are more efficient than those in others.  (If everyone is fully efficient, of course, this isn't possible).

C.               Olson on answer #1:

1.                 Land, labor, and capital explanations are clearlyinadequate.

2.                 World's knowledge available cheaply to all.

3.                 Important point: Migration raises world wealth bychange in real pay minus migration costs.

4.                 Related observation: Capital and labor are often tryingto migrate out of some countries.

5.                 Standard - and best - natural experiments: West vs.East Germany, North vs. South Korea, Hong Kong and Taiwan vs. mainland China

D.               If #1 is wrong, #2 must be right, but how?

IV.           Why #2 is Right: The Logic of Collective Belief

A.                Wittman's arguments about political competition andtransactions costs seem compelling to me.

B.                But: Empirically, the evidence for voter stupidity(i.e., systematically biased estimates) is overwhelming.  A couple samples (from the Survey ofAmericans and Economists on the Economy):

1.                 Why did gas prices rise?  Supply-and-demand, or a conspiracy of greed?

2.                 Is downsizing a major, minor, or non-reason why theeconomy is doing worse than it otherwise would?  What about foreign aid?

3.                 Overall, what could charitably be called"populist" biases (or, uncharitably, red-brown biases) dominate.

C.               "The Logic of Collective Belief" extendsmy previous argument that because the private cost of irrationality in politicsis zero, economic theory predicts an inordinately high level of politicalirrationality.

1.                 Remember that the key price is the private, marginalcost of irrationality, which can be quite different from the social cost.

2.                 Irrationality has to be carefully distinguished frominformation.  The ignorant recognizethey have a problem; the irrational do not! Wittman's arguments about information would be basically sound if voterswere rational.

D.               Irrationality on the demand side.

1.                 Thought experiment #1: Identical voters with near-neoclassicalbelief preferences vote unanimously for the inefficient platform.

2.                 Thought experiment #2: Otherwise identical voterswith heterogeneous near-neoclassical belief preferences implies that the median voteris identical to the median believer.

3.                 Log-rolling can make matters even worse.

E.                Irrationality on the supply side

1.                 Will politicians be rational?  Yes and no.

2.                 Yes: on estimating the marginal impact of theirbehavior on votes.

3.                 No: on estimating the actual results of theirpolicies.  Probably pays more to justshare the public's biases.

4.                 Applications:

a)                Why politicians are lawyers, not economists

b)                How irrationality can create political slack andpoll reversals

c)                 How misleading political advertising can work; howsupply side forces amplify the impact of irrationality

F.                General claim: Before you posit a cabal of specialinterests harming voters, make sure that voters dislike the policy inquestion.  If voters favor protection,antitrust, farm subsidies, etc., why is there any need for further explanationsfor the existence of these policies?

1.                 This does not mean that policy has to be efficient,but rather that voters as a group are harming voters as a group.

G.               Additional empirical evidence from the SAEE:"Sociotropes, Systematic Bias, and Political Failure"

V.              Irrationality and Dictatorship

A.                Dictators' decisions have a big impact on theirwealth, but they are so wealthy (sometimes in effect owning the entire country)that they may still buy highly irrational beliefs.  (e.g. collectivization)

B.                Also, virtually every dictatorship has to rely onsome segment of the population genuinely believing in official doctrine; whenthis stops continued rule becomes unstable. And again, the private marginal cost of believing official propaganda isessentially zero.

C.               Why does belief in a doctrine ever fade if the pricestays zero?  A tough question: clearly afew million people starving to death is often insufficient.

VI.           Why Some Countries are Rich and Others are Poor

A.                In a democracy, the more a country's electoratebelieves in the benefits of inefficient policies, the poorer that country willbe. 

1.                 E.g. Europe vs. the U.S. on unemployment.

2.                 Hyperinflation in Third World countries.

3.                 Slow reform in Russia

B.                In a dictatorship, the rationality of the rulinggroup becomes crucial.  (Note that evenfor relatively small elections, the probability of decisiveness isnegligible).  Thus, if you get a cliqueof delusional fanatics in power, you can expect wealth and growth to plummet.

1.                 E.g. Famine under Stalin and Mao.

2.                 Expulsions or exterminations of most entrepreneurialgroups, such as Jews, Armenians, Indians...

C.               My general approach could be right even ifeconomists' views about efficient policy were wrong.  But my approach gives an internally consistent way to explain thedivergence between what economists' characterize as efficient policy, and whatactual exists.  Namely, the economistsare right, and the public is wrong about:

1.                 The benefits of free markets (and how marketsoperate)

2.                 The benefits of foreign trade

3.                 Impact of labor regulation on employment

4.                 Benefits of privatization

5.                 Benefits of stable money

6.                 etc.

D.               Of course, the economists could be irrational insome areas too, and I in fact think that the profession is systematically wrongabout:

1.                 The social benefits of education (much education issignaling, not accumulation of human capital; and in any case there is littlereason to subsidize it)

2.                 Social benefits of regulation (e.g. safetyregulation, consumer protection)

3.                 General status quo bias

E.                If neither the public nor the experts is always(expectationally) right, what should a person believe?

1.                 If the private costs of rationality are high,argument is pointless because the average opinion of the experts will beapproximately correct.

2.                 If the private costs of irrationality are low orzero, then it is actually worth thinking matters through for yourself to judgewhether popular and/or expert opinion is wrong.

VII.        Application #1: The Growth of Government (Higgs)

A.                How would Wittman explain the growth of governmentin the U.S. in the 20^th century?

B.                How would I explain it?

C.               Higgs partly succumbs to the fallacy of treatingsocial costs as if they were private, marginal costs.  Just because the costs of a policy increase it does not followthat voters' support will decline.

D.               But his general approach of focusing on ideology andideological change makes perfect sense in my framework.  If beliefs are divorced from reality tobegin with, they may evolve in irrational but predictable ways.  (E.g., people may tend to believe thatgovernment programs are beneficial after they come into existence).

E.                Further thoughts?

VIII.     Application #2: The Decline of Socialism (Murrell)

A.                Most of the socialist dictatorships in the worldcollapsed during 1989-1991, and most adopted Western-style democracy as theirnew form of government.

B.                Most also expressed interest in adopting therelatively capitalist economic system of the West.

C.               My prediction: The countries where the electorate ismost irrationally hostile to efficient policies will adopt worse policies andconsequently have worse economic performance.

D.               My theory works quite well: Countries like Russiawhere anti-capitalist attitudes genuinely run deep have reformed must lesssuccessfully than more pro-market countries like Estonia, Poland, the Czechrepublic, etc.  Moreover economic growthin the post-socialist era has been mostly a function of the extent to whichgenuine reforms were rapidly adopted.

E.                Collapse of socialism is important for my accountbecause it shows that sometimes, ideology responds to evidencewithout private, marginal incentives. But again, socialism basically collapsed when it was doing relativelywell compared to previous eras. (Accounts that overlook mass famine and look only at official growthstatistics notwithstanding.  Considere.g. Becker's analysis).

F.                Further thoughts?