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Economics Endterm Summary
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Detailed summary to prepare for the endterm. Chapters: 20,26,28,30,31,32,33,34,35,36,37,38. Modern Principles of Economics 4th Edition
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ECONOMICSChapter 20 – Political Economy and Public Choice
When does the self-interest of politicians and voters align with the social interest and when do these interests
collide?
Public choice (political economy): the study of political behaviour using the tools of economics.
Institutions and Incentives that Govern the Behaviour of Voters
1. Voters and the incentive to be ignorant
- Do voters have an incentive to be well informed about politics? No. Knowledge is good, but the price of it is
often high.
- When choosing a politician, studying (examining voting histories, listening to speeches etc.) does not have a high
payoff. Your vote will highly unlikely to change the outcome of the election. The outcome of the election is
mainly determined by what other people do.
- Voters are rationally ignorant about politics because the incentives to be informed are low.
- Rationally ignorant: occurs when the benefits of being informed are less than the costs of becoming informed.
- Voters are often uniformed or misinformed about important political questions. E.g. many Americans were
unaware of the largest sources of US government spending (welfare, interest on federal debt, defense, foreign
aid, social security, health care).
- Rational ignorance about political matters is important for at least three reasons:
• It is difficult for voters to make informed choices.
• Voters will make decisions on the basis of low-quality, unreliable, or potentially biased information.
• No everyone is rationally ignorant.
2. Special interests and the incentive to be informed
- By implementing a quota on sugar, the government is harming many sugar consumers, many of whom are
voters. However, many consumers are not aware of the quota’s existence and if they were, they would not do
much to oppose it as the quota is diffused among millions of consumers. Consumers have no incentive to be
informed.
- However, US sugar producers are more concentrated than the consumers and benefit largely from the quota.
Thus, they have a lot of money at stake and are rationally informed. Producers have an incentive to be informed
about the parties and politicians who are in favor of the quota.
- Being informed has an external benefit – underprovided.
3. A formula for political success: diffuse costs and concentrate benefits
- The sugar quota is a winning policy for politicians. It has diffuse costs and concentrate benefits.
• The costs of the sugar quota are diffused over millions of consumers. The consumers, who are harmed,
are rationally ignorant and have little incentive to oppose the policy.
• The benefits of the sugar quota are concentrated over a handful of producers. The producers, who are
benefited, are rationally informed and have a strong incentive to support the policy
• Thus, the self-interest of politicians does not always align with the social interest.
- The formula for political success works for many types of public policies. E.g. quota, tariff, subsidies, tax credits.
- Sometimes, there is even an incentive when government projects (e.g. roads, bridges) are concentrated on
residents and producers, while the costs are diffused across all tax payers. The government externalizes the cost
– pushing the costs onto tax payers.
- Lobbying: a form of advocacy with the intention of influencing decisions made by the government by individuals.
The lobbying industry has grown and the politicians are a significantly more concentrated group.
- When benefits are concentrated and costs are diffused, resources can be wasted on projects with low benefits
and high costs.
- Inefficient policies – less wealth and slower economic growth.
4. Voter Myopia and Political Business Cycles
- Rational ignorance and voter myopia can encourage politicians to boost the economy before an election in order
to increase their chances of reelection.
,- Generally, voters vote for the incumbent party
when the economy is doing well and vote against
it if the economy is doing poorly.
- Green line – share of the two-party vote won by
the incumbent (more than 50%).
- Blue line – share of the two-part vote predicted
by three variables: growth in personal disposable
income and the inflation rate in the election year
and a measure of how long the incumbent party has been in power.
- The incumbent part wins elections when the disposable income is growing, inflation is low and the incumbent
party has not been in power for too long.
- Personal disposable income – amount of income after taxes are paid. Source: wages, welfare, interest, dividends
etc.
- Inflation rate – the general increase in prices.
- Voters are very responsive to economic conditions in the year of an election.
- Voters are myopic – they do not look at the economic conditions over a president’s entire term but rather of the
election year.
- Politicians who want to be reelected therefore try and increase disposable income and reduce the inflation rate.
E.g. President Richard Nixon
Two Cheers for Democracy
- Voters in a democracy can be very powerful.
- When a policy is difficult to understand and only affects a small part of the economy, then lobbies/special
interests will get their way.
- When a policy is high visible and has a major effect on millions, voters are likely to have an opinion.
- Voters care about the bigger issues and therefore politicians have an incentive to serve them.
Median Voter Theorem/Model
- Median voter theorem: when voters vote for the
policy that is closest to their ideal point on a line, then
the ideal point of the median voter will beat any other
policy in a majority rule election.
- Median voter is Inez. The median voter is the voter
such that half of the candidates want more spending
and the other want less spending.
- Democracy tends to push politicians towards the ideal
point of the median voter.
- If the median voter does not change, neither does the
policy.
- Under the conditions of median voter theorem,
democracy seeks out a policy that cannot be beaten in
a majority rule election.
- Not always true – if a voter does not vote for the policy that is closest to their ideal point or if the voter cares
about two issues that cannot be forced onto a single dimension scale.
Democracy and Nondemocracy
- Democracies tend to be the wealthiest countries and
despite the power of special interests, tend to be the
countries with the best supporting markets, property
rights, rule of law, fair government and other institutions
supporting economic growth.
- Economics freedom index – index that captures good
economic policy.
- There is a strong correlation between economic freedom
and a higher standard of living.
- Countries that are the most democratic are among the wealthiest countries in the world and have the most
economic freedom. Except Singapore and Hong Kong.
,- Citizens in democracies may eb rationally ignorant but are better informed than citizens in nondemocracies.
They can use their knowledge to influence public policy at a low cost by voting. Whereas in nondemocracies,
knowledge alone is not enough due to steep barriers created by government.
Democracy and Famine
- The major cause of famine is not lack of food alone, but also due to nondemocracies and lack of economic
power.
Government failure – when institutions of government fail to align self-interest with the social interest.
Democracies have a good record on averting mass famines, maintaining civil liberties and supporting economic
growth.
Rulers in these countries do not have much incentive to pay attention to the larger costs of their policies as borne by
the broader public - keep masses week and uninformed.
Chapter 26 – GDP and Measurement of Progress
- Statistics designed to measure the value of economic production – gross domestic product (GDP) and gross
domestic product per capita.
- GDP per capita is a rough estimate of a country’s standard of living.
What is GDP?
- Gross domestic product (GDP): the market value of all final goods and services produced within a country in a
year.
• Market value: GDP measures an economy’s total output of goods and services. Some goods are more
valuable than others and therefore you don’t simply add up the quantities. To measure total output, GDP
uses market values to determine how much each good or service is worth and then sums the total. GDP is
calculated by multiplying the price of final goods and services by the quantity produced and then adding
the market values.
• Final: Intermediate goods are goods that are bundled or processed with other goods for sale at a later
stage (e.g. computer chip). Final goods are sold to final users and the consumed/held in personal
inventories (e.g. computer, tractor, machinery). Using only final goods avoids double counting.
• Goods and services: the output of the economy includes both goods and services. Services provide a
benefit to individuals without the production of tangible output (e.g. haircuts, entertainment). Service
sector increase – recreation and medical care.
• Produced: GDP is meant to measure production so sales of used goods are not included (e.g. selling
second hand cars, stocks, bonds, old houses).
• Within a country: GDP is market value of goods and services produced by labour and capital located in
that country regardless of the nationality of the workers. Gross national product (GNP): the market value
of all final goods and services produced by a country’s permanent residents, wherever located, in a year.
• A year: How much the nation produces annually, not in its entire history. National wealth refers to the
nation’s entire stock of assets.
- GDP per capita: GDP divided by the population.
Growth Rates
- The growth rate of GDP tells us how rapidly the country’s production is rising or falling over time.
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Nominal vs. Real GDP
- Nominal variables: such as nominal GDP, have not been adjusted for changes in price.
- Changes in price – inflation.
- Comparing GDP over substantial periods of time using nominal GDP creates a problem. Therefore, if we want to
compare GDP over time, we should compare real GDP.
- Real variables: such as real GDP, have been adjusted for changes in prices by using the same set of prices in all
time periods.
- A real variable is one that corrects for inflation (a general increase in prices over time).
, The GDP Deflator
- The GDP deflator is a price index that can be used to measure inflation.
- It is the ration of nominal to real GDP, multiplied by 100.
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Real GDP Growth per Capita
- GDP may be a misleading measure when population growth rates are high.
Cyclical and Short-Run Changes in GDP
- GDP is also used to measure short-run fluctuations in an economy, namely the ups and downs in economic
growth.
- Recession: a significant widespread decline in economic activity across the economy, lasting more than a few
months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales.
- Recessions are of special concern for policymakers and the public.
- Recessions are widespread, not only geographically, but also across sectors.
- Expansions/booms – when real GDP grows at a faster rate than normal.
- Business fluctuations/business cycles: the short-run movements in real GDP around its long-term trend
(“normal” growth rate).
- It is often unclear when a recession begins and ends.
The Many Ways of Splitting GDP
- The different method allows us to check our calculations.
1. The national spending approach to GDP: Y = C + I + G + NX
Y = nominal GDP
C = market value of consumption goods and services
I = market value of investment goods/capital goods
G = market value of government purchases
NX = net exports
- Consumption spending: private spending on final goods and services. Mostly made by households. Includes
spending on health care (even when financed by insurance or government) and education (even though is
thought as investment in ‘human capital’).
- Investment spending: private spending on tools, plants and equipment (capital) used to produce future output.
Mostly made by businesses, however also includes new home production. Stocks are not an investment – not
purchasing new capital goods but a transfer in ownership.
- Government purchases: spending by all levels of government on final goods and services. Transfers are not
included in government purchases such as wealth transfers e.g. welfare and grants. Includes government
consumption (printers) and investment (roads) purchases.
- Net exports: the value of exports minus the value of imports. Net exports will be positive when exports are
greater than imports.
- Method involves adding the spending.
2. Factor income approach to GDP: Y = Employee compensation + Rent + Interest + Profit
When a consumer spends money, money is received by:
- Workers = Employee compensation (wages + benefits)
- Landlords = rent
- Owners of capital = interest
- Businesses = profit
- Method involves adding all the receiving.
- However not every dollar spent is received. E.g. sales taxes – creates a difference so when calculating GDP suing
income approach, sales taxes need to be added.
Problems with GDP as a Measure of Output and Welfare
- We do not know the market value of all goods and services.
- GDP does not count the underground economy.
• Illegal or underground-market transactions are omitted from GDP.
• E.g. cocaine, counterfeit good, informal markets (not registered with the government).
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