POLITICAL ECONOMY

Lecture 1: Introduction
 Political Economy
• A Quatation: “Economists must not only know their economic
models, but also understand politics, interests, conflicts,
passions the essence of collective life. For a brief period of time
you could make changes by decree; but to let them persist, you
have to build coalitions and bring people around. You have to be
a politician”.
• From Adam Smith’s Wealth of Nations in 1776 Žor perhaps the
Physiocrats even earlier. until at least John Stuart Mill’s
Principles of Political Economy in 1848, what we now call
‘‘economics’’ was in fact generally referred to as ‘‘political
economy.’’ This terminology in large part reflected the belief that
economics was not really separable from politics.
• With the division of economics and political science into distinct
disciplines, economists abstracted from political and institutional
factors. The desire for methodological progress and for a more
rigorous basis for economic analysis were important motivations
in this separation.
• how politics affects economic outcomes
 Political Economy?
• “The new political economy” - has a strong interest in the
question of how politics affects economic outcomes. The
approach using to answer the question in large part by its
use of the formal and technical tools of modern economic
analysis to look at the importance of politics for economics.
• Modern economic analysis is used not just in the formal
sense of a mathematical approach; it is also conceptual,
viewing political phenomena in terms of optimization,
incentives, constraints, et cetera. Hence, what really
distinguishes the new political economy is not so much the
volume, but the sort of research being done.
• The New Political Economy: A general definition is that it is
the study of the interaction of politics and economics.
• If economics is the study of the optimal use of scarce
resources, political economy begins with the political nature
of decision making and is concerned with how politics will
affect economic choices in a society.
• Society should be defined broadly to include not only
countries or other such jurisdictions, but also firms, social
groups, or other organizations.
 continued
• Politics is defined as the study of power and authority, and the
exercise of power and authority. Power, in turn, means the ability of
an individual (or group) to achieve outcomes which reflect his
objectives.
• Other definition: people who want authority struggle to get it while
others try to control those who hold it.
• Questions of power and authority are relevant only when there is
heterogeneity of interests, that is, a conflict of interests between
economic actors in a society. How then does a society make
collective policy decisions that affect it as a whole when individual
members have conflicting interests? How do individuals, classes, or
groups within a larger society gain power or authority to attempt to
have the societal choice reflect their preferred course of action?
Politics may be thought of generally as the study of mechanisms for
making collective choices. Asking how power or authority are
attained and exercised can be thought of as a specific form of the
general question of what mechanisms are used to make collective
decision.
• Economics is the study of the optimal use of scarce resources
contains an implicit, but crucial, assumption when applied to policy
choice, namely, that once the optimal policy is found, it will be
implemented. The problem of policy choice is simply a technical or
computational one. Once the optimal policy has been calculated,
the policymaker then implements it, where this decision is taken as
 continued

• Political economy thus begins with the observation that actual

policies are often quite different from ‘‘optimal’’ policies, the latter
defined as subject to technical and informational, but not political,
constraints.
• Political constraints refer to the constraints due to conflict of
interests and the need to make collective choices in the face of
these conflicts.
• Positive political economy thus asks the question how political
constraints may explain the choice of policies and thus economic
outcomes. that differ from optimal policies, and the outcomes those
policies would imply. To put the same point another way, the
mechanisms that societies use in choosing policies in the face of
conflicts of interest will imply that the result will often be quite
different than what a benign social planner would choose.
• This positive view implies a normative approach as well: normative
political economy would ask the question of how, given the existing
political constraints, societies can be led to best achieve specific
economic objectives.
• This includes not only how to ‘‘overcome’’ political constraints
within the existing institutional framework, but also the design of
political institutions to better achieve economic objectives.
• Political economy differ to public economics (or public finance) and
public choice.
 HETEROGENEITY
• Individual preferences, heterogeneity of tastes, of
endowments, and of expectations. Markets are driven
by heterogeneity.
• Choice of economic policies.
• The importance of heterogeneity for political
economy. : two propositions. First, heterogeneity or
conflict of interests is necessary for there to be
political constraints. Heterogeneity is a necessary
condition. Without heterogeneity, there would be
nothing to study.
• Second, the effect of politics on economics follows
from the mechanisms by which these conflicts are
resolved. Our focus. Heterogeneity is also necessary
for there to be markets, but heterogeneity of interests
plays out quite differently when addressed through
the market than through the political process.
 Heterogeneity
• Given the necessity of conflict of interests for there to be a
political economy problem, one is led to ask: what are
important types of heterogeneity for political economy? There
are many, which we find useful to separate into two basic
classes, giving rise to two crucial types of conflict of interests.
The first conflict reflects underlying heterogeneity of actors
‘‘coming into’’ the political arena, implying they have different
policy preferences. There are a number of reasons. They may
simply have different tastes over goods, broadly defined, or
different relative factor endowments. They may find
themselves in different situations not easily summarized in
terms of tastes or endowments that lead them to prefer
different policies. Or, they may just differ in how they think
the world works, and hence what policies would best achieve
a given aim.
• individuals are heterogeneous in a number of dimensions,
leading them to prefer different policies ex ante. We apply to
this heterogeneity the general term ex-ante heterogeneity,
which plays a crucial role in political economy.
 Heterogeneity
• There is another central type of heterogeneity. Even when
political-economic actors have the same ‘‘primitives’’
endowments, preferences, etc. there will generally still be a
conflict of interests. Actors may all equally value a good, but
there is conflict if its distribution (if it is private) or the
distribution of the costs of providing it (if it is public) is
determined by a collective choice. Economic policies
generally have distributional implications.
• Therefore, when a policy does (or can) have distributional
consequences, self-interested ‘‘representative’’ agents will
be in conflict over distribution. This includes the rents that
office-holding may provide to those in office, whether these
are pecuniary benefits or simply the ‘‘ego rents’’ associated
with holding office. Since ‘‘distribution’’ can also refer to
conflicts arising from ex-ante heterogeneity of factor
endowments, we use the general term ex-post
heterogeneity for this type of heterogeneity.
• These two concepts of heterogeneity will appear in various
forms thought in the book and lecture
• Look on page 13-15 on ex-ante and ex-post heterogeneity.
 Political Economy
• Political economy starts with the problem of choice in a society with
heterogeneous agents, but with a very different focus than multi-agent welfare
economics. The focus is on the process by which it is decided what policy to
adopt, and, more specifically, on what policy choice will emerge from a
specific political process.
• The issue is not the technical problem of the implication of different weights,
but the political problem of how the weights are chosen (representing the
question of how conflicts of interests are resolved) and its economic
implications.
• In the consumption versus saving problem with either ex-ante heterogeneity
(difference in how present and future are weighted) or ex-post heterogeneity
(the incentive to increase one’s share of current consumption at the expense of
others), the focus is on the implications for capital accumulation of the
society’s current aggregate consumption being politically determined.
• This means both how the political mechanism determines the in a political-
economic equilibrium and how this decision in turn affects capital
accumulation and welfare. Heterogeneity of interests is crucial for the problem
to be of any political interest. If all individuals had the same discount factor and
there was no possibility for consumption to differ across individuals, societal
and individual variables would be identical, no matter what the collective
choice mechanism, and there would be no political problem.
• The idea that the political process may bias the result away from a socially
preferred solution has at least two aspects to it. (Public Economics and Public
Choice)
 Economic Models for Political Analysis
• As mentioned, we defined political economy as the study of how the
political nature of decision making affects policy choices and, ultimately,
economic outcomes. This focus is based on the fact that in the real world,
economic policy is not chosen by the social planner who safely inhabits
economics textbooks, sheltered from agents with conflicting interests while
he calculates optimal policy.
• Economic policy is the result of a decision process that balances
conflicting interests so that a collective choice may emerge. This is what
we meant by the phrase ‘‘the political nature of decision making.’’
• In order to study political economy, that is, to study the effects of politics
on economic outcomes, we must therefore begin with some political and
economic building blocks. One building block is decision making
mechanisms themselves. When there are conflicts of interests over
economic policies, so that different groups have different preferred policies,
some mechanism must be used for choosing a policy.
• That is what is meant by a collectie choice mechanism, that is, a
mechanism for ‘‘aggregating’’ diverse preferences into a single collective
preference or policy not in a technical sense of simply weighting individual
preferences to derive a social welfare function, but in the political sense of
investing a decision with authority, so that it becomes accepted policy.
• The other building block is an economic model, used to study both the
positive question of how policies affect outcomes and the normative
question of how to evaluate these effects for individual and social welfare.
A number of economic tools and models that are useful in political
 THE PRINCIPAL AGENT PROBLEM
• The delegation of decisions to policymakers with different preferences is
pervasive in the making of collective choices. In fact, one may argue it is inherent
to collective decision making. In any society with a large number of interests,
decision making will necessarily be representative, in that individuals will choose
representatives to make policy who do not have exactly the same preferences as
they do over policies.
• From a theoretical perspective, representative politics is an example of a
principal agent problem. This is true not only in representative democracy as a
whole, that is, in the role of voters in choosing their representatives in the
legislative and executive branches of government, but also within the workings of
these organizations.
• The principal agent paradigm is also useful, and sometimes central, to other
political relationships as well, such as international policy cooperation and
gaining support for large-scale economic reform and transition.
• The principal–agent problem is a general problem of mechanism design under
incomplete information. In the applications that we use, an ‘‘agent’’ takes actions
‘‘on behalf of’’ a ‘‘principal,’’ where the optimal action from the principal’s point
of view depends on some information known only to the agent. Example doctor-
patient, or lecturer –students etc.
• A key characteristic of the general principal agent problem is that the relation
between the principal and the agent is not exogenous; it is chosen by the
principal to maximize his expected utility. This focus on endogenous mechanisms
of control will sometimes limit the applicability of the principal agent paradigm to
political problems, but it will not eliminate it.
 Decision making Mechanisms
• Related to Public Choice and politics
• The theory of political decision making
• Studying the effect on outcomes of different ways of making collective choices.
• Political institutions clearly matter for outcomes, but that observation alone does not tell us which
institutional details matter. Legislative rules on when a proposal under consideration may be
amended are often crucial to policy outcomes if ‘‘when’’ refers to the stage in the process at
which amendments may be proposed.
• whether the decision making process ‘‘matters,’’ but which aspects of the process are crucial and
which aspects we can abstract away from.
• One can err in either direction: one can specify institutions and differentiate decision making
processes in such detail that no regularities emerge; or, one can represent institutions on so
abstract a level that the result tells us little about what to expect from real-world institutions.
• Analogy like production
• A relation between the political mechanism and economic outcomes, that is, a ‘‘production
function’’ relating the desires of heterogeneous interests to collective decisions and final
economic outcomes, is necessarily a ‘‘reduced form’’ to someone doing research in political
economy.
• But, the question of how much underlying detail is necessary in order to understand a given
phenomenon is at least as complicated as the analogous question for standard production
functions. It is probably far more complicated, not only because ‘‘Reduced form’’ should not be
taken in its most literal sense as a functional relation between resources devoted to the political
process and final outcomes, but more generally to the idea that one is not interested in all the
institutional details in considering, for example, the effect of elections on unemployment. Reduced
forms in this literal sense are considered we have far less experience with political economy, but
also because the concept of maximum output for a given input is clearly inappropriate for a
‘‘political production function.’’.
• No simple answer. Political institutions, elections, lobbying etc.
 CHOOSING DECISION MAKING MECHANISMS
• Constitutions
• The Creation of Government and Majority Rule
• At base, political or collective action under the individualistic view of the state is
much the same as the mutually beneficial exchange relationship of individuals in
the market. Two or more individuals find it mutually advantageous to join forces to
accomplish certain common purposes. (Buchanan and Tullock)
• The first question public choice asks is why rational self-interested individuals
would create the institutions of government. The answer usually given is that
there exist situations . . . in which the independent, self-interested actions of each
individual lead to outcomes that are Pareto inferior to what could be achieved
through cooperative agreement. (Mueller)
• However, all individuals will not benefit equally under each possible sort of
cooperative agreement, so that the decision about what will be the ‘‘rules of
cooperation’’ becomes crucial.
• Choosing the rules by which decisions will be made is a conceptually thorny
issue. One approach is to argue that since governments are formed by a
voluntary agreement among citizens, the rules for choosing government policies
should be such that the government chooses to engage in activities that make all
citizens better off.
• Checks and Balances.
• Separation of powers with simple ‘‘division of authority’’ in which a unit has sole
authority over a decision, or with the case of multiple units having independent
jurisdiction in the same area.