Political Economics

Lecture 5
How do institutions shape economies?
• Institutions matter: countries with better
institutions achieve better economic
performance
• What are the mechanisms?
• How do economies work in oligarchic and
democratic states?
• How do (highly) inefficient autocracies secure
their survival?
 Outline of the lecture
1. What political system fosters best economic
performance? Does the answer to this
question change depending on the time
horizon considered? What are the
mechanisms at play? Acemoglu (2008)’s
comparative exercise
2. Reflection on the MVT and its consequences
on the stability of political systems
1) Society with 2 “types” of individuals
 Current activity is:

Entrepreneurs:

Workers:
 Define oligarchy and democracy
• Individuals decide on two policies:
– Tax rate, t (with total tax revenue being redistributed)
– Barrier to entry, b which raises the cost of becoming
an entrepreneur
• Democracy is a society where t and b are decided
by all individuals by majority rule
• Oligarchies are societies where only the current
entrepreneurs (elite) decide upon those policies
 Optimal policies in democracy: t
• Based on the median voter theorem, since we have a
majority of workers in the society t=tmax
• tmax may depend on features of the political system.
The point is that a 100% tax rate is never feasible
• This in turn has detrimental consequences for
economic growth, as entrepreneurs incentives for
investment and production are shaped by fiscal
policies
 Optimal policies in democracy: b
• For similar reasons democracy sets b=0 as the
majority of citizens are workers, and do not want to
prevent themselves from becoming entrepreneurs in
future periods
Democracy when activity is:

Entrepreneurs:

Workers:
 Optimal policies in oligarchy: t
• Based on the median voter theorem, since we have
only entrepreneurs voting in the society t=0
• No incentive to make any redistribution of their
profits
• This, in turn, provides the largest incentives for
investment and economic activity to entrepreneurs
• High(er) aggregate economic output
 Optimal policies in oligarchy: b
• Since the decision of the barrier to entry is taken
only by individuals currently in the “privileged”
position, they have the strongest incentive to set a
high b to prevent any entry which would have two
effects:
– Reduce the profits as it increases competition
– Increase the market wage as it increases the demand for
workers
Oligarchy when activity is:

Entrepreneurs:

Workers:
 Summing up: static perspective
• Provided the “initial” elite is selected from the
population of individuals with comparative
advantage in the current activity:
– Oligarchic societies achieve higher economic
output than democracies as the distortive effects
of taxation (and redistribution) do not operate
– Inequality is much higher in oligarchies
• (Is assumption always realistic? Consider the
cases of Warriors/Priests)
Democracy when activity is:

Entrepreneurs:

Workers:
Oligarchy when activity is:

Entrepreneurs:

Workers:
Summing up: dynamic perspective
• The social mobility in democracy allows the
economy to adjust to the new technologies, or
new opportunities (but taxation always limits
aggregate output)
• In oligarchic societies elites hold on power
relying on the barriers erected, thereby
reducing their ability to adjust over time
 Generalization beyond
2 periods / 2 types
output

Democracy
Oligarchy

t
 Historical evidence?
• Caribbean versus North American colonies
• In the XIX century:
– Oligarchic society in the Caribbean region, based
on plantation system were among the richest in
the world (above North American colonies)
– With the new technologies and the opportunities
created by industrialization the situation gradually
reversed
 Historical evidence?
• Pre- and post-WWII Japan, and post-WWII
Korea
• Both cases relatively oligarchic societies in
which the government favoured major
producers with subsidized loans and
protectionist policies
• Both systems had a dramatic growth during
the post-war era, but slowed down over the
past decades
 Discussion
• Institutions matter
• The protection of property rights has been
identified as the key institution, which foster
economic growth
• But…
• Whose property right should be protected and
how?
• Relevant question when there is conflict between
protecting the property rights of various groups
 Discussion
• In this model protecting the property rights of
current producers comes at the costs of limiting
future opportunities to future potential
producers
• Empowering current producers (to protect their
profits from taxation) leads them to abuse their
power to protect their incumbency advantage
• Trade-off between current and long-run efficiency
• The issue is far from trivial…
 2) Reflections on the MVT
• The distribution of wealth/capital is crucial for
the equilibrium taxation of a democracy:
– If the median voter is relatively rich, we expect
low taxation, which in turn implies less distortions
and more efficient economic production
– If the median voter is relatively poor, high taxation
is expected, which damages the economy
• This mechanism should not operate in non
democratic societies…
Persson and Tabellini (1994)
 Who wants a democracy?

A
Median voter preferred t
B

0 1

The top of the distribution prefers a non-democratic regime

 De Luca et al. (2015)
• With a theory model we describe this
mechanism and show that:
– In society with a high inequality in capital
distribution, there is a large share of the (rich)
population which strictly prefers an unconstrained
autocracy to a democracy
– Depending on the capital endowment of the
autocrat, the loss due to embezzlement by the
autocrats are offset by the lower tax rate (as
compared to democracy)
• Is that affecting the stability of a democracy?
 Summary
1. Oligarchic societies may be more efficient in the
short run as they implement lower taxation
(MVT). In the long run, however, entry barriers
created by the elites reduce social mobility.
Democracies instead allow the most fit to the
purpose to emerge.
2. Inequality reduce growth in democracies (MVT).
As a consequence, capital rich individuals prefer
unconstrained autocrats to democracies. In
sufficiently unequal societies, the share can be
dangerously high for the stability of the political
system.
 (Simple) MVT model
• Assume a continuum of individuals distributed
according to their income
• Suppose the society needs to take a decision
on one policy (e.g., tax rate)
• The larger the income of an individual, the
lower her/his preferred tax rate
• (Choosing t=1 leads to no income inequality)
 (Simple) MVT model
• Suppose 2 parties compete in an election
(majority rule) and assume away any
commitment issue
• Individuals vote the party whose policy is
closer to their preferred one
• What is the optimal policy announced by the
parties?
 (Simple) MVT model

A B
0 1
 (Simple) MVT model

A B
0 1
 (Simple) MVT model

A B
0 1
 (Simple) MVT model

A
B
50% 50%
0 1

Median voter preferred t

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