i

Political Economy and

Policy Analysis
Most of economics takes politics for granted. Through some (often implausible)
assumptions, it seeks to explain away political structures by characterizing them
as stable and predictable or as inconsequential in understanding what goes on in
an economy. Such attempts are misguided, and this book shows how
governments and political institutions are composed of people who respond
to incentives and whose behavior and choices can be studied through the
lens of economics.
This book aims to bridge the gap between economics and politics, and in
doing so hopes to instill in the reader a deeper appreciation for social
scientific thinking. Opening with a refresher on microeconomics and an
introduction to the toolkit of political economy, it ensures that the necessary
building blocks are in place before building up from the level of the
individual and the firm to show how a political–economic equilibrium can be
achieved. The text explores how to separate primitives—the external parts of
a model that we cannot affect—from outcomes—the internal parts of a
model that we can. Moreover, it demonstrates that economic and political
issues alike can be studied within the same general framework of analysis.
Political Economy and Policy Analysis offers readers the chance to gain a more
sophisticated understanding of political processes, economic processes, and the
interplay among them. Adopting an applied microeconomics approach, it will
be ideal for upper-level undergraduate or postgraduate courses on political
economy, public choice, or policy analysis.

Antonio Merlo is the Dean of the School of Social Sciences and the George A.
Peterkin Professor of Economics at Rice University, USA. He is also the
founding and current director of the Rice Initiative for the Study of
Economics (RISE). In 2012, he was elected a Fellow of the Econometric
Society. His areas of expertise are political economy, policy analysis, public
economics, bargaining theory and applications, and empirical microeconomics.
iii

Political Economy
and Policy Analysis

ANTONIO MERLO
First published 2019
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
and by Routledge
52 Vanderbilt Avenue, New York, NY 10017
Routledge is an imprint of the Taylor & Francis Group, an informa business
© 2019 Antonio Merlo
The right of Antonio Merlo to be identified as author of this work has been
asserted by him in accordance with sections 77 and 78 of the Copyright,
Designs and Patents Act 1988.
All rights reserved. No part of this book may be reprinted or reproduced or
utilised in any form or by any electronic, mechanical, or other means, now
known or hereafter invented, including photocopying and recording, or in
any information storage or retrieval system, without permission in writing
from the publishers.
Trademark notice: Product or corporate names may be trademarks or
registered trademarks, and are used only for identification and explanation
without intent to infringe.
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data
Names: Merlo, Antonio (Economist), author.
Title: Political economy and policy analysis / Antonio Merlo.
Description: Abingdon, Oxon ; New York, NY : Routledge, 2019. | Includes
bibliographical references and index.
Identifiers: LCCN 2018037493 (print) | LCCN 2018039635 (ebook) |
ISBN 9780429490309 (Ebook) | ISBN 9781138591776 (hardback : alk. paper) |
ISBN 9781138591783 (pbk. : alk. paper)
Subjects: LCSH: Economics—Political aspects. | Economic policy. |
Policy sciences.
Classification: LCC HB74.P65 (ebook) | LCC HB74.P65 M47 2019 (print) |
DDC 330—dc23
LC record available at https://lccn.loc.gov/2018037493

ISBN: 978-1-138-59177-6 (hbk)

ISBN: 978-1-138-59178-3 (pbk)
ISBN: 978-0-429-49030-9 (ebk)

Typeset in Dante and Avenir

by Apex CoVantage, LLC
v

To my father, who taught me by example the meaning of work ethic.

To the memory of my mother, who taught me by example the meaning of resilience

and perseverance.

To my wife, who teaches me every day by example the meaning of empathy and
unconditional love.
Contents

Preface ix
Acknowledgments xi
1 Overview and introduction 1
2 Basic tools of microeconomics 5
2.1 A simple economy 7
2.2 Efficiency 8
2.3 Competitive equilibrium 10
2.4 Equity 13
2.5 The Social Planner Problem 17
2.6 Game theory 20
2.6.1 A simple game 20
2.6.2 Games with more than two actions 24
2.6.3 Games with a continuum of actions 27
2.7 Discussion 30
3 Basic tools of political economics 32
3.1 The Voting Problem 33
3.2 Median voter theorems 43
3.3 Discussion 50
4 Voters 52
4.1 Voter turnout 52
4.1.1 The calculus of voting 53
4.2 Sincere voting and strategic voting 62
4.2.1 Split-ticket voting 65
4.3 Discussion 68
vii Contents vii

5 Electoral competition 71
5.1 The Downsian model 71
5.2 The citizen-candidate model 76
5.2.1 A simple model with three types of voters 77
5.2.2 A general model with a continuum of voter types 80
5.3 Discussion 87
6 Parties 88
6.1 Voter mobilization 88
6.2 Policy platforms 91
6.3 Candidate recruitment 96
6.4 Discussion 100
7 Lobbies 102
7.1 Exogenous lobbies 103
7.1.1 Ex ante lobbying 104
7.1.2 Ex post lobbying 108
7.2 Endogenous lobbies 111
7.3 Discussion 113
8 Political careers 117
8.1 The political labor market 117
8.2 A model of politicians’ careers 118
8.3 Discussion 124
9 Public goods 125
9.1 A simple economy with public goods 127
9.2 Private provision 129
9.2.1 Competitive markets 129
9.2.2 Voluntary contribution games 131
9.3 Political provision 135
9.3.1 Heterogeneous preferences and
homogeneous income 136
9.3.2 Heterogeneous income and homogeneous
preferences 140
9.3.3 Heterogeneous preferences and heterogeneous
income 142
9.4 Discussion 143
10 Public schools 145
10.1 Political provision of primary education 145
10.1.1 Elected superintendent 148
10.1.2 Appointed superintendent 148
10.1.3 Elected politicians or appointed bureaucrats? 151
viii Contents viii

10.2 Taking the model to data 152

10.3 Discussion 154
11 Higher education 157
11.1 Pure private system 158
11.2 Pure public system 160
11.3 Mixed system 164
11.4 Discussion 167
12 Redistribution 169
12.1 Efficiency and redistribution 170
12.2 Political economy of redistribution 171
12.2.1 A different type of heterogeneity 181
12.3 Discussion 184
13 Health care 187
13.1 Health insurance 187
13.1.1 Private health insurance 188
13.1.2 Publicly provided health care 192
13.2 Electoral competition and health care 195
13.3 Discussion 198
14 Mobility 199
14.1 Local public goods 200
14.2 Local redistribution 203
14.3 Federalism 208
14.4 Discussion 212

Bibliography 214
Index 218
ix

Preface

I have written this book to bridge the gap between economics and politics,
which has become an unfortunate norm across much of the social sciences.
In so doing, I also hope to instill in the reader a deeper appreciation for
social scientific thinking. To understand what we are talking about you will
need to be able to think critically and abstractly, taking out bits and pieces of
information from a larger picture and using them to build up to a political–
economic equilibrium. You will need to separate primitives—the exogenous
parts of a model that we cannot affect—from outcomes—the endogenous
parts of a model that we can. You will also need to understand that economic
and political issues alike can be studied within the same general framework of
analysis, where a theory is a combination of models and equilibrium concepts
that starts from primitives to ultimately explain outcomes. And of course, you
will gain a more sophisticated understanding of political processes, economic
processes, and the interplay among them.
This book is ideally suited to serve as a textbook for a semester-long course,
though it could be easily used in combination with other texts to cover any
portion of a course devoted to topics in political economy and/or policy anal-
ysis. The book is aimed at students with an understanding of basic economic
principles and a working knowledge of calculus. If you have taken a calculus-
based microeconomics foundations course you will be able to hit the ground
running.
As you go through the various chapters, you will encounter some formal
mathematics, which can often seem intimidating to some people. In fact,
some would even go as far as claiming that economics really is just a bunch
of esoteric formulas scribbled on a board. Well, this is not true. It turns out
x Preface x

that good economics does require ironclad math. It is not how difficult the math
is, it is how clean the logic is, how precise the language we use. And sometimes,
using the rigor of mathematics can help us clarify our thinking around complex
issues and avoid drawing faulty conclusions from shoddy generalizations. If you
are feeling intimidated, do not despair, as there are plenty of resources that can
help you get on track. Math is not the be-all and end-all; it is a useful tool to get
there.
xi

Acknowledgments

This book is the outcome of a process whose primitives are the many people
who have helped me throughout the process. Though we take primitives in
our models as given, I most certainly do not take these primitives for granted.
I owe a debt of gratitude to my dissertation advisor, Chris Flinn, who
modeled what it means to be an ideal mentor, by giving me strong foundations
and teaching me how to do research, while at the same time helping me
develop my own identity as a scholar. I am also grateful to Jess Benhabib,
Andy Schotter, and Chuck Wilson for their mentorship that extended beyond
my years as a graduate student at New York University.
My colleagues at the University of Minnesota were also instrumental in the
early years of my academic career as a budding political economist. V. V. Chari,
John Geweke, Ed Green, the late Leo Hurwicz, Tim Kehoe, Andy McLennan,
Richard Rogerson, Ed Prescott, Tom Sargent, and Neil Wallace never hesitated
to offer me their invaluable advice, guidance, and support. So did Steve Brams,
the late George Downs, Douglas Gale, Boyan Jovanovic, Yaw Nyarko, Adam
Preworksi, Debraj Ray, and all of my colleagues at New York University
when I joined the Department of Economics and the Department of Politics
as a faculty member in the late 1990s.
I have also benefited tremendously from the daily interactions and stimulat-
ing conversations with the many distinguished scholars I have had the privilege
of having as colleagues at the University of Pennsylvania, including Hal Cole,
Frank Diebold, the late Lawrence Klein, Dirk Krueger, George Mailath,
Bobby Mariano, Andy Postlewaite, Mark Rosenzweig, Holger Sieg, and
Randy Wright, and my current colleagues at Rice University, including
Flavio Cunha, Hülya Eraslan, Mallesh Pai, Xun Tang, and Ken Wolpin.
xii Acknowledgments xii

Over the years, I have received inputs from many talented political econo-
mists, including Daron Acemoglu, Philippe Aghion, Alberto Alesina, Nageeb
Ali, Jim Alt, Scott Ashworth, David Austen-Smith, Sandeep Baliga, the late
Jeff Banks, Dave Baron, Marco Battaglini, Roland Benabou, Jon Bendor,
Doug Bernheim, Tim Besley, Renee Bowen, Steve Callander, Alessandra
Casella, Francesco Caselli, Micael Castanheira, Steve Coate, Ernesto Dal Bo,
Avinash Dixit, Allan Drazen, John Duggan, Georgy Egorov, Dennis Epple,
Tim Feddersen, Mark Fey, Jeff Frieden, Vincenzo Galasso, Andrea Galeotti,
Dino Gerardi, Mikhail Golosov, Joanne Gowa, Gene Grossman, Bard
Harstad, Elhanan Helpman, John Huber, Bob Inman, Matt Jackson, Tasos
Kalandrakis, Navin Kartik, Brian Knight, Keith Krehbiel, Per Krusell, Eliana
La Ferrara, Roger Lagunoff, Michel Le Breton, John Ledyard, Gilat Levy, Ales-
sandro Lizzeri, John Londregan, Cesar Martinelli, Nolan McCarty, Adam Meir-
owitz, Matthias Messner, Helen Millner, Massimo Morelli, Andrea Moro, Roger
Myerson, Martin Osborne, Rohini Pnade, Keith Poole, Jim Poterba, Nicola
Persico, Torsten Persson, Wolfgang Pesendorfer, Per Petterson-Lidbom,
Thomas Piketty, Matias Polborn, Andra Prat, Antonio Rangel, Ronny Razin,
James Robinson, Gerard Roland, John Roemer, Tom Romer, Howard
Rosenthal, Alvaro Sandroni, Christian Schultz, Ken Shepsle, Ken Shotts, Matt
Shum, Al Slivinski, Eric Snowberg, Jim Snyder, Francesco Squintani, David
Stromberg, Guido Tabellini, Michael Ting, Aleh Tsyvinski, Francesco Trebbi,
Ebonia Washington, Shlomo Weber, Jorgen Weibull, Leeat Yariv, and Fabrizio
Zilibotti.
Many of the ideas and concepts contained in this book grew out of joint
work with my coauthors, Arianna Degan, Daniel Diermeier, Cristina Echevar-
ria, Hülya Eraslan, Leonardo Felli, Vincenzo Galasso, Ayşe İmrohoroğlu,
Michael Keane, Massimiliano Landi, Robert Marshall, Andrea Mattozzi, Fran-
çois Ortalo-Magné, Thomas Palfrey, Aureo de Paula, Peter Rupert, John
Rust, Andrew Schotter, Xun Tang, Charles Wilson, and Ken Wolpin. Their
direct and indirect contributions to this work are significant.
I started teaching political economy at both the graduate and the undergrad-
uate level in the early 1990s. This is where the process that lead to this book
began. I have taught it to students at the University of Minnesota, New York
University, the University of Pennsylvania, and Rice University. All these
cohorts of students have given me a wealth of their insightful perspectives
into the subject matter of this book over the years and I am tremendously grate-
ful to each and every one of them. This journey has helped me solidify my own
understanding of what this book should be about and how it should be pitched.
Many of these students have also helped me through the process of bringing
what started as a collection of class notes to a full-fledged book, and I am espe-
cially grateful to Alexander Amari, Daniela Iorio, Claire Lim, Karam Kang,
xiii Acknowledgments xiii

Ekim Muyan, Bob Rebelein, Deniz Selman, Michela Tincani, and Peter
Volkmar.
Some of the material in Chapters 4, 5, 6, and 8 are taken from my essay
“Whither Political Economy? Theories, Facts and Issues” which appeared in
the edited volume by Richard Blundell, Whitney K. Newey, and Torsten
Persson, Advances in Economics and Econometrics: Theory and Applications, Ninth
World Congress, Volume I, Econometric Society Monograph No. 41, published
by Cambridge University Press in 2006. I thank the publisher for allowing
me to reproduce some of the material here, which I developed for a lecture
I delivered at the Ninth World Congress of the Econometric Society, held in
London in August 2005.
The team of editors at Routledge who worked on this book improved it tre-
mendously. Andy Humphries, Senior Editor for Economics and Finance, pro-
vided the right mix of criticism and encouragement. Anna Cuthbert, Editorial
Assistant for Economics, provided invaluable help and support throughout
the publishing process.
I owe a huge debt of gratitude to my wife, Gia Merlo. Were it not for her
persistence and steady encouragement, this book would have never seen the
light of day. Finally, I am enormously grateful to my daughter, Martina
Merlo. No matter how meaningful the birth of this book is to me, it does
not compare to the happiness Martina’s birth brought into my life.
1

Overview and 1
introduction

Most of economics takes politics for granted. Through some (often implausible)
assumptions, it seeks to explain away political structures by characterizing them
as stable and predictable, or as inconsequential to understand what goes on in
an economy. To someone like me, who grew up in Italy during a time when
there was a new government almost every year and politics permeated virtually
every aspect of daily life, such attempts are misguided.
Governments and other political institutions, far from being unchanging and
benign monoliths, are composed of people who respond to incentives and
whose behavior and choices can be studied through the lens of economics.
And this book aims to do exactly that: to examine and explain the choices of
politicians and governments, starting from the level of individuals and building
up to equilibria. Using the tools of microeconomics, we will take many of the
concepts you may have already seen—preferences, technology, endowments,
and market equilibria, among others—and apply them to the political realm:
a broad enterprise that we will call political economy.
As is often said, it is only possible to see further if one is standing on the
shoulders of giants. Before we begin our study of political economy we will
want to learn about some of the great thinkers who paved our way.
When Adam Smith, father of modern economics, published The Wealth of
Nations in 1776 there was no conceptual distinction between politics and eco-
nomics. In as much as you will study John Stuart Mill, David Ricardo,
Thomas Malthus, and others in courses on the history of economic thought,
it should be noted that these thinkers were very much considered writers on
‘political economy’ in their time. This makes good sense, since in the 18th and
19th centuries these thinkers lacked many of the tools and knowledge—now
2 Overview and introduction 2

Figure 1.1 Overview: 1776–1900.

integral in the social sciences—necessary to separate political processes from

economic ones. They could scarcely imagine the insights of modern psychol-
ogy, sociology, and political science, much less the mathematical rigor that
was added to the study of economics in the 20th century by pioneers like
Paul Samuelson.
Indeed, that added rigor marked the first major transformation for political
economy. Between 1900 and 1980, economists from the United States and
Europe devised formal ways of expressing economic and political concepts
mathematically using calculus and statistics. The problem, however, was that
oftentimes the mathematical expressions relied on drawing stark and simplistic
contrasts between the political and economic realms. For example, in the 1950s,
Kenneth Arrow, Gerard Debreu, and Lionel McKenzie developed the powerful
formal framework of general equilibrium theory but excluded politics from
their analysis. They sought to characterize economic equilibria by relegating
political factors to considerations that were outside of their models; it is as
though there is a vector of policy parameters, θ, with which we ask what,
conditional on θ, we can surmise about an economy, with the implicit under-
standing that policies are somehow determined by political forces that operate
outside of the economy. Roughly at the same time, the pioneering work of econ-
omists Anthony Downs, James Buchanan, and Gordon Tullock did exactly
the opposite, by focusing on political outcomes as the equilibrium objects of
their analyses grounded in the realm of politics, while regarding economic phe-
nomena as ‘nuisance parameters’ coming from the totally separate realm of
economics.
Yet we know that we are not born operating on two distinct planes, one
political and the other economic. It is not as though political parties and politi-
cians are from Mars while firms and consumers are from Saturn. Our challenge
3 Overview and introduction 3

Figure 1.2 Overview: 1900–1980.

in this book is to bring closer together the great insights of politics and econom-
ics into the science of modern political economy, an ongoing process that began
in the 1980s. Thus, in as much as we will consider Barack Obama and Donald
Trump as democratically elected leaders affecting the most important policy
and economic issues, we will also see them as individuals seeking to maximize
their utility subject to constraints. Similarly, we will look at voters in much the
same way that we would think about consumers deciding on what to buy,
where to live, how much to save, and so forth. With this logic, we will be
able to explain things like why and when people vote, what kinds of politicians
end up running for office, when, why, and to what extent societies decide to
redistribute wealth, and why some communities spend more than others to
support their public schools. So, forget the notion that the ‘dismal science’
cannot explain politics. With the tools of modern economics, starting from
basic primitives and assumptions about peoples’ preferences, we will explain
political and economic choices. And by the end of this book, you will have
taken your first steps as a fledgling political economist.
In Chapter 2, we will review some of the economics concepts that are nec-
essary to follow along throughout the book. Chapter 3 then introduces the basic
concepts of political economics which we will use as the building blocks to tran-
sition from the study of an economy to that of a political economy. Voters, elec-
toral candidates, parties, lobbies, politicians and their career choices are the
focus of the next five chapters, respectively. In Chapter 9, we will then fully
integrate everything we have learned in the previous chapters and begin to
analyze the political economy of specific policy issues, starting with public
goods. Public schools, higher education, redistribution, health care, and immi-
gration round up the rest of the chapters.
4 Overview and introduction 4

Figure 1.3 Overview: 1980–Present.

In the news
If you would like to familiarize yourself with the topic and the author of this
book before plunging right into the reading, I suggest you watch the Pareto
lecture I gave at the Collegio Carlo Alberto in June 2014, “The Devil Is in the
Detail” available here: http://vimeo.com/110141762.
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