Part III: Political Economy

In order to operate, a government needs to decide two things:

1)How are decisions made?

2)How are responsibilities split?

Note: This chapter only covers select issues in political economy

Part III: Political Economy

Direct DemocracyRepresentative DemocracyFederal System BackgroundAdvantages of DecentralizationDisadvantages of Decentralization

Public ChoicePUBLIC CHOICE – a field of applying economic

principles to the understanding of political decision making

We will examine two models of democratic decision making:

1)Direct Democracy

2)Representative Democracy

Direct DemocracyIn direct democracy, everyone has a say in the

political decision making process, leading to a variety of approaches and issues:

1)Unanimity Rules

2)Majority Voting Rules

3)Logrolling

4)Arrow’s Impossibility Theorem

Unanimity RulesLindahl (1919/1958) designed a procedure to ensure

unanimous agreement on provision of public goods.

Each voter has a demand curve, where PRICE is the fraction of the public good the voter will pay (tax share), and QUANTITY is the resulting quantity they will want.

Two voters will agree on provision of public goods when their combined price equals one at a certain quantity level.

This can be shown through the following overlay of demand curves:

Unanimity Rules

Unanimity RulesThe prices, or tax shares, where two people

demand the same amount of public goods, are LINDAHL PRICES.

Unanimity Rules are feasible through an auction system, where an auctioneer keeps listing different tax schemes until everyone agrees on one.

Unanimity RulesUnanimity Rules suffer from two problems:

1)People can still misrepresent their preferences to partially free-ride

2)Unanimous decisions take a long time with many people It is guaranteed that no one is exploited but… Historically, unanimous decisions have been

required to ensure no decision is made.

Majority Voting RuleDifficulty in unanimous decisions often leads to the

MAJORITY VOTING RULE – one more than half the voters must favor a measure for it to be approved.

To illustrate, assume Econ 350 had 3 different marking options:

1)Paper – long paper and one midterm

2)Exams – two midterms and a short paper

3)Assignment – two assignments, one midterm, and a short paper

Majority Voting Rule

In this case, even though each person prefers a different arrangement, in a vote:

Exams beat paper (2 to 1)Exams beat assignment (2 to 1)Therefore, regardless of voting, exams win

This is not always the case however…

Voter:

Choice House Super Mario oGsMC

First Exams Paper Assign

Second Assign Exams Exams

Third Paper Assign Paper

Voting Paradox

In this case:Exams beat assignment (2 to 1)Assignment beets paper (2 to 1)Paper beats exams (2 to 1)VOTING PARADOX – individual voter’s preferences

are consistent, but the community’s are not

Voter:

Choice House Super Mario Chuck Noris

First Exams Paper Assign

Second Assign Exams Paper

Third Paper Assign Exams

Voting ParadoxIn the case of a voting paradox, the order of the

voting agenda can determine the winner

AGENDA MANIPULATION – process of organizing the order of votes to assure a favorable outcome

Alternately, if pair voting (option A vs. option B) is continually used a decision is never reached.

CYCLING – when paired majority voting on more than two possibilities goes on indefinitely without a conclusion ever being reached.

Voting ParadoxThe voting paradox arises when one agent has a

DOUBLE-PEAKED PREFERENCE – utility moves down as you move away from a preference, then up as you move farther way.

SINGLE-PEAKED PREFERENCE – utility keeps moving down the farthest you move from a preference.

If we examine the previous decision in terms of # of non-paper components, we see a double peak:

Double Peaked Preferences

Here, Super Mario and Chuck Noris have single-peaked preferences while House has double peaked preferences (3 is better than 1 (less), but worse than 2 (less)

When choices are not based on a single dimension, multipeaked preferences are more common (ie: would you prefer teleportation, super strength, or mind reading as a super power?)

Voter:

Choice House Super Mario Chuck Noris

First Exams (2) Paper (1) Assign (3)

Second Assign (3) Exams (2) Exams (2)

Third Paper (1) Assign (3) Paper (1)

Median Voter Theorem

MEDIAN VOTER – voter who’s preferences lie in the middle of all voter’s preferences

MEDIAN VOTER THEOREM – as long as all preferences are single peaked, the outcome of majority voting reflects the preferences of the median voter

Median Voter Theorem Example

Assume that the final exam could be either 2, 3, 4, 5, or 8 questions long, each with exactly 20% of the vote.

Moving from 8 to 5 would get 80% of the vote, and moving from 5 to 4 would get 60% of votes.

However, moving from 4 to 3 would only get 40% of votes; 4, the median voter’s preference, wins through majority voting.

LogrollingLOGROLLING – trading of votes to obtain

passage of a package of legislative proposalsLogrolling is common in the US, and allows

laws to be passed that normally would fail through considering how strongly people feel for a proposal.

Consider the following table reflecting benefits from 2 proposals:

Logrolling

Without logrolling, each proposal would fail (2v1) With logrolling, a hospital and pool (net benefit 315) would be

supported by Melanie (net benefit 80) and Scarlet (net benefit 345) Although this sometimes benefits society, through special interest

groups it can sometimes harm society

Logrolling

Without logrolling, each proposal would fail (2v1) With logrolling, a hospital and library (net benefit

-20) would be supported by Melanie (net benefit 160) and Rhett (net benefit 40)

Society’s welfare decreases through a coalition of special interests

Arrow’s Impossibility TheoremThus far, all voting techniques we’ve examined

have been flawedNobel laureate Kenneth Arrow (1951) proposed

6 criteria collective decision-making should follow in a democratic society:

1)A decision is made regardless of preferences (ie: multipeaked)

2)All possible outcomes can be ranked

3)Must be responsive to individuals’ preferences (if everyone prefers A to B, society must rank A higher than B).

Arrow’s Impossibility Theorem4) Consistency (if A is preferred to B and B is

preferred to C, C must be preferred to A)

5) INDEPENDENCE OF IRRELEVANT ALTERNATIVES – ranking of A and B cannot be influenced by another option C.

6) Dictatorship is ruled out.

Unfortunately, Arrow’s Impossibility Theorem shows that all 6 requirements can’t be met (5 can); a democratic society cannot be guaranteed to make consistent decisions.It may make good decisions often but 100% can’t

be guaranteed

Representative Democracy

Everyone voting on every decision is impractical in many areas, so often politicians are democratically elected to make decisions Referendums occur, but are very uncommon

and costly

If certain qualifications hold, the median voter theorem can predict the policies of the elected representatives:

Success of the MiddleIn the case of two

candidates, M and S:M will get all votes

left of himself, and some votes between M and S

S will get all votes right of himself, and some votes between M and S

M will win the electionThe representative that most follows the median

voter will win

Middle Winning QualificationsAlthough this is a surprisingly common result, it

doesn’t always hold true because:

1)Multi-dimensional rankings – often the median voter is different for different issues (ie: social issues vs. taxes) – a politician may win a vote through one policy and lose it through another

2)Ideology – some politicians may care about more than just winning elections – they may hold to an ideology Carlyle King (former Co-operative Commonwealth

Federation (CCF…now NDP) Saskatchewan president discussed ideology vs. election appeal:

Ideology vs. Election Appeal“The trouble is that socialist parties have gone a-

whoring after the Bitch Goddess. They have wanted Success, Victory, Power; forgetting that the main business of socialist parties is not to form governments but to change minds. When people begin to concentrate on success at the polls, they become careful and cautious; and when they become careful and cautious, the virtue goes out of them.” – Carlyle King

Who said politics boring and wasn’t edgy?

Middle Winning Qualifications3) Personality – often politicians win or lose

depending on personality (many argue that Mulroney’s low popularity came out of his arrogance)

4) Leadership – often politicians can influence public opinion

5) Decision to vote – not everyone votes, so the ACTUAL median voter may not be the median voter of those who actually vote

EI and Income RedistributionEI naturally redistributes wealth from those who

don’t suffer employment loss to those who doSince some people have claims more often and

longer claims, there is even more redistribution

IS Employment Insurance good as an income redistribution program?There are those who agree…(next slide)There are those who disagree…(2 slides hence)

EI and Income Redistribution YESEmployment Insurance supplements social

assistancePeople receiving EI may not need welfare programs

Some argue that Employment Insurance has less of a work disincentive than typical welfareThere is no implicit tax rate on earningsEI requires a certain level of work, and therefore is

similar to “workfare” (Osberg, 1995)

EI helps those who normally have employment while social assistance helps those who have limited ability to be self-supporting

EI and Income Redistribution NOEmployment Insurance does a poor job of

redistributing income to the poorPeople in equal positions are not treated equally

(horizontal equity)Tax burdens are not distributed fairly across people

with different abilities to pay (vertical equity)

Employment Insurance causes major labour market distortions (firms and workers)

EI History – 1930’s1933 – 25% unemployment, 15% “on relief”

“On relief” largely covered by provincial and municipal governments

1935 social insurance program ruled ultra vires; outside the federal government’s jurisdiction

1867 Constitution Act amended (by federal and provincial governments) to allow for federal unemployment insurance

EI History –1940’s and 1950’s1940 Unemployment Insurance Act

Covered jobs with MODERATE risk of unemployment (not high or low risk) 42% of labour force

50% of wage benefits, plus 15% if marriedlasting for 1/5 of days worked in last 5 years, minus

1/3 of days already claimed in last 3 years

1950’s – UI extended to seasonal workers and “self-employed” fishermen

EI History –1971 Reforms1971 Unemployment Insurance Act (Bill C-229)

Covered 93% of labor force (including self-employed)

Minimum eligibility – 8 weeks of workBenefit 66% of wage, 75% with dependents

Had a maximum insurable earnings levelSickness and maternity benefits increasedDuration linked to weeks worked in qualifying period

Increased when national unemployment exeeded 4%Increased when regional unemployment exceeded

national by 1-3% (regional extended benefits)

EI History –1971 Reform ImpactUnemployment was constant between 1971

and 1972, yet:People covered: 5.4 million to 7.8 millionWeeks of benefits: 22.6 million to 30.5 millionAverage weekly payment: $40.28 to $61.79Expenditure more than tripled:

$0.59 billion to $1.87 billion

Expenditure rose from 0.8% of GNP in 1971 to 2.1% in 1975

EI History –1975 ReformsThose who quit or were fired from misconduct

couldn’t claim for 6 weeks (up from 3)Age limit reduced to 65 years (from 70)75% dependent coverage eliminated (all 66%)

Increased benefits became linked to an 8 year moving average, instead of 4% trigger

EI History –1977 ReformsNew entrants, re-entrants to labor force and

people with repeated claims needed more weeks of employment to qualifyExemptions for repeat claimants in high-

unemployment regions

Benefits reduced to 60% of wage (from 66%)High income earners clawed back at 30% in net

income was 1.5 times maximum insurable earnings

EI History –1980’sUnemployment went from 7.6% (1981) to

11.9% (1983)Benefits rose from $4.76 billion to $10.1 billionMacdonald Royal Commission on the

Economic Union and Development Prospects for Canada (1985) concluded:UI increased unemployment rates since 1971Income redistribution should be replaced by a NIT

The commission was opposed by Altantic Canada and labor movement and was never adopted

EI History –1980’s1989 Bill C-21 did some changes:

UI funds could be used for training, relocation assistance, and other employment measures

This was meant to fight long-term unemploymentRepeat users no longer had different qualification

provisionsUI became entirely funded by employer and

employee contributions (no general fund government funding) (as of 1991-1992)

EI History –1990’sUnemployment rose to 11.3%, causing an UI

deficitGovernment increased employee and employer

contributionsThis may have lead to more lay-offs

1993 benefits reduced to 57% (from 60%)Those who quit without just cause became ineligible

for UI benefits

EI History –1990’s1994 – UI eligibility in high unemployment

regions increased to 12 weeks (from 10)20 weeks was required in other regions

Benefits could last from 17 to 50 weeks depending on weeks worked and regional unemployment

Benefit reduced to 55% (from 57%)But raised to 60% for low-income recipients with

dependents

Employee contributions increased again

EI History –1996 Reforms1996 Employment Insurance Act eligibility:

Eligibility based on HOURS of last 52 weeks420-700, depending on unemployment rate910 hours for new entrants to labor force and

those entering after 2 years600 hours for sickness, maternity, or parental

benefitsFishing benefits depend on earnings in a fishing

season ($2500 to $4200 depending on regional unemployment)

This change took part time work and seasonal work into account much better

EI History –1996 Reforms Benefits55% of insurable earnings, to a maximum of

$39,000 (reduced from $42,380)This has held constant, allowing a maximum $413

payment per weekLow-income claimants with children can get a

Family Supplement to increase their benefits to 80% (family income less than $25,921)

Incomes exceeding $48,750 repay 30% of benefits2 week waiting periodCoverage time depends on hours of work and

regional unemployment rate Week limits for maternity, sickness, and paternal

Labour Market Effects of EIMoral Hazard problems exist if:

a) An insured individual can affect the probability and magnitude of a loss and

b) This changing behaviour is unobservableMoral Hazard doesn’t focus on those who

abuse and cheat the systemMoral Hazard can apply to both employers and

employees

Labour Market Effects of EISome studies (Grubel et al. 1975) found that an

increase in EI generosity increased the unemployment rate

But other studies (Corak 1994) found no aggregate effect (but he allowed for non-aggregate effects)

Other factors affect the unemployment rate aside from EI

Labour Market Effects of EIThe labour market effects of the Canadian

Employment Insurance System can be divied into:

1)Direct Effects (layoffs, quits, duration of employment, labour force participation)

2)Systemic Effects (industrial mix, labour mobility, education)

3)Macroeconomic Effects (automatic stabilizing effects)

Direct EffectsUnemployment is caused by:

1)Seasonal variations in demand

2)Business cycle fluctuations in demand

3)Long term trends in the economy

EI is aimed at the second cause. Seasonal layoffs are predictable and therefore

not an insurance riskTrends require retraining or moving, not

temporary income replacement

Direct Effects - LayoffsFrom 1980 to 1988,

58% of lost jobs were permanent layoffs 21% temporary layoffs21% quitting (Baker et al, 1996)

When a firm needs to cut costs, including labour, it can reduce hours or lay offWith EI, laying (which has EI support) off is more

attractive than reducing hours (which has no EI support)

Therefore EI encourages layoffs

Some firms (incl. gov.) may design job length according to minimum EI work requirements

Direct Effects - QuitsPrior to 1993, workers who quit got UI in

Canada but not the states, resulting in:Equal job quitting in Canada and the US20.6 weeks average unemployment in Canada11.2 weeks average unemployment in US

(Baker et al, 1996)

If EI applies to quitters, the unemployment rate is increased by longer job searches

Direct Effects – Unemployment Duration

Better EI benefits can lengthen the time people spend looking for “the perfect job”This increases the unemployment rate

BUTThis extra time spent searching can lead to a

better fitThis leads to better labour market performanceThis leads to lower job turnoverThis decreases the unemployment rate

Direct Effects – Labor Force Participation

All workers pay the same EI premiums, but marginal workers who are often unemployed benefit moreTherefore marginal workers are encouraged to join

the labour force by better EI benefitsIf the number of jobs is constant, this increases

unemployment

Sharis and Kuch (1978) found EI increased the labor force, especially among married females

Systemic Effects– Industrial Mix

EI Premiums vary with wageThis relationship doesn’t vary among industries

Premiums are NOT based on expected EI benefits or layoff likelihoodThis does vary among industries

This causes seasonal jobs and small firms to gain more benefits that they pay in

EI therefore subsidizes seasonal and volatile work by taxing stable employment

(See table in future slide)

Benefit-Tax Ratios 2004

High=More Benefits than Premiums

Systemic Effects– Labor Mobility

EI provides greater support to industries and provinces with higher unemployment rates

EI gives Unemployed workers the support to move to a lower-unemployment area and find a job, increasing labor mobility

BUTEI also DECREASES the income gain from

moving, decreasing labor mobilityStudies are inconclusive, plus 70% of people

change provinces for non-work reasons

Benefit-Tax Ratios 2004

High=More Benefits than Premiums

Systemic Effects– Education

If EI is generous, there is a greater opportunity cost to stay in school instead of entering the workforce (especially in seasonal industries)

In the 1970’s many young people in rural Atlantic Canada chose a “pogey”/Employment Insurance lifestyle over education

Yet in 1991, a greater percentage of young people in Atlantic Canada attended university than the national average.

Macroeconomic Effects –Automatic Stabilization Effects

If EI benefits paid out increase and total premiums decrease in a recession AND

EI premium incomes increase and benefits paid out decrease during a boom THEN

EI acts as an automatic economy stabilizerThis does seem to occur in the recessions of the

early 1980’s and the early 1990’s and the boom of the later 1980’s BUT

EI structure has changed over time (especially increasing premiums and disallowing long-term deficits), reducing this effect

EI Revenue Minus Expenditure

Distributional Effects of Employment Insurance

Like many government programs, EI can have a variety of distributional effects, which can be divided into:

1)Distribution of Benefits

2)Financing

3)Regional Redistribution

4)Experience-Rated Premiums

5)Coverage

Distributional Effects – Distribution of Benefits

In the following slide, we see that individuals with income between $10K and $25k make only 31.6% of the labour force but make up 50.5% of claimantsEI does have redistributed effect

BUT

Higher incomes receive higher benefits (often even after clawbacks)

EI often doesn’t affect lowest-income households (disabled, single parents, part-time workers, etc.)

Distributional Effects – Distribution of Benefits

Distributional Effects – Financing

2006 Premiums are $1.87 for employees and $2.62 for employers (per $100) up to a maximum insurable earnings of $39,000Premiums are effectively a “payroll tax”

Studies show EI burden often falls on the employees (as opposed to employers)

Since very low (don’t work) and very high (many investments) income earners often are less a part of EI, its financing has only limited, imperfect optimal income redistribution

Distributional Effects – Regional Redistribution

EI tends to redistribute income from West to East (Quebec and Atlantic)

EI also therefore redistributes income to primary industries (agriculture, forestry, fishing, and trapping) and construction from other industries

EI violates horizontal equity (equal treatment of equals), since two identical people in different unemployment regions have different minimum work requirements

Distributional Effects – Experience-Rated Premiums

In the US, employers who lay off frequently have higher premiums (similar to auto insurance and high-risk drivers)

In Canada, this would mean higher premiums in industries such as construction,

therefore lower wagesLower premiums other industries, therefore higher

wages

BUTSome low wage jobs have high layoff rates

Distributional Effects – Experience-Rated Premiums

Experience-rated premiums tend to DECREASE unemployment, as firms have a penalty for layoffsHigh layoff industries would contract as low layoff

industries would increase

Unemployment would increase short term as workers move from high to low layoff industries

Quebec and Atlantic Canada have many high layoff industries, and would greatly suffer

Distributional Effects – Coverage (2005 Table)

EI covered 43.4% of unemployedGov. claims EI covers 80% of target; it is not meant to

cover some categories

Employment Insurance Conclusion

EI has Insurance and Income Redistribution characteristics (based on loss and need)

Insurance Characteristics:Only contributors are covered Higher income have higher loses therefore higher

benefits

Income Redistribution CharacteristicsLow-income benefit enhanced through Family

supplementHigh-income benefits are clawed back

Employment Insurance Conclusion

Problem of Insurance and Income RedistributionBalancing two goals may prevent doing either goal

wellPerhaps there should be 2 separate programs?But even 2 separate programs would interact

EI reforms (such as hour-based eligibility) have been improvements, but issues and tensions remain even after over 25 years

Chapter 11 Conclusion

Unemployment has increased since 1950, with fluctuations

Unemployment insurance has been essential, but often seen as increasing unemploymentEI affects unemployment through impact on

layoffs, quits, employment duration, labor force participation, industrial mix, labor mobility, education, and automatic stabilization

EI is a government program due to insurance failure due to market failure and adverse selection

Chapter 11 Conclusion

EI has many income distribution effects:Transfers to primary industries and

constructionTransfers to Quebec and Atlantic Canada

In 1996, EI eligibility changed to hour-based

Changes over time have improved EI, but the tension between insurance and income redistribution remains