Political Economy

Economics & Law - NIT Northern Institute of Technology / TUHH, Hamburg · part of my Technology Management MBA · study notes for revision.

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So far this course has usually treated the government as a kind of referee standing outside the game: markets fail, and a wise, public-spirited state steps in to fix them. This chapter takes that comfortable assumption away. What if the people who run the government - voters, politicians, civil servants - are exactly the same self-interested decision-makers we met in chapter 1? Not villains, just ordinary people responding to their own incentives. Once you look at politics that way, a whole new set of failures appears - and they are the mirror image of market failure.

Tip

The whole chapter in one line: politics is a market too. The people in it chase votes, budgets and rents rather than the public good - so government failure is just as real as market failure, and good policy means choosing between two imperfect options, not comparing a messy market to a perfect state.

1 · Public choice: politics without the halo

Public choice is the branch of economics that points its own toolkit back at government. Its founding move is deceptively simple: stop assuming that political actors are selfless public servants, and instead model them the way we model everyone else - as utility-maximisers who respond to incentives.

The field grew up in the late 1950s (James Buchanan and Gordon Tullock are the names to remember) and was born in the US and UK, so it was mainly built to understand how democracies actually work - as opposed to how the textbooks say they should work.

The traditional story and the public-choice story look very different:

	Traditional view	Public-choice view
What government does	Acts for the public interest	Acts on the self-interest of the people inside it
Politicians	Maximise social welfare	Maximise votes and staying in power
Bureaucrats	Neutral administrators	Maximise budget, staff, power, prestige
Voters	Informed, engaged citizens	Rationally ignorant - one vote rarely decides anything
Result	Policy fixes market failures	Policy can itself be a source of failure

The three sets of players each pull in their own direction:

Votersmaximise their own welfare - but one vote rarely changes the result

↓

Politiciansmaximise votes and re-election, not efficiency

↓

Bureaucratsmaximise budget, power, staff, prestige

Public choice models all three groups as ordinary self-interested actors. Political outcomes then reflect their private incentives - which need not line up with what is best for society.

Why does this matter for a law-and-economics course? Because laws and policies are incentives, just like prices. If the people writing them are chasing votes and budgets, then the rules we get are the output of a market - the political market - and that market can misfire. Public choice is what lets us predict when a government will regulate, and when it will not.

Note

Rational ignorance - a key idea. A single voter almost never swings an election, so it is not worth their time to study every policy in detail. Being uninformed is, for them, a rational choice. That leaves room for politicians to pick policies that look attractive to distracted voters but are quietly inefficient - and for small, organised groups to get their way over the large, disorganised majority.

2 · Rent-seeking: spending real money to grab a bigger slice

The engine that drives most government failure is rent-seeking. To see it, you first need the idea of an economic rent.

An economic rent is any payment a resource earns above the minimum needed to keep it in its current use. The bit above that minimum (the minimum is called the transfer earnings) is pure surplus. A patch of land that would earn €10,000 a year in farming but is rented to a developer for €50,000 earns €40,000 of rent. A monopoly’s extra profit, a protected firm’s tariff-shielded margin, an exclusive licence’s scarcity value - all rents.

Rent-seeking is spending real resources to capture one of these rents rather than to create anything new. The crucial contrast:

Value-creatinginvent, build, invest, produce - the pie gets bigger

vs

Rent-seekinglobby, bribe, litigate - the pie is just re-sliced, and shrinks

Same effort, opposite effect. Productive activity adds to total welfare; rent-seeking merely transfers wealth - while burning resources in the fight.

The resources poured into that fight typically look like this:

LobbyingBriberyPolitical campaigningLegal battlesRegulatory manipulationAdministrative paperwork

None of these produce a single extra good or service - yet they consume lawyers, lobbyists, executives’ time and cash.

Why it is socially wasteful: Tullock’s insight

Here is the classic setup, from Gordon Tullock (1967), “The Welfare Costs of Tariffs, Monopolies, and Theft”. Take a domestic producer and a good that could be imported cheaply at price p0. The government slaps on a tariff (an import tax) that lifts the price to p1. The standard textbook says: the harm is just the deadweight loss - the “DWL”, the little triangle of trades that no longer happen because the price is too high.

Tullock’s point: the triangle is not the whole cost. Someone had to lobby to get that tariff, and their salaries and campaign spending are real resources burned. On top of that, there is the cost of collecting the tax, of coast guards stopping smugglers, of accountants gaming the rules, and the waste of subsidising an inefficient local producer. Add it all up:

True social cost= usual DWL triangle + resources burned seeking the rent

DWL triangle the standard monopoly/tariff loss from trades that don’t happen

Rent-seeking cost lobbying, bribery, litigation, enforcement - spent chasing (or defending) the transfer

Tullock’s own line says it best in plain terms: the real damage of a transfer is not the transfer itself, but that it leads people to sink resources into trying to grab it - or to stop others grabbing it.

An intuitive example: theft

Tullock’s sharpest illustration is theft. A stolen bicycle is, on paper, “just a transfer” from victim to thief - no good is destroyed. So why is society worse off? Because the possibility of theft sets off an arms race. Thieves invest in burglary tools and time; victims invest in locks, alarms, cameras, insurance, guards. All of that spending produces nothing new - it only shifts, or defends, existing property. That defensive-and-offensive spending is the social cost of theft, and it is exactly the same logic as lobbying for a monopoly. A monopoly worth capturing draws real resources into the scramble to capture it - and into the scramble to break it.

Caution

Watch the trap in “theft is efficient”. A cute exam argument runs: the thief risked prison, so he must value the item more than the victim, so the transfer is efficient. It is wrong. It ignores every resource burned on policing, courts, prisons, locks and alarms - plus the way insecure property rights choke off investment. Once those social costs are counted, theft is deeply inefficient. The “gain” from the transfer is dwarfed by the resources wasted fighting over it.

3 · Krueger’s paradox: sometimes a monopoly is the lesser evil

Anne Krueger (1974) took Tullock’s idea into the real world of developing economies, where governments hand out import licences, quotas and permits. Her insight: rent-seeking can happen even in a competitive setting - many firms competing for the same scarce licence - and the total waste can be enormous.

Picture a licence that is worth €1 million to whoever wins it. If ten firms each think they have a shot, each might rationally spend up to €1 million on lobbying and bribes to win it. Collectively that is €10 million burned - ten times the prize - to decide who gets a €1 million rent. This leads to Krueger’s famous, counter-intuitive conclusion:

Grant a monopoly directly

• Causes the usual monopoly harm: higher price, lower output, a DWL triangle
• But no resources are wasted competing for the right
• Cost = the monopoly inefficiency, and nothing more

Let firms compete for a licence

• Many firms sink money into lobbying, bribing, padding capacity
• That spending can exceed the value of the licence itself
• Cost = monopoly DWL plus a mountain of rent-seeking waste

So, paradoxically, if intense rent-seeking is unavoidable, society may be better off simply awarding a monopoly than running a costly contest for a licence. Krueger even suggested that banning imports outright could beat licensing them, because a licence system is precisely what triggers the wasteful scramble. The lesson is not “monopolies are good” - it is that the process of allocating a government-created rent can cost more than the rent is worth.

4 · The median-voter theorem: why everyone rushes to the centre

If public choice is about supply (what politicians and bureaucrats do), the median-voter theorem is the cleanest model of the demand side - how voters’ preferences shape which policy wins.

The median voter is the person sitting exactly in the middle of the line-up: order every voter by their preferred policy, and the median is the one with half the voters on each side. The theorem says that under majority rule, the winning policy tends to be that median voter’s favourite - and that competing parties therefore drift toward the centre.

Take a concrete example. Five voters, each with a preferred income-tax rate:

Voter	A	B	C	D	E
Preferred tax	10%	15%	20%	25%	30%

Voter C at 20% is the median. Any candidate who proposes 10% loses A’s rivals; propose 30% and you lose everyone to the left. Whoever plants their flag closest to 20% wins a majority. And here is the dynamic: if my opponent stands at 15%, I can beat them by moving to just right of 15% and scooping up everyone from there to the top. They respond by hopping over me. The chase only stops when both of us are standing on the median.

Low taxvoter A · 10%

→

B · 15%

→

MEDIANvoter C · 20% - where both parties end up

→

D · 25%

→

High taxvoter E · 30%

Two vote-maximising parties are both pulled toward the median voter. This is why left-wing and right-wing parties so often end up sounding surprisingly alike at election time - they are fishing in the same middle-of-the-road pond.

The assumptions - and where the theorem breaks

The result is elegant but fragile. It only holds under some fairly strong conditions, and every real election bends at least one of them:

Assumption it needs	What goes wrong when it fails
Single dimension - one issue, left-to-right	Real politics has many dimensions (tax and immigration and climate). With two or more, there may be no stable centre at all - majorities can cycle endlessly (A beats B beats C beats A).
Single-peaked preferences - each voter has one favourite and likes options less the further they sit from it	If some voters prefer extremes to the middle (a “hollow” preference), the median result collapses.
Majority rule, everyone votes	In reality turnout varies. If moderates stay home and only the passionate extremes show up, the effective median shifts away from the centre.
Only positions matter, not intensity	The theorem counts heads, not how strongly people care. A small group that cares intensely (and lobbies) can outweigh a lukewarm majority.
No agenda control	Whoever sets the ballot - which options appear, in what order - can steer the outcome, even with the same voters.

The Israeli 2021 election is the standard classroom puzzle: Naftali Bennett led a party with only 6 of 120 seats yet became prime minister. The one-dimensional left-right axis says that is impossible. But that election ran on a different single axis - for or against Netanyahu - and on that line, Bennett sat close to the pivot. Change the dimension, and you change who the “median” is.

Note

Is the median-voter theorem itself a rent-seeking story? In a way, yes - and that is the pessimistic reading. A politician who quietly abandons what they believe and re-positions purely to sit on the median is spending effort to capture the office, not to serve the public. The convergence to the centre can be a symptom of vote-seeking, not statesmanship.

5 · Government failure: putting it together

We now have both halves of the picture. Market failure (chapters on externalities, market power, information) is when a free market delivers an inefficient result. Government failure is the political twin: when the cure is as bad as, or worse than, the disease. The main channels:

Rent-seeking & capturepolicy bent to serve organised lobbies and incumbents

+

Poor information & capacitythe state lacks the data or expertise the market has

+

Misaligned incentivesbureaucrats maximise budgets; politicians maximise votes

+

Corruption & short-termismbribery, favouritism, and spending timed to elections

↓

= Government failurean intervention that misses, or worsens, the target

Rent-seeking is only one channel. Add weak information, incentives that reward the wrong things, corruption, and rules that are slow to change (rigidity), and a well-meant policy can end up costing more than the problem it set out to solve.

Two more channels are worth naming because they show up everywhere:

• The bureaucracy problem (Niskanen). Civil servants often know more about a programme’s true costs than the politicians funding it - an information asymmetry. A department head who benefits from a bigger budget (more staff, more prestige) has every reason to overstate the benefits and understate the costs, so government tends to grow past its efficient size.
• Concentrated benefits, dispersed costs. Farm subsidies are the textbook case: a small, organised group of farmers gains a lot each and lobbies hard; millions of consumers each lose a little through higher taxes and prices and never bother to organise. The policy passes even though it makes society poorer overall, because the political arithmetic favours the intense few over the indifferent many.

Here is the direct comparison the course wants you to carry away:

Market failure the market misfires

• Externalities - costs spilled onto third parties
• Market power - monopoly prices, lost output
• Asymmetric information - adverse selection, moral hazard
• Public goods under-provided

Government failure the fix misfires

• Rent-seeking & regulatory capture
• Missing information / expertise
• Budget-maximising, vote-maximising incentives
• Corruption, rigidity, short-term horizons

Tip

The punchline of the whole course. Neither markets nor governments are perfect. The naive move is to compare a messy real market against an idealised perfect state - and always conclude “the government should fix it”. The grown-up move is to compare two imperfect alternatives and pick the one that fails less - then design the rules (accountability, transparency, competition, clear property rights) that hold back the worst failures on each side. Intervention is worth it only when its benefit genuinely exceeds its cost, government failures included.

Revision summary

Tip

The one-minute recap

• Public choice analyses politics with economics: voters, politicians and bureaucrats are self-interested actors, not selfless public servants. Politicians maximise votes, bureaucrats maximise budgets, and voters are often rationally ignorant.
• Rent-seeking is spending real resources - lobbying, bribery, litigation - to capture a transfer (a monopoly, tariff or licence) instead of creating value. Because the true social cost is the DWL triangle plus the resources burned in the scramble (Tullock 1967), it is worse than textbooks admit. Theft is the intuitive case: locks and alarms are pure waste.
• Krueger’s paradox: if firms will compete wastefully for a licence, the total rent-seeking cost can exceed the licence’s value - so granting a monopoly outright may be the cheaper option.
• Median-voter theorem: under majority rule, one dimension and single-peaked preferences, the outcome matches the median voter, pulling parties to the centre. It breaks with multiple dimensions, low/uneven turnout, intense minorities, and agenda control.
• Government failure - via rent-seeking, weak information, misaligned incentives, corruption and rigidity - is the real twin of market failure. Good policy compares imperfect alternatives and builds rules to limit the worst failures on both sides.

Next: The Investment Climate → - the whole toolkit, applied to what makes firms actually invest.