Using Economic Modelling Basic to build a simple Political Economic Model (Part 3)

December 8th 2016 (First draft)

December 9th 2016 (First revision)

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In our first and second articles about economic modelling, we have discussed briefly about what economic modelling is and its importance. To further illustrate the concept, we also provided a very basic and somewhat unrealistic model dubbed “the two-period consumption model” of an agent whose preference and utility are assumed to represent those of an entire economy. From this rudimentary and simplistic model alone, we were able to derive some neat implications about the economy the agent operates within. We concluded that to reach the optimal outcome, the agent would need to consume as little as possible in the present so he can save and earn interest for future consumption.

While the model is stripped off many interesting elements (no government, no capital, no education, no future and past generations, no production, etc), the groundwork for its construct and constraints is broadly applicable to other models. First, we put forth a set of assumptions to simplify the scenario. Second, we define the variables and formulae that represent how the modelled economy operates and how its agents interact. Third, we identify the constraints necessary to bind the model so that we do not end up with non-sense. Fourth, we test our model by solving it mathematically and manipulate it to arrive at the variables/values/interactions of interest. Remember, the more complex the model, the more intricate the framework, the more logical thinking and calculation required. For this reason, the true hardcore economic models are virtually impossible to solve (and sometimes even to comprehend) with our naked eyes alone. Knowledge of computer programs like EXCEL, SPSS, R, STATA, MATLAB, EVIEW, and so forth is thus necessary to get any useful interpretation. These programs are of course not built specifically just for economists, but economists use them anyway to aid in their analyses. That is why economics can take years of learning (well, just like many other disciplines) to master. Having spent 6 years in training, even I sometimes find economics daunting. No wonder why it is called dismal science.

The truth is I feel a bit frustrated that an interesting field like economics is inaccessible to the majority of the population due to the barrier mentioned. It should not be this way. Economics can be made easy and intuitive. But, that is also one of its major flaws. Due to the inherent merit of economics, the ease of simplification, there bounds to be a lot of partial and false information being conveyed as complete and correct. There are people who over-simplify economics, depriving it of the very essence it is made of. These people have little, vague, or no economic background and resort to pure guesswork and false knowledge from media and irrelevant experience to untangle economic phenomena. What a great sin it is. This is just as equally dangerous as understanding nothing at all. Such individuals tend to think of economics as finance and accounting, as politics and philosophy, as ideology and convention instead of a framework for analysis. The same goes for politics. You will see many proclaiming themselves as being politically savvy. They treat fieldwork as final research product and present their reckless findings. They single out politics in discussion even though it is meant to be studied along with other disciplines like economics, psychology, philosophy, finance, and so forth.

And, that is when political economics comes in to save the day. One of the primary purposes of our article is, thus, to correct the misconception, to show once and for all that politics goes beyond traditional understanding, that it is just as much related to economics as it is to other fields. Below, we will employ a non-mathematical self-made political economic model, a mixture between what known as “Stigler” and “Peltzman” models, to understand the market of legislation. Note that this is a model created merely as a humble framework of thinking. Unlike the previous article’s model, the current model does not involve mathematical elements because the goal is not to make you mathematically proficient, but to open up a new realm of thinking that enriches your knowledge of politics and economics. Hopefully, if you are not bored enough to stop midway, you will be able to appreciate a bit of political economy, grasp the common inefficiency problems of government intervention, and recognize the hidden form of corruption so widespread even in the most advanced of nations that you might wonder why nobody has ever mentioned it to you. You will begin to see the vast uncharted territory of knowledge invisible to the mass.

Why should we study the legislation market?

Because it enables a better understanding of the legalized corruption known as “Rent-Seeking”. It is a pivotal concept that strikes a blow to the proponents of government intervention. It is an important idea that sheds light on the weakness of our current governing regime, be it authoritarian or democratic. It allows for a new perspective in how you see the world and how you judge. So, what is rent-seeking?

In economics, “Rent-Seeking” is an act of using resources to lobby for benefits or advantageous ground without offering any net gain to the society. In other words, rent seeking expands the deadweight loss to the overall economy; it is an inefficient allocation of scarce resource from one group to another without expanding the economic pie for everyone. It is about gain for one party and loss for the rest, not a win-win situation. Even worse, it is a form of corruption, hidden away and too under-rated in the developed world while being much more visible and over-rated in the developing world. Yet, rent-seeking is widely practiced in all forms of society because if accomplished, it highly rewards the lobbying group, albeit at the expense of the whole society. This has become a strong incentive for businesses to lobby politicians to get what they want. Why is it so? Why has such perverse behaviour been so successful and rewarding? Why has it gone unpunished? Economics has the answer. It goes beyond the traditional accreditation to greed of the rich and corrupted soul of the public officials. It requires us, however, to first understand the model of legislation market in political economics.

PUBLIC CHOICE THEORY: THE (CORRUPTED) LEGISLATION MARKET

To begin, we have to make some reasonable assumptions about the legislation market itself, its product, and the agents interacting within that market. Here are the assumptions:

  1. Just like any market, legislation market will ultimately find equilibrium through the force of demand and supply of its sole product, the legislation.

  2. The suppliers are legislators (politicians) who have the power to propose drafted laws/regulations (the bills) to be considered by the legislative branch of their government. Legislators can also show support for certain bills to increase the likelihood of them being passed. Keep these two points in mind as they will be pivotal for our later discussion.

  3. The demanders in this case are lobbyists (constituents). They are individuals representing special interest groups who perceive themselves as being either adversely or favourably affected by certain laws and regulations of the country within which they operate. They have very strong incentive to support or oppose those laws. There are two types of constituents in this market. One is highly-concentrated producer groups and another is dispersed consumer groups.

  4. The state as represented by the government has the power and rights to coerce and seize individual’s wealth for the purpose of redistribution, which is then used by the special interest groups to benefit themselves.

  5. These supplier and demanders are on the same playing field, and what brings them together is private incentive (self-interest behaviour). Legislators want to get re-elected and will transfer wealth to either one of the group depending on who can maximize their chance of re-election. Constituent wants to maximize their well-being. The two groups of constituents both can provide pecuniary and non-pecuniary political supports. The legislators then hold an auction. The two groups bid votes and political support.

  6. We assume no market failure exists. This is unrealistic but will relieve the heavy workload our brain will have to later endure. Of course, with market failure, we have to account for the inefficiency created by the free market itself and then weigh between the improvement and/or deterioration to the market-induced inefficiency (market failure) brought about by government intervention.

Running for office requires lots of funding, and this need for quantity and certainty by politicians is what distinguishes the lobbying power of consumers vs. that of producers. Businesses, especially organized producer groups and corporates giants have the incentive to maximize their profit. The public, hereinafter regarded as consumers, has the incentive to maximize their utility from consumption by lowering the price of goods and services as much as they possibly can. These two groups can provide support and funding for politicians, but to what extent really depends on how strong the incentive is. It all comes down to a set of constraints that act in opposite direction to the incentive. There are 4 observable constraints in the real world as will be discussed below.

Concentrated vs Dispersed groups: information visibility, information cost, free-rider problem, and organization cost

It is probably a common knowledge that to support or oppose something, you need to rally a good number of people, band together and protest. While this seems obvious and frequent, let me assure you that very few problems are recognized and addressed through this method. Many inefficient bills are overlooked or completely out of sight. For example, earmarking fund to irrigate non-fertile farmland on the righteous claim to save millionaire famers would be a huge waste of resource (especially water) to the whole society. Say, it saved one hundred farmers (producers) $1 million each annually, but it costs the whole society $200 million for the same period. Of course, this is extremely inefficient. The total benefit comes to $100 million while the total cost is $200 million. The remaining $100 million is wasted by the administrative process, the inefficiency reduction, and the leaky-bucket process of the redistribution of income. Yet, we rarely see any form of public demonstration against this kind of agricultural subsidy. Why?

There are four constraints that lower the incentive of the public and the market to correct the inefficiency, all of which are strongly tied to the concentration level of the lobbying groups.

A. Information visibility

When a group is highly concentrated and well-organized like farmer group, they are able to easily identify the huge benefit receivable per head. Therefore, each member of a well-organized group is more likely and willing to contribute to the cost and effort of bringing a desirable law/policy to light because the law/policy is concerned with the thing they care most about, their profit. Since farmer group is small and concentrated, the stake per farmer in this case is large and apparent. The support receivable for politicians from such groups is also more visible and manageable.

The larger and more dispersed group – i.e., the public – do not readily perceive any difference to their livelihood due to the farm bill. They might later become aware of the small cost incurred to them, something like $1 per person. Who cares about this puny amount? But, remember this is only the explicit cost of the farm bill (that supports the wasteful irrigation), not to mention the hundreds of thousands more of such bills. Unfortunately, it is easier for legislators to say that a policy saves existing farmer jobs and make their country great again instead of spending hours to explain the implicit cost, the unsustainability and the overall adverse repercussion of the policy. It is simply more convenient to tell people that I have saved 100 existing jobs than telling them that I have destroyed 1,000 non-existing jobs (which is the idea of creative destruction of free market). Think about it. Wasting water on barren farmland will inevitably help the farmers (thus, save their jobs), but the resource wasted could as well have been used to construct a highway that would have created 1,000 construction jobs as well as promoting capital circulation and economic vibrancy. However, the mere fact that this was non-existent at the time of passing the farm bill makes it unattractive and simply invisible. This is the shortcoming of our current political system (yet, there seems to be no better option/practice). To state it differently, it makes more sense, from any legislator’s perspective, to support and pass 100 more inefficient bill with visible benefit than working their butt off to repeal 1 inefficient bill. The later might entail huge but hidden merits, which makes it much harder to convince the congress and the public (i.e., it comes at higher cost, greater risk, and lower prospect of yielding any political support at all).

Hence, this constraint imposed by information obscurity favours inefficient to efficient legislations and wealth redistribution from dispersed consumer groups to the more concentrated producer groups.

B. Information cost

When a new law or policy is enacted, you do not see a full detailed description of the explicit and implicit benefits and costs it involves. With an intricate economic system, it is even harder to determine the long-term outcomes of the approved bill. Things get worse when the cost is well-hidden behind the more visible and concentrated benefits. Information is thus costly to obtain. But, “costly” is a rather subjective term. Since the stake per head is so great, highly-concentrated producer groups tend to have well-secured sources of funding for the purpose of gathering information pertaining to the well-being of their groups. Hence, information is almost always affordable to them. The broader and more dispersed group, a.k.a the public, operates at individual level, and consequently, financial mobilization is usually an insurmountable barrier to them. I dare say, information about any laws/regulations/polices at all is virtually unaffordable to the mass.

Plus, individually, consumers have very little incentive to acquire information anyway. This is known as “Rational Irrationality” or “Rational Ignorance”. Think about it. It costs them $1 per person to co-exist with the bad policy, but it might cost way more than $1 to find out what really is going on. The rational person would thus choose to be ignorant. The problem, as already mentioned, is that there exists countless number of inefficient bills like the farm bill being passed every year. The little cost accumulates to probably trillions of dollars in aggregate.

Again, the second constraint allows concentrated group to dominate in political auctioning process.

C. The free-rider problem

And, because laws/regulations/policies are public goods, they will bring benefit or incur cost to you even if you only sat still and contributed nothing. Just like a public road, once made available, you cannot exclude anyone from using it. Likewise, agricultural policy, once in effect, will benefit all farmers whether they are contributors or non-contributors. This creates the so-called “free-rider problem”. People want a piece of the pie for free. No effort, no commitment, no time and private resource spent willingly. For this reason, a well-organized (concentrated) body will almost always find it easier to reduce or completely eliminate the free-rider problem. Larger unorganized body such as that of the public (consumer group) usually have lots of free-riders who choose to ignore or flat out refuse to contribute to the cause. And, since the group is large and dispersed, it is impossible to trace and ban the free-riders, and it is also extremely difficult to manage and enforce internal rules. Free-rider problem in widely dispersed group thus persists. This is rationality at its worst.

To sum up, free-rider problem, just like the first two constraints, leads to a political environment that favours the highly-concentrated producer groups over the dispersed consumer group.

D. Organization cost

The three constraints described so far dictate the type of steady state within the legislation market, all of which seem to favour highly concentrated interest groups and inefficient bills. This explains why we see lots of suspicious and unjustifiable laws and policies. We can also infer that there are many more with hidden cost and over-inflated benefits.

But, there exists another constraint that prevents the society from correcting this problem, which is the simple fact that establishing a well-organized group (with members of small stake, free-riding oriented, and low wiliness to contribute) is just extremely costly and unlikely to succeed.

Once again, this last constraint enhances the lobbying power of concentrated producer group and increases the proportion of bad laws.

The introduction of Consumer Price to the Legislation Market

From what we have discussed thus far, you might be inclined towards the false notion that the world is completely corrupted and that ordinary citizens belonging to the large dispersed group will never win in the auctioning process for beneficial legislations. Ultimately, with that line of thought, we would arrive at a conclusion that the world is full of monopolies because new laws, regulations and policies will in one way or another restrict new entries. In other words, producers will have their profit maximized while consumer is entirely devoid of the consumer surplus (think of it as extra happiness from consuming goods at cheaper price than what you are willing to pay for) they so enjoy.

However, every cloud has a silver lining. The fact that legislators have to balance between producers and consumers’ support implies that price is also a major concern. Laws and policies that increase producers’ profits tend to also increase price of goods and services. Rising price is notoriously known for inducing public unrest; thus, reducing political support. Politicians are once again bound by this additional constraint. The simplified political support model can thus be written as:

S = S (Profit, Price);

where dS/d(Profit) > 0

dS/d(Price) < 0

This is just to say that the gain in political support is a function of profit and price, increasing as profit increases and decreasing as price increases. What is worth noticing is that producer’s profit as well will suffer if price increases too much. Profit is thus a concave function of price (technically known as a quadratic function), meaning there is a maximum point beyond which profit falls as price increases (due to lower quantity of goods and service demanded as price keeps rising). So, even from producers’ perspective, price should be high enough for maximizing profit, but low enough as to not crowd out customers. For further illustration, see the graph below. The profit curve is denoted as “profit (price)” meaning profit as a function of price.

For legislators, we see that the support curve increases from S1(profit, price) to S2(profit, price) to S*(profit, price) as we move up and to the left of the graph, which simply reflects a rise in profit and decrease in price. Of course, on top of the above mentioned theoretical constraints, we also face another constraint imposed by concave-shape profit function of producers. The optimal point, as shown on the graph, is thus at point B where the support curve (S*) is tangent to the producer’s profit curve. What this tells us is that ultimately, for the purpose of maximizing political support, the legislation market will produce a set of laws, regulations and policies that prevent producers from being pure monopoly (which corresponds to point C with producer’s profit reaching its maximum) or being perfectly competitive (which corresponds to point A where the economic profit is zero). This helps us understand why we have no perfectly competitive market and no free-reign monopoly in the real world since regulations are usually imposed on both forms of the market. What it also implies is that rent-seeking is prevalent and it favours highly concentrated producer groups, but no to the extend that consumer surplus completely depletes.

The bottom line is that political equilibrium is a result of an ongoing interaction between politics and economics. Regulatory and rent-seeking behavior are influenced by how private interest interferes with public interest. Milton Friedman once said that in the political realm, invisible hand will lead those with the intention to serve public interest to instead promote private interest, a complete opposite of what Adam Smith’s invisible hand does for the economy. The legislation market will ultimately allow highly concentrated groups and inefficient laws, regulations and policies to dominate. Notwithstanding, it will still favour the least inefficient method among other things because greater inefficiency leads to greater social loss – i.e. higher per capita stake for the less concentrated consumer group and probably higher price – which will inevitably foster public resentment and aggression. Politicians do not like that, and they therefore must strike a delicate balance. In theory, society is worse off due to the greater inefficiency, an unavoidable outcome of rent-seeking in the legislation market. Still, we have come far from the worst possible scenario, and though the room for improvement definitely exists, I reckon that we have chosen one of the best among many worse alternatives. Keep in mind though that any reckless attempt to achieve perfection will have unintended consequences. The model presented remains a humble framework of analysis, a rather messy foundation of thought put together for the sake of fun and learning. While I laud the model, my intention is never to confine your thought and imagination. I encourage you to explore and expand further the thinking done here. Only then can you properly appreciate the elegance of true politics as a branch of economics and vice versa. Only then can economic modelling serves its true purpose.