Economics, Politics, and Institutions

Some thoughts on using economics to explain behavior outside of markets

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With this being election week in the United States, I thought it might be useful to write a bit about how economists apply their tools to politics. Thus, this isn’t going to be a post about the actual election or the policies of the winner (or loser). Instead, it is about the economic approach to politics and the lessons that can be drawn.

It should come as little surprise that economists see politics as another form of exchange. Critics often argue that economists have a cynical view of politics. They argue that economists just see politicians as self-interested actors who care only about re-election or wealth maximization. Economists ignore the extent to which people in politics are motivated by a desire to promote the common good. While I think that there is some truth to that claim, I also do not think these things are mutually exclusive. For example, caring about the common good and caring about re-election need not be in conflict with one another. Conceivably, a politician who pursues the common good should receive popular support! At the same time, while non-economists criticize economists for being cynical, one might argue that non-economists aren’t cynical enough. The wealth-maximizing incentives of political office do matter and can help one to explain political behavior.

Today, I would like to discuss a familiar model of politics alongside some insightful commentary on that model, provided by the late, great Jack Hirshleifer. My hope is that in doing so, I can give a glimpse into how the tools of economics can be applied to political decisions while at the same time noting some important insights that Hirshleifer had about political economy more generally.

A classic model of political behavior, as Brian has previously written about, is Sam Peltzman’s theory of regulation. A useful way to think about this theory is actually as a theory of redistribution. There are interest groups out there and those interest groups use their resources to bid on the right to tax others. For the politician/regulator (who are assumed to be the same), there are diminishing returns to helping particular groups. Thus, there are trade-offs to helping one group at the expense of others. The politician must balance these trade-offs. As Brian pointed out, this produces a number of important results that might otherwise be difficult to explain:

Combined, Peltzman’s theory predicts that competitive industries or natural monopolies will be more likely to be regulated. Both come from thinking through the role of diminishing returns in the political market.

Peltzman argues his theory “may help explain such phenomena as the concurrence of regulation of ostensible "natural monopolies" like railroads, utilities, and telephones with that of seemingly competitive industries like trucking, airlines, taxicabs, barbers, and agriculture.”

Jack Hirshleifer referred to Peltzman’s theory of regulation as “share the pain, share the gain.” He also pointed out that another significant implication of this result is that, given an initial redistribution by the regulator, any exogenous shock that produced a gain (or pain) for one interest group would be spread by the regulator across all groups. Hirshleifer even noted the remarkable similarity between that result and Becker’s work on the family. In Becker’s model, the head of the household redistributes benefits created by one family member to the entire family. As a result, Hirshleifer joked that this might be the first argument in favor of paternalistic regulation.

Of course, at the same time, Hirshleifer raised a number of key points. His main critique is that for a “general theory of regulation,” there are a number of things missing. Some of these points have been made and explored elsewhere, but warrant discussion.

He notes that Peltzman’s model simplifies its analysis by lumping the politician and regulator into one person. However, as he points out, economics has much to say about the nature of how regulation is conducted. For example, the incentives of someone directing an agency in a permanent position is likely to lead them to want to build up the agency, expanding the size and scope of regulation. On the other hand, someone who is given a short-term appointment has little incentive to pursue the same course of action.

Hirshleifer also argues that it is useful to apply the analysis of competition to regulatory agencies in the same way that we do with firms. For example, in the United States, we should expect state-level regulation to differ from regulation done by the federal government. The reason is that federal regulation applies to all, whereas state-level regulation only applies to those legally or physically domiciled within the particular state. Thus, we would expect states to compete on particular margins when it comes to state regulation. Firms will find that some states will have “better” or “worse” regulation on particular margins and firms have the ability to vote with their feet. States must therefore compete on the bundle of regulation that they provide. Peltzman’s “share the pain, share the gain model” therefore implies that a state regulator’s attempt at redistribution is constrained by the entry and exit decisions of particular groups.

But Hirshleifer’s most profound point was one that he later dedicated a significant chunk of his career to studying. This point was that much of what an economist typically does is what he called “constitutional economics.” What he meant by this is that typical models and discussions of economics take a lot of things for granted, in particular the rules of the game. Property rights and the enforcement thereof are often implicit in these analyses. This is not a critique, it is just about the nature of the question that is being asked.

Yet, he also noted that what Peltzman and others typically discuss could be called “constitutional politics.” In these sorts of analysis, economists are typically concerned with changing the rules and redistributing resources. But this is also done within the context of particular, existing rules.

Hirshleifer argued that one should actually think about political economy in terms of a “hierarchy of games.” Market interactions are the lowest level of this hierarchy, taking as given the rules created by higher-level games. Constitutional politics play a role in determining those rules. However, at the highest-level is “non-constitutional politics.” Hirshleifer defined this as “subject only to the laws of nature,” which might overstate the case, but nonetheless illustrates his point that some decisions occur on a higher-level where property rights do not exist and force determines outcomes. Hirshleifer, in his comment and in his later work, really emphasized this as an unexplored (or, at least, under-explored) area for economists — and something worth studying.

This point is significant. I thought about this recently with the Nobel Prize announcement and the subsequent reaction post written by Mark Koyama. In that post, Mark noted that, “But while much of the profession became interested in the effects of institutions, less attention has been paid to the question of institutional change.” This is understandable. Economists typically refer to institutions as determining “the rules of the game for society” and economics is fundamentally about how people make decisions in the context of particular constraints and rules. Economists love to use the line, “you tell me the rules and I will tell you what to expect.” And yet, Hirshleifer’s point (very much echoed by Koyama’s post) is that economists should not cede the ground on the determination of those institutions and institutional change.

Ultimately, this post isn’t about one particular argument or paper. The post is really about thinking like an economist. There are always additional margins to consider. Economics has a lot to say about human behavior, even outside the typical market context. An understanding of price theory, however, is foundational to that claim. The points raised by Hirshleifer are important primarily because they illustrate how someone grounded in price theory might look at non-market decision-making and apply the typical tools we often discuss here at Economic Forces to these contexts. Doing so provides many useful insights and poses new questions to explore. Although more of this is being done now than when Hirshleifer originally made his argument, there remains untapped potential for expanding price theory’s horizons.