Chapter 15 Competitive and Monopsonistic Labor Markets 52 offers. Their firms may also be subject to takeover, given that bright investors can buy the firm, replace the existing management team with a more competent team, and then sell the firm at a higher price. The poor performance of one management team can represent a profitable opportunity for their competitors in the market for firms and management talent. Concluding Comments In a competitive labor market, wage rates are determined by the interaction of willing suppliers of labor (employees) and demanders of labor (employers). Suppliers are influenced significantly by the nonmonetary benefits of employment, as well as by the value they place on their next-best alternative employment. Thus differences in money wage rates may not reflect true differences in full wage rates. Demand is influenced by the laborer’s productivity and the price of the laborer’s product. In a competitive labor market, any attempt to change workers’ incomes through minimum standards for wages or working conditions can benefit some workers only at the expense of others. As the economist Milton Friedman complains, “The old saying is that Quakers went to the New World to do good and ended up doing well. Today, well- meaning reformers go to Washington to do good and end up doing harm.” 62 Can the mixed results of minimum wage legislation be construed as a clear-cut improvement in social welfare? Economic analysis cannot address that highly subjective question. The best we can do is present the deductions drawn from theory and evidence. Unfortunately, both are conflicting, as evident in the theoretical implications of minimum-wage hikes under competitive and monopsonistic conditions and as evident in the differing empirical findings. We have also shown that while it is nice to suggest that workers be paid according to performance, the issues of providing the “right” pay for the “right” performance are thorny ones for managers. Regrettably, the reality of managing can be tricky, as evident in our discussion of executive pay, or, rather, “excessive” pay. There are good economic explanations for executives to be paid more than they are “worth.” Review Questions 1 The government requires employers to pay time-and-a-half for labor in excess of forty hours a week. How should managers be expected to react to that law? What effect should such a law have on the quantity of labor demanded? Why? 2 Does union support of laws outlawing child labor square with the private interests of union members? Should society protect some of its members from some kinds of employment regardless of monetary considerations? Why? 62 Milton Friedman, “Migrant Workers,” Newsweek (July 27, 1970): 60 Chapter 15 Competitive and Monopsonistic Labor Markets 53 3 How could the minimum wage rate and migrant housing standards be expected to affect the prices of consumer goods? Explain, using supply and demand graphs. 4 Suppose government requires employers to pay a minimum wage of $10 per hour to workers over twenty-two years of age. What effect should such a law have on the employment opportunities and wage rates of persons under twenty-two? 5 Average real wages have increased steadily over the last 100 years. What do you think is the main cause of the increase? 6 Suppose there were a cap put on executive pay by the government. Suppose that “excessive wages” of executives were “excessively” taxed. What would be the effects on wages of workers down the corporate ladder? CHAPTER 16 Public Choice: Politics in Government And the Workplace I have no fear, but that the result of our experiment will be, that men may be trusted to govern themselves without a master. Could the contrary be proved, I should conclude, either that there is no God, or that he is a malevolent being. Thomas Jefferson revious chapters have discussed the effects of various government policies on the market system in general and the firm in particular. We looked at government efforts to control the external costs of pollution. We considered the economic impact of price controls and consumer protection laws, for example, on the market for final goods and services. Throughout the analysis we have focused on assessing the economic efficiency of government policy. We said little about how government policy is determined or why government prefers one policy to another. In this chapter, we will shift our focus to the functioning of government itself. Using economic principles, we will examine the process through which government decisions are made and carried out in a two-party democratic system, and consider its consequences. Today, when government production accounts for a substantial portion of the nation’s goods and services, no student of economics can afford to ignore these issues. A study of the political process is especially important for many MBA students, mainly because a non-trivial amount of your time will be involved with seeking to change one governmental policy or another. Moreover, politics is also endemic to many businesses. Our discussion of the “economics of politics” has various implications for how businesses can be expected to operate, especially those that rely on “participatory management” processes (which are necessarily democratic to one extent or another). The Central Tendency of a Two-Party System In a two-party democratic system, elected officials typically take middle-of-the road positions. Winning candidates tend to represent the moderate views of many voters who are neither liberals nor conservatives. For this reason there is generally little difference between Republican and Democratic candidates. Even when the major parties’ candidates differ strongly, as Ronald Reagan and Walter Mondale did at the start of their 1984 presidential campaign, they tend to move closer together as the campaign progresses. P Chapter 16 Public Choice: Politics in Government and the Workplace 2 Figure 16.1 illustrates politicians’ incentives to move toward the center. The bell- shaped curve shows the approximate distribution of voters along the political spectrum. A few voters have views that place them in the wings of the distribution, but most cluster near the center. Assuming that citizens will vote for the candidate who most closely approximates their own political position, a politician who wants to win the election will not choose a position in the wings of the distribution. Suppose, for instance, that the Republican candidate chooses a position at R 1 . The Democratic candidate can easily win the election by taking a position slightly to the left, at D 1 . Although the Republican will take all the votes to the right of R 1 and roughly half the votes between R 1 and D 1 , the Democrat will take all the votes to the left. Clearly the Democrat will win an overwhelming majority. _________________________________ FIGURE 16.1 The Political Spectrum A political candidate who takes a position in the wings of a voter distribution, such as D 1 or R 1 , will win fewer votes than a candidate who moves toward the middle of the distribution. In a two- party election, therefore, both candidates will take middle-of-the-road positions, such as D and R. The smart politician, therefore, will choose a position near the middle. Then the opposing candidate must also move to the middle, or accept certain defeat. Suppose, for instance, that the Republican candidate chooses position R, but the Democrat remains at D 1 . The Republican will take all the votes to the left of R and roughly half the votes between R and D 1 . She will have more than the simple majority needed to beat her Democratic opponent. In short, both candidates will choose political positions in the middle of the distribution. Politicians can misinterpret the political climate, of course. Even with polls, no one can be certain of the distribution of votes before an election. Just as producers find the optimum production level through trial and error, politicians may suffer several defeats before finding the true center of public opinion. Inevitably, however, political competition will drive them toward the middle of the distribution, where the median voter group resides. The median voter is in the middle of the political distribution. The recent history of presidential elections illustrates how politicians play to the views of the median voter. After an election in which the successful candidate won by a wide margin, the losing party as moved toward the position of the winning party. After Barry Goldwater lost by a wide margin to Lyndon Johnson in 1964, the Republican Party made a deliberate effort to pick a more moderate candidate. As a result, the contest Chapter 16 Public Choice: Politics in Government and the Workplace 3 between Richard Nixon and Hubert Humphrey in 1968 was practically a dead heat. After George McGovern was defeated by Richard Nixon in 1972, Democrats realized they too needed a less extreme candidate. Their choices in 1976 and 1984, Jimmy Carter and Walter Mondale, were more moderate. In more recent times, after Ronald Reagan soundly defeated Jimmy Carter and Walter Mondale and George Bush beat Michael Dukakis in 1988, the Democrats began what appeared to be a move back toward the center, picking Bill Clinton, a centrist candidate whose policies, in many ways, have been more conservative than were George Bush’s. The Economics of the Voting Rule So far we have been assuming that a winning candidate must receive more than 50 percent of the vote. Although most issues that confront civic bodies are determined by simple-majority rule, not all collective decisions are made on that basis, nor should they be. Some decisions are too trivial for group consideration. The cost of a bad decision is so small that it is uneconomical to put the question up for debate. Other decisions are too important to be decided by a simple majority. Richard Nixon was elected president with only 43 percent of the popular vote in 1968 (when a third-party candidate, George Wallace, took almost 14 percent), but Nixon’s impeachment would have required more than a majority of the Senate and the House of Representatives. In murder cases, juries are required to reach unanimous agreement. In such instances, the cost of a misguided decision is high enough to justify the extra time and trouble required to achieve more than a simple majority. The voting rule that government follows helps determine the size and scope of government activities. If only a few people need to agree on budgetary proposals, for example, the effect can be to foster big government. Under such an arrangement, small groups can easily pass their proposals, expanding the scope of government activity each time they do so. However, under a voting rule that requires unanimous agreement among voters—a unanimity rule—very few proposals will be agreed to or implemented by government. There are very few issues on which everyone can agree, particularly when many people are involved. A unanimity rule can be exploited by small groups of voters. If everyone’s vote is critically important, as it is with a unanimous voting rule, then everyone is in a strategic bargaining position. Anyone can threaten to veto the proposed legislation unless he is given special treatment. Such tactics increase the cost of decision-making. Government represents the people’s collective interest, but the type of voting rule used determines the particular interests it represents and the extent to which it represents them. Chapter 16 Public Choice: Politics in Government and the Workplace 4 The Inefficiencies of Democracy As a form of government, democracy has some important advantages. It disperses the power of decision making among a large number of people, reducing the influence of individual whim and personal interest. Thus it provides some protection for individual liberties. Democracy also gives political candidates an incentive to seek out and represent voters’ interests. Competition for votes forces candidates to reveal what they are willing to do for various interest groups. Like the market system, however, the democratic system has some drawbacks as well. In particular, democracy is less than efficient as a producer of some goods and services. The fact that the democratic form of government is inefficient in some respects does not mean that we should replace it with another decision-making process, any more than we should replace the market system, which is also plagued by inefficiencies. Instead, we must measure the costs of one type of production against the other, and choose the more efficient means of production in each particular case. We must weigh the cost of externalities in the private market against the cost of inefficiencies in the public sector. Neither system is perfect, so we must choose carefully between them. Median Voter Preferences When you buy a good like ice cream in the marketplace, you can decide how much you want. You can adjust the quantity you consume to your individual preferences and your ability to pay. If you join with your neighbors to purchase some public service, however, you must accept whatever quantity of service the collective decision-making process yields. How much of a public good government buys depends not only on citizens’ preferences, but also on the voting rule that is used. Consider police protection, for instance. Perhaps you would prefer to pay higher taxes in return for a larger police force and lower crime rate. Your neighbors might prefer a lower tax rate, a smaller police force, and a higher crime rate, but public goods must be purchased collectively, no matter how the government is organized. If preferences differ, you cannot each have your own way. Under a democracy, the preferences of the median voter group will tend to determine the types and quantities of public goods produced. If you are not a member of that group, the compromise that is necessary to a democracy inflicts a cost on you. You probably will not receive the amount of police protection you want. The Simple-Majority Voting Rule Any decision that is made less than unanimously can benefit some people at the expense of others. Because government expenses are shared by all taxpayers, the majority that votes for a project imposes an external cost on the minority that votes against it. Consider a democratic community composed of only five people, each of whom would benefit to some degree from a proposed public park. If the cost of the park, $500, is divided evenly among the five, each will pay a tax of $100. The costs and benefits to Chapter 16 Public Choice: Politics in Government and the Workplace 5 each taxpayer are shown in Table 16.1. Because the total benefits of the project ($550) exceed its total cost ($500), the measure will pass by a vote of three to two, but the majority of three imposes net costs of $50 and $75 on taxpayers D and E. Table 16.1 Costs and Benefits of a Public Park for Five People Individuals (1) Dollar Value of Benefits to Each Person (2) Tax Levied on Each Person (3) Net Benefit (+) or Net Cost (-) [(2) - (3)] (4) Vote For or Against (5) A $200 $100 + $100 For B 150 100 + 50 For C 125 100 + 25 For D 50 100 - 50 Against E 25 100 - 75 Against Total $550 $500 When total benefits exceed total costs, as in this example, decision by majority rule is fairly easy to live with, but sometimes a project passes even though its cost exceeds its benefits. Table 16.2 illustrates such a situation. Again, the $500 cost of a proposed park is shared equally by five people. Total benefits are only $430, but again they are unevenly distributed. Taxpayers A, B, and C each receive benefits that outweigh a $100 tax cost. Thus A, B, and C will pass the project, even though it cannot be justified on economic grounds. Table 16.2 Costs and Benefits of a Public Park for Five People Alternative Schedule Individuals (1) Dollar Value of Benefits to Each Person (2) Tax Levied on Each Person (3) Net Benefit (+) or Net Cost (-) [(2) - (3)] (4) Vote For or Against (5) A $140 $100 +$ 40 For B 130 100 + 30 For C 110 100 + 10 For D 50 100 - 50 Against E 0 100 - 100 Against Total $430 $500 It is conceivable that many different measures, each of whose costs exceed its benefits, could be passed by separate votes under such a system. If all the measures were considered together, however, the package could be defeated. Consider the costs and benefits of three proposed projects—a park, a road, and a school—shown in Table 16.3. If the park is put to a vote by itself, it will receive the majority support from A, B and C. Similarly, the road will pass with the support of A, C, and E, and the school will pass Chapter 16 Public Choice: Politics in Government and the Workplace 6 with the support of C, D, and E. If all three projects are considered together, however, they will be defeated. Voters A, B, and D will reject the package (see column 4). Table 16.3 Costs and Benefits of a Park, a Road, and a School Park Road School Total, 3 Projects (1) (2) (3) (4) Individuals Benefit Cost Vote Benefit Cost Vote Benefit Cost Vote Benefit Cost Vote A $120 $100 For $250 $200 For $50 $400 Against $420 $700 Against B 120 100 For 50 200 Against 50 400 Against 220 700 Against C 120 100 For 250 200 For 500 400 For 870 700 For D 50 100 Against 50 200 Against 500 400 For 600 700 Against E 50 100 Against 250 200 For 500 400 For 800 700 For Total $460 $500 $750 $1,000 $1,600 $2,000 $2,910 $3,500 Many if not most measures that come up for a vote in a democratic government benefit society more than they burden it. Moreover, voters in the minority camp can use “logrolling” (vote trading) to defeat some projects that might otherwise pass. For instance, voter A can agree to vote against the park if voter D will vote against the school. Our purpose is simply to demonstrate that, in some instances, the democratic process can be less than cost efficient. Political Ignorance In some ways, the lack of an informed citizenry is the most severe problem in a democratic system. The typical voter is not well informed about political issues and candidates. In fact, the average individual’s welfare is not perceptibly improved by knowledge of public issues. A simple experiment will illustrate this point. Ask everyone in your class to write down the name of his or her congressional representative. Then ask them for the name of the opposing candidate in the last election. You may be surprised by the results. In one survey, college juniors and seniors, most of whom had taken several courses in economics, political science, and sociology, were asked how their U.S. senators had voted on some major bills. The students score no better than they would have done by guessing. 1 In the United States, most voters do not even know which party controls Congress, 2 and public opinion polls indicate that most voters greatly underestimate the cost of programs like Social Security. 3 1 Richard B. McKenzie, “Political Ignorance: An Empirical Assessment of Educational Remedies,” Frontiers of Economics (Blacksburg, VA.: University Publications, 1977) 2 Donald E. Stokes and Warren E. Miller, “Party Government and the Saliency of Congress.” Public Opinion Quarterly 26 (Winter 1962): 531-546. 3 Edgar Browning, “Why the Social Insurance Budget Is Too Large in a Democracy,” Economic Inquiry 13 (September 1974): 373-388 Chapter 16 Public Choice: Politics in Government and the Workplace 7 If voters were better informed on legislative proposals and their implications, government might make better decisions. In that sense, political information is a public good that benefits everyone. Nevertheless, as we have seen before, in large groups people have little incentive to contribute anything toward the production of a public good. Their individual contributions simply have little effect on the outcome. To remain politically free, people must exercise their right to determine who will represent them. The result is that they often cast their votes on the basis of impressions received from newspaper headlines or television commercials—impressions carefully created by advertisers and press secretaries. Special Interests The problem of political ignorance is especially acute when the benefits of government programs are spread more or less evenly, so that the benefits to each person are relatively small. Benefits are not always spread evenly: subgroups of voters—farmers, labor unions, or civil servants—often receive more than their proportional share. Members of such groups thus have a special incentive to acquire information on legislative proposals. Farmers can be expected to know more about farm programs than the average voter. Civil servants will keep abreast of proposed pay increases and fringe benefits for government workers, and defense contractors will take a private interest in the military budget. Congressional representatives, knowing they are being watched by special- interest groups, will tend to cater to their wishes. As a result, government programs will be designed to serve the interest of groups with political clout, not the public as a whole. Cyclical Majorities In their personal lives, most people tend to act consistently on the basis of rational goals. If an individual prefers good A to good B, and good B to good C, the rational individual will choose A over C repeatedly. Collective decisions made by majority rule are not always consistent. Consider a community of three people, whose preferences for goods A, B, and C are as follows: Individual Order of Preference I A, B, C II B, C, A III C, A, B Supposed these three voters are presented with a choice between successive pairs of goods, A, B, and C. If the choice is between good A and good B, which will be preferred collectively? The answer is A, because individuals I and III both prefer it to B. If A is pitted against C, which will be preferred? The answer is C, because individuals II and III both prefer it to A. Since the group prefers A to B and C to A, one might think it Chapter 16 Public Choice: Politics in Government and the Workplace 8 would prefer C to B, but note that if C and B are put up to a vote, B will win. A cyclical, or revolving majority has developed in this group situation. This phenomenon can lead to continual changes in policy in a government based on collective decision-making. Although there is no stable majority, the individuals involved are not acting irrationally. People with perfectly consistent personal preferences can make inconsistent collective choices when acting as a group. Fortunately, the larger the number of voters and issues at stake, the less likely a cyclical majority is to develop. Still, citizens of a democratic state should recognize that the political process may generate a series of inconsistent or even contradictory policies. The Efficiencies of Competition Among Governments In the private sector, competition among producers keeps prices down and productivity up. A producer who is just one of many knows that any independent attempt to raise prices or lower quality will fail. Customers will switch to other products or buy from other producers, and sales will fall sharply. To avoid being undersold, therefore, the individual producer must minimize its production costs. Only a producer who has no competition—that is a monopolist—can afford to raise the price of a product without fear of losing profits. These points apply to the public as well as the private sector. The framers of the Constitution, in fact, bore them in mind when they set up the federal government. Recognizing the benefits of competition, they established a system of competing state governments loosely joined in federation. As James Madison Described in The Federalist papers, “In a single republic, all the power surrendered by the people is submitted to the administration of a single government: and the usurpations are guarded against by a division of the government into distinct and separate departments.” 4 Under the federal system, the power of local governments is checked not just by citizens’ ability to vote, but also by their ability to move somewhere else. If a city government raises its taxes or lowers the quality of its services, residents can go elsewhere, taking with them part of the city’s tax base. Of course, many people are reluctant to move, and so government has a measure of monopoly power, but competition among governments affords at least some protection against the abuses of power. Local competition in government has its drawbacks. Just as in private industry, large governments realize economies of scale in the production of services. Garbage, road, and sewage service can be provided at lower cost on a larger scale. For this reason, it is frequently argued that local governments, especially in metropolitan areas, should consolidate. Moreover, many of the benefits offered by local governments spill over into surrounding areas. For example, people who live just outside San Francisco may benefit from its services, without helping pay for them. One large metropolitan government, 4 Alexander Hamilton, John Jay, and James Madison, The Federalist: A Commentary on the Constitution of the United States, no. 51 (New York: Random House, Modern Library edition, 1964), pp. 338-339. . $100 For $250 $200 For $50 $400 Against $420 $700 Against B 120 100 For 50 200 Against 50 400 Against 220 700 Against C 120 100 For 250 200 For 500 400 For. (3)] (4) Vote For or Against (5) A $200 $100 + $100 For B 150 100 + 50 For C 125 100 + 25 For D 50 100 - 50 Against E 25 100 - 75 Against Total $550 $500 When