# Public Finance and Public Choice

## 4. Choices in the Public Sector

#### Learning Objectives

1. Compare public interest theory and public choice theory.
2. Use public choice theory to explain rational abstention and why legislative choices may serve special interests.

How are choices made in the public sector? This section examines two perspectives on public sector choice. The first is driven by our examination of market failure. Choices in the public sector are a matter of locating problems of market failure, determining the efficient solution, and finding ways to achieve it. This approach, called the public interest theory of government, assumes that the goal of government is to seek an efficient allocation of resources.

An alternative approach treats public sector choices like private sector choices. The body of economic thought based on the assumption that individuals involved in public sector choices make those choices to maximize their own utility is called public choice theory. Public choice theory argues that individuals in the public sector make choices that maximize their utility - whether as voters, politicians, or bureaucrats, people seek solutions consistent with their self-interest. People who operate business firms may try to influence public sector choices to increase the profits of their firms. The effort to influence public choices to advance one's own self-interest is called rent-seeking behavior.

#### Public Interest Theory

In the approach to the analysis of public sector choices known as public interest theory, decision making is a technical matter. The task of government officials is to locate the efficient solution and find a way to move the economy to that point.

For a public good, the efficient solution occurs where the demand curve that reflects social benefits intersects the supply curve for producing the good; that is, the solution at quantity Qe and price P1 given in Panel (a) of Figure 15.3 "Correcting Market Failure" Because this demand curve for a public good is not revealed in the market, the task for government officials is to find a way to estimate these curves and then to arrange for the production of the optimum quantity. For this purpose, economists have developed an approach called cost-benefit analysis, which seeks to quantify the costs and benefits of an activity. Public officials can use cost-benefit analysis to try to locate the efficient solution. In general, the efficient solution occurs where the net benefit of the activity is maximized.

Public sector intervention to correct market failure presumes that market prices do not reflect the benefits and costs of a particular activity. If those prices are generated by a market that we can regard as perfectly competitive, then the failure of prices to convey information about costs or benefits suggests that there is a free-rider problem on the demand side or an external cost problem on the supply side. In either case, it is necessary to estimate costs or benefits that are not revealed in the marketplace.

The public interest perspective suggests an approach in which policy makers identify instances of potential market failure and then look for ways to correct them. Public choice theory instead looks at what motivates the people making those policy choices.

#### The Public Choice Perspective

Public choice theory discards the notion that people in the public sector seek to maximize net benefits to society as a whole. Rather, it assumes that each participant in the public sector seeks to maximize his or her own utility. This section introduces the flavor of the public choice approach by examining two of its more important conclusions: that many people will abstain from voting, and that legislative choices are likely to serve special interests.

#### Economics and Voting: The Rational Abstention Problem

Public choice theory argues that individuals do not leave their self-interests behind when they enter the voting booth - or even when they are thinking about whether to go to the voting booth. The assumption of utility maximization by voters helps us to understand why most people do not vote in most elections.

Suppose your state is about to hold a referendum on expanded support for state recreation areas, to be financed by an increase in the state sales tax. Given your own likely use of these areas and the way in which you expect to be affected by the tax, you estimate that you will be better off if the program passes. In fact, you have calculated that the present value of your net benefits from the program is $1,000. Will you vote? As a utility maximizer, you will vote if the marginal benefits to you of voting exceed the marginal costs. One benefit of voting is the possibility that your vote will cause the measure to be passed. That would be worth$1,000 to you. But $1,000 is a benefit to you of voting only if it is your vote that determines the outcome. The probability that any statewide election will be decided by a single vote is, effectively, zero. State elections that are decided by as many as a few hundred votes are likely to be subject to several recounts, each of which is likely to produce a different result. The outcomes of extremely close elections are ordinarily decided in the courts or in legislative bodies; there is no chance that one vote would, in fact, determine the outcome. Thus, the$1,000 benefit that you expect to receive will not be a factor in your decision about whether to vote. The other likely benefit of voting is the satisfaction you receive from performing your duty as a citizen in a free society. There may be additional personal benefits as well from the chance to visit with other people in your precinct. The opportunity cost of voting would be the value of the best alternative use of your time, together with possible transportation costs.

The fact that no one vote is likely to determine the outcome means that a decision about whether to vote is likely to rest on individual assessments of the satisfactions versus the costs of voting. Most people making such decisions find the costs are greater. In most elections, most people who are eligible to vote do not vote. Public choice analysis suggests that such a choice is rational; a decision not to vote because the marginal costs outweigh the marginal benefits is called rational abstention.

Rational abstention suggests there is a public sector problem of external benefits. Elections are a way of assessing voter preferences regarding alternative outcomes. An election is likely to do a better job of reflecting voter preferences when more people vote. But the benefits of an outcome that reflects the preferences of the electorate do not accrue directly to any one voter; a voter faces only some of the benefits of voting and essentially all of the costs. Voter turnouts are thus likely to be lower than is economically efficient.

In the 2000 presidential election, for example, just 50.7% of the voting-age population actually cast votes. President Bush received 47.9% of the vote, which means he was elected with the support of just 24% of the electorate. Mr. Bush actually received fewer votes than his opponent, Albert Gore, Jr. Mr. Bush, however, won a majority in the Electoral College. The Case in Point essay describes the 2000 election in more detail. Voter turnout was higher in the 2004 and 2008 presidential elections.

#### Legislative Choice and Special Interests

One alternative to having the general public vote on issues is to elect representatives who will make choices on their behalf. Public choice theory suggests that there are some difficulties with this option as well.

Suppose legislators seek to maximize the probability that they will be reelected. That requires that a legislator appeal to a majority of voters in his or her district. Suppose that each legislator can, at zero cost, learn the preferences of every voter in his or her district. Further, suppose that every voter knows, at zero cost, precisely how every government program will affect him or her.

In this imaginary world of costless information and ambitious legislators, each representative would support programs designed to appeal to a majority of voters. Organized groups would play no special role. Each legislator would already know how every voter feels about every issue, and every voter would already know how every program will affect him or her. A world of costless information would have no lobbyists, no pressure groups seeking a particular legislative agenda. No voter would be more important than any other.

Now let us drop the assumption that information is costless but retain the assumption that each legislator's goal is to be reelected. Legislators no longer know how people in the district feel about each issue. Furthermore, voters may not be sure how particular programs will affect them. People can obtain this information, but it is costly.

In this more realistic world of costly information, special-interest groups suddenly play an important role. A legislator who does not know how elderly voters in his or her district feel about a certain issue may find a conversation with a representative of the American Association of Retired Persons (AARP) to be a useful source of information. A chat with a lobbyist for the Teamster's Union may reveal something about the views of union members in the district. These groups also may be able to influence voter preferences through speeches and through public information and political action efforts.

A legislator in a world of costly information thus relies on special-interest groups for information and for support. To ensure his or her reelection, the legislator might try to fashion a program that appeals not to a majority of individuals but to a coalition of special-interest groups capable of delivering the support of a majority of voters. These groups are likely to demand something in exchange for their support of a particular candidate; they are likely to seek special programs to benefit their members. The role of special-interest groups is thus inevitable, given the cost of information and the desire of politicians to win elections. In the real world, it is not individual voters who count but well-organized groups that can deliver the support of voters to a candidate.

Public choice theorists argue that the inevitable importance of special-interest groups explains many choices the public sector makes. Consider, for example, the fact noted earlier in this chapter that a great many U.S. transfer payments go to groups, many of whose members are richer than the population as a whole. In the public choice perspective, the creation of a federal transfer program, even one that is intended to help poor people, will lead to competition among interest groups to be at the receiving end of the transfers. To win at this competition, a group needs money and organization - things poor people are not likely to have. In the competition for federal transfers, then, it is the nonpoor who often win.

The perception of growing power of special-interest groups in the United States has led to proposals for reform. One is the imposition of term limits, which restrict the number of terms a legislator can serve. Term limits were first established in Colorado in 1990; California and Oklahoma established term limits the same year. Subsequently, 18 other states adopted them. They have been found unconstitutional in four State Supreme Courts (Massachusetts, Oregon, Washington, and Wyoming). They have been repealed by the state legislatures of Idaho and Utah. Thus, term limits now apply in 15 states".

One argument for term limits from the public choice perspective is that over time, incumbent legislators establish such close relationships with interest groups that they are virtually assured reelection; limiting terms may weaken these relationships and weaken special interests. The Supreme Court ruled in 1995 that individual states could not impose term limits on members of Congress. If such limits are to prevail at the federal level, a constitutional amendment will be required.

Arguments against the term limits approach include the fact that term limits automatically remove experienced legislators who could be very effective. They also restrict voter choice.

A second type of reform effort is a proposal that campaigns for seats in Congress be federally funded. If candidates did not need to seek funding from special interests, the influence of these groups would wane.

#### Key Takeaways

• Public interest theory examines government as an institution that seeks to maximize public well-being or net social benefit. It assumes government will seek the efficient solution to market failure problems.
• Public choice theory assumes that individuals engage in rent-seeking behavior by pursuing their self-interest in their dealings with the public sector; they continue to try to maximize utility or profit.
• It may be rational for eligible voters to abstain from voting, according to the public choice theory.
• Public choice theory suggests that politicians seeking reelection will try to appeal to coalitions of special-interest groups.

#### Try It!

Here is a list of possible explanations for government programs and policies. In each case, identify whether the explanation reflects the public interest theory or the public choice theory of government action.

1. "It is possible to explain much government activity by investigating the public's demand for government services, but one should not ignore the incentives for increased supply of government services".
2. "Through careful application of cost-benefit analysis, we can identify the amount of a public good that should be provided by the government".
3. "The determination of what are merit or demerit goods is inherently political rather than scientific and more often than not can be traced to the efforts of groups with an ax to grind or some private motive to pursue".
4. "While it is possible that policy makers follow some well-reasoned-out application of ability-to-pay or benefit-received principles, it is more credible to recognize that many of the taxes in this country reflect the fact that groups find it in their interest to organize to get tax burdens shifted to others".
5. "It is in the public interest to correct the market failure caused by monopoly firms. Therefore, it behooves us to do so".