gil s. epstein shmuel nitzan e n p is t t ze Endogenous a i nn Public Policy and E n d o Contests g e n o u s P u b l i c P o l i c y a n d C o n t e s t 1 23 s Endogeneous Public Policy and Contests · Gil S. Epstein Shmuel Nitzan Endogeneous Public Policy and Contests 123 ProfessorGilS.Epstein ProfessorShmuelNitzan Bar-IlanUniversity DepartmentofEconomics 52900Ramat-Gan Israel [email protected] [email protected] LibraryofCongressControlNumber:2007929500 ISBN 978-3-540-72242-7 SpringerBerlinHeidelbergNewYork Thisworkissubjecttocopyright.Allrightsarereserved,whetherthewholeorpartofthematerialiscon- cerned,specificallytherightsoftranslation,reprinting,reuseofillustrations,recitation,broadcasting,re- productiononmicrofilmorinanyotherway,andstorageindatabanks.Duplicationofthispublicationor partsthereofispermittedonlyundertheprovisionsoftheGermanCopyrightLawofSeptember9,1965, initscurrentversion,andpermissionforusemustalwaysbeobtainedfromSpringer.Violationsareliable forprosecutionundertheGermanCopyrightLaw. 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Preface This book sets out to analyze the question of endogenous policy determin- ation, taking into account basic economic and political considerations that are relevant in a variety of institutional and political environments, in lib- eral democracies as well as nondemocratic political environments. Focusing on the role of interest groups and their lobbying and rent-seeking efforts in the determination of public policy, we apply strategic contest theory as our basicmethodologyandclarifythefundamentalparametersthatdeterminethe behaviorofthegovernment(therulingpoliticianand/orthebureaucrats/civil servants)andoftheinterestgroups–thecontestantsfortheprizesassociated withpublicpolicy.Ouranalysisfocusesontherelationshipbetweenthesefun- damental parameters (the objective of the government, political culture, the contest success function, the stakes of the interest groups and their charac- teristics–lobbyingpower,preferences)andpublicpolicy,thecontest-winning probabilities of the interest groups and their efforts – the resources they ex- pend.Weprovidecomprehensiveillustrationsoftheusefulnessoftheproposed approachinfivespecificcases:thedeterminationofmonopolyprice,privatiza- tionpolicy,migrationquotas,minimum wageandpromotionin tournaments. Thebookhastwoalternativefunctions.Itcanbeusedasatextforacourse onendogenouspublicpolicyforadvancedundergraduateorgraduatestudents. Itcanalsobeused(partlyorasawhole)aspartofanadvancedundergraduate or graduate course in public economics, political economy or public choice. The book consists of an introductory chapter and five parts containing 15 chapters. The introduction provides a brief overview of the literature on public-policydetermination,clarifiesthedistinctivecharacteristicsofourpro- posed approachand its advantages and disadvantages. PartA,The Basic Contest,introducesthebasiccontestthatweapplyand rationalizes its existence. This part has two chapters. Chapter II, The Policy Contest, describes the basic policy contest and derives its equilibrium under the two most commonly assumed contest success functions that specify the winning probabilities of the contestants, corresponding to their efforts (rent seekingorlobbyingexpenditures).ChapterIII,Contest Rationalization – Mi- VIII Preface crofoundations, providesamicrofoundationforthe public-policycontest.Our rationalizationhingesontheexistenceofgovernment(politicians’)preferences thattakeintoaccountthe lobbyingoutlaysofthe interestgroups,inaddition to public well being. Part B, The Extended Contest: With Government, introduces our first modelofendogenouspublicpolicy,wherethegovernmentdeterminesthepro- posed public policy and the contest success function (CSF) is of the simple lottery (logit) type proposed by Tullock (1980). By this most popular CSF, acontestant’swinningprobabilityisequalto the ratiobetweenhis owneffort and the total efforts made by the contestants in attempting to win the prize implied by the proposed public policy. The effect of political culture on the proposedpublicpolicy,thecontestants’effortsandtheirwelfareisthenexam- ined. We also study the effect of political culture on relative rent dissipation and on the nature of the proposed policy (is it compromise enhancing, rela- tivetothe policysupportedbytheinterestgroups),assumingalternativeand moregeneralCSFs. PartB hasthree chapters.ChapterIV, Endogenous Pub- lic Policy, presents the extended game that has two stages.In the first stage, abureaucratproposesapolicy.Inthesecondstage,theothertwoplayers,the interest groups, compete for, or against, approval of the proposed policy by the electedpolitician. The second-stagesubgame is the standardrent-seeking rent-avoidancecontestpresentedinPartA.Inthiscontest,theinterestgroups competeforbenefitsassociatedwiththeapprovalorrejectionoftheproposed policy,expendingresourcesthatare(partly)receivedbythe rulingpolitician. Thepoliticianandthebureaucratarenotnecessarilyextremerentseekers.De- pending on the political culture, they may also care about the enhancement of the aggregate welfare of the interest groups. The bureaucrat’s objective function hinges on a single parameter: the weight assigned to social welfare relative to the total rent-seeking or lobbying outlays. This parameter repre- sents the political culture or the degree of politicization of the government. Our analysis in this chapter focuses on the effect of changes in the degree of politicization on the proposed public policy and, in turn, on the lobbying efforts by the interest groups and their expected welfare. In Chapter V, Cul- ture, Politicization and Relative Rent Dissipation, we focus on clarifying the relationship between political culture and relative rent dissipation; the ratio between the total rent-seeking outlay and the expected prize in equilibrium. Chapter VI, Lobbying and Compromise, is concerned with the possibility of lobbying that is not compromise enhancing. Specifically, the objective of this chapteris to specify sufficient conditionsfor lobbyingthat givesrise to a pro- posedpolicythatismoreextremethantheproposalspreferredbytheinterest groups taking part in the extended contest. PartC,The Policy Effect,investigatesageneralclassoftwo-playerpublic- policycontestsandexaminestheeffectofachangeintheproposedpolicythat may affect the payoffs of one or both of the contestants, on their effort and performance. In particular, we focus on the role of three types of asymme- try between the contestants on their effort and performance. This part has Preface IX three chapters. Chapter VII, Effort and Performance, presents a comprehen- sive comparative-statics analysis of the public-policy contest. In particular, it is concerned with the clarification of the role of three types of asymmetry betweencontestantsonthe sensitivityoftheireffortandtheirperformanceto the proposed public policy. Chapter VIII, Prizes (Size and Distribution) and Efforts, further clarifies the effect of changes in public policy that determine the prize system on the total effort invested by the contestants. In partic- ular, we clarify why more restrained government intervention that directly reduces the prizes of the two contestants may have the “perverse” effect of increasing their total exerted efforts. Chapter IX, Asymmetry and Corrective Public Policy, is concerned with the conditions that ensure the existence of an effective corrective tax-transfer policy that complements an existing inef- ficient public-policy proposal. Effectiveness of corrective policy means, first, that it secures an efficient contest outcome. Secondly, that given the existing inefficient policy proposal, it is optimal from the viewpoint of both interest groups. Part D, The Extended Contest: Without Government, introduces our sec- ondmodelofendogenouspublicpolicy,wherethegovernmentdoesnotdeter- mine the proposed public policy. Rather, the two competing policies are de- termined by the interest groups.This part has two chapters. Chapter X, The Social Cost of Rent Seeking when Consumer Opposition Influences Monopoly Behavior, presents a simple version of the extended contest where the pol- icy is determined endogenously, not by the government, but by one of the contestants. To clarify the relationship between this model and the existing literature and to illustrate its significance, we present the model applying a monopoly–consumer context. Chapter XI, Strategic Restraint, presents the secondgeneralextendedcontestwherepublic-policyproposalsaredetermined by the two interest groups. The objective of this chapter is to establish that competition over endogenously determined policies reduces polarization and, in turn, wasteful lobbying activities. The last part E, Applications, presents five illustrations of the usefulness of the extended contests presented in Parts B and D. These applications are presented in Chapters XII, XIII, XIV, XV and XVI that deal, respectively, with Monopoly Price Determination, Privatization, Migration Policy, Mini- mum Wage and Tournaments. The book is based on joint research that has been presented in papers that appeared in print since 2002; see Epstein and Nitzan (2002a), (2002b), (2002c),(2003a),(2003b),(2004),(2005),(2006a),(2006b),(2006c),(2006d), (2006e)andDruk-Gal,EpsteinandNitzan(2004).Wearegratefultothepub- lishers of these works for permission to republish all or part of the material they contain. We are also grateful to Ira Gang, Mark Gradstein, Nava Ka- hana, Martin Kolmar, Kai Konrad, Ed Lazear and Wolfgang Leininger, who made useful suggestions for improvement in various parts of this work. Part of our joint research was completed while visiting CESifo and IZA. We are X Preface most grateful to these institutions for their warm hospitality and supporting researchenvironment. Gil S. Epstein is on the faculty of the Department of Economics at Bar- IlanUniversity,Israel.He is anAssociateEditor oftheJournal of Population Economics and a Research Fellow in IZA. His papers on migration and pub- lic policy, public choice, political economy and labor economics have been published in leading journals in economics. Shmuel Nitzan is the incumbent of the Sir Isaac Wolfson Chair in Eco- nomics at Bar Ilan University, Israel.He has published extensively in leading economics journals on various topics in political economy, collective decision making, social choice, voting theory and public economics. He is the author of Collective Decision Making: An Economic Outlook (with Jacob Paroush) and Collective Preference and Choice. September, 2007 Gil S. Epstein Shmuel Nitzan Contents Notation.......................................................XV I Introduction.............................................. 1 Part A The Basic Contest II The Policy Contest....................................... 9 1 Policy and Stakes ........................................ 9 2 Contest Equilibrium...................................... 11 a The Logit (Generalized Lottery) CSF .................... 12 b The All-pay Auction ................................... 13 III Contest Rationalization − Microfoundations.............. 15 1 The Public-policy Contest................................. 17 2 The Condition for Preferred Randomness ................... 18 3 Applications............................................. 21 a The Most Common CSFs............................... 21 b Comparison of the Common CSFs ....................... 23 4 Summary ............................................... 24 Part B The Extended Contest: With Government IV Endogenous Public Policy ................................ 29 1 The Public-policy Game .................................. 31 a The Contest Between the Interest Groups ................ 32 b Example: Public-good Provision......................... 35 c Public Policy and Rent-seeking Outlays .................. 36 d The Government: Bureaucrats and Politicians............. 36 2 Politicization and Welfare................................. 39