Constitutional “Rules” and Intergenerational Fiscal Policy

This paper analyzes the impact of alternative political institutions on sustainable fiscal policies. We study the choice of intergenerational transfers as outcomes of an infinite social security game among successive selfish median voters. Majoritarian systems accord the current median voter maximum fiscal discretion but no direct influence over future policy. This political arrangement sustains, among others, dynamically inefficient transfers and volatile, non-stationary sequences. Constitutional rules award to the minorities veto power over fiscal policy changes proposed by the majority. This unanimity provision is equivalent to partial precommitment. Under constitutional rules, sustainable fiscal policies feature Pareto efficient, non decreasing transfer sequences.     

From “tax state” to “debt state”

The paper is motivated by Joseph A. Schumpeter's The Crisis of the Tax State. It inquires whether the buildup of government debt in peacetimeprosperity is a threat to the stability, existence or creation of viable tax states. The paper begins by setting out Schumpeter's conception of the tax state and the nature of recent political-economic events which have reinvigorated the concept. Next the paper sets out some simple debt dynamics and sketches a debt-induced business cycle arising from heavy reliance on debt finance in peacetimeprosperity. Finally, the paper assesses threats to the tax state in light of recent work on path dependence and positive feedback. An attempt is made to throw some light on whether the plethora of new, and often small, states spawned by the demise of communism can be viable tax states.Essay on Government, the Tax State and Economic Dynamics submitted to the Third Schumpeter Prize Competition.     

Vertical and Horizontal Trust Networks in Bureaucracies: Evidence from the Third Reich

In a seminal contribution to the literature on bureaucracy, Breton and Wintrobe (The Logic of Bureaucratic Conduct: An Economic Analysis of Competition, Exchange, and Efficiency in Private and Public Organization. New York, NY: Cambridge University Press, 1982) develop a model wherein subordinates and superiors in a bureaucratic structure trade with each other to advance the objectives of the superiors. The success of such an organizational arrangement (for superiors) is based upon the development of vertical trust networks in a way that facilitates the promise of informal payments by superiors in return for informal services provided by their subordinates. Breton and Wintrobe [Journal of Political Economy 94 (1986) 905] also provide a theoretical application of their model by describing the Nazi bureaucracy as a conglomeration of competing agencies that zealously carried out the Final Solution to the Jewish question. As an extension, this note develops two compelling empirical examples of vertical and horizontal trust networks within the Nazi regime: Einsatzgruppen As (Special Action Detachments) attempt to liquidate all Lithuanian Jews after the German invasion of the U.S.S.R. in 1941 and the 20 July 1944 attempt to assassinate Adolf Hitler.JEL Classification: D23, D73.     

A Dynamic Characterization of Rawls's Maximin Principle: Theory and Implications

The purpose of this paper is to provide a reinterpretation of the maximin principle in Rawls's theory of justice. As we discuss the issue of social justice, we differentiate the point in time at which rectifying practices are discussed and the time intervals in which these practices are implemented; we explore the information content for people behind the veil of ignorance; and we distinguish the means and ends for social justice. With these points clarified, we interpret the veil of ignorance in Rawls's theory as a form of Knightian uncertainty, and show that Rawls's maximin criterion would be chosen by rational individuals behind the veil of ignorance.     

“Buy Domestic” Campaigns and Optimal Tariffs

This paper attempts to analyze the strategic use of optimal tariffs and to examine the effects of national bias on the optimal trade policy and social welfare in a two-country, two-good, price competition model derived from Neven et al. (1991). The major findings are as follows. (1) If all consumers prefer the domestic good, then buy domestic campaigns will decrease the prohibitive tariff rate and increase local welfare. (2) If at least some consumers prefer the foreign good, but not to a great extent, then buy domestic campaigns will not change the optimal tariff rate, but may improve local welfare. (3) When all consumers greatly prefer the foreign good, then promotion of buy domestic decreases the optimal tariff rate, but it cannot improve social welfare. With this framework, we also prove that buy domestic campaigns serve as a substitute for tariffs with respect to a strategic trade policy.     

Rawls,rules and objectives: A critique of the two principles of justice

John Rawls has made two large claims for the two principles of justice: that they are what everyman would choose behind the veil of ignorance as the foundation for laws and institutions, and that they are the rock bottom requirement for the stability of political liberalism. I argue here that these claims are altogether unsubstantiated. The two principles are more like a social welfare function than like what we ordinary think of as justice. They are a false social welfare function in the sense that everyman would not choose them behind the veil of ignorance. Their connection with the stability of liberal democratic government is tenuous at best. Stability is dependent on the entire corpus of rules by which a society is guided, rules that are no more identifiable behind the veil of ignorance than when the veil is lifted. There no basis for supposing that the appropriate rules can be derived from the two principles of justice, and there is some question as to whether they can be derived from any well-specified social welfare function. What remains valid in the two principles was recognized long before the two principles were enunciated. The exaggeration of common ideas in the two principles is not enlightening.     

‘Expected utility / subjective probability’ analysis without the sure-thing principle or probabilistic sophistication

Summary. The basic analytical concepts, tools and results of the classical expected utility/subjective probability model of risk preferences and beliefs under subjective uncertainty can be extended to general event-smooth preferences over subjective acts that do not necessarily satisfy either of the key behavioral assumptions of the classical model, namely the Sure-Thing Principle or the Hypothesis of Probabilistic Sophistication. This is accomplished by a technique analogous to that used by Machina (1982) and others to generalize expected utility analysis under objective uncertainty, combined with an event-theoretic approach to the classical model and the use of a special class of subjective events, acts and mixtures that exhibit almost-objective like properties. The classical expected utility/subjective probability characterizations of outcome monotonicity, outcome derivatives, probabilistic sophistication, comparative and relative subjective likelihood, and comparative risk aversion are all globally robustified to general event-smooth preferences over subjective acts.Received: 4 May 2004, Revised: 4 October 2004, JEL Classification Numbers: D81.This paper presents a considerably improved version of the concept of event-differentiability from Machina (1992). An alternative definition has been independently developed by Epstein (1999) in his analysis of the concept of uncertainty aversion. I am grateful to Kenneth Arrow, Mark Durst, Jürgen Eichberger, Daniel Ellsberg, Clive Granger, Simon Grant, Edi Karni, Peter Klibanoff, David Kreps, Duncan Luce, Robert Nau, Uzi Segal, Peter Wakker, Joel Watson and especially Larry Epstein, Ted Groves and Joel Sobel for helpful discussions and comments. This material is based upon work supported by the National Science Foundation under Grants No. 9209012 and 9870894.     

Individual Decision Making in a Negative Externality Experiment

The experimental treatments analysed in this paper are simple in that there is a unique Nash equilibrium resulting in each player having a dominant strategy. However, the data show quite clearly that subjects do not always choose this strategy. In fact, when this dominant strategy is not a focal outcome it does not even describe the average decision adequately. It is shown that average individual decisions are best described by a decision error model based on a censored distribution as opposed to the truncated regression model which is typically used in similar studies. Moreover it is shown that in the treatments where the dominant strategy is not focal dynamics are important with average subject decisions initially corresponding to the focal outcome and then adjusting towards the Nash prediction. Overall, 66.7% of subjects are consistent with Payoff Maximization, 27.8% are consistent with an alternate preference maximization and 5.6% are random.     

The Veil of Uncertainty Unveiled

A central assumption of constitutional economics is that in the process of constitutional decisionmaking the players' uncertainty about their post-constitutional positions (veil of uncertainty) serves the useful purpose of making unanimity and fairness at the constitutional level more rather than less probable. The paper argues that this assertion is false if the conventional assumption holds true that social contracts are threatened by a prisoners' dilemma incentive structure. By means of a simple two-person game-model it is shown that, if players are fully aware of all their partial interests, agreement on a Pareto-efficient rule will be the iterated dominance equilibrium of the game played at the constitutional level. A veil of uncertainty cannot do better. It may, however, induce disagreement or discrimination, if the prisoners' dilemma violates the cardinal property often assumed. This raises the question why the choice of rules which typically takes place in full knowledge of the players' post-constitutional positions poses so many problems although, from a theoretical point of view, unanimity seems so easy to achieve. Finally, it is examined, if there is any salutary role the veil of uncertainty is able to play in view of a post-constitutional prisoners' dilemma.     

Agency in a market setting

This paper examines a market in which a continuum of principals and agents interact in a game. Principals offer contracts while agents decide on sets of acceptable contracts. A mechanism from a class satisfying efficiency, unbiasedness, and continuity properties then matches principals and agents. With risk neutral agents, when the contribution of principals and agents to the total gains from trade in a pairing are additively separable, the equilibria of the game coincide with the competitive equilibria for the market. In particular, all contracts used in Nash equilibrium induce first-best effort levels. Both principals and agents have exogenous opportunities outside this market. In equilibrium, agents have endogenously determined outside opportunities available from employment by another principal, and this may be the binding participation constraint in a principal-agent pairing. The results are extended to special non-separable cases and to the case of identical risk averse agents.We are grateful to seminar participants at Indiana University, the University of Kentucky, and Vanderbilt University for comments on earlier versions of this work. Referees' comments led us to generalize the model and to more clearly specify the point of the paper.     

Breeding hybrid strategies: optimal behaviour for oligopolists

Oligopolistic pricing decisions-in which the choice variable is not dichotomous as in the simple prisoner's dilemma but continuous-have been modeled as a generalized prisoner's dilemma (GPD) by Fader and Hauser, who sought, in the two MIT Computer Strategy Tournaments, to obtain an effective generalization of Rapoport's Tit for Tat for the three-person repeated game. Holland's genetic algorithm and Axelrod's representation of contingent strategies provide a means of generating new strategies in the computer, through machine learning, without outside submissions.The paper discusses how findings from two-person tournaments can be extended to the GPD, in particular how the author's winning strategy in the Second MIT Competitive Strategy Tournament could be bettered. The paper provides insight into how oligopolistic pricing competitors can successfully compete, and underlines the importance of niche strategies, successful against a particular environment of competitors.Bootstrapping, or breeding strategies against their peers, provides a means of examining whether repetition leads to cooperation: we show that it can, under certain conditions, for simple and extended two- and three-person GPD repeated games. The paper concludes with a discussion of the relationship between Selten's trembling-hand perfect equilibrium and Maynard Smith's evolutionarily stable strategies, with practical simulations of successful and unsuccessful invasions by new strategies.     

Economics as mechanism: The mind as machine in Hayek's sensory order

InThe Sensory Order, Friedrich A. Hayek describes the human mind as an apparatus of classification that evolves through experience and that reaches decisions by modeling the alternative courses of action that are available to it. Hayek's mechanistic conception of mind argues aginst the possibility of central planning and against the cogency of any rule that denigrates subjective decision making by employers or other economic agents. As implied by Gödel's proof, no brain, human or mechanical, can ever be sufficiently complex to explain itself. There will therefore always be certain knowledge and rules that cannot be articulated to the satisfaction of a central planner or tribunal.     

Democracy and Opinion Falsification: Towards a New Austrian Political Economy

Hayek's view of democracy as a process of forming opinion is taken as a starting point for inquiring into issues largely neglected by Public Choice and Constitutional Economics. In an Austrian perspective, fallible individual knowledge, political entrepreneurs and dissenting minorities attain a distinctive role in the process of political competition. Based on the observation that political opinions consist of preferences and theories, the concept of opinion falsification is introduced. It is a spontaneous result of social interaction creating preference falsification - the disguise of true feelings, but also knowledge falsification – the discovery of false beliefs. Democratic constitutions can limit the scope of preference falsification and increase the potential for knowledge falsification, thus supporting Hayek's view that it is in its dynamic, rather than its static, aspects, that the value of democracy proves itself.     

Implementing Generality while Reducing the Risk for Fiscal Explosion

The generality principle, advocatedby Buchanan and Congleton (1998), requires that political decisionstreat all citizens equally qua citizens. The effects of implementingsuch a constitutional rule on lobbying, public expenditures,economic efficiency, and disposable incomes are explored. Themain contribution is to propose a way of mitigating potentiallynegative effects not discussed by Buchanan and Congleton, especiallythe risk for fiscal explosion. It is suggested that if generalityis augmented with a rule stating that public expenditures asa share of GDP are not to rise, this will probably render generalitymore attractive than non-generality for most citizens.     

Hugging Trees: Claiming de Facto Property Rights by Blockading Resource Use

This paper explores conflicts between two groups,the industry and theenvironmentalists, over whether an indivisible resource (e.g., an ancient tree) should be harvested or preserved. In a complete information war ofattrition the environmentalists' willingness to blockade harvest attemptsmay control resource use as effectively as if they held property rights. Optimal government intervention will override this ability for somebenefit/cost combinations but may augment it for other combinations.Introducing uncertainty about the environmentalists' benefits results inextended disputes and consequent lack of efficiency. Governmentintervention for welfare reasons generally reduces these efficiencylosses.     

Fully endogenous mechanism selection on finite outcome sets

Summary This paper defines a choice process over social outcomes in which agents choose the institutional rules ormechanisms themselves without outside interference. Truly endogenizing the mechanism selection process in this way, however, involves facing an infinite regress problem in which outcomes are chosen by games which are themselves chosen by games, ad infinitum. This paper allows the possibility of such an infinite regress which we callfully endogenous mechanism selection.We introduce the notion ofFree Choice which restricts the class of mechanisms in the regress to those which prevent agents from being locked in to an equilibrium outcome by the actions of others. Under this condition, the infinite regress is shown to get truncated with the number of selection iterations endogenously determined. It turns out that the outcomes resulting from a Free Choice-constrained regress are (Weakly) Pareto optimal; in particular, these outcomes solve a weighted Rawlsian Maxmin criterion. We also show that these outcomes are invariant to the equilibrium concept used to evaluate games in the regress.This paper is based on the author's dissertation from the University of Minnesota (November, 1989).I am very grateful for the guidance, advice, and encouragement from my advisor, Marcel K. Richter, and for the many helpful suggestions from David Levine. I have also benefited from conversations with Nabil Al-Najjar, Gerhard Glomm, Leonid Hurwicz, James Jordan, Ramon Marimon, Andrew McClennan, Ariel Rubinstein, and William Thomson.     

Mutually Destructive Bidding: The FCC Auction Design Problem

In general, synergies across license valuations complicate the auction design process. Theory suggests that a simple (i.e., non-combinatorial) auction will have difficulty in assigning licenses efficiently in such an environment. This difficulty increases with increases in fitting complexity. In some environments, bidding may become mutually destructive. Experiments indicate that a properly designed combinatorial auction is superior to a simple auction in terms of economic efficiency and revenue generation in bidding environments with a low amount of fitting complexity. Concerns that a combinatorial auction will cause a threshold problem are not borne out when bidders for small packages can communicate.     

Let's Get Physical! Or Financial? A Study of Electricity Transmission Rights

I test experimentally the predictions of neoclassical theory for a radial electricity market without rights to the transmission line, with rights that give the owner a financial right to a share of the transmission congestion charges collected by a network operator, and with physical rights which give the owner the exclusive right to utilize a portion of the transmission line. I find that physical rights lead to more right market signals, diminish some market-power, and remove an uncertainty about electricity transmission congestion better than financial rights or the absence of rights.     

Assessing the impact of environmental charges a partial general equilibrium model of the forest sector

This paper provides a theoretical and empirical analysis of how environmental charges affect a particular sector of the economy. Our approach allows a simple comparison of how partial and general equilibrium results may differ.A research grant from the Nordic Council is gratefully acknowledged.     

Sector-specific capital, “Bang-bang” investment,and the Filippov solution

Bang-bang investment in a two-sector growth model with immobile capital is rational and leads to a unique and globally stable long-run equilibrium along a sliding trajectory. This steady state coincides with the stationary equilibrium in the traditional model with non-sector-specific capital.This article was written while the authors were visiting scholars at Cornell University. We gratefully acknowledge financial assistance from the Erasmus University Trust Fund and the Netherlands Scientific Organization. We would like to thank, without implicating, two anonymous referees, Martijn Herrmann, Jean-Marie Viaene, Claus Weddepohl, and the participants of seminars at the University of Maryland, the University of Montreal, and Erasmus University Rotterdam for perceptive remarks and useful comments. Jeroen Hinloopen and Rien Wagenvoort provided able graphical assistance. The views expressed in this article are those of the authors and not necessarily those of the World Bank.