Part III: Political Economy
In order to operate, a government needs to
decide two things:
1) How are decisions made?
2) How are responsibilities split?
Note: This chapter only covers select issues in
political economy
Part III:
Political Economy
Direct Democracy
Representative Democracy
Federal System Background
Advantages of Decentralization
Disadvantages of Decentralization
Public Choice
PUBLIC CHOICE – a field of applying economic
principles to the understanding of political
decision making
We will examine two models of democratic
decision making:
1) Direct Democracy
2) Representative Democracy
Direct Democracy
In direct democracy, everyone has a say in the
political decision making process, leading to a
variety of approaches and issues:
1) Unanimity Rules
2) Majority Voting Rules
3) Logrolling
4) Arrow’s Impossibility Theorem
Unanimity Rules
Lindahl (1919/1958) designed a procedure to ensure
unanimous agreement on provision of public goods.
Each voter has a demand curve, where PRICE is the
fraction of the public good the voter will pay (tax
share), and QUANTITY is the resulting quantity they
will want.
Two voters will agree on provision of public goods when
their combined price equals one at a certain quantity
level.
This can be shown through the following overlay of
demand curves:
Unanimity Rules
Unanimity Rules
The prices, or tax shares, where two people
demand the same amount of public goods, are
LINDAHL PRICES.
Unanimity Rules are feasible through an auction
system, where an auctioneer keeps listing
different tax schemes until everyone agrees on
one.
Unanimity Rules
Unanimity Rules suffer from two problems:
1) People can still misrepresent their preferences
to partially free-ride
2) Unanimous decisions take a long time with
many people
 It is guaranteed that no one is exploited but…
 Historically, unanimous decisions have been
required to ensure no decision is made.
Majority Voting Rule
Difficulty in unanimous decisions often leads to
the MAJORITY VOTING RULE – one more
than half the voters must favor a measure for it
to be approved.
To illustrate, assume Econ 350 had 3 different
marking options:
1) Paper – long paper and one midterm
2) Exams – two midterms and a short paper
3) Assignment – two assignments, one midterm,
and a short paper
Majority Voting Rule
Voter:
Choice
House
Super Mario
oGsMC
First
Exams
Paper
Assign
Second
Assign
Exams
Exams
Third
Paper
Assign
Paper
In this case, even though each person prefers a
different arrangement, in a vote:
Exams beat paper (2 to 1)
Exams beat assignment (2 to 1)
Therefore, regardless of voting, exams win
This is not always the case however…
Voting Paradox
Voter:
Choice
House
Super Mario
Chuck Noris
First
Exams
Paper
Assign
Second
Assign
Exams
Paper
Third
Paper
Assign
Exams
In this case:
Exams beat assignment (2 to 1)
Assignment beets paper (2 to 1)
Paper beats exams (2 to 1)
VOTING PARADOX – individual voter’s
preferences are consistent, but the community’s
are not
Voting Paradox
In the case of a voting paradox, the order of the
voting agenda can determine the winner
AGENDA MANIPULATION – process of
organizing the order of votes to assure a
favorable outcome
Alternately, if pair voting (option A vs. option B) is
continually used a decision is never reached.
CYCLING – when paired majority voting on more
than two possibilities goes on indefinitely
without a conclusion ever being reached.
Voting Paradox
The voting paradox arises when one agent has a
DOUBLE-PEAKED PREFERENCE – utility
moves down as you move away from a
preference, then up as you move farther way.
SINGLE-PEAKED PREFERENCE – utility keeps
moving down the farthest you move from a
preference.
If we examine the previous decision in terms of #
of non-paper components, we see a double
peak:
Double Peaked Preferences
Voter:
Choice
House
Super Mario
Chuck Noris
First
Exams (2)
Paper (1)
Assign (3)
Second
Assign (3)
Exams (2)
Exams (2)
Third
Paper (1)
Assign (3)
Paper (1)
Here, Super Mario and Chuck Noris have singlepeaked preferences while House has double
peaked preferences (3 is better than 1 (less),
but worse than 2 (less)
When choices are not based on a single
dimension, multipeaked preferences are more
common (ie: would you prefer teleportation, super
strength, or mind reading as a super power?)
Median Voter Theorem
MEDIAN VOTER – voter who’s preferences lie in
the middle of all voter’s preferences
MEDIAN VOTER THEOREM – as long as all
preferences are single peaked, the outcome of
majority voting reflects the preferences of the
median voter
Median Voter Theorem Example
Assume that the final exam could be either 2, 3,
4, 5, or 8 questions long, each with exactly 20%
of the vote.
Moving from 8 to 5 would get 80% of the vote,
and moving from 5 to 4 would get 60% of votes.
However, moving from 4 to 3 would only get 40%
of votes; 4, the median voter’s preference, wins
through majority voting.
Logrolling
LOGROLLING – trading of votes to obtain
passage of a package of legislative proposals
Logrolling is common in the US, and allows
laws to be passed that normally would fail
through considering how strongly people feel
for a proposal.
Consider the following table reflecting benefits
from 2 proposals:
Logrolling
 Without logrolling, each proposal would fail (2v1)
 With logrolling, a hospital and pool (net benefit
315) would be supported by Melanie (net benefit
80) and Scarlet (net benefit 345)
 Although this sometimes benefits society, through
special interest groups it can sometimes harm
society
Logrolling
 Without logrolling, each proposal would fail (2v1)
 With logrolling, a hospital and library (net benefit
-20) would be supported by Melanie (net benefit
160) and Rhett (net benefit 40)
 Society’s welfare decreases through a coalition of
special interests
Arrow’s Impossibility Theorem
Thus far, all voting techniques we’ve examined
have been flawed
Nobel laureate Kenneth Arrow (1951) proposed
6 criteria collective decision-making should
follow in a democratic society:
1) A decision is made regardless of preferences
(ie: multipeaked)
2) All possible outcomes can be ranked
3) Must be responsive to individuals’ preferences
(if everyone prefers A to B, society must rank
A higher than B).
Arrow’s Impossibility Theorem
4) Consistency (if A is preferred to B and B is
preferred to C, C must be preferred to A)
5) INDEPENDENCE OF IRRELEVANT
ALTERNATIVES – ranking of A and B cannot
be influenced by another option C.
6) Dictatorship is ruled out.
Unfortunately, Arrow’s Impossibility Theorem
shows that all 6 requirements can’t be met (5
can); a democratic society cannot be
guaranteed to make consistent decisions.
It may make good decisions often but 100% can’t
be guaranteed
Representative Democracy
Everyone voting on every decision is impractical
in many areas, so often politicians are
democratically elected to make decisions
 Referendums occur, but are very uncommon and
costly
If certain qualifications hold, the median voter
theorem can predict the policies of the elected
representatives:
Success of the Middle
In the case of two
candidates, M and
S:
M will get all votes
left of himself, and
some votes between
M and S
S will get all votes right of himself, and some votes
between M and S
M will win the election
The representative that most follows the median
voter will win
Middle Winning Qualifications
Although this is a surprisingly common result, it
doesn’t always hold true because:
1) Multi-dimensional rankings – often the median
voter is different for different issues (ie: social
issues vs. taxes) – a politician may win a vote
through one policy and lose it through another
2) Ideology – some politicians may care about
more than just winning elections – they may
hold to an ideology
 Carlyle King (former Co-operative Commonwealth
Federation (CCF…now NDP) Saskatchewan
president discussed ideology vs. election appeal:
Ideology vs. Election Appeal
“The trouble is that socialist parties have gone awhoring after the Bitch Goddess. They have
wanted Success, Victory, Power; forgetting that
the main business of socialist parties is not to
form governments but to change minds. When
people begin to concentrate on success at the
polls, they become careful and cautious; and
when they become careful and cautious, the
virtue goes out of them.” – Carlyle King
Who said politics boring and wasn’t edgy?
Middle Winning Qualifications
3) Personality – often politicians win or lose
depending on personality (many argue that
Mulroney’s low popularity came out of his
arrogance)
4) Leadership – often politicians can influence
public opinion
5) Decision to vote – not everyone votes, so the
ACTUAL median voter may not be the median
voter of those who actually vote
EI and Income Redistribution
EI naturally redistributes wealth from those who
don’t suffer employment loss to those who do
Since some people have claims more often and
longer claims, there is even more redistribution
IS Employment Insurance good as an income
redistribution program?
There are those who agree…(next slide)
There are those who disagree…(2 slides hence)
EI and Income Redistribution YES
Employment Insurance supplements social
assistance
People receiving EI may not need welfare programs
Some argue that Employment Insurance has
less of a work disincentive than typical welfare
There is no implicit tax rate on earnings
EI requires a certain level of work, and therefore is
similar to “workfare” (Osberg, 1995)
EI helps those who normally have employment
while social assistance helps those who have
limited ability to be self-supporting
EI and Income Redistribution NO
Employment Insurance does a poor job of
redistributing income to the poor
People in equal positions are not treated equally
(horizontal equity)
Tax burdens are not distributed fairly across people
with different abilities to pay (vertical equity)
Employment Insurance causes major labour
market distortions (firms and workers)
EI History – 1930’s
1933 – 25% unemployment, 15% “on relief”
“On relief” largely covered by provincial and
municipal governments
1935 social insurance program ruled ultra vires;
outside the federal government’s jurisdiction
1867 Constitution Act amended (by federal and
provincial governments) to allow for federal
unemployment insurance
EI History –1940’s and 1950’s
1940 Unemployment Insurance Act
Covered jobs with MODERATE risk of
unemployment (not high or low risk)
42% of labour force
50% of wage benefits, plus 15% if married
lasting for 1/5 of days worked in last 5 years, minus
1/3 of days already claimed in last 3 years
1950’s – UI extended to seasonal workers and
“self-employed” fishermen
EI History –1971 Reforms
1971 Unemployment Insurance Act (Bill C-229)
Covered 93% of labor force (including selfemployed)
Minimum eligibility – 8 weeks of work
Benefit 66% of wage, 75% with dependents
Had a maximum insurable earnings level
Sickness and maternity benefits increased
Duration linked to weeks worked in qualifying period
Increased when national unemployment exeeded 4%
Increased when regional unemployment exceeded
national by 1-3% (regional extended benefits)
EI History –1971 Reform Impact
Unemployment was constant between 1971
and 1972, yet:
People covered: 5.4 million to 7.8 million
Weeks of benefits: 22.6 million to 30.5 million
Average weekly payment: $40.28 to $61.79
Expenditure more than tripled:
$0.59 billion to $1.87 billion
Expenditure rose from 0.8% of GNP in 1971 to
2.1% in 1975
EI History –1975 Reforms
Those who quit or were fired from misconduct
couldn’t claim for 6 weeks (up from 3)
Age limit reduced to 65 years (from 70)
75% dependent coverage eliminated (all 66%)
Increased benefits became linked to an 8 year
moving average, instead of 4% trigger
EI History –1977 Reforms
New entrants, re-entrants to labor force and
people with repeated claims needed more
weeks of employment to qualify
Exemptions for repeat claimants in highunemployment regions
Benefits reduced to 60% of wage (from 66%)
High income earners clawed back at 30% in net
income was 1.5 times maximum insurable
earnings
EI History –1980’s
Unemployment went from 7.6% (1981) to
11.9% (1983)
Benefits rose from $4.76 billion to $10.1 billion
Macdonald Royal Commission on the Economic
Union and Development Prospects for Canada
(1985) concluded:
UI increased unemployment rates since 1971
Income redistribution should be replaced by a NIT
The commission was opposed by Altantic
Canada and labor movement and was never
adopted
EI History –1980’s
1989 Bill C-21 did some changes:
UI funds could be used for training, relocation
assistance, and other employment measures
This was meant to fight long-term unemployment
Repeat users no longer had different qualification
provisions
UI became entirely funded by employer and
employee contributions (no general fund
government funding) (as of 1991-1992)
EI History –1990’s
Unemployment rose to 11.3%, causing an UI
deficit
Government increased employee and employer
contributions
This may have lead to more lay-offs
1993 benefits reduced to 57% (from 60%)
Those who quit without just cause became ineligible
for UI benefits
EI History –1990’s
1994 – UI eligibility in high unemployment
regions increased to 12 weeks (from 10)
20 weeks was required in other regions
Benefits could last from 17 to 50 weeks
depending on weeks worked and regional
unemployment
Benefit reduced to 55% (from 57%)
But raised to 60% for low-income recipients with
dependents
Employee contributions increased again
EI History –1996 Reforms
1996 Employment Insurance Act eligibility:
Eligibility based on HOURS of last 52 weeks
420-700, depending on unemployment rate
910 hours for new entrants to labor force and
those entering after 2 years
600 hours for sickness, maternity, or parental
benefits
Fishing benefits depend on earnings in a fishing
season ($2500 to $4200 depending on regional
unemployment)
This change took part time work and seasonal work
into account much better
EI History –1996 Reforms Benefits
55% of insurable earnings, to a maximum of
$39,000 (reduced from $42,380)
This has held constant, allowing a maximum $413
payment per week
Low-income claimants with children can get a
Family Supplement to increase their benefits to
80% (family income less than $25,921)
Incomes exceeding $48,750 repay 30% of benefits
2 week waiting period
Coverage time depends on hours of work and
regional unemployment rate
Week limits for maternity, sickness, and paternal
Labour Market Effects of EI
Moral Hazard problems exist if:
a) An insured individual can affect the
probability and magnitude of a loss and
b) This changing behaviour is unobservable
 Moral Hazard doesn’t focus on those who
abuse and cheat the system
 Moral Hazard can apply to both employers
and employees
Labour Market Effects of EI
Some studies (Grubel et al. 1975) found that an
increase in EI generosity increased the
unemployment rate
But other studies (Corak 1994) found no
aggregate effect (but he allowed for nonaggregate effects)
Other factors affect the unemployment rate
aside from EI
Labour Market Effects of EI
The labour market effects of the Canadian
Employment Insurance System can be divied
into:
1) Direct Effects (layoffs, quits, duration of
employment, labour force participation)
2) Systemic Effects (industrial mix, labour
mobility, education)
3) Macroeconomic Effects (automatic stabilizing
effects)
Direct Effects
Unemployment is caused by:
1) Seasonal variations in demand
2) Business cycle fluctuations in demand
3) Long term trends in the economy
EI is aimed at the second cause.
 Seasonal layoffs are predictable and therefore
not an insurance risk
 Trends require retraining or moving, not
temporary income replacement
Direct Effects - Layoffs
From 1980 to 1988,
58% of lost jobs were permanent layoffs
21% temporary layoffs
21% quitting (Baker et al, 1996)
When a firm needs to cut costs, including
labour, it can reduce hours or lay off
With EI, laying (which has EI support) off is more
attractive than reducing hours (which has no EI
support)
Therefore EI encourages layoffs
Some firms (incl. gov.) may design job length
according to minimum EI work requirements
Direct Effects - Quits
Prior to 1993, workers who quit got UI in
Canada but not the states, resulting in:
Equal job quitting in Canada and the US
20.6 weeks average unemployment in Canada
11.2 weeks average unemployment in US
(Baker et al, 1996)
If EI applies to quitters, the unemployment rate
is increased by longer job searches
Direct Effects –
Unemployment Duration
Better EI benefits can lengthen the time people
spend looking for “the perfect job”
This increases the unemployment rate
BUT
This extra time spent searching can lead to a
better fit
This leads to better labour market performance
This leads to lower job turnover
This decreases the unemployment rate
Direct Effects –
Labor Force Participation
All workers pay the same EI premiums, but
marginal workers who are often unemployed
benefit more
Therefore marginal workers are encouraged to join
the labour force by better EI benefits
If the number of jobs is constant, this increases
unemployment
Sharis and Kuch (1978) found EI increased the
labor force, especially among married females
Systemic Effects–
Industrial Mix
EI Premiums vary with wage
This relationship doesn’t vary among industries
Premiums are NOT based on expected EI
benefits or layoff likelihood
This does vary among industries
This causes seasonal jobs and small firms to
gain more benefits that they pay in
EI therefore subsidizes seasonal and volatile
work by taxing stable employment
(See table in future slide)
Benefit-Tax
Ratios 2004
High=More
Benefits than
Premiums
Systemic Effects–
Labor Mobility
EI provides greater support to industries and
provinces with higher unemployment rates
EI gives Unemployed workers the support to
move to a lower-unemployment area and find a
job, increasing labor mobility
BUT
EI also DECREASES the income gain from
moving, decreasing labor mobility
Studies are inconclusive, plus 70% of people
change provinces for non-work reasons
Benefit-Tax
Ratios 2004
High=More
Benefits than
Premiums
Systemic Effects–
Education
If EI is generous, there is a greater opportunity
cost to stay in school instead of entering the
workforce (especially in seasonal industries)
In the 1970’s many young people in rural
Atlantic Canada chose a “pogey”/Employment
Insurance lifestyle over education
Yet in 1991, a greater percentage of young
people in Atlantic Canada attended university
than the national average.
Macroeconomic Effects –
Automatic Stabilization Effects
If EI benefits paid out increase and total
premiums decrease in a recession AND
EI premium incomes increase and benefits paid
out decrease during a boom THEN
EI acts as an automatic economy stabilizer
This does seem to occur in the recessions of the
early 1980’s and the early 1990’s and the boom of
the later 1980’s BUT
EI structure has changed over time (especially
increasing premiums and disallowing long-term
deficits), reducing this effect
EI Revenue Minus Expenditure
Distributional Effects of
Employment Insurance
Like many government programs, EI can have
a variety of distributional effects, which can be
divided into:
1) Distribution of Benefits
2) Financing
3) Regional Redistribution
4) Experience-Rated Premiums
5) Coverage
Distributional Effects –
Distribution of Benefits
In the following slide, we see that individuals
with income between $10K and $25k make only
31.6% of the labour force but make up 50.5%
of claimants
EI does have redistributed effect
BUT
Higher incomes receive higher benefits (often
even after clawbacks)
EI often doesn’t affect lowest-income
households (disabled, single parents, part-time
workers, etc.)
Distributional Effects –
Distribution of Benefits
Distributional Effects –
Financing
2006 Premiums are $1.87 for employees and
$2.62 for employers (per $100) up to a
maximum insurable earnings of $39,000
Premiums are effectively a “payroll tax”
Studies show EI burden often falls on the
employees (as opposed to employers)
Since very low (don’t work) and very high
(many investments) income earners often are
less a part of EI, its financing has only limited,
imperfect optimal income redistribution
Distributional Effects –
Regional Redistribution
EI tends to redistribute income from West to
East (Quebec and Atlantic)
EI also therefore redistributes income to
primary industries (agriculture, forestry, fishing,
and trapping) and construction from other
industries
EI violates horizontal equity (equal treatment of
equals), since two identical people in different
unemployment regions have different minimum
work requirements
Distributional Effects –
Experience-Rated Premiums
In the US, employers who lay off frequently
have higher premiums (similar to auto
insurance and high-risk drivers)
In Canada, this would mean
higher premiums in industries such as construction,
therefore lower wages
Lower premiums other industries, therefore higher
wages
BUT
Some low wage jobs have high layoff rates
Distributional Effects –
Experience-Rated Premiums
Experience-rated premiums tend to
DECREASE unemployment, as firms have a
penalty for layoffs
High layoff industries would contract as low layoff
industries would increase
Unemployment would increase short term as
workers move from high to low layoff industries
Quebec and Atlantic Canada have many high
layoff industries, and would greatly suffer
Distributional Effects –
Coverage (2005 Table)
EI covered 43.4% of unemployed
Gov. claims EI covers 80% of target; it is not
meant to cover some categories
Employment Insurance Conclusion
EI has Insurance and Income Redistribution
characteristics (based on loss and need)
Insurance Characteristics:
Only contributors are covered
Higher income have higher loses therefore higher
benefits
Income Redistribution Characteristics
Low-income benefit enhanced through Family
supplement
High-income benefits are clawed back
Employment Insurance Conclusion
Problem of Insurance and Income
Redistribution
Balancing two goals may prevent doing either goal
well
Perhaps there should be 2 separate programs?
But even 2 separate programs would interact
EI reforms (such as hour-based eligibility) have
been improvements, but issues and tensions
remain even after over 25 years
Chapter 11 Conclusion
Unemployment has increased since 1950, with
fluctuations
Unemployment insurance has been essential,
but often seen as increasing unemployment
EI affects unemployment through impact on layoffs,
quits, employment duration, labor force
participation, industrial mix, labor mobility,
education, and automatic stabilization
EI is a government program due to insurance
failure due to market failure and adverse
selection
Chapter 11 Conclusion
EI has many income distribution effects:
Transfers to primary industries and construction
Transfers to Quebec and Atlantic Canada
In 1996, EI eligibility changed to hour-based
Changes over time have improved EI, but the
tension between insurance and income
redistribution remains