REFORMING THEORIES OF REFORM

According to the modern theory of institutions, two factors are critical to the performance of an economic system: the information held by the various actors and their incentives. Yet in the past and even in our times, scholars have frequently ignored these factors in their proposals for reform.

In 1908 the Italian scholar Enrico Barone published an article entitled (in translation) “The Ministry of Production in the Collectivist State.” Barone's article encouraged economists and other social scientists to follow a path that took them away from the central issues of information and incentives. Barone, a pioneer in mathematical modeling, used his tools to establish a formal equivalence between the basic categories in a market economy based on private ownership and those in a socialist economy managed by a central authority. In the two instances, optimization involved solving a comparable set of equations.

Barone's vision of the fundamental issues of an economic system has been shared by many scholars in the twentieth century. In the 1930s the famous Lange–Lerner blueprint of a managed economy envisioned a system of “market socialism” where a central planning bureau (CPB) balanced supply and demand by using a trial-and-error method to set prices. The managers of the state-owned enterprises were to be given instructions hailing from Econ 101: (a) pick a combination of productive factors that minimize average costs and (b) set marginal costs equal to the prices determined by the CPB.

Agenda rules

In chapter 6 it appeared that bureaucratic supply induced a good deal of stability in the model of the budgetary game as it was presented in the opening section. As far as public goods are concerned, the model is able, in principle, to explain stability, provided that bureaucratic price discrimination is possible.

The stability question remains to be answered for the cases in which bureaucratic supply does not induce stability. This is the purpose of the present chapter. One must then think of services with unevenly distributed benefits such as minority private and group goods, and of public goods in situations where price discrimination is not possible.

In the initial analysis of political decision-making, it was mentioned that budgetary games generally lack cores or other stable solutions, so that attention has to be focused on the institutions of the budgetary process. Institutions are, of course, not an invention of economic theory. Indeed, the importance of rules that lead to the selection of a small group of ‘feasible’ proposals before any political decision-making in the proper sense starts, has since long been recognized in the organizational process branch of budgetary theory: recall, for instance, the notion of ‘taking the base for granted’ as a major ingredient of the organizational process perspective on budgetary decision-making. In this light, the recent upswing of interest in the institutional aspects of collective decision-making among economists can be interpreted as a late recognition that the organizational process theorists have been looking at the crucial factors all along. However, this interpretation must be qualified in two respects.

Elements of game theory

Political authorities are often collective bodies: cabinets, councils, houses of parliament, etc. The analytical tools for the study of interaction among members of collective bodies will be taken from the theory of games, especially from the theory of a specific type of n-person game that will be introduced and described in the present section and that will be called a ‘budgetary game’. In the next section some additional concepts with respect to budgetary games will be defined, namely those of the preference set, the dominant set and the Pareto superior set. With the help of these concepts it will be possible to review in the following sections some elementary game-theoretic results and to consider the consequences of these results for the problem of stability in budgetary games.

Up to this point the theory of public demand has been considered only at the level of the individual politician. In reality, we observe collective bodies. These bodies do not only decide for themselves but for all citizens of government. This state of affairs raises the question of how individual politicians interact with one another as members of a committee in the process of reaching decisions, and this question leads to the analysis of collective decision-making in the proper sense. As it turns out, game theory is an almost indispensable analytical tool when entering this domain.

The required elements of game theory will be introduced in a way that is understandable to the reader who has no prior knowledge.

Public and private goods

An important building block for the theory of legislative demand is the distinction between ‘public goods’ and ‘private goods’. The term ‘public good’ will be used in this book for an economic good that can, and does, benefit everybody. This is the definition which is known as the ‘polar case of a pure Samuelsonian public good’. A pure public good in this sense has two outstanding characteristics. The first is the supply characteristic known as ‘non-rivalry’ among consumers. It implies that at given costs of supply, an additional consumer does not affect the benefits of existing consumers (the good ‘can benefit everybody’). The second is the demand characteristic of ‘universal demand’. A good can qualify as a public good, only if it actually figures in everybody's utility function (the good ‘does benefit everybody’). This definition stands in opposition to the one of a pure private good: an economic good that can, and does, benefit only a single person.

In view of the important consequences of the distinction between public and private goods, it seems useful to review the concept of a Samuelsonian public good. It is also useful to consider some intermediate cases.

First, it must be emphasized that the concept of ‘public good’ as defined here has nothing to do with government. Public goods are provided privately and publicly. Conversely, governments are providing public and private goods. Of course, there are certain reasons why public goods, according to certain normative criteria, may be provided more efficiently in the public than in the private sector, but there are also circumstances under which the opposite will be the case.

Public Choice should be a tool for improved management of the government. Dr Kraan has taken a major step in this direction by applying it to the actual process of budgeting. The book is not only a step forward in theory, it should be a major step towards making Public Choice a practical aid to a number of officials and politicians.

Speaking for myself, one of the more important aspects of this book is that it indicates that a lot of theoretical work which was actually developed to a large extent by Americans looking at the open American government also applies to European governments, although there things are less open. This is no surprise to me. I had always thought this was true, but I am delighted to have evidence instead of having to depend on my instincts. Here, again, Kraan has made a major step forward and pointed the way to what we hope will be considerable additional research.

There are also fairly sizeable theoretical improvements here. Relying on his experience, Kraan argues that the bureaucracy, in those areas where the differences among politicians are not too great, plays a constructive role. It tends to clarify and bring together the positions of the politicians, with the result that the endless cycling which may be regarded as the inevitable consequence of the Arrow theorem does not occur. In those cases where the differences among politicians are sizeable, Kraan follows a hint from the ‘Calculus of Consent’, arguing that as long as all of the proposals are for increasing the budget it is possible for log-rolling to lead to a definite outcome.

Demand and supply in the public sector

Market economies are characterized by the public protection of private property rights. In such economies, goods can be alienated only on the basis of mutual agreement between proprietors. Usually such alienation involves exchange between suppliers and demanders, where suppliers are households that want to sell certain economic goods at a certain price and demanders are households that want to purchase certain economic goods at a certain price. The exchange decision is a contract that specifies quantities and sums of money to be transferred. The term ‘market mechanism’ is commonly used to denote the rule that relates the result of a contract or a set of contracts to the characteristics of demand and supply.

However, many households in market economies consist of more than a single individual. As far as the private sector is concerned, one can think of business corporations, families, foundations and associations. As far as the public sector is concerned, one can think of governments and incorporated public agencies. Since such a collective houshold can own property, it needs a mechanism of internal coordination in order to express its demand or supply in markets.

The term ‘budget mechanism’ is commonly used to denote the rule that relates the characteristics of demand or supply by a collective houshold to the preferences of its members. Note that the budget mechanism is not an alternative for the market mechanism, but rather a necessary complement to it for the case a household comprises more than a single individual.

The extended budgetary game

In chapter 4 bureaucratic supply behaviour was considered from the perspective of its effects upon the preferences of the individual politician. It seems reasonable to assume that if the political authority consists of a collective body, the bureaucrat will not only take into account the effects of strategic cost revelation upon individual preferences, but also the effects upon the outcomes of political decision-making. In other words, the bureaucrat will pay attention to interaction among politicians and she will make her strategy choices in view of her expectations. Furthermore, it may be assumed that as soon as decision-making involves more than a single service, not only does politico–bureaucratic interaction become a relevant aspect of the budgetary game, but also interaction among the bureaucrats themselves. That is to say, bureaucrats will take into account the supply behaviour of other bureaucrats in order to optimize their strategies.

The endogenization of bureaucratic strategies implies that bureaucrats enter as fully-fledged players into the budgetary game. In the resulting extended game, the bureaucrats are entirely different kinds of players than the politicians. This distinction concerns both the objectives which motivate each kind of player and the types of ‘moves’ each kind of player is allowed to make. The objectives and the moves have been discussed in chapters 3 and 4 respectively; it has been assumed that politicians seek the implementation of preferred policies, and that bureaucrats seek some optimal combination of Managerial Discretionary Profit (MDP) and output. Furthermore, the moves of politicians were assumed to consist of votes and those of bureaucrats of transformations of the Apparent Budgetary Cost Function (ABCF), in the sense discussed in chapter 4.

Perspectives on budgetary decision-making

The subject of this book is the analysis of the budgetary process in representative government from the perspective of public choice theory. Since there is a large literature on the budgetary process as well as on public choice theory, it seems appropriate to start with some clarification about the place of the present volume within both areas of scholarly activity.

The budgetary process in representative government is a theme which is being studied from different theoretical perspectives, public choice theory being only one of them. Looking at the postwar literature, four main perspectives can be distinguished.

The first is the normative perspective. This has been characteristic of the mainstream public finance literature, as exemplified, for instance, by the seminal handbook by R.A. Musgrave (1959). The central concern in this literature has been the application of welfare theoretical principles to the budgetary decisions of government. Major new developments in this literature originated in revisions of welfare theory itself. One can think, for instance, of the generalization of the conditions for optimal allocation of public goods, as initiated by Samuelson (1954), and the development of a new approach to social welfare functions (so-called ‘social choice theory’), as initiated by Arrow (1951).

Within the normative literature there is also a more practically oriented current, alongside the welfare theoretic branch. This is the area of financial management that gave rise to procedural innovations such as the Planning–Programming–Budget–System(PPBS), Management by Objectives (MBO) and Zero-Base-Budgeting (ZBB) in the USA, Programme Analysis and Review (PAR) and the Financial Management Initiative in the UK and the Reconsideration Procedure in the Netherlands.

Public finance always was a normatively oriented subject of study. Modern textbooks about ‘public economics’ build on this tradition but intersperse exposition about normative themes with pieces of analysis about the actual course of decision-making. In that approach, the positive sections serve to add a flavour of pragmatism to the main arguments about ‘motives for public intervention’ and ‘optimal allocation’. This Introduction moves the opposite way: it focuses on the positive theory of the budgetary process and adds some pieces of normative analysis by way of critical perspective. For those who are interested in positive analysis, this approach has the advantage that the relevant theoretical ideas can be developed systematically and in their natural order.

The positive economic theory of the budgetary process belongs, by method and subject, to the field of ‘public choice theory’. This exposition builds particularly on two important themes of that field, namely the model of legislative demand and the model of agency supply. However, no prior knowledge of public choice theory is assumed; all relevant concepts and ideas are introduced and developed in the text. The only desirable prerequisite is an elementary knowledge of microeconomic theory.

This book is conceived as a systematic introduction to the positive theory of the budgetary process. As such, it aims to serve a double purpose: it should be suitable for use in a public finance or public economics course for economics students, possibly alongside a more normatively oriented textbook, and it should be useful to public sector economists who want to improve their knowledge of positive theory.

The deficiencies of the budget mechanism

The integrated models of public demand and supply treated in chapters 6 and 7 make it possibly to identify a number of deficiencies of the budget mechanism. It should be kept in mind, however, that the models do not offer a complete explanation of the budgetary process in any specific government, but rather purport to explain elements of the process that are relevant to many different governments. Other partial aspects, that may be equally important in some specific government, are not treated.

An example of an element that has not been treated is the interaction between the representative assembly and the supreme executive authority. It was mentioned in chapter 2 that in the parliamentary and presidential systems of representative government both political authorities have to approve of budgetary decisions. The question arises as to what happens when both authorities have arrived at different (potential) decisions. In practice, this is a highly important element of the budgetary process that has to be studied on the basis of government-specific models because the competence rules that govern the relations between both political authorities vary strongly between governments. It was mentioned in chapter 2 that the executive authority has a much stronger position vis-à-vis the representative assembly in the parliamentary than in the presidential system. In the presidential system, much depends upon the expiration term of budgetary decisions. If this term is unlimited, the position of the President is much stronger than if annual authorizations are required.

The economic theory of bureaucracy

In the western world a large part of the publicly provided services is produced by public agencies. Although there are considerable differences between governments, public production is everywhere a common phenomenon. It is useful to emphasize this fact at the outset of this chapter, because it is neither a logical necessity nor an intended result of policy design. Furthermore, it has not always prevailed in the past. Even such ‘typically public’ tasks as tax collection and national defence have in earlier times been contracted out to private persons and organizations. The great expansion of the public production sector is a development of the twentieth century, and more particularly of the latter half of that century. It is, of course, tempting to presume a relationship between this development and the expansion of the public consumption sector which has taken place in the same period; it seems as if the political authorities have shown a systematic preference for public suppliers over private ones. Whether this is true or not, and if true, whether there have been good reasons for it, can be answered only on the basis of careful positive analysis. The present chapter reviews the work in this area, and presents the basic model of agency supply.

The first attempt to theorize about production in large, state-like organizations dates back to the 1930s and is due to the German sociologist Weber (1921, 1948). To this end Weber introduced the term ‘bureau’.