Political economy models offer diverse perspectives on policy

Broadly speaking, models of political economy can be classified into four main categories: the standard model, public choice theory, the Chicago political economy approach, and the transaction cost view.

Standard models view policy making as a technical or engineering problem where a policy maker seeks to maximize some sort of social welfare function with an optimal policy. This approach is similar to most rational-agent models in economics. The only innovation in this approach is the introduction of constraints to maximize social welfare, such as the ability to raise taxes or make transfer payments. However, it ignores the actual policy making process and the institutional and political forces that act upon it. It assumes that policy makers will find out and implement the policy that provides maximum benefit within the constraints.

Public choice theory provides a richer understanding of political economy. This theory, influenced by the ideas of Knut Wickell and promoted by Nobel laureates James M. Buchanan and Gordon Tullock, incorporates, in the words of Alistair Cook, the obvious but often overlooked view in academia that politicians are no less selfish than the rest of us. The main argument of this school of thought is that as soon as a policy enters the political arena, policy makers stop evaluating it on the basis of its economics and are motivated to serve the interest of politics. Therefore any policy emerging from the quagmire of political transaction is likely to be sub-optimal and fail the Wexelian test of Pareto efficiency. This leads to government failure in the form of rent seeking, policy manipulation, distributive politics, log rolling, legislative bargaining and institutionalized corruption. The sources of such governmental failure are voter ignorance, leadership quality and institutional weakness. Adherents of this school believe that policymaking is less an optimization exercise, but rather about solving the problem of designing a constitution, procedures, and institutions that prevent government failure.

Chicago political economy (CPE) pioneered by Gary Baker, Sam Peltzman and George Stigler is closely related to but distinct from public choice theory. This school views politics as a game of competition for the support of voter groups, which leads politicians to enact policies that maximize their political base through transfer of votes or direct monetary transfers. In this school of thought, policymaking is viewed through the prism of value theory and the government is essentially designed as a mechanism that redistributes wealth.

Perhaps the most interesting description of political economy is by Avinash Dixit, who views the policy making process through the game theory lens of transaction costs. He believes that the state is an incomplete system and that the constitution and laws that guide the actions of the state are essentially incomplete contracts between citizens and special interest groups on the one hand and politicians, administrators and policy makers on the other. This contract is for the implementation of a policy or program by politicians in exchange for votes and financial contributions. Policy making is thus a game between several participating principals (citizens and special interest groups) who attempt to influence the actions of agents (policy makers) to their own advantage. It is a dynamic game in which each policy is a game whose players try to maximize their profits. What makes this dynamic game of policy making even more complex is that its rules are made by the participants moving forward and each participant tries to manipulate these rules. The reason for government failure in this policymaking game is transaction costs, which often arise from information asymmetry, lack of contract enforceability, moral hazard, adverse selection, and low incentive power. In Dixit’s view, a political contract is similar to a contract between a company’s management and its shareholders, but is more incomplete and suffers from limited rationality. A classic example of this game was provided by the Reagan Administration of America. Ronald Reagan campaigned on an agenda of deregulated trade, but he was also seen as one of the most protectionist American presidents of the late 20th century. His administration renewed and tightened the anti-trade Multifiber Agreement, forced Japan to accept a ‘voluntary’ ban on automotive exports to the US, and imposed import quotas on motorcycles, steel and other goods. According to Dixit, the difference between what was promised and what was accomplished was the result of multiple principles playing a dynamic game of policy making to further their interests.

Thus the field of political economy provides a wealth of models and frameworks with which to evaluate government performance and understand the political economy of a country. My next column will attempt to examine how some of these models apply to India and analyze the performance of the Indian government in the context of our unique political economy.

Updated: July 25, 2023, 09:11 PM IST