Models of Political Economy

Hannu Nurmi

• Publisher: Routledge
• Year: 2006
• eBook ISBN: 9781134338627
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Models of Political Economy will introduce students to the basic methodology of political economics. It covers all core theories as well as new developments including:

• decision theory
• game theory
• mechanism design
• games of asymmetric information.

Hannu Nurmi's text will prove to be invaluable to all students who wish to understand this increasingly technical field.

1 Introduction

This book deals with the tools needed for understanding political, social and economic life. Our main subject, political economy, gained – according to a widely held view – the status of a distinct area of study in the 18th and 19th centuries, in other words, well before the modern disciplinary classification was introduced. The early practitioners of political economy were moral philosophers rather than economists or political scientists. The devolution of economics, sociology and political science from the master science, philosophy, was still many decades away at the time when Adam Smith and David Hume outlined their ideas of political economy. In his classic treatise of 1776, the former defined political economy as follows (Smith [1776] 1961):

Political economy, considered as a branch of the science of a statesman or legislator, proposes two distinct objects: first to provide a plentiful revenue or subsistence for the people, or more properly to enable them to provide such a revenue or subsistence for themselves: and secondly, to supply the state or commonwealth with a revenue sufficient for the public services. It proposes to enrich both the people and the sovereign.

Some 70 years later, James Mill ([1844] 1995) resorted to a familiar analogy:

Political Economy is to the State what domestic economy is to the family. …[Political economy] has two grand objects, the Consumption of the Community, and that Supply upon which the consumption depends.

Smith’s definition is phrased in a manner familiar from the early modern political science literature. The main task of scientific activity was to be of assistance for rulers (see Skinner 1978). The origins of the modern political science can be traced to the mirror-of-princes texts of the 15th and 16th centuries. These aimed at counseling princes in their search for virtue and greatness. In Smith’s view the task of political economy is to assist the rulers in providing well-being to their subjects and in securing the necessary means for running what would today be called the public sector. In Mill’s definition, what distinguishes political economy from household economy are the actors, not the activities. Both economies depend on the satisfaction of consumption and supply needs.

The classic views basically amount to extending the principles of running a successful household to a new domain, namely to the affairs of the state. Political economy was seen as an essential aspect of statecraft. The provision for consumption and the requisite supply assume a view of the operation and organization of the actors involved. Despite the strong emphasis on statecraft, the authors of the classical period did not envisage much of a role for the state or statesmen in the running of the economy. Left alone by the state, private economic agents (consumers, producers, merchants, etc.), while pursuing their own interests, were supposed to bring about outcomes that are collectively optimal. Thus, the markets were assumed to regulate themselves with beneficial outcomes for both the state and the people. In fact, the classic authors all but did away with the ‘political’ in political economy.

This approach was strongly opposed by Marx who questioned the evolutionary mechanism underlying the classical view. While Smith had argued that markets emerge as a result of the welfare maximization pursuit of the actors and can be viewed as facilitating this pursuit, Marx questioned the ‘arrow of causality’ of the theory, namely that the individual interests bring about the economic organization known as markets (see Marx [1939] 1973). In Marx’s view it was rather the economic organization with its production relationships that determined the individual interests. The production relationships, in their turn, were based on the development of the productive forces. The Marxist analysis entailed a considerable enlargement of the scope of political economy. Most importantly, the class structure of the society was to be seen as part and parcel of political economy.

The neoclassical view of political economy agrees with the classic one in treating the economy as an analytically separable subsystem of the society, but introduces new philosophical and technical elements. To wit, the foundations of economic behavior were sought in the utilitarianism and marginal calculus was invented to explain the workings of the economies (see Caporaso and Levine 1992: 79–99). With the assignment of utilities to outcomes and to actions producing them, the domain of political economy widened from the classical one to cover basically all human action.

Over the span of some 200 years, the concept of political economy has thus acquired several distinct meanings. Most definitions, however, share the idea of an interaction of two conceptually distinct societal subsystems – the political subsystem and the economic one. It would thus seem possible to use this idea as the focal point in outlining the proper domain of the concept. Unfortunately, the concept of politics is equally multi-faceted. In various times and places, politics has denoted the art of government, power, public affairs, authoritative allocation of scarce resources and conflict management (see e.g. Heywood 1997: 4–12).

Also the concept of economy takes on several meanings. This is the case not only in everyday parlance but also in the texts of the prominent authorities of political economy. In the classic political economy writings of Smith stressing the separation of the economy from politics, the former seems to pertain to markets and the behavior of actors in market transactions. But there is also another meaning attached to the concept of economy in Smith’s (and also in Marx’s) view. In this meaning, economy consists of particular types of activities, namely those related to production of goods and services (Caporaso and Levine 1992: 24). Production and exchange are thus the basic characteristics of an economy. There is, however, a third more general connotation of ‘economic’. This relates to the reasoning underlying economic activities. It is their deliberative and calculating nature that makes them economic (Caporaso and Levine 1992: 21–24). What makes a deliberation economic is the importance given to costs and benefits as well as the suitability of means to ends. Economy in this sense can obviously be extended far beyond production and exchange.

Even though the concept of economics is less disputed, it seems – given the wide disagreement over the meaning of politics – difficult to delineate the domain of political economy as an intersection of two reasonably well-defined subsystems. A more promising approach might be to concentrate on what kinds of activities are involved in political economy. Caporaso and Levine (1992) see the common core of various views on political economy in systems of want satisfaction. This certainly includes the classic and neoclassic views. Also the Marxian concept would seem to fall within the realm of this abstract characterization. On the other hand, systems of want satisfaction as such may include ones that we would not like to count as parts of political economy. For example, a family may establish a ‘system’ for allowing smokers to indulge in their habit in a designated room to minimize the inconvenience for non-smokers without depriving the smokers of their short-term pleasure. While this system is undoubtedly related to want satisfaction, it does not belong to political economy in the intuitive sense of the term. The reason for this conclusion is that the system in question is not public in the sense that matters political are thought to be. So, while the notion of want satisfaction captures an essential aspect of political economy, it is too wide to provide a definition of it.

In this book we adopt a characterization of political economy that rests largely on one of the concepts of economics mentioned above, namely one emphasizing the reasoning underlying the activity. We shall define political economy as the application of means–ends reasoning to behavior in the public realm. In other words, we see the defining feature of political economy in the calculus that economic and political actors resort to in political and economic life. Understood in this sense, the concept of political economy includes that of public choice (Mueller 2003: 1). The latter is commonly defined as the application of economic reasoning to non-market settings, in general, and to politics, in particular. Thus, political economy is essentially wider than public choice in applying similar reasoning to economy as well as to politics. Our particular focus renders the distinction between public choice and political economy inconsequential since what we shall be dealing with is the type of reasoning that has been called economic. Whether it is being applied to politics or economy is of secondary importance in our analysis.

Extending the idea of economic reasoning to non-market settings is tempting mainly because the principles of this reasoning can be expressed in a concise way. The specification of those principles and their analysis has been the primary contribution of the rational choice theory. At the outset this theory was mainly preoccupied with setting up the principles of behavior in fairly stable environments. So, for example, in classic political economy the profit maximization in markets was viewed as an important instance of rational behavior. At the same time the properties of the markets as an institution were discussed by Smith and his followers. The political economy of today is interested not only in the principles of market behavior but in analogous principles in other spheres of human life. However, along with the behavior principles, the properties of the institutions are very much focused upon also. This focus is a natural consequence of the observation that principles of rationality may differ in different institutional environments. A given type of behavior may result in desired outcomes in certain institutional settings, but may fail to do so in others. Consequently, if one’s interest is in securing certain types of outcomes, both the prevailing institutions and the behavior principles they are likely to be accompanied with should be taken into account. In fact, in terms of the likelihood of achieving certain types of outcomes, it becomes possible to talk about rational institutions in the means–ends sense. Thus, the principles of rationality can, under some circumstances, be extended to institutions as well as to behavior principles.

Our discussion will proceed as follows. In the next chapter we introduce some basic concepts of philosophy of science with the aim of specifying how the current research in political economy relates to the most common goals of scientific inquiry. Although political economy as a field can be viewed as sui generis, the research into it may well be characterized using the standard vocabulary of philosophy of science. The next chapter introduces the basic agent of the political economy, economic man or homo oeconomicus. This idealized agent is fundamental to political economy which in its neoclassical version approaches its research object from the point of view of choice under various types of constraints. Choices, in turn, are seen as the results of calculus or deliberation or, more generally, decision making. Thus, the chapter on homo oeconomicus will dwell on the principles of decision making. This discussion is based on an assumption of a passive environment which, of course, runs counter to the intuitive view of the decision settings in political economy. Therefore, the next chapter introduces other deliberating agents and outlines the basic ingredients of the theory of games, one of the primary tools of modern political economy.

Group decision theory can be viewed as an extension of game theory to the setting where members of a group make collective decisions, for example on the provision of collective goods. However, this theory has emerged largely independently of game theory and forms a link between market behavior and the design of institutions. These two subjects will be introduced and analyzed in separate chapters. The chapters on evaluation of public policies and theories of justice are basically applications of game and group choice theory to political economy. However, the former uses results from other fields as well, notably from multiple criterion decision theory and the theory of aggregation. The theories of justice, in turn, introduce new concepts, namely those related to fairness, into the theory of political economy. While most of the game and decision theoretic literature emphasizes efficiency, it is obvious that considerations pertaining to justice also enter the design and evaluation of institutions in political economy.

The crucial concept of this text is that of decision. Political economy consists of structures, events, developments and patterns in which human decisions play a central role. Therefore, a text on the models of political economy must devote primary attention to analyzing the basic ingredients of decision making. We shall begin by focusing first on decisions in stable and non-reactive environments to become familiar with the basic vocabulary as well as with the essential performance criteria. The first model is thus one with one active agent, the decision maker, aiming at specified goals resorting to the choices available to him/her (hereinafter, her). We then proceed to strategic environments by introducing other agents with similar or different goals and choice options. In group choice settings the new element is the institutional framework within which the choices are made. With strategic actors acting under specified institutional constraints we have the basic tools for modeling political economy. Extending these to cover settings where institutions also undergo change (evolution) or can be deliberately designed to achieve certain ends is the subject of the last chapters of this text.

1.1 Suggested reading

In addition to the Caporaso and Levine (1992) text referred to above there are several treatises that aim to cover the entire field of political economy. Hillman (2003) and Mueller (2003) are excellent – and extensive – overviews of the relevant literature. Both authors have also made important contributions to the research in the field of political economy. Dahl and Lindblom (1976) as well as Lindblom (1977) are often regarded as a modern classic in political economy. Freeman (1989) provides a systematic comparison of several politico-economic systems and a concise exposition of the main theoretical approaches. A useful introductory text is Przeworski (2003). For advanced readers, Austen-Smith and Banks (1999, 2005) as well as Persson and Tabellini (2000) are excellent texts, the former with an emphasis on political theory and the latter on determinants of economic policy. There are two major periodicals specializing in political economy: Journal of Political Economy and European Journal of Political Economy, but several others, e.g. Social Choice and Welfare, Public Choice, Homo Oeconomicus and Economics of Governance, also regularly publish articles in this field.

2 What are we aiming at?

Research in political economy is motivated by a wide variety of reasons. Some authors aim at making policy recommendations, others point to successes and/or failures in economic policy. Some works aim at making sense of what happened in the past, while others strive for predicting the future. Some writers derive their research problems from scholarly literature, others from everyday political and economic events. On closer inspection, these and many other motivations can be reduced to a fairly small number of basic goals of scientific inquiry: explanation, prediction, causal attribution and theory building. These have been extensively dealt with in philosophy of science. In this chapter our focus is on what this field of research tells us about these basic goals of scientific work. Admittedly there may be other, more personal goals involved in scholarly work; for example, authors may aim at fostering their academic careers and/or at impressing their colleagues. These motivations belong to the field of sociology and psychology of science which is beyond the scope of the present work.¹

2.1 Explaining political economy

In political economy, as in many other fields of research, the interests of scholars and laymen often differ. Yet there are also problems that both of these parties deem important. These are typically related to major politico-economic events, such as major policy statements, unexpected changes in developmental trends or emergence of new institutions. Thus, few would doubt either the scholarly or lay importance of President Roosevelt’s announcement on 8 December 1941 which amounted to the United States joining the Second World War against Germany and Japan. Similarly, the economic policy announcements of Alan Greenspan and Jean-Claude Trichet concerning the monetary policy of Federal Reserve and European Central Bank, respectively, are of obvious interest for both researchers and citizens as are, albeit for different reasons, the decisions of the main actors (primarily the chief executive officer and the chief financial officer) in the course of events that led to one of the largest corporate downfalls in history, the bankruptcy of Enron Corporation in December of 2001 (see e.g. Bryce 2002).

Also the European Council decision made in Laeken, Belgium in mid-December of 2001 to commence the framing of a constitution for the European Union by setting up a convention was a decision of both academic and practical importance. In 2004 the convention published its proposal for the constitutional treaty of Europe. It outlines the basic rights of the citizens of the European Union, the legal competency of the Union, its basic institutions and their working principles, the financing of the Union and many other more specific regulations. The ratification process began in the member countries in 2005. Some countries decided to subject the treaty proposal to a referendum. In early summer of 2005, the proposal was rejected in two referenda: one in France and one in the Netherlands.

With regard to the decisions and events just described it is natural to ask why they were made or why they took place. Answers to these questions are normally called explanations of the respective decisions or events. Thus, when a historian points to the air force attack on Pearl Harbor in December 1941 and the ensuing policy planning discussions in the United States government which, a day later, culminated in the declaration of war against Japan, what she aims to provide is an explanation of the event. Similarly, the accounts reporting the debates in boardrooms of Federal Reserve and European Central Bank are intended as explanations for the decisions announced by the respective chairmen. In a similar vein, the explanation of what caused the nosedive of Enron’s stock market value in 2001 is sought in the decisions made by its leadership.

At first sight, the explanations of the same events and decisions may vary from one audience to another. What is a good explanation for a normal 5-year-old child may not convince an adult with university degree and vice versa. There seems to be an inherently subjective element involved in explanations. This is a proper subject for psychology or sociology of science. What philosophy of science, especially its analytic tradition, has attempted to do is to provide objective general criteria for valid explanations. Of particular importance is Carl Hempel’s (1965) program which aims at setting up general requirements to be fulfilled by any account, presented in any field of inquiry, in order to be considered scientific explanation.

Carl Hempel (1905–1997) was one of the leading representatives of the analytic tradition in the philosophy of science. A student of the great names of the famous Vienna Circle – Carnap, Schlick and Waisman – he received his doctorate in Berlin. In 1930s he emigrated first to Belgium and later to the US where he taught at Yale, Princeton and Berkeley. His main works are related to concept formation, confirmation theory and the nature of scientific explanation (Murzi 2001).

The basic idea in Hempel’s view is that explanations are arguments. Arguments, in turn, are statement sequences arranged so that some statements – called conclusions or, in the present contexts, explananda (in singular, explanandum) – can be derived from others – called premises or explanantia (in singular, explanans). Of particular importance is deductive derivation. In his earliest models of explanation Hempel insisted that explananda be derivable from explanantia as in a deductive argument (Hempel and Oppenheim 1948). Deductive arguments are characterized by the property that once their premises are true, their conclusions must also be true. Thus, in a valid explanation the thing to be explained must be linked to statements that are (i) true, and (ii) must logically entail what is to be explained. The essential feature is that, given the information contained in the premises, the event to be explained was to be expected (Hempel 1965: 367–368). In later accounts, Hempel retreats somewhat from the strict deducibility requirement, but not from the desideratum that, given explanantia, the explananda are to be expected.²

In scientific explanation as seen by Hempel, the statements that explain a fact or phenomenon contain universal laws, i.e. statements that maintain some necessary connection between certain types of facts or phenomena. Paramount examples of these statements are laws of nature which connect, for example, volume, pressure and temperature of gases. To explain phenomena amounts to showing that they are in fact instances of a general law that covers these types of phenomena. For this reason Hempel’s view is often called the covering law account of explanation.

When applying Hempel’s Idea to human sciences, the first problem we encounter is that, at least intuitively, much – indeed, most – of our behavior is not subject to law-like regularities. This is, of course, not to say that there are no laws of behavior, but, at least, our present day knowledge does not include them to the extent that one could argue that many – let alone most – social science explanations were based on them.³ Yet, explanations abound in the social sciences, but rat...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• List of Figures
• List of Tables
• Preface
• 1 Introduction
• 2 What are we aiming at?
• 3 Homo æconomicus
• 4 Economic man under attack
• 5 Games: descriptions and solutions
• 6 Bargaining and coalitions
• 7 Decision making in committees
• 8 Designing for elections and public goods provision
• 9 What kind of government?
• 10 Aspects of policy evaluation
• 11 Homo æconomicus: should we let him go?
• Notes
• Bibliography