- Email: [email protected]
Public economics yesterday, today and tomorrow
Journal of Public Economics 86 (2002) 327–334 www.elsevier.com / locate / econbase
Public economics yesterday, today and tomorrow Jean-Jacques Laffont ´ de Brienne, Batiment F, Universite des Sciences Sociales, Manufacture des Tabacs, 21 allee 31000 Toulouse, France
1. Introduction Public economics, that is to say the study of public intervention in the economy, has emerged from public finance in the 1950s to reach its autonomy 1 at the beginning of the seventies, with, in particular, the creation of the Journal of Public Economics in 1971. With some oversimplifications, we are going to argue that modern public economics was born from taking into account more or less explicitly the informational constraints of the State in its role of production, allocation and distribution of resources. The criticism of the benevolent State by the Virginia Polytechnic Institute and Chicago Schools, followed today by a renewal of political economy, constitutes the second major key to read the new developments of public economics. This leads us to a presentation in four parts. Section 2 will overview the implications of the Arrow–Debreu general equilibrium paradigm in public economics. Section 3 will present some essential results obtained in public economics when the informational constraints of the State are taken into account. The paradigm of the benevolent State will be criticized in Section 4. Section 5 will briefly sketch our view of the immediate future for public economics.
E-mail address: [email protected] (J.-J. Laffont). 1 For syntheses the reader can consult several textbooks Atkinson and Stiglitz (1980), Boadway and Wildasin (1984), Laffont (1988), Starrett (1988), Henry (1989) as well as the Handbook of Public Economics (Auerbach and Feldstein (1985)). 0047-2727 / 02 / $ – see front matter 2002 Elsevier Science B.V. All rights reserved. PII: S0047-2727( 01 )00188-8
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J.-J. Laffont / Journal of Public Economics 86 (2002) 327 – 334
2. Public economics and the Arrow–Debreu model In the Arrow–Debreu world of complete information with a benevolent State, redistribution problems are dealt with through the second welfare theorem. Under convexity assumptions on the production sets, any Pareto optimal allocation of resources can be decentralized as a competitive equilibrium eventually after a redistribution of initial resources through lump sum taxes. Similarly, the financing of public goods with lump sum taxes does not alter the efficiency of a competitive allocation of resources. Well before 1970, the efficiency criteria for the allocation of public goods (the Bowen–Samuelson conditions), the proper internalization of externalities, the pricing of budget balanced public firms are well understood within this world. An essential worry animates the theorists. The second welfare theorem assumes the convexity of production sets which is problematic in public economics. The internalization of externalities by the creation of appropriate markets (Arrow (1969)) faces, in the case of negative externalities, the non convexity of the production sets extended to include pollution rights (Starrett (1972)). Only non linear taxes which appear informationally very demanding are susceptible of implementing Pareto optimal allocations. Also, for numerous public services, the non convexity of production sets (the natural monopoly hypothesis) seems to be the rule. Pricing at marginal cost with public funding of deficits by lump sum taxes, suggested for example by Hotelling (1938), calls upon the general equilibrium theorists. The desirable generalization according to which the competitive equilibria with marginal cost pricing of activities produced with non convex technologies are Pareto optimal simply does not hold. Guesnerie (1975) produces examples where some distributions of initial resources are incompatible with Pareto efficiency even if those goods are priced at marginal cost. When Beato and Mas-Colell (1985) show that, in the absence of lump sum taxes, even productive efficiency can be violated, this line of research ends with the conclusion that pricing at marginal cost does not allow in general equilibrium the decentralization of Pareto optima. But, why would one wish to decentralize Pareto optima with a benevolent State under complete information? The question of how to manage public firms will be reconsidered some fifteen years later by the new economics of regulation.
3. Public economics and asymmetric information
3.1. Optimal taxation of income Even if we can now identify some precursors (Vickrey, 1945), Mirrlees (1971) must be celebrated as the first decisive inroad of non linear pricing and of the
J.-J. Laffont / Journal of Public Economics 86 (2002) 327 – 334
329
theory of incentives in public economics. This article, essential from a methodological point of view, has led to a large theoretical and empirical literature. The core of Mirrlees’ modeling is the asymmetric information concerning the agents’ intrinsic productivities. A lump sum tax allowing to redistribute resources would need the knowledge of these productivities assumed to be exogenous. Accordingly, one must content itself with taxes based on observable incomes which depend on those productivities, but also on the number of worked hours, variable which is also assumed non observable by the tax authority. Thanks to a simplifying assumption on preferences according to which the marginal rate of substitution between income and leisure is a monotonic function of the intrinsic productivity of the agent, Mirrlees can provide a complete characterization of the constraints imposed by the decentralization of information about productivities on the allocation of resources. By calling upon the Pontryagin principle, he can then obtain a number of properties of the tax schedule which maximizes a Benthamite social welfare function, in particular the fact that the marginal taxation rate of the most productive agents must be zero. The economists agree upon the weak impact of this work on economic policy. This is probably due to the highly stylized nature of the model which ignores tax evasion, the audit of incomes, etc. These questions addressed more recently are more difficult to study because of the non convexities they produce and the commitment issues they raise. Nevertheless, the incentives–redistribution trade-off exhibited by this literature is a major lesson of this period which invalidates the second welfare theorem. More redistribution leads to less productive efficiency.2
3.2. General taxation theory The general equilibrium framework chosen by Diamond and Mirrlees (1971) to provide a general theory of linear taxation has had a more practical influence. The informational constraints amount here to the linearity of income taxation and of excise taxes. Beyond the result of productive efficiency proved in a general framework, this article elevates taxation theory to the level of general economic theory. The problem of optimal taxation appeared then clearly as the problem of the optimal set of tax bases and tax rates, given the difficulties of observing economic transactions and given the other asymmetries of information suffered by the tax authorities. Despite all these efforts general results from second-best optimal taxation (Guesnerie, 1995) remained meager and had to be relayed by an approach using simulations of calibrated general equilibrium models. The less ambitious program of searching for reforms locally beneficial in the Pareto sense has provided the methodological framework of many reforms in developing 2
More recently, several authors have showed that in dynamic models with limited liability constraints redistribution may lead to more efficiency. In any case efficiency and distribution cannot be separated.
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J.-J. Laffont / Journal of Public Economics 86 (2002) 327 – 334
countries (see Ahmad and Stern, 1991). Economic studies with micro data have enabled a better understanding of the equity–efficiency trade-offs of public policies (King, 1983).
3.3. The free rider problem Public economics has known a particular excitement in the seventies, when, starting with the articles of Groves (1973) and Clarke (1971), new solutions were proposed to solve the free rider problem, namely the problem of how to decide the level and funding of public goods when the State does not know the agents’ willingnesses to pay for those public goods. Even, if the empirical relevance of these constructions is debatable, the achievements realized in incentive theory ´ (Green and Laffont, 1979; Aspremont and Gerard-Varet, 1979) have played an important role for other fields of economics which have imported those tools in the 1980s and 1990s. The principle according to which one must charge an agent the cost he imposes on the rest of society by his presence is the key to induce him to act in an optimal social way despite the absence of information about his characteristics. One can then construct dominant strategy mechanisms which lead agents having quasilinear preferences (linear in the private good) to reveal truthfully their preferences while still implementing the optimal levels of public goods. These mechanisms are in general neither budget balanced nor individually rational. The balance of the budget can be obtained by weakening the strength of incentives to Bayesian rather than dominant strategy implementation. Individual rationality can be partially restored by requiring it only ex ante. The importance of asymmetric information for public intervention has been well understood at this occasion. In a first step it has led to the Revelation Principle which establishes the validity of a centralized approach to public decision making even in presence of adverse selection and moral hazard. It provides a normative framework alternative to the Arrow–Debreu model when the State suffers from asymmetric information. The notion of incentive compatible Pareto optimum, i.e., an allocation which maximizes the Pareto criterion under incentive constraints, has emerged as the new criterion of economic feasibility which allows us to compare institutions in a more realistic fashion. Today, public economics continues its progression by relaxing the implicit and explicit assumptions underlying the Revelation Principle (see Section 5).
3.4. The regulation of public services Loeb and Magat (1979) and Baron and Myerson (1982) have modeled the regulation of natural monopolies as a problem of optimal control under asymmetric information. The regulator ignores in particular the precise characteristics of the monopoly’s cost function. This information gap obliges in general the regulator to
J.-J. Laffont / Journal of Public Economics 86 (2002) 327 – 334
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give up a rent to the monopoly, called the information rent, which comes from the possibility of an efficient firm to mimic a less efficient one at a lower cost. The optimization of regulation consists then in mitigating this costly information rent by distortions of the allocation of resources which entail inefficiencies. In the Baron–Myerson model for example, this amounts to decrease the production level to decrease the rent, or to price above marginal cost. More generally, one gets back the usual first-order optimality intuitions of the economist if one includes in costs the social cost of information rents. Laffont and Tirole (1993) have constructed a theory of regulation based on a double asymmetry of information, an unknown cost parameter and an unobservable effort level of the managers which decreases cost. The efficiency–rent trade-off takes here the form of the choice of a cost reimbursement rule which at one extreme can be of a fixed price type and favors cost minimization or at the other extreme of a cost plus type and favors the extraction of information rents. Optimal regulation can often be implemented by a menu of cost reimbursement rules and by the generalized Ramsey pricing approach. These theories have produced a rigorous framework to analyze the traditional regulations such as rate of return regulation or price cap regulation. The liberalization of public services consists in regulating only the natural monopoly segments, if any, of these network industries while opening competition in the services using those segments. This leads to the important problem of choosing access prices which ensure a good interface between regulated and competitive segments. How to choose access pricing rules to optimize the use of networks while still ensuring their financing and their development? When networks compete such as in telecommunications, should we maintain public regulation of access to avoid maybe collusion on reciprocal access charges, or leave it to competition policy? For the segments opened to competition, competition policy must be implemented. This regulation of monopolies is part of the public economics of imperfectly competitive sectors for which a bridge must be found between the regulation of monopolies and competition policy. However, the theorization of competition policy is still largely an open question.
3.5. The reform of the State To the old debates between socialism and capitalism have succeeded debates of about the scope of public interventions and more generally opened a debate about the reform of the State. Taking into account the informational difficulties of the State has led naturally to address frontally the problems of the structure of the State, in particular of its hierarchical structure. Consequently, the theoretical and empirical study of corruption (Rose-Ackerman, 1978) has become an essential topic in development economics. This corruption exists in the implementation of the traditional regalian
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rights of the State, but also at the occasion of its public intervention: regulation, economic aid, procurement . . . The State must delegate to intermediaries who have their own private interests the implementation of its policies and must modify it’s policies to take into account the incentives of those intermediaries. It often takes the form of less powerful incentive schemes which decrease the stakes of collusion or of the organization of these intermediaries in more or less independent bodies. The intervention of a State which takes into account collusion constraints is of course apparently less efficient, but it is much more realistic.
4. Political economy of public economics Most of public economics has developed by assuming that the State is a benevolent dictator which maximizes social welfare defined by a social welfare function. One can characterize this approach by saying that it has neglected the incentive problems existing in the delegation of economic policy to politicians. This weakness early stressed by the Virginia Polytechnic Institute School and the Chicago School is today at the center of a vast effort of political economy which attempts to reintroduce in economic analysis political constraints. This effort largely initiated in macroeconomics and international economics is today at the center of debates in public economics (Dixit, 1996; Laffont, 2000). Indeed, it is by giving up the myth of the benevolent State that one can hope to develop a meaningful theory of privatization. Shapiro and Willig (1990) assume that governments have private agendas. Privatization of public firms creates an asymmetry of information between the political power and the firm which makes more difficult the pursuit of those private agendas and which can then benefit citizens. It is like that also that one can hope to theorize the marginal cost pricing controversy and get back the intuition of the classical economists (Smith, 1776; Walras, 1897) favoring average cost pricing (see Laffont, 2000). It is also along these lines that one can address the theory of decentralization which must arbitrate between efficiency losses and the gains obtained from better accountability (Seabright, 1996).
5. Public economics and incomplete contracts Even with asymmetric information, contract theory with no restriction on contracts establishes via the Revelation Principle the superiority of a centralized organization of the economy in which all the information flows up to the State through incentive compatible mechanisms before instructions organizing optimally economic activities flow down to economic agents. This counter-intuitive result comes from the assumptions underlying the
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Revelation Principle: perfect rationality of all economic agents, absence of communication costs, availability of rational and benevolent judges, perfect commitment power . . . In addition to developing the complete contract paradigm to approach areas such as education economics and health economics for example, where it can still yield new insights, the present and immediate future of theoretical public economics consists in relaxing step by step these hypotheses. Unfortunately, for most of them, we do not know how to proceed in a fundamentalist way. There is no bounded rationality model which is yet very robust. We do not know how to model communication costs in a economically meaningful way. We have no model of judges’ behavior . . . So, theorists take shortcuts which are not theoretically very satisfactory, but provide some insights. For example, the simplicity of contracts necessary for bounded rationality reasons or the lack of benevolent judges may limit the commitment power of contracts. As a shortcut one may study what happens if commitment is only possible in the short run, or if one cannot commit not to renegotiate (Dewatripont, 1989). Similarly, multi-principal structures may result from communication costs or from the desire to fight corruption. They can be taken as given to characterize the inefficiencies that the Nash behavior of principals entails (Martimort, 1992; Stole, 1991). The political economy of public economics can be viewed as resulting from the necessary simplicity of constitutional rules. The non-verifiability paradigm (Williamson, 1975; Hart, 1995) corresponds also to ad hoc restrictions on contracting. We will see public economic theory approaching better the real world through these constraints on contracting. However, I see some limits to this approach. From a theoretical point of view, it may make no sense to combine various ad hoc restrictions on contracting which would not result from the same underlying phenomena. From an empirical point of view, the econometrician will need structural forms which combine the most realistic contracting constraints. This entails delicate choices when they are not derived from well defined institutional constraints. There will be a trade-off as always between working with simple but clearly wrong structural forms as most of empirical public economics proceeds with today and more realistic but complex and doubtful ones.
References Ahmad, E., Stern, N., 1991. The Theory and Practice of Tax Reform in Developing Countries. Cambridge U.P, Cambridge. Arrow, K., 1969. Joint Economic Committee, The Analysis and Evaluations of Public Expenditures: the PPB System The Organization of Economic Activity: Issues Pertinent To the Choice of Market Versus Non-market Allocations. Government Printing Office, Washington, D.C. ´ Aspremont, C., Gerard-Varet, L.A., 1979. Incentives and incomplete information. Journal of Public Economics 11, 25–45.
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Atkinson, A., Stiglitz, J., 1980. Lectures On Public Economics. McGrawhill, London. Auerbach, A., Feldstein, M., 1985. Handbook of Public Economics. North-Holland, Amsterdam. Baron, D., Myerson, R., 1982. Regulating a monopolist with unknown cost. Econometrica 50, 911–930. Beato, P., Mas-Colell, A., 1985. On marginal cost pricing with given tax-subsidy rules. Journal of Economic Theory 37, 356–365. Boadway, R., Wildasin, D., 1984. Public Sector Economics. Little, Brown, Boston. Clarke, E., 1971. Multipart pricing of public goods. Public Choice 8, 19–33. Dewatripont, M., 1989. Renegotiation and information revelation over times: the case of optimal labor contracts. Quarterly Journal of Economics 104, 489–620. Diamond, P.J., Mirrlees, J., 1971. Optimal taxation and public production, Part I: production efficiency and Part II: tax rules. American Economic Review 61, 8–27, and pp. 261–278. Dixit, A., 1996. The Making of Economic Policy: A Transaction Cost Politics Perspective. MIT Press, Cambridge. Green, J., Laffont, J.J., 1979. Incentives in Public Decision Making. North Holland, Amsterdam. Groves, T., 1973. Incentives in teams. Econometrica 41, 617–631. Guesnerie, R., 1975. Pareto optimality in non convex economies. Econometrica 43, 1–30. Guesnerie, R., 1995. A Contribution To the Pure Theory of Taxation, Econometric Society Monographs. Cambridge U.P. Hart, O., 1995. Firms, Contracts and Financial Structures. Oxford University Press, Oxford. Henry, C., 1989. Microeconomics For Public Policy. Clarendon, Oxford. Hotelling, H., 1938. The general welfare in relation to problems of taxation and of railway and utility rates. Econometrica 6, 242–269. King, M., 1983. Welfare analysis of tax reforms using household data. Journal of Public Economics 21, 183–214. Laffont, J.J., 2000. Incentives and Political Economy. Oxford University Press, Oxford. Laffont, J.J., 1988. Fundamentals of Public Economics. MIT Press, Cambridge. Laffont, J.J., Tirole, J., 1993. A Theory of Incentives in Procurement and Regulation. MIT Press, Cambridge. Loeb, M., Magat, W., 1979. A decentralized method of utility regulation. Journal of Law and Economics 22, 399–404. ´ Martimort, D., 1992. Multi-principaux avec anti selection. Annales d’Economie et de Statistiques 28, 1–38. Mirrlees, J., 1971. An exploration in the theory of optimum income taxation. Review of Economic Studies 38, 175–208. Rose-Ackerman, R., 1978. Corruption: A Study in Political Economy. Academic Press, New York. Seabright, P., 1996. Accountability and decentralization in government: an incomplete contract model. European Economic Review 40, 61–90. Shapiro, C., Willig, R., 1990. Economic rationales for the scope of privatization. In: mimeo. Smith, 1776, The Wealth of Nations, The Modern Library, New York, (1937 edition). Starrett, D., 1972. Fundamental non convexities in the theory of externalities. Journal of Economic Theory 4, 180–199. Starrett, D., 1988. Foundations of Public Economics. Cambridge U.P, Cambridge. Stole, L., 1991. Mechanism Design under Common Agency. In: mimeo, MIT. Vickrey, W., 1945. Measuring marginal utility by reactions to risk. Econometrica 13, 319–333. Walras, L. (1897), L’Etat et les chemins de fer, Revue du Droit Public et de la Science Politique, ´ Walras Œuvres Economiques Completes, ` reprinted in August et Leon Vol. X, Economica, Paris, 1992. Williamson, O.E., 1975. Markets and Hierarchies. The Free Press, New York.
Public economics yesterday, today and tomorrow Jean-Jacques Laffont ´ de Brienne, Batiment F, Universite des Sciences Sociales, Manufacture des Tabacs, 21 allee 31000 Toulouse, France
1. Introduction Public economics, that is to say the study of public intervention in the economy, has emerged from public finance in the 1950s to reach its autonomy 1 at the beginning of the seventies, with, in particular, the creation of the Journal of Public Economics in 1971. With some oversimplifications, we are going to argue that modern public economics was born from taking into account more or less explicitly the informational constraints of the State in its role of production, allocation and distribution of resources. The criticism of the benevolent State by the Virginia Polytechnic Institute and Chicago Schools, followed today by a renewal of political economy, constitutes the second major key to read the new developments of public economics. This leads us to a presentation in four parts. Section 2 will overview the implications of the Arrow–Debreu general equilibrium paradigm in public economics. Section 3 will present some essential results obtained in public economics when the informational constraints of the State are taken into account. The paradigm of the benevolent State will be criticized in Section 4. Section 5 will briefly sketch our view of the immediate future for public economics.
E-mail address: [email protected] (J.-J. Laffont). 1 For syntheses the reader can consult several textbooks Atkinson and Stiglitz (1980), Boadway and Wildasin (1984), Laffont (1988), Starrett (1988), Henry (1989) as well as the Handbook of Public Economics (Auerbach and Feldstein (1985)). 0047-2727 / 02 / $ – see front matter 2002 Elsevier Science B.V. All rights reserved. PII: S0047-2727( 01 )00188-8
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J.-J. Laffont / Journal of Public Economics 86 (2002) 327 – 334
2. Public economics and the Arrow–Debreu model In the Arrow–Debreu world of complete information with a benevolent State, redistribution problems are dealt with through the second welfare theorem. Under convexity assumptions on the production sets, any Pareto optimal allocation of resources can be decentralized as a competitive equilibrium eventually after a redistribution of initial resources through lump sum taxes. Similarly, the financing of public goods with lump sum taxes does not alter the efficiency of a competitive allocation of resources. Well before 1970, the efficiency criteria for the allocation of public goods (the Bowen–Samuelson conditions), the proper internalization of externalities, the pricing of budget balanced public firms are well understood within this world. An essential worry animates the theorists. The second welfare theorem assumes the convexity of production sets which is problematic in public economics. The internalization of externalities by the creation of appropriate markets (Arrow (1969)) faces, in the case of negative externalities, the non convexity of the production sets extended to include pollution rights (Starrett (1972)). Only non linear taxes which appear informationally very demanding are susceptible of implementing Pareto optimal allocations. Also, for numerous public services, the non convexity of production sets (the natural monopoly hypothesis) seems to be the rule. Pricing at marginal cost with public funding of deficits by lump sum taxes, suggested for example by Hotelling (1938), calls upon the general equilibrium theorists. The desirable generalization according to which the competitive equilibria with marginal cost pricing of activities produced with non convex technologies are Pareto optimal simply does not hold. Guesnerie (1975) produces examples where some distributions of initial resources are incompatible with Pareto efficiency even if those goods are priced at marginal cost. When Beato and Mas-Colell (1985) show that, in the absence of lump sum taxes, even productive efficiency can be violated, this line of research ends with the conclusion that pricing at marginal cost does not allow in general equilibrium the decentralization of Pareto optima. But, why would one wish to decentralize Pareto optima with a benevolent State under complete information? The question of how to manage public firms will be reconsidered some fifteen years later by the new economics of regulation.
3. Public economics and asymmetric information
3.1. Optimal taxation of income Even if we can now identify some precursors (Vickrey, 1945), Mirrlees (1971) must be celebrated as the first decisive inroad of non linear pricing and of the
J.-J. Laffont / Journal of Public Economics 86 (2002) 327 – 334
329
theory of incentives in public economics. This article, essential from a methodological point of view, has led to a large theoretical and empirical literature. The core of Mirrlees’ modeling is the asymmetric information concerning the agents’ intrinsic productivities. A lump sum tax allowing to redistribute resources would need the knowledge of these productivities assumed to be exogenous. Accordingly, one must content itself with taxes based on observable incomes which depend on those productivities, but also on the number of worked hours, variable which is also assumed non observable by the tax authority. Thanks to a simplifying assumption on preferences according to which the marginal rate of substitution between income and leisure is a monotonic function of the intrinsic productivity of the agent, Mirrlees can provide a complete characterization of the constraints imposed by the decentralization of information about productivities on the allocation of resources. By calling upon the Pontryagin principle, he can then obtain a number of properties of the tax schedule which maximizes a Benthamite social welfare function, in particular the fact that the marginal taxation rate of the most productive agents must be zero. The economists agree upon the weak impact of this work on economic policy. This is probably due to the highly stylized nature of the model which ignores tax evasion, the audit of incomes, etc. These questions addressed more recently are more difficult to study because of the non convexities they produce and the commitment issues they raise. Nevertheless, the incentives–redistribution trade-off exhibited by this literature is a major lesson of this period which invalidates the second welfare theorem. More redistribution leads to less productive efficiency.2
3.2. General taxation theory The general equilibrium framework chosen by Diamond and Mirrlees (1971) to provide a general theory of linear taxation has had a more practical influence. The informational constraints amount here to the linearity of income taxation and of excise taxes. Beyond the result of productive efficiency proved in a general framework, this article elevates taxation theory to the level of general economic theory. The problem of optimal taxation appeared then clearly as the problem of the optimal set of tax bases and tax rates, given the difficulties of observing economic transactions and given the other asymmetries of information suffered by the tax authorities. Despite all these efforts general results from second-best optimal taxation (Guesnerie, 1995) remained meager and had to be relayed by an approach using simulations of calibrated general equilibrium models. The less ambitious program of searching for reforms locally beneficial in the Pareto sense has provided the methodological framework of many reforms in developing 2
More recently, several authors have showed that in dynamic models with limited liability constraints redistribution may lead to more efficiency. In any case efficiency and distribution cannot be separated.
330
J.-J. Laffont / Journal of Public Economics 86 (2002) 327 – 334
countries (see Ahmad and Stern, 1991). Economic studies with micro data have enabled a better understanding of the equity–efficiency trade-offs of public policies (King, 1983).
3.3. The free rider problem Public economics has known a particular excitement in the seventies, when, starting with the articles of Groves (1973) and Clarke (1971), new solutions were proposed to solve the free rider problem, namely the problem of how to decide the level and funding of public goods when the State does not know the agents’ willingnesses to pay for those public goods. Even, if the empirical relevance of these constructions is debatable, the achievements realized in incentive theory ´ (Green and Laffont, 1979; Aspremont and Gerard-Varet, 1979) have played an important role for other fields of economics which have imported those tools in the 1980s and 1990s. The principle according to which one must charge an agent the cost he imposes on the rest of society by his presence is the key to induce him to act in an optimal social way despite the absence of information about his characteristics. One can then construct dominant strategy mechanisms which lead agents having quasilinear preferences (linear in the private good) to reveal truthfully their preferences while still implementing the optimal levels of public goods. These mechanisms are in general neither budget balanced nor individually rational. The balance of the budget can be obtained by weakening the strength of incentives to Bayesian rather than dominant strategy implementation. Individual rationality can be partially restored by requiring it only ex ante. The importance of asymmetric information for public intervention has been well understood at this occasion. In a first step it has led to the Revelation Principle which establishes the validity of a centralized approach to public decision making even in presence of adverse selection and moral hazard. It provides a normative framework alternative to the Arrow–Debreu model when the State suffers from asymmetric information. The notion of incentive compatible Pareto optimum, i.e., an allocation which maximizes the Pareto criterion under incentive constraints, has emerged as the new criterion of economic feasibility which allows us to compare institutions in a more realistic fashion. Today, public economics continues its progression by relaxing the implicit and explicit assumptions underlying the Revelation Principle (see Section 5).
3.4. The regulation of public services Loeb and Magat (1979) and Baron and Myerson (1982) have modeled the regulation of natural monopolies as a problem of optimal control under asymmetric information. The regulator ignores in particular the precise characteristics of the monopoly’s cost function. This information gap obliges in general the regulator to
J.-J. Laffont / Journal of Public Economics 86 (2002) 327 – 334
331
give up a rent to the monopoly, called the information rent, which comes from the possibility of an efficient firm to mimic a less efficient one at a lower cost. The optimization of regulation consists then in mitigating this costly information rent by distortions of the allocation of resources which entail inefficiencies. In the Baron–Myerson model for example, this amounts to decrease the production level to decrease the rent, or to price above marginal cost. More generally, one gets back the usual first-order optimality intuitions of the economist if one includes in costs the social cost of information rents. Laffont and Tirole (1993) have constructed a theory of regulation based on a double asymmetry of information, an unknown cost parameter and an unobservable effort level of the managers which decreases cost. The efficiency–rent trade-off takes here the form of the choice of a cost reimbursement rule which at one extreme can be of a fixed price type and favors cost minimization or at the other extreme of a cost plus type and favors the extraction of information rents. Optimal regulation can often be implemented by a menu of cost reimbursement rules and by the generalized Ramsey pricing approach. These theories have produced a rigorous framework to analyze the traditional regulations such as rate of return regulation or price cap regulation. The liberalization of public services consists in regulating only the natural monopoly segments, if any, of these network industries while opening competition in the services using those segments. This leads to the important problem of choosing access prices which ensure a good interface between regulated and competitive segments. How to choose access pricing rules to optimize the use of networks while still ensuring their financing and their development? When networks compete such as in telecommunications, should we maintain public regulation of access to avoid maybe collusion on reciprocal access charges, or leave it to competition policy? For the segments opened to competition, competition policy must be implemented. This regulation of monopolies is part of the public economics of imperfectly competitive sectors for which a bridge must be found between the regulation of monopolies and competition policy. However, the theorization of competition policy is still largely an open question.
3.5. The reform of the State To the old debates between socialism and capitalism have succeeded debates of about the scope of public interventions and more generally opened a debate about the reform of the State. Taking into account the informational difficulties of the State has led naturally to address frontally the problems of the structure of the State, in particular of its hierarchical structure. Consequently, the theoretical and empirical study of corruption (Rose-Ackerman, 1978) has become an essential topic in development economics. This corruption exists in the implementation of the traditional regalian
332
J.-J. Laffont / Journal of Public Economics 86 (2002) 327 – 334
rights of the State, but also at the occasion of its public intervention: regulation, economic aid, procurement . . . The State must delegate to intermediaries who have their own private interests the implementation of its policies and must modify it’s policies to take into account the incentives of those intermediaries. It often takes the form of less powerful incentive schemes which decrease the stakes of collusion or of the organization of these intermediaries in more or less independent bodies. The intervention of a State which takes into account collusion constraints is of course apparently less efficient, but it is much more realistic.
4. Political economy of public economics Most of public economics has developed by assuming that the State is a benevolent dictator which maximizes social welfare defined by a social welfare function. One can characterize this approach by saying that it has neglected the incentive problems existing in the delegation of economic policy to politicians. This weakness early stressed by the Virginia Polytechnic Institute School and the Chicago School is today at the center of a vast effort of political economy which attempts to reintroduce in economic analysis political constraints. This effort largely initiated in macroeconomics and international economics is today at the center of debates in public economics (Dixit, 1996; Laffont, 2000). Indeed, it is by giving up the myth of the benevolent State that one can hope to develop a meaningful theory of privatization. Shapiro and Willig (1990) assume that governments have private agendas. Privatization of public firms creates an asymmetry of information between the political power and the firm which makes more difficult the pursuit of those private agendas and which can then benefit citizens. It is like that also that one can hope to theorize the marginal cost pricing controversy and get back the intuition of the classical economists (Smith, 1776; Walras, 1897) favoring average cost pricing (see Laffont, 2000). It is also along these lines that one can address the theory of decentralization which must arbitrate between efficiency losses and the gains obtained from better accountability (Seabright, 1996).
5. Public economics and incomplete contracts Even with asymmetric information, contract theory with no restriction on contracts establishes via the Revelation Principle the superiority of a centralized organization of the economy in which all the information flows up to the State through incentive compatible mechanisms before instructions organizing optimally economic activities flow down to economic agents. This counter-intuitive result comes from the assumptions underlying the
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Revelation Principle: perfect rationality of all economic agents, absence of communication costs, availability of rational and benevolent judges, perfect commitment power . . . In addition to developing the complete contract paradigm to approach areas such as education economics and health economics for example, where it can still yield new insights, the present and immediate future of theoretical public economics consists in relaxing step by step these hypotheses. Unfortunately, for most of them, we do not know how to proceed in a fundamentalist way. There is no bounded rationality model which is yet very robust. We do not know how to model communication costs in a economically meaningful way. We have no model of judges’ behavior . . . So, theorists take shortcuts which are not theoretically very satisfactory, but provide some insights. For example, the simplicity of contracts necessary for bounded rationality reasons or the lack of benevolent judges may limit the commitment power of contracts. As a shortcut one may study what happens if commitment is only possible in the short run, or if one cannot commit not to renegotiate (Dewatripont, 1989). Similarly, multi-principal structures may result from communication costs or from the desire to fight corruption. They can be taken as given to characterize the inefficiencies that the Nash behavior of principals entails (Martimort, 1992; Stole, 1991). The political economy of public economics can be viewed as resulting from the necessary simplicity of constitutional rules. The non-verifiability paradigm (Williamson, 1975; Hart, 1995) corresponds also to ad hoc restrictions on contracting. We will see public economic theory approaching better the real world through these constraints on contracting. However, I see some limits to this approach. From a theoretical point of view, it may make no sense to combine various ad hoc restrictions on contracting which would not result from the same underlying phenomena. From an empirical point of view, the econometrician will need structural forms which combine the most realistic contracting constraints. This entails delicate choices when they are not derived from well defined institutional constraints. There will be a trade-off as always between working with simple but clearly wrong structural forms as most of empirical public economics proceeds with today and more realistic but complex and doubtful ones.
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