Reading “Power and Prosperity” by Mancur Olson.

References:

1. Augusto Pinochet (Chile)
2. Chung Hee Park, Doo-Hwan Chun (S.Korea)
3. Chiang Kai-shek (Chinese Taiwan)
4. Lee Kuan Yew (Singapore)
5. Deng Xiaoping (Mainland China)

And DDR, C.I.S., and other regimes suffered?

Democracies are won by promising to re-distribute stuff from minorities to the majority.

The easiest arithmetic example comes from supposing that the revenue-maximizing tax rate is one- third and that the majority earns one-third of the national in- come in the marketplace. The rational autocrat will then find that the last dollar in taxes that he collects reduces the na- tional income by $3, and one-third of this loss is his loss, so he breaks even on this last dollar of tax collection and is at his revenue-maximizing rate. But if a majority mistakenly chooses this same tax rate, it hurts itself, for it loses $2 (the same dollar lost by the autocrat, plus $1 of market income) from the last dollar it collected in taxes. Thus, a majority would maximize its total income with a lower tax rate and a smaller redistribution to itself than would be chosen by an au- tocrat.

Really? Why does not the king lose the same dollar of market income?

Generally, the revenue-maximising rate is about the one which makes sure that king’s share of the income falls by 1 over his tax revenue.

The point is that, in his logic, the king gets about 1/income, because taxation is his only source of income, and the majority is also getting money from the market.

Are the majorities that do not to re-distribution.

Dynastic succession increases the likelihood of long-term planning.

Autocrats are usually replaced with other autocrats, or, even worse, roving bandits.

He uses Schumpeter’s definition of democracy: “a system in which leadership of the present government is subject to replacement because of the free electoral competition”.

Breadth of franchise is NOT the key to why autocracies are replaced with democracies.

Claim: autocracies are replaced with democracies when democracies defeat them in war (or subversion).

But why do the victors themselves not become autocrats?

1. There are too many of them and the power is too distributed
2. There are conditions which prevent fracturing
3. The area is not under a threat from the outside

Well, simply because leaders of various factions do not want their stuff confiscated.

But not the other way round. And make no mistake, it’s not that democracy creates property rights, it’s that property rights are necessary condition.

So, basically the second chapter is more or less meaningless. Austrian economists have shown the same results, with more confidence.

Adam Smith: The Invisible Hand of the Market: In an exchange, both parties profit.

Ronald Coase defined “market imperfections” as transaction costs.

Hierarchical firms exist as places where transaction costs are reduced to much smaller than those on a “real market”.

Pollution damage, negative externalities.

Government fines must be larger than the loss of the people, to force companies to reduce pollution.

There are also positive externalities, when companies train their employees to better work, and they become better people in general.

“Pigou theorem” (1948): when externalities are present, “laissez-faire” market does not lead to Pareto-efficient outcome.

Non-purchasers cannot be excluded.

(Example: rancher’s cattle is trampling a farmer’s crops.)

When non-purchasers can negotiate, the Pigou theorem is wrong, and through the “Coaseian bargain”, a Pareto-efficient outcome can be attained, unless transaction costs are lower than the gains.

Can we extend Coase Theorem to non-voluntary exchange (i.e., the government)?

(My example: you give me all your money, and I do not kill you. Perfect bargain, both of us are better off: I get richer, and you stay alive.)

If we do, we produce weird results.

The title is misleading.

Example: two families live near a small road. The positive outcome of having a road is sometimes so good that one of the families will build a road on its own, even though it will only receive a half of the benefit.

A stupid formulaic model is the following:

A road costs \(C\), the total benefit from the road is \(3C\), a family is getting \(1.5C\), and everyone is happy.

When there are 5 families, the benefit must be at least \(5C\).

Note: I am feeling that this logic reverses the cause and the effect. I would believe that the total benefit of the road is always N, the number of families.

Small numbers of people are likely to cooperate, because adding a single participant strongly decreases costs.

If a road costs C, for two parties, each has to pay \(C/2\), for three \(C/3\), the difference is \(C/N - C/(N+1)\). The smaller the \(N\), the bigger the profit.

For large numbers, \(C/N - C/(N+1)\) is very small.

Moreover, for the case when it is possible to “buy less” of a good, if the payoff of the “amount of good” is super-proportional, it is often profitable to pay the shared fee.

The “Error” is the “Prisoner’s Dilemma”.

The issue with the “Prisoner’s Dilemma” is that communication complexity must be 0.

The very reason for the single Nash Equilibrium in this example is that the two criminals:

1. Cannot cooperate (Transaction costs are infinite),
2. Cannot enforce their contract through a court (this is why in reality the criminals have “Thieves-in-Law”).

There is a fundamental difference between private and public goods. For private goods, those who do not participate in purchasing and bargaining still receive the goods. Individuals have an incentive to search for good bargain. If transaction costs are high, then a bargain might be not worth the gain, so this situation is still efficient.

Here he describes a game of bargaining in a large group with zero transactions costs. Interestingly, in this case, there might be different outcomes! And the outcome depends on which party acts first!

The example is the following: The group wants to buy “a good”. According to Coase theorem, in the absence of compulsion and with zero transactions costs, this is an efficient bargain: everyone shares equally.

However, in this case, the “non-provision” is a good threat. Some society members might actually demand ransom for their signature, effectively making their contribution zero or negative. This is clearly not optimal!

Even if the free-riders do not have a definitive say, they can bargain indefinitely. (This is a mathematical statement, for which I do not have a formula to illustrate.) Again, they have a threatening argument of non-participation, and without them, a good cannot be purchased.

When misfits can be punished, collective bargaining works.

Example: “union shop”, “closed shop”, “agency shop” in labour unions.

Sometimes it even works with positive incentives, that is, premiums rather than punishments. For example, sometimes a government pays subsidies to dissenting companies, or pays companies to hire workers.

Groups can only organise in two circumstances:

1. Groups are small
2. There are “selective incentives” (i.e., punishments)

Ethnographic research supports the results of the previous chapter. Primitive tribes usually have very little coercion, not slavery, and split in two when conflicts arise. This is confirmed by modern anthropologists, and also by Caesar and Tacitus.

Contrary to that, large groups never establish order through voluntary cooperation. Autocrats, however, can organise societies quite easily. Sometimes, even “democracies” form after autocracies fall. (Presumably, there is no way to go from a primitive society directly to a “democracy”.)

Question: can libertarianism work in multiple layers of small groups of groups?

Question: the previous chapter says that large groups cannot organise, however Chapter 2 says that if analysed as “large monoliths”, democratic majorities have an overencompassing interest, and thus are more prosperous than autocracies; how do these two claims can be compatible?

Rational ignorance: voter knowledge is a “public good”. Time investment is large, but the payoff is shared among everyone.

He claims that preventing fraud is easy, the government just tells everyone “do not be cheated, buyer beware”, and that’s it.

It seems that this argument has aged really badly.

His other argument is that in societies with a “rule of law”, citizens trust the police and tell them everything, is somehow a little better.

Example: the government sets prices. Then both the seller and the buyer have an incentive to violate the law, and therefore the law is not respected.

The argument in this chapter is kind of better. It is cheaper to enforce the law which is in the public’s mind, justified.

(In other words, while it is very easy to corrupt a democracy by SIGs, it is much harder to corrupt a society which is maintaining laws that are “practically democratic”, that is they represent what the society thinks.)

Question: how to maximise extraction beyond the revenue-maximising tax rate?

1. Confiscate capital,
2. Print money to increase inflation,
3. Borrow money and not pay back.

All three above require a short planning horizon.

(2) and (3) were never used by Stalin.

(1) should, in theory, be impractical, because private owners manage their enterprises better than career bureaucrats. However, Stalin found a way to use (1).

His claim is that by nationalising all capital, Stalin could: (1) collect not just taxes, but all revenue, (2) direct the income into investment instead of consumption. He says that the rate of capital accumulation in the Soviet Union was higher than anywhere else in history.

(I am sceptical of this claim.)

Stalinist Soviet Union had, in some sense, the highest corporate taxes in the world: 100% of income. This made taxing individuals unnecessary, especially since wages were low and prices high, and all set by the government.

Moreover, since taxes on individuals were low, this encouraged overtime work to the unprecedented degree. “Taxation increased productivity.”

Olson is vaguely describing that a lot of data would be needed to be collected, so there are at least two difficulties:

1. Subordinates lie,
2. Data gets distorted as in the game of a “broken phone”,
3. The amount of data is simply huge.

(This place would benefit from many more numerical models of information collection and distortion.)

If we were to construct a model of a planned economy, we would probably model it as a graph, where each node would represent a unit. Units would be operated by workers, and managed by officials. Units which receive/pipe inputs/outputs into one another would be called “serial”, and those running in parallel, “parallel”, in some sense, competing.

Bureaucrats are constrained in their inefficiency.

Serial relationships The “serial” bureaucrats have their own quotas, which they have to meet, so they had incentives to report on each other. (On the other hand, Soviet economy was unique in that there were cases when suppliers could choose buyers, and thus had influence on them.)

Interestingly, the Soviet system had “Gosarbitrazh”, which dealt with about 700 000 cases per year.

In such a system, the actors who have the least influence are, of course, the final users.

Parallel relationships They have “socialist competition”, which in some ways works, but distorts incentives. There were also party members, who had to report department statistics to the government. (Like in China.)

As things become more stable, SIGs start to form, and in Soviet systems they form just as well as in democracies. Moreover, since planned economies consist of large “chunks”, they organise voluntarily much better than in democracies, where there interests groups are large.

But how exactly do those SIGs act?

“Soft budget constraint” is a polite term for a phenomenon when your firm can run at a loss, and the government will cover the losses. The term invented by Janos Kornai in the year 1970.

It is usually the result of the situation when a company’s political influence exceeds its economic efficiency. (In democracies this is called “too big to fail”.)

Soviet Union had counter-market laws, especially the tax system.

But this alone cannot explain the phenomenal level of corruption in the USSR.

Let us remember that the “stationary bandit” relies on his henchmen to collect taxes. When an autocrat collects just the “revenue-maximising” rate, he is interested in minimising the amount of tax collectors, to reduce corruption. When an autocrat is a Soviet-type autocrat, he has to have many tax collectors to manage the system.

These tax collectors have a collective incentive to collude.

There is no economic theory that suggests either rapid or slow privatization can cause inflation.

Partial answer: All transition economies have huge budget deficits, and compensate them with printing new money (inflation).

But why?

Claim: The cause of the communist regimes becoming broke is that taxes were implicit rather than explicit. Implicit taxes require a lot of tax collectors, and they become corrupt and start to demand subsidies, not bring taxes.

The key difference between the defeated WWII countries and the defeated Cold War countries is the speed of liquidation. WWII countries had their SIGs entirely liquidated, Cold War countries had them alive and kicking.

Those SIGs have “internal contradictions”, as Karl Marx said.

Understand how the power dynamics works in democracies. In other words “why some countries are rich and other are poor”.

In even more different words, the stool of the “market economy” has three legs:

1. supply
2. demand
3. ??????

Claim (disputed): Productive markets only work in common cultures. (As in “markets pre-suppose a common consensus, say, religious.”)

Kinds of markets:

1. Self-enforcing (say, market in the street), emerge naturally
2. Socially-contrived (say, carbon quotas), require enforcement

The necessary conditions for a spontaneous market:

1. Gains are significant
2. Trades are self-enforcing
   1. Instantaneous, or
   2. Where withdrawal from trade is a good threat

Markets with distorted prices usually reduce the quantity of trade, but not that much reduce the “gains of trade”. (See the graph, but this should be obvious.)

Since self-enforcing and self-protected markets exist everywhere, it seems that the difference between rich and poor countries is in socially contrived markets.

Observation: Democracies are much better at long-term property enforcement than autocracies or soviet regimes.

Therefore, they can make more and more long-term contracts.

(I think that Olson is not factoring in enough of his Chapter 1 here.)