[SOUND] Hello. Welcome back. In this next to the last lecture of the course, I would like to discuss some issues which are rarely included in syllabuses of public economics courses, which is a pity because these issues are quite essential for our proper understanding what makes for good governance and what makes public sector governance more or less efficient. In public economics, governments are usually perceived as black boxes which gobble up, consume, tax payer's monies and dispense regulations, public goods, and services. Today I invite you to look inside these black boxes to see what's happening under the hood. And to discuss the incentives of government officials at all levels of government hierarchy, from the very top from chief executives, senior administrators, all the way down to rank and file public servants. I was arguing in the first lecture of this course that governments are public agencies set by societies to regulate economies, prevent externalities, supply public goods and services. At the same time, of course, governments are very complex, multi-layer organizations with subordination, hierarchy, flow of information, chain of command, and so forth. And these two features of government - the first one is an agency serving the society at large and the second one a complex hierarchy, an organization - pose two types of agency problems which I want to discuss at length in this lecture. The first one is the external agency problem which occurs between governments and societies at large. These are principal-agent setups and in this setups societies are principals and governments are agents of these principals. The internal agency problems occur inside government. And there are plenty of such problems. Such relations occur between senior administrators, chief executives, and their subordinates, rank and file public servants. In this lecture, we will discuss both types of these agency problems and our main interest will be in performance of agents in the settings and the incentives that drive such performance. I would like to start with external agency problem. And we will discuss it from two perspectives. These problems are resolved by different types of accountability, and the distinction is between what is known as accountability ex post and accountability ex ante. To give you an initial understanding of what these types of accountability are, in the case of accountability ex post societies retain services of chief executives. And they observe their performance, they gauge their performance, and at the end of the term for which the executive is retained they decide whether this relation has to be continued or terminated. And that, of course, will depend on society satisfaction with what has been achieved so far. In the case of internal accountability, societies have to endorse any government actions before these actions are taken. So, we'll discuss both of these settings in turn and let's start with accountability ex post. To discuss the accountability ex post in external agency I would like to use a model, or a setup, if you will, which was proposed about 30 years ago by american political scientists Baron and Ferejohn. Of course, it's a very stylized model but still it gives us a good grasp on what is happening between government, and society and what we can expect from accountability ex post. The main lesson of this model will be that accountability ex post does not provide 100% satisfactory solution of external agency problem. And we will see what the quality of such solution depends on. So, here is the model. Let's assume that the executive is expected to exert some efforts. And the society is interested in her efforts because that will make society better off. The society's payoff is u(x) and it's proportional to x. And this proportionality coefficient theta, for the time being is considered being fixed, given and known to both parties and then we'll relax this assumption. Now, you can also think about x as a portion of a resource that the executive controls. And again, his duty is to devote this resource completely to the society's needs but, in fact, he can use at least a portion of this resource to his own need because of the imperfect solution of external agency problem. v(x) is the executive's payoff and it comprises the balance of the resource that the executive controls and that he keeps to himself, or he saves the utility of his efforts. And the second component of the executive's payoff is what is denoted by capital R. And this is the so-called ego-rent. Ego-rent comprises the executive salary, usually quite high, but not exceptionally high. We will get back to that later in this lecture. It also includes his perks and the appreciation of power, prestige, and everything else. This is essentially what makes people to strive to take high level public offices. Now, the critically important thing is to decide what the re-election threshold will be. The society sets this threshold, and it's purpose is to enable the society to decide if the relations with the executive has to be continued or terminated. If the executive delivers the utility u(x) above or equal to this threshold, then the society will be happy to continue its relationship in the agency setting with the very same executive. If u(x) falls below u-star, then this relationship will be terminated. Now, the society certainly doesn't want to set this re-election threshold too low because in that case, the executive will keep a lot of rent at the expense of society. But it would be, perhaps, unrealistic to expect that x should be equal to 1 in which case u(x) will be equal to theta because, in that case, the executive will rationally prefer to rip the society off of this resource entirely. And, of course, in that case, he would have no hope to be reelected, but there will be a significant one-time payoff which, of course, equals to 1 plus R, and given that the society has set its re-election threshold unrealistically high, for the executive that would be the preferred choice. Of course, the society would fire this executive for gross dereliction of duty. But the next one, who will replace this one, will do exactly the same, and then there will be a permanent replacement of executives and each and every of them will be delivering very poor services simply because the society holds its public servants to unrealistically high performance standards. So, let's be, on the one hand, let's be optimal but, on the other hand, let's be pragmatic. And let's choose this re-election threshold u-star, such that if this threshold is met year after year after year in which case the executive would earn in the first year, in the first period this utility, and then the very same utility would be earned in the second year, but it will be multiplied by delta, which is the discount coefficient. Delta squared next year, so on and so forth. And this is a geometric progression. And it summarizes to 1 over 1 minus delta times the one period utility. So, let's make sure that with this re-election threshold, this life long discounted utility is not less that what the executive can do if he rips the society off this resource entirely and serves for just one year. And the optimal re-election threshold then can be found from this equation when these two payoffs are just equal to each other. Well, perhaps, to be on the safe side, make u-star infinitesimally higher than it takes to satisfy this equation. But for simplicity's sake, let's assume it would suffice to take u-star exactly satisfying this equation. And that gives me the optimal re-election threshold u-star equals theta times delta times 1 plus R. And I should also mention that this formula is correct if R is not too large. And I invite you to think why this is the case and what would be the optimal re-election threshold if R is very high. And also please notice that in this case the executive's payoff equals 1 plus R, but this payoff is not earned as a result of complete dereliction of duty in one period, it earns after many years of public service where society's expectations, and I should stress that optimal expectations, about the executives performance are met. So, this is basically what the accountability ex post model is all about. And I would like to now to draw your attention to some factors that affect the quality of the principal agent solution by accountability ex post. Well, first of all it's important to conclude that the threat of termination of the agency relationship in and of itself does not ensure complete fulfillment of duties. And there is still some rent that the society allows the executive to keep simply because of the imperfection of accountability ex post. Second, when we have a look at this model, we see that the society's re-election threshold, the society's utility actually positively depends on delta, which is the discount coefficient, and on R which is the ego-rent. And both of that makes perfect sense. If ego-rent is high, if an executive is entitled to more available perks, that, of course, makes him being in his office more valuable. And that, all else equal, precludes this executive from doing something that would make the society to terminate the relationship with this particular individual. And delta, high delta also means that the accountability ex post model delivers better performance results. And that can be interpreted, for example, as an indication that more frequent re-elections, in which case delta would be higher, of course, makes all else equal the government performance of higher quality because it makes it more valuable for executives to stay in office for more than just one short period. And, finally, I would like to draw your attention to something that adversely affects government performance and this is government transparency. Let me get back to the model by Baron-Ferejohn and to this formula, whereby the utility of the society is x, which is the effort of the executive times theta which is some multiplier. And up until this point, we thought that theta was fixed and given to both parties. Now let's assume that this is no longer the case and, in fact, theta is a random shock. And as such, it's known and observable by the government, but it's not known or at least not fully known to the society. And that creates an informational asymmetry between government and society. And this asymmetry is particularly painful for the society and it's particularly costly to the society when there is a lack of government transparency. Let's think what might happen in the case when government performance is affected not only by government's effort but also some random shocks. Quite obviously that weakens the society's control over government performance and we can expect that quality of the ex post solution of the external agency problem will suffer as a result. And that is, of course, indeed the case. Why? Because the executive is still guaranteed his full reservation payoff, 1 plus R, but this time he can obviously do quite a bit better. Why? Well, because if circumstances are good, then in that case, the executive could easily meet the society's expectations and reappointment threshold and at the same time, he would exert much less efforts or, perhaps, would appropriate much more public resources. And he would do it with full impunity, because the society's simply unaware that circumstance favor such activities. Well, of course, if circumstances are poor, then in that case, the executive would give up and will use all of the resource completely and will still guarantee to himself this reservation payoff 1 plus R. But this opportunity to keep some additional rent and this rent occurs exactly as a result of informational asymmetry, so we should call it the informational rent. That rent makes the executive better off and, of course, that can only happen at the expense of the society and, hence, a lack of government transparency which results in such informational asymmetry leaves the society worse off. So, a very natural policy implication of this analysis is that government transparency and everything that contributes to government transparency are very valuable for the society and that, of course, includes the freedom of media and the freedom of information. [SOUND]
