Reform, Lobbies and Welfare: A Common Agency Approach

Policy makers make policy decisions, which affect the utility of private citizens. The traditional explanation for government intervention in the economy is the existence of market failure. Nevertheless, despite public policy interventions, the economy may fail to reach the efficient frontier. Hence, unless we suppose that efficient policies are not feasible (second and third best arguments), we need a theory of inefficient decisions by policy makers. Therefore the following questions arises: How do policy makers take policy decisions? What is their objective function? The objective of this paper is to verify if policy-makers' preferences for monetary transfers can generate inefficiency. We analyse a policy making process where the policy decisions are a reform and a compensating taxation. The main feature of the reform is that it creates gainers and losers. Redistributive taxation can be used to compensate losers. Formally, the relationship between the citizens and the policy maker is modeled as a common agency game, where the citizens, organized in lobby groups, are the principals and the policy maker is the agent. With the possibility for at most two lobbies, we find that one-lobby equilibrium is inefficient and the two-lobbies equilibrium is efficient. When we check for the Nash equilibrium we find that, non-lobby and one-lobby are not Nash equilibria and two-lobbies is a Nash equilibrium. Finally, the unique Nash equilibrium is robust to the introduction of a political constraint on tax parameters.