Competitive federalism
The Tiebout strategy to endow jurisdictions with the optimality conditions for perfect competition consists in getting rid of both the consumers’ and the politicians’ moral hazard behaviour.
On the one hand, in this decentralization model the preference revelation problem, which is typical of public goods, is solved. Inside smaller communities, the politicians’ information costs are drastically reduced, so that the asymmetric information problem between residents and elected representatives is overcome. Buchanan’s optimality condition for public goods subject to congestion, with exclusion by a positive price, is a more general revelation mechanism of individuals’ preferences than the Samuelson condition. Once fully mobile individuals have autonomously chosen to settle in the most preferred lower-level jurisdiction, the correct preference is elicited from residents by a local government. On the other hand, similarly to ‘price-taking’ firms in competitive markets, the local jurisdictions of the Tiebout model are ‘utility-taking’, as the consumer - no longer the central government - is the principal of the local government agent. Since the decision to settle in a certain jurisdiction corresponds to a willingness to ‘buy’ a certain package, this preference expressed by mobile individuals replaces equilibrium prices as the signal of efficiency. The assumption is that local governments efficiently organize the provision of public goods by taxing mobile factors with benefit-related levies. Individuals are then informed of the cost of consuming different levels of public goods and pay the exact amount of taxes for the benefits they receive.The so-called ‘yardstick competition’ approach takes a step in the direction of making the individual the principal of the local government agent. By eliciting preference revelation from consumers, an increase in the efficiency of public goods provision is expected.
Granted that lower-level jurisdictions are sufficiently similar to be comparable, voters may use information on other jurisdictions as a yardstick to evaluate their government’s achievements. The correspondence between market competition and inter-jurisdictional competition is achieved when individuals - in addition to the exit option both from the market and from the jurisdiction - also enjoy the condition of freedom of exit from a jurisdictional government. They get rid of public policies they dislike by voting against the party - or the coalition of parties - which has implemented them, instead of abandoning the jurisdiction (Salmon, 1987). In the Tiebout model, the ‘voting with one’s feet’ mechanism fulfils the objective of no longer subsuming the jurisdictions’ public good provision to voting majorities manipulated by political parties, but subjecting it directly to the scrutiny of the market by means of the exit option. On the contrary, in the yardstick competition approach, voting against the government corresponds to making recourse to ‘voice’ (Hirschman, 1970), which has a greater generality than exit and does not require the hypothesis of zero cost mobility.Given the objective of convincing the non-sympathetic electorate to join its own political side, opposition political coalitions governing similar lower- level jurisdictions struggle to be recognized as the best performer. The reciprocal monitoring among the competing governments of lower-level jurisdictions not only solves the typical agency problem of asymmetric information between government and citizens, but is also alleged to have the same efficiency-enhancing effect of fiscal competition. Moreover, similarly to the horizontal competition across governments of lower-level jurisdictions, vertical competition between federal and local elected representatives sharing the same area of responsibility may discipline lower-level politicians aiming at upper-level governmental positions.
The economic analysis of yardstick competition also relies upon the unexpected utility theory of rational choice.
The transaction utility theory (Thaler, 1985) builds upon the so-called ‘reference point effect’. In evaluating political issues, individuals may recognize a reference point - a standard - and are influenced by it. Whenever the goal of economic efficiency is associated with compliance with a certain standard (for instance, a balanced public budget or a certain employment rate), the individuals of one jurisdiction - by looking at the other jurisdictions’ performance - might attach a negative (positive) utility in the event that their jurisdiction’s performance is worse (better) than the others. The conclusions drawn from the comparison will dictate their behaviour in the polls. The main difference between the yardstick competition and the transaction utility theory approaches is that in the latter the behaviour of both the politicians and the voters is biased by the reference point effect, while in the former there is an information asymmetry favouring the politicians, as voters are unaware of all circumstances determining the respective performance of governments of similar jurisdictions.Since the degree of similarity among lower-level jurisdictions is often low, the moral hazard problem raised by asymmetric information is a major obstacle. The specialization in legal services pursued by the state of Delaware is an interesting application of the yardstick competition approach to subsidiarity as an efficiency-enhancing mechanism. The Delaware politicians chose to boost tax-raising by giving the incentive to private companies looking for a reduction in negotiation and litigation costs to establish their legal location in their state through the strengthening of the supply of legal services (Romano, 1987). It has been alleged in the literature that excessive deregulation has been produced by courts handing down sentences that are aimed at pursuing efficiency in company law by heeding company interests. Since juridical positions in the United States are elective, and the lawyers hired by the managers of the companies often become judges and vice versa, the thesis has been put forward that this outcome depends upon the personal relationships between managers and judges. The indication is that the moral hazard problem stems from the perverse functioning of the agency relationship between mobile companies and public officials, whatever the level - central or local - of government.