Econ 247

1. Econ 247 Principles of Policy Analysis

2. Overview • Markets are a good way to organize economic activities • However, the government often plays a role in today’s modern economies

3. Examples • Governments often interfere in economic activities: • Regulating prices of goods • Restricting trade in certain commodities • Imposing taxes • Banning trade or certain activities • Setting standards

4. Rationales for public policy Market failures: occur when the market fails to achieve the desired outcome (fails to maximize social welfare). When does the market fail? • Externalities • Imperfect competition • Public Goods • Imperfect information • Government intervention can potentially correct market failures

5. Other Rationales for public policy Besides intervention to correct market failures, the government may intervene in markets for • Distributional concerns • Ethical reasons • Political pressures

6. Rationales for public policy • However, public policies can have unintended consequences • Individuals react to the policy in a way that weakens its effect • Other decision makers can be affected • Tradeoffs involved between different policy objectives

7. Economic Systems, Resource Allocation, and Social Well-Being

8. The Economic Problem • Resources are used to produce goods and services to satisfy human needs and wants. • Resources are limited. • Needs and wants are unlimited. Society has to make a decision

9. What, How and for Whom? • Society has to decide: • What goods will be produced using the scarce resources.

10. What, How and For Whom? • Society has to decide: • How to produce them

11. What, How and For Whom? • Society has to decide: • Who gets the goods and services produced

12. Answer Different possible answers The answer will determine the type of economic system.

13. Answer • Solution 1: • Individuals own resources • They freely decide how to allocate their resources in a way that is meaningful to them. A Pure Market Economy

14. Answer • Solution 2 • The government assumes ownership of all resources • The government decides how to allocate them A Pure Command Economy

15. Answer • Solution 3: • A system that combines elements of the pure market and the pure command system A Mixed Economy

16. Resource Allocation in a Command Economy A state planning commission develops a plan that determines production quantities for each major product Resources allocated accordingly to each sector Ministries, bureaus, local and regional planning offices were involved

17. Resource Allocation in a Command Economy Workers assigned to positions according to a planning committee. Often the government committed itself to creating a job to each individual Households allocated a set amount of goods, a system often called a rationing system

18. Problems of Central Planning • Informational Requirements • Planners needed to collect information to determine the quantities to be produced of each good, the technology to use, which resources to allocate and how to distribute the finished goods. • Often shortages and surpluses existed • Problems with pricing • Quality of products suffered

19. Problems of Central Planning 2. Incentives for Efficient Production • Production units run by government officials instead of owners • Workers were paid an amount independent of their true effort • No incentives to put extra effort as the resulting gains will be shared by all workers

20. Resource Allocation in a Market Economy • Resource owners offer them to the best uses • Workers decide how many hours to work. Similarly landowners and capital owners decide where to put their resources • All decisions are coordinated in markets • The market outcome determines the quantity of resources allocated for each use and the price

21. Resource Allocation in a Market Economy • Market Structure • Purely Competitive Markets • Large number of buyers and sellers • Each seller offers standardized product • Product prices free to move up or down • Buyers and sellers must be mobile • Freedom of entry and exit • Purely Monopolistic Markets • One seller • Imperfectly Competitive Markets

22. Surplus Shortage Market Demand and Supply Price $ 9 S D 8 7 6 5 4 S D 3 5 6 7 8 9 10 Quantity

23. Prices as Signals in a Market System • Prices act as signals • Prices inform producers of how much to produce and therefore how much of the resources to be allocated to this use • A change in preferences will result in a price change which guides resource allocation • A higher price results with stronger preferences as the demand curve shifts right. More resources will be allocated to this use

24. Economists’ changing perceptions of Government • Optimal balance of markets and government • Adam Smith and the invisible hand • Government needs to enforce the law and provide basic infrastructure • By 1940 government should play a bigger role • The great depression • Concern for inequality

25. Economists’ changing perceptions of Government • Government as a benevolent social guardian when the market fails: • Decreasing cost industries • Uncertainties and investment • Infant Industry • This gave rise to several regulations e.g.,: • Public sector enterprises • Anti monopoly laws

26. Economists’ changing perceptions of Government • Government Failure: government comprised of self interested bureaucrats • Economics of information: • specific knowledge regarding production technologies is embodied in market participants who are in a better position to make production decisions • Focus on incentive compatible mechanisms

27. Economists’ changing perceptions of Government • Regulatory capture: • An agency regulating a particular industry may end up serving the interests of that industry • Social ties or a source of jobs • Collective action • Lobbies that influence governments decisions are small groups of particular interests • Large groups are less likely to organize because the gains to each individual are small and people free ride

28. Economists’ changing perceptions of Government • Rent seeking: • Government regulation may create opportunities for profit • Resources can be wasted to get this profit • Examples: queuing in lines, bribery, excess investment • Bureaucratic capture: • Once an agency to regulate is established it acquires political power • Self interest of bureaucrats supported by the winners from the policy