1. Economics Workshop Strategy Unit
1-3 February 2006
Sandeep Kapur

2. WORKSHOP OBJECTIVES
To provide rigorous but non-mathematical training in economics, enabling participants to
develop a simple but reliable toolkit for economic analysis
practise its application using concrete problems
apply economic theory to their own work

3. Introduction to Economics Concepts and Tools

4. Basic Concepts
MICROECONOMICS: study of decisions made by consumers, producers, and their interaction in specific markets
MACROECONOMICS: the big picture – emphasizes interactions in the economy as a whole

5. Basic Concepts POSITIVE ECONOMICS tries to explain behaviour
NORMATIVE ECONOMICS prescriptions, usually based on value judgment

6. The central questions What goods and service to produce?
How to produce? (choice of technology)
For whom? (income distribution)
FREE MARKET ECONOMY
what, how & for whom decided by prices, incomes, wealth
COMMAND ECONOMY
central authority directs use of resources

7. Degrees of government intervention differ..
Cuba
- China - Denmark - UK - USA -
Hong Kong

8. Scale of government Spending as share of national income (%) 1880 1930
1960
2004
Japan 11 19 18 37
USA 8 10 28 36 UK 24 32 43
Germany 31 47
France 15 35 53
Sweden 6 57

9. The Production Possibility Frontier
Maximum quantity one good that can be produced, given quantities of other goods being produced
A, B, C efficient
(on the frontier)
D, E inefficient
(inside the frontier)
F, G unattainable
(outside the frontier)

10. Basic Concepts
OPPORTUNITY COST of any good or service
Quantity of other goods sacrificed to get one more unit of this good
The underlying notion of trade-offs.

11. Economic Models
MODEL
Deliberate simplification of reality
like a map
DATA
Time Series
Cross-Section
Panel Data

12. Tools: Visualizing data
A scatter diagram

13. Tools: Interpreting the data+
Bus fare
Bus Revenue
It appears that higher bus fares lead to higher revenue…

14. … but it might not be true
Suppose the two clusters are from two different time periods – what might that suggest? +
Bus fare
Bus Revenue
High tube fare
Low tube fare

15. Revenue = fare x journeys
Tools: Modelling
Bus revenue depends on bus fares
Revenue = fare x journeys
Number of bus journeys depends on bus fares
But also on other things
price of other modes of travel (tube fares)
reliability relative to other modes of travel
relative comfort and perception of safety

17. How Markets Work Demand, Supply, and Price Adjustment

18. Market
DEMAND quantity buyers wish to buy at each price
SUPPLY quantity producers wish to sell at each price
MARKET
any arrangement in which prices adjust to reconcile buyers and sellers intentions
EQUILIBRIUM PRICE the price at which market clears (i.e. quantity demanded = quantity supplied)

19. Market PRICE ADJUSTMENT Equilibrium price clears market Supply curve
Demand curve
Equilibrium
Quantity
quantity
PRICE ADJUSTMENT
Equilibrium price clears market

20. Price Controls
Suppose government sets minimum price above market clearing price
Price
Controlled price
Supply curve
Equilibrium price
Demand curve
Examples incl
CAP
Minimum Wages
Rent Control
Equilibrium quantity
Quantity

21. DEMAND IN DETAIL elaborating on the ‘other things’
Demand curve shows relation between price of a good and quantity demanded of that good.
How does demand change when
1 price of a related good changes?
substitutes vs complements
2 consumer’s income changes?
normal goods vs inferior goods
3 tastes change?
role of fashions and fads, culture

22. COMPARATIVE STATICS (effect of changing the ‘other things’)
Suppose income rises, increasing demand

23. SUPPLY IN DETAIL elaborating the ‘other things’
How does SUPPLY of a good vary when
technology improves?
input prices change? energy, labour, capital
3 regulation imposes extra costs?

24. COMPARATIVE STATICS
Suppose technical breakthrough raises supply…

25. COMPARATIVE STATICS
An important difference
If demand shifts, equilibrium price and quantity move in the SAME DIRECTION
If supply shifts, equilibrium price and quantity move in OPPOSITE DIRECTIONS

27. Introduction to Economics GROUPWORK
1 Are the following statements positive or normative?
(a) Higher tax rates cut revenue from tobacco taxes
(b) Poor countries get an unfair share of world income
(c) Smoking is antisocial & should be discouraged
(d) Airbus needs public support
(e) Airbus deserves public support
(f ) Airbus is a good investment for Britain

28. GROUPWORK
The price of crude oil increased from $2.90 to $9 per barrel in 1973, in a coordinated move by OPEC members.
(a) How did the OPEC members manage to raise the price? Show using a supply-demand diagram for the oil market.
(b) What happened to the demand for coal and the price of coal? Show using a supply-demand diagram for the coal market.
(c) What happened to the demand for fuel-guzzling cars?
(d) What happened to supply and demand for oil eventually?

29. GROUPWORK 3 The following data describe price and output of a product:
(a) Plot a scatter diagram
(b) “Higher prices make firms raise output.”
“People buy less when prices are higher”
Does the diagram shed any light on these statements?
Could both be correct? Explain.
Year
Price
Output
1985
100
101
1986
104
107
1987
108
112
1988
122
1989
118
128
1990
117
1991
1992 98
103

31. Elasticity of Demand and Supply

32. Price Elasticity of Demand
Measures the price sensitivity of demand
% change in the quantity demanded
% change in price
Elastic demand: sensitive to price changes
Inelastic demand: relatively insensitive
Depends ultimately on substitution possibilities

33. Implications for Revenue
Price
In demand is elastic,
a fall in price raises the quantity demanded by a greater percentage than the price. Thus revenue rises as price falls
In demand is inelastic,
a fall in price raises the quantity demanded by a smaller percentage than the price. Thus revenue falls as price falls
Price
Quantity
Quantity

34. Example Brazil coffee exports 1993 1994 1995 price (1995 US $/lb) 0.9
2.0
2.1
export quantity (1990 = 100)
113
102 85
Revenue
204
179

35. Other elasticities Cross price elasticity of demand
for good i with respect to changes in price of good j
% change in the quantity demanded of good i
% change in price of good j
Positive when goods are substitutes
Negative when goods are complements

36. Other elasticities Income elasticity of demand
% change in the quantity demanded
% change in real income
Normal good have positive income elasticity of demand
Greater that 1 for luxury goods
Less than 1 for necessities
Inferior good have negative income elasticity

37. Price Elasticity of Supply
% change in the quantity supplied
% change in price
Supply elasticities are usually positive

38. Theory of Consumer Choice
A consumer has preferences over different goods and services
Budget constraint describes the different bundles that the consumer can afford given prices and income
Consumer makes herself as well off as possible, given the budget constraint

39. The Effect of Relative Price Changes
The effect of price changes
Substitution effect: you buy less of things that have become relatively expensive.
Income effect: the decrease in real income due to price increase may reduce purchases of all goods.

40. Impact of wage rates on labour supply
The two effects may work in oppositive directions…
As wage rates increase
workers want to work longer hours because work is relatively more attractive (substitution effect)
workers may want to work less because higher incomes make them want to consume more leisure (income effect)
The net effect could go either way

41. What government does Why intervene?

42. Government Intervention
Intervention in free markets is usually motivated by
Equity considerations
Efficiency considerations
Ethical or moral arguments

43. EQUITY How fair is the distribution of goods and services?
Of course, fairness is a value judgement
In principle, we can distinguish between
Horizontal equity: equal treatment of equals
Vertical equity: different treatment of different people to reduce effects of inequality

44. Equity of Allocations Allocation: a description of who gets what
Starting from A, a move to E or F reflects a decrease in equity

45. Efficiency of allocations
Relative to initial point A
B is better for all (and C is worse)
D is better for one, and no worse for other
B & D are said to be Pareto improvements on A

46. Economic Efficiency
An allocation is Pareto efficient (given tastes, resources and technology) if it is impossible to find another allocation that makes someone better off and nobody worse off.
There can be more than one Pareto efficient allocation, and
even inequitable allocations may be Pareto efficient

47. Are Markets Pareto Efficient?
Key Questions
Do free markets lead to Pareto efficient outcomes? Always?
If sometimes not, why not?
What are the implications for policy?

48. Competitive Markets In competitive markets
there are many firms, each too small to have any influence on market price (they are ‘price takers’)
competition ensures prices are close to the marginal cost of production (marginal cost measures the opportunity cost of producing another unit of the good)
of course, this assumes no tax or other distortions

49. Competitive Equilibrium & Pareto Efficiency
In undistorted, competitive markets
consumers align their consumption choices to market prices
prices equal the marginal cost of production
so that there is no way to reallocate resources to generate a Pareto improvement
PUNCH LINE: Competitive equilibrium is Pareto efficient (The Invisible Hand Theorem!)

50. AN IDEA If indeed markets are efficient
rely on markets to achieve efficiency, and
confine government intervention to redistribution
However markets may not always be efficient
Market Failure: a circumstance in which equilibrium in free markets fails to achieve an efficient allocation

51. Group Work: Efficiency and Equity…
Government intervention in the economy is pervasive. For each type of intervention listed below identify the possible rationale. Is it primarily
(Pareto) efficiency considerations?
a desire for greater equity?
something else?
Income tax
Taxation of petrol
Windfall tax on utilities
Regulating utility prices

52. …Group Work Regulating discharge of sewage in the Thames
Legislation against insider trading
Banning the use of cocaine
Unemployment insurance
Making primary school compulsory
Maintaining an army
Running the NHS
Running the Post Office
Is there a trade-off between equity and efficiency?

53. Market Failures Why intervene? How to intervene?

54. Sources of Market Failure
Externalities
Public goods
Imperfect competition
Imperfect information
We will look at each of these in turn

55. MARKET FAILURE: Externalities
EXTERNALITY
A circumstance in which an individual's choices affects others' utility or productivity
the effect is direct (not through market or prices)

56. Externalities: examples
Adverse consumption externality: smoking
Beneficial consumption externality: painting the exterior of your house
Beneficial production externality: bees and orchards
Adverse production externality: pollution

57. Why Externalities Matter
THE ESSENTIAL PROBLEM
Market mechanism aligns private costs and benefits
Externalities imply divergence between social and private costs (or social and private benefit)
If divergences exist, should not expect socially efficient allocations

58. Adverse Production Externality
For social optimum, social marginal cost = social marginal benefit
At free market equilibrium E, output is higher than social optimum Q*
SOLUTION 1 (Pigou). Corrective taxation

59. Property Rights Solution 2 (Coase)
Assign property rights and let people trade these rights in ‘pseudo-market’
Initial assignment affects distribution but gets an efficient outcome
This solution does not work if there are high transactions costs or free riding
Efficient quantity is Q*

61. MARKET FAILURE: Public Goods
Examples: national defence, safe streets, TV signal
CHARACTERISTICS
NON-RIVAL CONSUMPTION: my consumption does not diminish what is available for you
NON-EXCLUDABILITY: impossible or too costly to prevent people from consuming it

62. Public Goods CONSEQUENCES
Free-riding: difficult to make people pay for use
And may not be efficient to charge for use
In general, markets cannot provide public goods
SOLUTION
Public provision, financed through taxes
Note that government needs to ensure right quantity, but does not need to produce it itself

63. MARKET FAILURE: Imperfect Competition
The essential problem of monopolies
with market power, monopoly price exceeds marginal cost,
leading to Pareto inefficiency
importantly, inefficiency lies in the restriction of output
Solution must somehow align price to marginal costs

64. MONOPOLY: Solutions
Solution 1. Nationalize (politically not very feasible)
Solution 2. Break monopoly (eg anti-trust action in US)
However, no good for ‘natural monopolies’ (where strong economies of scale make a case for preservation of monopoly).
And in some sectors monopoly is good for R&D, or for internal coordination.

65. MONOPOLY: Solutions
Solution 3. Regulate Prevent abuse of monopoly power through price and non-price controls (UK approach) Practical issues: when is regulation necessary? What form?
Solution 4. Nurture competition Encourage new entrants, (but will they enter and will it only lead to cream skimming?)

66. MARKET FAILURE: Imperfect information
Information is not perfect: often there is asymmetry of information between buyers and sellers.
This leads to the problems of
adverse selection
moral hazard
Resulting in ‘incomplete markets’ or even ‘missing markets’

67. Adverse Selection
Occurs when individuals use their private information to accept or reject a contract or transaction. E.g., those who know themselves to be careless buy insurance more readily.
If so, insurance company finds itself insuring a bunch of careless people (an ‘adverse selection’ of the population rather than an average selection).
In extreme cases, the market may collapse altogether, a case of ‘missing markets’.
SOLUTIONS: mitigate informational problems or provide goods directly

68. Moral hazard
Occurs when the contract changes itself changes behaviour. E.g., once you have bought insurance, the incentive to be careful is weakened.
Greater carelessness increases risk of loss to the insurance company: this is moral hazard
A partial solution
Insurance company forces you to bear some risk (excess payments or coinsurance) to maintain incentives to be careful.
In extreme cases, private markets may not provide any insurance (unemployment insurance?)
SOLUTIONS: Regulation, direct provision

69. Inefficiency due to Strategic Interaction
Individual optimization does not always result in the best social outcomes
Country 2
No nukes
Nukes
8, 8
1, 12
12, 1
2, 2
Country 1
More generally, the ‘tragedy of the commons’
SOLUTION: coordinate individual choices through agreements

70. Government Failure
However, we must beware of the possibility of government failure.
For instance, the possibility that governments may face the same informational constraints as markets.
If so, government intervention may just replace market failure with government failure

71. Group Work: Pollution control
You are the National Rivers Regulator, tackling the problem of a chemical firm that is polluting the Thames
If everything could be quantified and valued, show in a diagram how a pollution tax can induce the firm to behave in a socially efficient manner.
Instead of the tax you offer the firm a pollution quota (specifying the maximum pollution it can discharge in any year). Show the size of the quota in the diagram. What difference does it make to the efficient quantity of pollution?
Now suppose information is harder to come by. As the regulator, you are not entirely certain about the firm's cost curve. Does this affect your choice between tax and quotas?
Lastly, suppose there are two chemical firms discharging into the river, one cleaner than the other. Is it better to
set a pollution tax? (same rate per unit polluted for both?)
set each a quota?
auction pollution quotas?

73. Public Spending

74. Public Spending Government expenditure: around 40% of GDP
Social insurance: contributory benefits such as unemployment, sickness, pensions benefits
Equity: non-contributory benefits, such as income support, housing benefit, family support
Merit goods: what society believes all should have (externalities or paternalism): benefits-in kind, education, health
Public goods: law and order, defence
The big three – social security, healthcare and education – account for 3/5 of the total.

75. Health care

76. Health Care: a merit good?
Sources of muddled thinking
an emotional issue
is health a basic right? But so is food
is health care a commodity like any other? like cars, houses, etc.

77. Health Care: the issues
Is a private market for health care efficient?
Is it equitable?
Is public production and allocation more efficient? More equitable?
Efficiency
macro: what fraction of GDP on health
micro: how to allocate resources within system
Equity: but of what?

78. Health Care: the product
Health care is only an input. Output -- improved health outcomes -- also depends on diet, environment, lifestyle
Does health care reduce suffering? prolong life? improve life?
And how valuable is improved health? Impact on output, earnings, income? Impact on happiness

79. Why intervene in health care
Would a private health care market be efficient?
Imperfections in competition
Imperfections due to asymmetric information and insurance
Externalities and public goods aspects
In addition to efficiency issues
equity issues
ethical issues

80. Imperfect competition
Would a private health care market be perfectly competitive?
monopoly power of medical associations
market power of drug companies
Possible solutions
Regulation
Countervailing power (say, drug purchases by the NHS)

81. Imperfect information
Do people know if they are ill? What treatment do they need? What is available?
Here seller (doctor) knows more than buyer
technical complexity of information
patients' inability to weigh alternatives
high cost of errors
In sum, this is hardly rational consumer choice
Solutions: provision of information and regulation but both are costly
Public provision?

82. Problems with Health Insurance
Pattern of demand: small probability of major expenditure
Usually buy insurance in such situations but insurance markets suffer from many problems
adverse selection: attract especially sick
moral hazard: tendency to ‘over-treat’
correlated risk are hard to insure: epidemics
missing markets for congenital problems
Can intervene to reduce these problems, but causes other problems.
Social insurance?

83. Externalities and public good
Problem: Communicable diseases are a negative externality
A solution: to subsidise treatment
In general, the public good aspect of basic healthcare

84. Other reasons for intervention
Equity arguments
Moral and ethical arguments
babies, organs should not be sold

85. How to intervene?
EFFICIENCY: who should PRODUCE health care? private, public, or mixed production?
Equity: how should we PAY for it?
tax (payments based on ability or need?)
tax + private (help for the poor?)
private insurance (compulsory?)
Should production and finance be handled together? e.g. health maintenance organisations

86. Other questions Macro-economic issue
How much should we spend on health? rising cost of health care
ageing population
more sophisticated (and expensive) treatment

87. Health care in the UK: case notes
THE PATIENT: NHS
GPs provide primary care: guide and gatekeeper
Since 2003, Foundation Trusts, with financial and managerial autonomy run hospitals
Primary Care Trusts purchase hospital care, community services
Strategic Health Authorities to oversee Primary Care Trusts and NHS Trusts
Department of Health

88. THE CASE HISTORY Universal and virtually free access Publicly financed
Good health outcome
Cheap: expenditure is 7-8% of GDP,
But rising (up by 70% in real terms , due to bulges in birth rate in post-war period, ageing population & new, costly treatments)
A recurrent crisis of confidence: queues, alleged inefficiencies

89. Spending per head, US$PPP Spending, per cent of GDP
Health Spending, 2001
Spending per head, US$PPP
Spending, per cent of GDP
Australia
2350
8.9%
France
2561
9.5%
Japan
1984
7.6%
Germany
2808
10.7% UK
1992
USA
4887
13.9%

90. DIAGNOSIS? Inefficient or under-funded? If inefficient, why?
skills shortages?
bureaucratic inefficiency?
absence of choice for patients?
If under-funded,
more public money or private resources?

91. PREVIOUS TREATMENT 1989 White Paper called for an ‘internal market’
invisible hand rather than central control
separation of funding from provision: purchaser can buy from competing providers
GP fund-holders to manage own budgets
Hospital Trusts, with greater managerial control and financial autonomy
Were the objectives genuine, or just a response to fiscal crisis?

92. SWITCHING PROTOCOL Prior to 1991, central planning
: quasi markets
: move away from markets
2003-: competition and choice

93. LONG-TERM CARE More public money or is privatisation inevitable?
Will this create a dual structure, for rich and poor? Implications for life expectancy?
Private health care currently cheap (residual use only, complicated treatment done by NHS, high number of young in privately insured, low cost of medical services in the UK), but will this last?

95. Group Discussion: Education
Identify the salient characteristics of education as a commodity. Do you consider it to be a ‘merit good’?
Do you expect private markets for education to be efficient? Identify reasons for any market failures.
Government involve often generates its own inefficiencies. Identify reasons for any government failures.
Private markets for education may well be inequitable. Should we worry about this?
‘If a university degree has any worth, individuals will be prepared to pay for it. This makes a case for more private finance in higher education.’ Comment.

97. Government Failure

98. Public versus Private Sector
When comparing public with private sector, it is important to remember that
public sector losses were sometimes intentional
cost structures differ: Post Office vs private couriers

99. Is the public sector inefficient?
Evidence
Private sector firms are more efficient PROVIDED they operate in markets with strong competition
Key issue: not ownership, but severity of competition (or competition policy)
E.g., many UK utilities improved in RUN-UP to privatisation, while they were still in public hands
But this is not to deny that there have been serious inefficiencies

100. Agency theory and incentives
Imagine a project where
the agent's effort affects probability of success
effort is unobservable or hard to measure
If so,
the principal needs to provide incentives (carrot or stick) to induce effort
without incentives, individuals may slack-off
Lesson: incentives matter

101. Why is the public sector less efficient?
1. The incentives problem
At the organisational level: no fear of bankruptcy, no competition
At the individual level: not enough carrot (relatively fixed salary) or stick (relative security of tenure)
In sum, incentive structures are relatively flat
Why not use better incentive schemes in the public sector?
Mostly because measuring success is harder due multiplicity of objectives and poor information
2. Institutional aspects: what DO civil servants do?

102. Lessons for policy makers
Market failure does not make an automatic case for intervention (or a helping hand)
Sometimes government intervention makes matters worse. Informational problems affect both public and private sectors.
regulation may have perverse effects (fumbling hand)
vulnerability of civil servants to rent-seeking behaviour (grabbing hand)
Weigh existing inefficiencies against risk of government failure

103. Industrial Policy Correcting market failures

104. INDUSTRIAL POLICY
Central idea: market failure calls for an active role for the government
Based on the idea that intervention can
Correct failures in markets for knowledge
Assist in the diffusion of new technologies
Correct for excessive risk aversion
Circumvent coordination failures, etc.
However, the possibility of government failure

105. Research & Development
PROBLEM: Inventions are a public good, so that unregulated markets may not produce enough
THREE SOLUTIONS
Patents: confer time-bound legal monopoly on the inventor
Procurement: use government research labs e.g. defence
Patronage: provide subsidies to universities

106. New technologies and standards
Problem: uncertainty about new technologies and standards may cause
lock-in in to poor standards
delays in adoption
Solution: guide technological choices?

107. Risk Problem: Markets may display excessive risk aversion
Collectively, society can pool risks across projects & spread risks across population
Solution: underwrite private sector losses? venture capital?

108. Coordination of economic activity
Location externalities and new lessons in economic geography
Sunrise industries: correct deficient incentives to acquire skills and imperfection in markets for loans to new firms
Sunset industries: managing the transition: prevent survival of an inefficiently large number of firms

109. Cost-Benefit Analysis

110. COST-BENEFIT ANALYSIS
Analysis of costs and benefits: useful for
Capital projects
Policy and programme development
Use or disposal of existing assets
Environmental standards, health and safety
Procurement decisions

111. THE PROCESS Justify action and set objectives
Appraise the options including the ‘do minimum’ and so-called politically infeasible ones Identify costs and benefits of each option
Adjustments
non-market impacts
risk and optimism
distributional impacts
Develop and implement solutions
Evaluation

112. (Social) Cost-Benefit analysis
FORMS OF APPRAISAL
Financial Appraisal
Compare revenue with costs, as private firm does
(Social) Cost-Benefit analysis
Evaluate costs and benefits of each option, including costs and benefits that the market does not value
Cost-effectiveness analysis
If benefits are hard to evaluate, compare the costs of achieving some target level of benefits
Multi-criteria analysis
Computed the weighted score for each option based on its performance on defined criteria.

113. OPPORTUNITY COST OF CAPITAL
SOME TECHNICALITIES
TIME PREFERENCE
People prefer £1 today to £1 tomorrow
demand a premium to postpone consumption
OPPORTUNITY COST OF CAPITAL
cost in terms of opportunities foregone
rate r at which you borrow
DISCOUNTING AND NET PRESENT VALUE
What discount rate should we use?
INFLATION erodes future values
either all values real or all values nominal

114. Decision rule: Net Present Value Criterion
Forecast the cash flow generated by the project over its lifetime
Assess opportunity cost of capital, and discount future cash flows
Calculate the net present value (NPV): sum of discounted net flows
Decision Rule
ONE OPTION: Invest if NPV is positive
MANY OPTIONS: Invest in project with highest NPV
All this is easier said than done

115. SOCIAL COST-BENEFIT ANALYSIS
While private sector cares about profits, government must consider a larger set of benefits and costs
The government uses the Net Present Value criterion but, to the extent social benefits and costs diverge from private benefits and costs, estimates of social NPV could differ
Social rate of time preference may differ from market rates of interest

116. VALUING NON-MARKET IMPACTS
Evaluate non-market consequences
externalities, including environmental ones
consumers’ surplus
saving of time
saving human life (‘prevented fatality’)
possibilities of catastrophic risk
Often hard to value these. Can use
Willingness to Pay (WTP)
Willingness to Accept (WTA)

117. Macroeconomic effects
Some caveats
Macroeconomic effects
Need not make allowances for broader effects, such as tax flow-backs, savings in benefit payments, etc. These may happen even if the proposed project is rejected and some other is accepted
What prices should the government use?
Best to use MARKET PRICES. The use of so-called ‘shadow prices’ can be justified only if there is severe market failure.

118. What if the project has irreversible consequence?
Other issues
What if the project has irreversible consequence?
Be cautious. Raise the threshold of acceptance for a project to compensate for the irreversibility.
Distributional impact
see how costs and benefits affect different groups

119. The effect of the chosen discount rate
Consider stream of positive returns: NPV falls as we use a higher discount rate
Choice of too high a discount rate will reject good projects
Choice of too low a discount rate will accept bad ones

120. What discount rate should the government use?
Should it use the market rate at which private firms attract finance?
In THEORY, the answer depends on aggregate impact of all public investment on private investment and consumption
In PRACTICE, government uses a fixed rate of ‘social time preference’ for consistency.
was set at 6% pa in real terms
now has been ‘stripped’ down to 3.5%
Lower rates for long-term projects

121. Risk and Uncertainty What if benefits or cost are uncertain?
Private firms add some risk premium to the discount rate: this lowers NPV, making acceptance of risky project less likely
Should the government discount risk? In principle, if the government can spread risk very thinly across the population, answer is NO.
In practice, risk evaluation and management is an important part.

122. Managing and Evaluating Risk
IDENTIFY all risks
Assess what can be transferred, at low cost, to the private sector
Use of pilot projects to learn more about costs and benefits. Use flexible designs avoid the risk of being hostage to fortune.
Eliminate optimism bias
Monte Carlo analyses: sensitivity analyses to look at NPV of project under alternative assumptions about the value of uncertain parameters

123. Green Accounting: A Case Study

125. The Welfare State

126. Supply-side economics
Central idea
Force government OUT of market place, to unleash private sector dynamism.
Use microeconomic incentives to increase productivity
Origins
disenchantment with Keynesian, ‘demand-side’ thinking
tax fatigue of the 1970s

127. Supply-side economics: suggestions
Cut marginal tax rates to provide incentive for hard work). Cut the dole, to increase labour participation. If output goes up, so might tax revenue (Laffer curve)
Cut taxes on savings, dividends, to reduce distortions
Cut business tax, allow more depreciation to induce new investment
Rein in the state, cut govt spending (cut real interest rates), encourage privatisation
Reform labour market (curb the Trade Unions) Encourage profit-sharing schemes to incentivise workers. Vocational training, etc.

128. Evaluation of Supply-side economics
did well on the inflation front
tax cuts may not induce more work Substitution effect (work more because work is rewarded more), vs income effect (work less as you can get goods you want with fewer hours of work). Evidence: inconclusive
likewise, cutting taxes on interest raises the return on saving, but may not induce people to save more
budgetary troubles US government found it easier to reduce public investment but not current expenditure (wages of civil servants). Laffer was off the mark
aggregate investment did not expand much, once you correct for the business cycle
incentive effects of some US tax cuts were perverse

129. In sum Implications for efficiency
Claims about likely efficiency gains were exaggerated
Implications for equity
Given that they aim to increase incentive to work and invest, supply-side policies -- if successful -- will inevitably widen the gap between those who succeed and those that fail.
Did alter income distribution (tax cuts were deeper for the rich public spending on poor fell)

130. THE WELFARE STATE Designed for both equity and efficiency Equity
reduce poverty (insurance) and create a more equal distribution of wealth
not just altruism, also desire for social cohesion
Efficiency
provide insurance against risks that market do not cover well (unemployment, illness)
provide social services to correct for market failures in health, education, housing, pensions

131. LESSONS OF HISTORY Dynamics of welfare state provision
welfare state disconnects relationship between effort and reward
but habits die hard: habit-restrained lags between welfare provision and deterioration of incentives
overshooting of welfare provision, leading to potential fiscal crises

132. LESSONS OF HISTORY Is the welfare state viable?
Thatcher's contribution: linking payments to inflation not earnings
Should benefits be targeted or universal?

133. Further reading
Begg, Fisher and Dornbush, Economics, 8th edition, PART 3
John Kay, The Truth about Markets: their genius, their limits, their follies, Allen Lane, 2003
Nicholas Barr, The Economics of the Welfare State, 4th edition, Oxford University Press, 2004

134. Economics Workshop Strategy Unit
Sandeep Kapur