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

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

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.. Hong Kong- China - Denmark - UK - USA -Cuba

8 Scale of government Japan USA UK Germany France Sweden Spending as share of national income (%)

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

15 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 Demand curve quantity price Equilibrium Quantity Equilibrium Price PRICE ADJUSTMENT Equilibrium price clears market Supply curve

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

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 1technology improves? 2input prices change? energy, labour, capital 3regulation 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 1Are 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 2The 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 3The 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. YearPriceOutput


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 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 Price Quantity

34 Example Brazil coffee exports price (1995 US $/lb) export quantity (1990 = 100) Revenue

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

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 a.(Pareto) efficiency considerations? b.a desire for greater equity? c.something else? 1.Income tax 2.Taxation of petrol 3.Windfall tax on utilities 4.Regulating utility prices

52 …Group Work 5.Regulating discharge of sewage in the Thames 6.Legislation against insider trading 7.Banning the use of cocaine 8.Unemployment insurance 9.Making primary school compulsory 10.Maintaining an army 11.Running the NHS 12.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 No nukesNukes No nukes 8, 81, 12 Nukes 12, 1 2, 2 More generally, the ‘tragedy of the commons’ SOLUTION: coordinate individual choices through agreements Country 1 Country 2 Individual optimization does not always result in the best social outcomes

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 a.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. b.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? c.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? d.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 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? 1.Imperfections in competition 2.Imperfections due to asymmetric information and insurance 3.Externalities and public goods aspects In addition to efficiency issues 4.equity issues 5.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 Health Spending, 2001 Spending per head, US$PPP Spending, per cent of GDP Australia % France % Japan % Germany % UK % USA %

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 1.Identify the salient characteristics of education as a commodity. Do you consider it to be a ‘merit good’? 2.Do you expect private markets for education to be efficient? Identify reasons for any market failures. 3.Government involve often generates its own inefficiencies. Identify reasons for any government failures. 4.Private markets for education may well be inequitable. Should we worry about this? 5.‘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 1.Patents: confer time-bound legal monopoly on the inventor 2.Procurement: use government research labs e.g. defence 3.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 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 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 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 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, 8 th 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, 4 th edition, Oxford University Press, 2004

134 Economics Workshop Strategy Unit Sandeep Kapur

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