Presentation on theme: "Economics Workshop Strategy Unit"— Presentation transcript:
1 Economics Workshop Strategy Unit 1-3 February 2006Sandeep Kapur
2 WORKSHOP OBJECTIVESTo provide rigorous but non-mathematical training in economics, enabling participants todevelop a simple but reliable toolkit for economic analysispractise its application using concrete problemsapply economic theory to their own work
4 Basic ConceptsMICROECONOMICS: study of decisions made by consumers, producers, and their interaction in specific marketsMACROECONOMICS: 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 ECONOMYwhat, how & for whom decided by prices, incomes, wealthCOMMAND ECONOMYcentral 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 19602004Japan11191837USA8102836UK243243Germany3147France153553Sweden657
9 The Production Possibility Frontier Maximum quantity one good that can be produced, given quantities of other goods being producedA, B, C efficient(on the frontier)D, E inefficient(inside the frontier)F, G unattainable(outside the frontier)
10 Basic ConceptsOPPORTUNITY COST of any good or serviceQuantity of other goods sacrificed to get one more unit of this goodThe underlying notion of trade-offs.
11 Economic ModelsMODELDeliberate simplification of realitylike a mapDATATime SeriesCross-SectionPanel Data
13 Tools: Interpreting the data +Bus fareBus RevenueIt 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 fareBus RevenueHigh tube fareLow tube fare
15 Revenue = fare x journeys Tools: ModellingBus revenue depends on bus faresRevenue = fare x journeysNumber of bus journeys depends on bus faresBut also on other thingsprice of other modes of travel (tube fares)reliability relative to other modes of travelrelative comfort and perception of safety
17 How Markets Work Demand, Supply, and Price Adjustment
18 MarketDEMAND quantity buyers wish to buy at each priceSUPPLY quantity producers wish to sell at each priceMARKETany arrangement in which prices adjust to reconcile buyers and sellers intentionsEQUILIBRIUM PRICE the price at which market clears (i.e. quantity demanded = quantity supplied)
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 when1 price of a related good changes?substitutes vs complements2 consumer’s income changes?normal goods vs inferior goods3 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 whentechnology improves?input prices change? energy, labour, capital3 regulation imposes extra costs?
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 GROUPWORKThe 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.YearPriceOutput1985100101198610410719871081121988122198911812819901171991199298103
32 Price Elasticity of Demand Measures the price sensitivity of demand% change in the quantity demanded% change in priceElastic demand: sensitive to price changesInelastic demand: relatively insensitiveDepends ultimately on substitution possibilities
33 Implications for Revenue PriceIn demand is elastic,a fall in price raises the quantity demanded by a greater percentage than the price. Thus revenue rises as price fallsIn demand is inelastic,a fall in price raises the quantity demanded by a smaller percentage than the price. Thus revenue falls as price fallsPriceQuantityQuantity
34 Example Brazil coffee exports 1993 1994 1995 price (1995 US $/lb) 0.9 2.02.1export quantity (1990 = 100)11310285Revenue204179
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 jPositive when goods are substitutesNegative when goods are complements
36 Other elasticities Income elasticity of demand % change in the quantity demanded% change in real incomeNormal good have positive income elasticity of demandGreater that 1 for luxury goodsLess than 1 for necessitiesInferior good have negative income elasticity
37 Price Elasticity of Supply % change in the quantity supplied% change in priceSupply elasticities are usually positive
38 Theory of Consumer Choice A consumer has preferences over different goods and servicesBudget constraint describes the different bundles that the consumer can afford given prices and incomeConsumer makes herself as well off as possible, given the budget constraint
39 The Effect of Relative Price Changes The effect of price changesSubstitution 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 increaseworkers 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
42 Government Intervention Intervention in free markets is usually motivated byEquity considerationsEfficiency considerationsEthical or moral arguments
43 EQUITY How fair is the distribution of goods and services? Of course, fairness is a value judgementIn principle, we can distinguish betweenHorizontal equity: equal treatment of equalsVertical 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 AB is better for all (and C is worse)D is better for one, and no worse for otherB & D are said to be Pareto improvements on A
46 Economic EfficiencyAn 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, andeven inequitable allocations may be Pareto efficient
47 Are Markets Pareto Efficient? Key QuestionsDo 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 marketsconsumers align their consumption choices to market pricesprices equal the marginal cost of productionso that there is no way to reallocate resources to generate a Pareto improvementPUNCH LINE: Competitive equilibrium is Pareto efficient (The Invisible Hand Theorem!)
50 AN IDEA If indeed markets are efficient rely on markets to achieve efficiency, andconfine government intervention to redistributionHowever markets may not always be efficientMarket 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 taxTaxation of petrolWindfall tax on utilitiesRegulating utility prices
52 …Group Work Regulating discharge of sewage in the Thames Legislation against insider tradingBanning the use of cocaineUnemployment insuranceMaking primary school compulsoryMaintaining an armyRunning the NHSRunning the Post OfficeIs there a trade-off between equity and efficiency?
53 Market Failures Why intervene? How to intervene?
54 Sources of Market Failure ExternalitiesPublic goodsImperfect competitionImperfect informationWe will look at each of these in turn
55 MARKET FAILURE: Externalities EXTERNALITYA circumstance in which an individual's choices affects others' utility or productivitythe effect is direct (not through market or prices)
56 Externalities: examples Adverse consumption externality: smokingBeneficial consumption externality: painting the exterior of your houseBeneficial production externality: bees and orchardsAdverse production externality: pollution
57 Why Externalities Matter THE ESSENTIAL PROBLEMMarket mechanism aligns private costs and benefitsExternalities 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 benefitAt 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 outcomeThis solution does not work if there are high transactions costs or free ridingEfficient quantity is Q*
61 MARKET FAILURE: Public Goods Examples: national defence, safe streets, TV signalCHARACTERISTICSNON-RIVAL CONSUMPTION: my consumption does not diminish what is available for youNON-EXCLUDABILITY: impossible or too costly to prevent people from consuming it
62 Public Goods CONSEQUENCES Free-riding: difficult to make people pay for useAnd may not be efficient to charge for useIn general, markets cannot provide public goodsSOLUTIONPublic provision, financed through taxesNote that government needs to ensure right quantity, but does not need to produce it itself
63 MARKET FAILURE: Imperfect Competition The essential problem of monopolieswith market power, monopoly price exceeds marginal cost,leading to Pareto inefficiencyimportantly, inefficiency lies in the restriction of outputSolution must somehow align price to marginal costs
64 MONOPOLY: SolutionsSolution 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: SolutionsSolution 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 ofadverse selectionmoral hazardResulting in ‘incomplete markets’ or even ‘missing markets’
67 Adverse SelectionOccurs 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 hazardOccurs 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 hazardA partial solutionInsurance 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 outcomesCountry 2No nukesNukes8, 81, 1212, 12, 2Country 1More generally, the ‘tragedy of the commons’SOLUTION: coordinate individual choices through agreements
70 Government FailureHowever, 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 ThamesIf 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 toset a pollution tax? (same rate per unit polluted for both?)set each a quota?auction pollution quotas?
74 Public Spending Government expenditure: around 40% of GDP Social insurance: contributory benefits such as unemployment, sickness, pensions benefitsEquity: non-contributory benefits, such as income support, housing benefit, family supportMerit goods: what society believes all should have (externalities or paternalism): benefits-in kind, education, healthPublic goods: law and order, defenceThe big three – social security, healthcare and education – account for 3/5 of the total.
76 Health Care: a merit good? Sources of muddled thinkingan emotional issueis health a basic right? But so is foodis 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?Efficiencymacro: what fraction of GDP on healthmicro: how to allocate resources within systemEquity: but of what?
78 Health Care: the product Health care is only an input. Output -- improved health outcomes -- also depends on diet, environment, lifestyleDoes 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 competitionImperfections due to asymmetric information and insuranceExternalities and public goods aspectsIn addition to efficiency issuesequity issuesethical issues
80 Imperfect competition Would a private health care market be perfectly competitive?monopoly power of medical associationsmarket power of drug companiesPossible solutionsRegulationCountervailing 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 buyertechnical complexity of informationpatients' inability to weigh alternativeshigh cost of errorsIn sum, this is hardly rational consumer choiceSolutions: provision of information and regulation but both are costlyPublic provision?
82 Problems with Health Insurance Pattern of demand: small probability of major expenditureUsually buy insurance in such situations but insurance markets suffer from many problemsadverse selection: attract especially sickmoral hazard: tendency to ‘over-treat’correlated risk are hard to insure: epidemicsmissing markets for congenital problemsCan intervene to reduce these problems, but causes other problems.Social insurance?
83 Externalities and public good Problem: Communicable diseases are a negative externalityA solution: to subsidise treatmentIn general, the public good aspect of basic healthcare
84 Other reasons for intervention Equity argumentsMoral and ethical argumentsbabies, 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 careageing populationmore sophisticated (and expensive) treatment
87 Health care in the UK: case notes THE PATIENT: NHSGPs provide primary care: guide and gatekeeperSince 2003, Foundation Trusts, with financial and managerial autonomy run hospitalsPrimary Care Trusts purchase hospital care, community servicesStrategic Health Authorities to oversee Primary Care Trusts and NHS TrustsDepartment of Health
88 THE CASE HISTORY Universal and virtually free access Publicly financed Good health outcomeCheap: 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, 2001Spending per head, US$PPPSpending, per cent of GDPAustralia23508.9%France25619.5%Japan19847.6%Germany280810.7%UK1992USA488713.9%
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 controlseparation of funding from provision: purchaser can buy from competing providersGP fund-holders to manage own budgetsHospital Trusts, with greater managerial control and financial autonomyWere the objectives genuine, or just a response to fiscal crisis?
92 SWITCHING PROTOCOL Prior to 1991, central planning : quasi markets: move away from markets2003-: 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.
98 Public versus Private Sector When comparing public with private sector, it is important to remember thatpublic sector losses were sometimes intentionalcost structures differ: Post Office vs private couriers
99 Is the public sector inefficient? EvidencePrivate sector firms are more efficient PROVIDED they operate in markets with strong competitionKey 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 handsBut this is not to deny that there have been serious inefficiencies
100 Agency theory and incentives Imagine a project wherethe agent's effort affects probability of successeffort is unobservable or hard to measureIf so,the principal needs to provide incentives (carrot or stick) to induce effortwithout incentives, individuals may slack-offLesson: incentives matter
101 Why is the public sector less efficient? 1. The incentives problemAt the organisational level: no fear of bankruptcy, no competitionAt the individual level: not enough carrot (relatively fixed salary) or stick (relative security of tenure)In sum, incentive structures are relatively flatWhy not use better incentive schemes in the public sector?Mostly because measuring success is harder due multiplicity of objectives and poor information2. 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
104 INDUSTRIAL POLICYCentral idea: market failure calls for an active role for the governmentBased on the idea that intervention canCorrect failures in markets for knowledgeAssist in the diffusion of new technologiesCorrect for excessive risk aversionCircumvent 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 enoughTHREE SOLUTIONSPatents: confer time-bound legal monopoly on the inventorProcurement: use government research labs e.g. defencePatronage: provide subsidies to universities
106 New technologies and standards Problem: uncertainty about new technologies and standards may causelock-in in to poor standardsdelays in adoptionSolution: guide technological choices?
107 Risk Problem: Markets may display excessive risk aversion Collectively, society can pool risks across projects & spread risks across populationSolution: underwrite private sector losses? venture capital?
108 Coordination of economic activity Location externalities and new lessons in economic geographySunrise industries: correct deficient incentives to acquire skills and imperfection in markets for loans to new firmsSunset industries: managing the transition: prevent survival of an inefficiently large number of firms
110 COST-BENEFIT ANALYSIS Analysis of costs and benefits: useful forCapital projectsPolicy and programme developmentUse or disposal of existing assetsEnvironmental standards, health and safetyProcurement 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 optionAdjustmentsnon-market impactsrisk and optimismdistributional impactsDevelop and implement solutionsEvaluation
112 (Social) Cost-Benefit analysis FORMS OF APPRAISALFinancial AppraisalCompare revenue with costs, as private firm does(Social) Cost-Benefit analysisEvaluate costs and benefits of each option, including costs and benefits that the market does not valueCost-effectiveness analysisIf benefits are hard to evaluate, compare the costs of achieving some target level of benefitsMulti-criteria analysisComputed the weighted score for each option based on its performance on defined criteria.
113 OPPORTUNITY COST OF CAPITAL SOME TECHNICALITIESTIME PREFERENCEPeople prefer £1 today to £1 tomorrowdemand a premium to postpone consumptionOPPORTUNITY COST OF CAPITALcost in terms of opportunities foregonerate r at which you borrowDISCOUNTING AND NET PRESENT VALUEWhat discount rate should we use?INFLATION erodes future valueseither all values real or all values nominal
114 Decision rule: Net Present Value Criterion Forecast the cash flow generated by the project over its lifetimeAssess opportunity cost of capital, and discount future cash flowsCalculate the net present value (NPV): sum of discounted net flowsDecision RuleONE OPTION: Invest if NPV is positiveMANY OPTIONS: Invest in project with highest NPVAll 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 costsThe 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 differSocial rate of time preference may differ from market rates of interest
116 VALUING NON-MARKET IMPACTS Evaluate non-market consequencesexternalities, including environmental onesconsumers’ surplussaving of timesaving human life (‘prevented fatality’)possibilities of catastrophic riskOften hard to value these. Can useWillingness to Pay (WTP)Willingness to Accept (WTA)
117 Macroeconomic effects Some caveatsMacroeconomic effectsNeed 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 acceptedWhat 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 issuesWhat if the project has irreversible consequence?Be cautious. Raise the threshold of acceptance for a project to compensate for the irreversibility.Distributional impactsee 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 rateChoice of too high a discount rate will reject good projectsChoice 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 consumptionIn PRACTICE, government uses a fixed rate of ‘social time preference’ for consistency.was set at 6% pa in real termsnow 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 likelyShould 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 risksAssess what can be transferred, at low cost, to the private sectorUse of pilot projects to learn more about costs and benefits. Use flexible designs avoid the risk of being hostage to fortune.Eliminate optimism biasMonte Carlo analyses: sensitivity analyses to look at NPV of project under alternative assumptions about the value of uncertain parameters
126 Supply-side economics Central ideaForce government OUT of market place, to unleash private sector dynamism.Use microeconomic incentives to increase productivityOriginsdisenchantment with Keynesian, ‘demand-side’ thinkingtax 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 distortionsCut business tax, allow more depreciation to induce new investmentRein in the state, cut govt spending (cut real interest rates), encourage privatisationReform 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 fronttax 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: inconclusivelikewise, cutting taxes on interest raises the return on saving, but may not induce people to save morebudgetary troubles US government found it easier to reduce public investment but not current expenditure (wages of civil servants). Laffer was off the markaggregate investment did not expand much, once you correct for the business cycleincentive effects of some US tax cuts were perverse
129 In sum Implications for efficiency Claims about likely efficiency gains were exaggeratedImplications for equityGiven 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 wealthnot just altruism, also desire for social cohesionEfficiencyprovide 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 rewardbut habits die hard: habit-restrained lags between welfare provision and deterioration of incentivesovershooting 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 earningsShould benefits be targeted or universal?
133 Further readingBegg, Fisher and Dornbush, Economics, 8th edition, PART 3John Kay, The Truth about Markets: their genius, their limits, their follies, Allen Lane, 2003Nicholas Barr, The Economics of the Welfare State, 4th edition, Oxford University Press, 2004
134 Economics Workshop Strategy Unit Sandeep Kapur