1. Public Policy Analysis MPA 404 Lecture 14

2. Previous Lecture  All about going through the exercise of calculating PV’s and IRR for projects.  Hypothetical example of two investments (a bank and a machine), their income streams, the calculation of PV’s from the income streams, and IRR calculations.  The example of bonds offered at a discount.

3.  Application 2: Detecting an Economic Shortage  In short, an economic shortage implies the shortage in supply of a specific commodity, service or otherwise. Shortages translate into a high price since there is less of the product/good than before. How can IRR be used to detect an economic shortage? The answer lies in the workings of a market economy on the basis of competition.  We will definitely be discussing economic principles and their applications in policy analysis (especially graphical analysis) later on. But for the moment, a simple explanation would do for this example. In a market economy, where competition has its presence, the change in profit rates lead to change in investment decisions, and thus in demand and supply. Suppose product A, due to a change in circumstances, gains a high price compared to product B. This in turn would induce investors/producers towards product A since its offering a higher profit opportunity. As production of product A picks up, the supply increases. The long run result is that the price of product A will fall to equilibrium level, thus restoring the earlier balance.

4.  As the dynamics of profitability change, so does the IRR and the opportunity cost of investment scenario. As product A becomes pricier, the opportunity cost for the investor not investing in this product rises. In other words, what it means is that the IRR of product A increases, which makes it more profitable than other alternatives (like B). So we would expect investors to pour their money in A’s production.  As stated above, in the long run, we would expect the prices to fall down as the production of A becomes sufficient to meet the demand, and its price comes down. That will be gauged by a gradually falling IRR over the long run.  What will be intriguing, from an economist’s point of view, is the possibility that the IRR of product A does not fall and still remains high in the long run. That will imply two things: one, the market principles of competition are weak, possibly due to the presence of monopoly (or oligopoly). And second, there is still shortage of the product (artificially created or otherwise). Thus the trick over here is to track the IRR over time. Its number in comparison with other’s will give a clue to whether a shortage persists or not?

5.  Application 3: Does regulation cause harm to an industry?  Example: the US drug manufacturers appealed to the government in the 1960’s not to introduce regulations because these will prove to be a huge disincentive for innovation, research and the introduction of new drugs. Indirectly, what they were stating was that with regulations, the industry would become unprofitable and investment will go elsewhere.  But that did not happen. Over time, the government and the private sector mad several studies based on IRR in the drug industry. It showed that despite the regulations and restrictions, IRR in the industry has remained pretty healthy. So in questions concerning public policy in the form of regulations, there needs to be an appreciation of the IRR of the industry over time to see the effects of the regulation.

6. How would we present long-run equilibrium graphically?  Let’s start with the very simple supply-demand framework. Consider the following depiction.  The first diagram represents the simple demand-supply equilibrium. Point ‘P’ is the equilibrium price, and ‘Q’ is the equilibrium quantity. That equilibrium is disturbed in the second graph. Take the above example of product A that is in low supply (a shortage). The movement of supply curve to the left represents that shortage. It meets the demand curve at a higher point than equilibrium point. Resultantly, the price also goes up.

7. Long-run graphical equilibrium How consumer and producer surplus is shown at the equilibrium