1. Understanding how the State works Bakuriani, July 2008

2. Outline  The legitimacy of the State: market failures  How the State works

3. How the market works  Spontaneous orders developing in a frame of property rights and contract (fingers of the visible hand)  An order of “extreme” complexity  Entrepreneurship as engine of discovery (“muscles of the invisible hand)  Evaluation in terms of  Progress (expansion of knowledge and wealth)  Individual dignity

4. Market “failures”  Production of public goods is not profitable  Technology might lead to monopoly position (“natural monopoly”)  Producers can collude and exploit consumers  Private decision makers neglect some of the consequences of their actions (externalities)  Unfair trade because of asymmetric information or lack of outside opportunities  Income inequalities

5. Market solutions to market “failures”!  Ronald Coase: the provision of lighthouse  You get get around natural monopolies so that their power is not unlimited  Extend the scope of market (externalities)  Rely on tort law  Asymmetric information is “normal” and not dangerous where markets work properly  Income inequalities are signaling devices  Power of voluntary associations and insurance mechanisms

6. Nirvana approach “The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing "imperfect" institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements. In practice, those who adopt the nirvana viewpoint seek to discover discrepancies between the ideal and the real and if discrepancies are found, they deduce that the real is inefficient. [...] “ Harold Demsetz, "Information and Efficiency: Another Viewpoint” Journal of Law and Economics, Vol. 12, No. 1 (Apr., 1969), pp. 1-22

7. Tools of State’s solutions to market failures  The State is an organization  It regulates  It taxes  To produce  To redistribute  In any cases it uses physical coercion

8. Two questions  How do we deal with the motivation problem?  How do we deal with the knowledge problem?

9. The logic of the actors involved in State’s choices  From individual preferences to “social preferences”  Behavior of the elector  Behavior of the candidates (Role of the median elector)  Behavior of the elected representative (logic of collective action)  Behavior of the civil servant

10. Can you regulate a spontaneous order?  Logical impossibility  Regulation often does not reach its target  Public housing  Health care  Education  European Agricultural policy  Flooding in Czech Republic  Regulation has unintended consequences  Merger regulation  Food and safety regulation (kitchen, etc.)

11. Bastiat: What is seen and what is not seen  In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.  There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

12. Bastiat again…  Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.