1. Microeconomics Level 2 Module 3 Sandeep Kapur

2. Welfare Economics Equity and Efficiency

3. 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

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

5. 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

6. Pareto 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. Note that there can be more than one Pareto efficient allocation, and a Pareto efficient allocation could be quite inequitable

7. Are Markets Pareto Efficient? Key Questions Do free markets always lead to Pareto efficient allocations? If not, why not? What are the implications for policy?

8. Competitive Equilibrium & Pareto Efficiency Consider two industries, meals and films. Suppose both are competitive and in equilibrium. Meals cost P m and films P f each. Last meal eaten yields P m extra utility to consumer; last film watched yielded P f P m and P f are also the marginal costs of production This suggests that there is no way to reallocate production to generate a Pareto improvement

9. An Example Suppose P f = 2P m consumers need two meals to give up one film But producers need twice as much resources to 'serve' a film instead of a meal So they could offer two meals for an extra film, but no net gain for consumers or producers PUNCH LINE: Competitive equilibrium is Pareto efficient (The Invisible Hand Theorem!)

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

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

12. 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 electricity prices

13. …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?

15. MARKET FAILURE: Taxation Suppose we have a tax only on films This tax wedge implies, for last film seen post-tax price exceeds producer's gain consumers’ value exceeds producer's value Implications for meals industry Marginal private cost of meals is below their marginal social cost

16. Taxes distort Consequently, if only films are taxed, films are too expensive and meals too cheap we get too many meals relative to social optimum, and too few films IDEA: a tax on meals too, to correct the imbalance

17. THE ‘SECOND BEST’ If there exists a price distortion, get rid of it to achieve the FIRST BEST(full efficiency) However, if you cannot get rid of the distortion in one market, it is not always efficient to arrange for other markets to be undistorted Rather, it helps to spread the inevitable distortion more thinly, by DELIBERATELY introducing new distortions in other markets

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

19. 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

20. 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

21. Adverse Production Externality For social optimum, want social marginal cost = social marginal benefit At the free market equilibrium E, output Q is higher than social optimum Q*: this results in dead-weight loss EFG SOLUTION 1 (Pigou). Corrective taxation

22. 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*

23. MARKET FAILURE: Public Goods ‘Consumed in same quantity by everyone’ Examples: 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

24. Why free markets can’t get public goods right Possible solutions The problem of free- riding Note that government needs to ensure right quantity, but does not need to produce it itself

25. MARKET FAILURE: Imperfect information In reality, information in markets is less than perfect (e.g. we often need to search) Often there is asymmetry of information between buyers and sellers Resulting in the problems of adverse selection and moral hazard This may result in ‘incomplete markets’ or even ‘missing markets’ Solutions: mitigate informational problems or provide goods directly

26. Moral hazard in insurance markets If your bike is fully insured against theft, you have no incentive to be careful (to lock it) if you lose it, insurance company bears the loss increased carelessness increases risk of loss: this is moral hazard The usual solution Insurance company forces you to bear some risk (excess payments or coinsurance) to maintain incentives to be careful Here you can buy only partial insurance. In some cases, no market at all

27. MARKET FAILURE: Imperfect Competition The essential problem With market power, price exceeds marginal cost, so social marginal benefit exceeds social marginal cost, leading to Pareto inefficiency Importantly, it is the restriction of output that is costly First-best solution align price = marginal costs

28. MONOPOLY: other problems Resources wasted in securing monopoly power (lobbying or ‘rent-seeking’), and maintaining it (excessive capacity, etc) Equity : political power of large companies

29. MONOPOLY: benefits Dynamic efficiency: more R&D? Better coordination of decisions Economies of scale Natural monopolies Very severe economies of scale so socially desirable to have one producer rather than duplicate fixed costs. Here, the first-best solution (i.e., price = marginal cost) causes losses

30. MONOPOLY: Solutions Solution 1. Nationalize and finance losses through taxes politically not very feasible Solution 2. Break monopoly e.g. anti-trust legislation in US However, no good for natural monopolies

31. 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?) In general, difficulties with the mix of remedies

33. 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 a quota? 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?

35. 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

36. Research & Development PROBLEM: Inventions are a public good, so that unregulated markets may not produce enough R&D activity equals 2-3% of GDP in OECD 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

37. New technologies and standards Problem: uncertainty about new technologies and standards may cause lock-in in to poor standards (QWERTY?) delays in adoption (VHS and Betamax) Solution: guide technological choices?

38. 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?

39. 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

40. 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

41. Taxation and Public Spending.

42. Taxation Variety of taxes Direct taxes: income tax, corporation tax Indirect taxes:on expenditure, VAT

43. Desirable Characteristics of Tax System Equity Efficiency Administrative simplicity Cost of ensuring compliance Responsiveness to changing economic circumstances

44. Progressivity of taxation Proportional: average tax rate constant Progressive: average tax rate rises with income Regressive: average tax rate falls with income We must assess progressiveness carefully: incidence of taxes, benefits, direct provision of goods

45. Tax incidence: who really bears the tax Tax incidence diagrams: either (as here) at consumer prices (supply curve shifts) or at producer prices (demand curve shifts) Relative to original equilibrium, gross price goes up but less than tax (i.e., net price goes down)

46. Tax incidence: who really bears the tax Regardless of who the tax is levied on, its INCIDENCE depends on elasticity of supply and demand Inelastic supply/demand means bear the tax Elastic supply/demand escape the burden

47. Principles of Optimal Taxation EFFICIENCY aim to minimise harmful effects on choice use lump-sum taxes wherever sensible if choosing variable taxes, choose tax rates to minimise distortion Ramsey principle: tax rate higher if supply or demand is inelastic of course, taxes often help correct other distortions: pollution taxes, and ‘sin’ taxes on cigarettes, alcohol

48. Principles of Optimal Taxation EQUITY : Two principles ‘Ability to pay’: take more from the rich ‘Benefits principle’: beneficiaries of public provision to pay more Vertical equity suggests progressive tax system but this may conflict with efficiency

49. 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

50. Public Spending The big three Social security Health Education account for 3/5 of all public spending. We shall study these more carefully

51. Health care

52. 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.

53. 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?

54. 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

55. 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

56. 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)

57. 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?

58. 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?

59. 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

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

61. 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

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

63. Health care in the UK: case notes THE PATIENT: NHS Department of Health Strategic Health Authorities to oversee Primary Care Trusts and NHS Trusts PCTs to oversee primary care: GPs, dentists, etc. NHS Foundation Trusts, with financial and managerial autonomy can borrow, hire and fire

64. THE CASE HISTORY Universal and virtually free access Publicly financed Good health outcome Cheap: expenditure 6-7% of GDP, But rising (up by 70% in real terms 1979- 96, bulges in birth rate in post-war period, ageing population & new, costly treatments) A recurrent crisis of confidence: queues, alleged inefficiencies

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

66. 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?

67. ONGOING CARE More public money Is there privatization by stealth? 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?

69. Group Work: Education 1Identify the salient characteristics of education as a commodity. Do you consider it a ‘merit good’? 2Do you expect private markets for education to be efficient? Identify reasons for any market failures. 3How can potential inequities in private markets for education? 4‘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.

71. The Welfare State

72. 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

73. Are governments less efficient than markets? 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

74. 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

75. 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?

76. Lessons for policy makers Market failure does not make an automatic case for intervention Sometimes government intervention makes matters worse. Informational problems affect both public and private sectors. –regulation often has perverse effects –vulnerability of civil servants to rent-seeking behaviour Weigh existing inefficiencies against risk of government failure Incentives matter

77. Supply-side economics Central idea Force government OUT of market place, to unleash private sector dynamism. Use microeconomic incentives to increase productivity Intellectual origins disenchantment with Keynesian, ‘demand-side’ thinking tax fatigue of the 1970s anti-government libertarian tradition in the US

78. 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.

79. 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

80. In sum Implications for efficiency  Claims about likely efficiency gains were exaggerated ‘there is nothing wrong with supply-side economics that division by 10 cannot cure.’ (Charles Schultze) 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)

81. 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,

82. 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

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

85. Cost-Benefit Analysis

86. 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

87. 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

88. FORMS OF APPRAISAL  Financial Appraisal Compare revenue with costs, as private firm does  (Social) Cost-benefit analysis Quantify costs and benefits of each option, including costs and benefits that the market does not value  Cost-effectiveness analysis If benefits are hard to quantify, compare the costs of achieving some target level of benefits

89. 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

90. 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

91. SOCIAL COST-BENEFIT ANALYSIS  While private sector cares about profits, government must consider a larger 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 NPV could differ  Social rate of time preference may differ from market rates of interest

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

93. 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.

94. 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: how costs and benefits affect different groups Tax impact, relative price movements

95. 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

96. 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

97. 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.

98. 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

99. Green Accounting: A Case Study

100. Further reading  Begg, Fisher and Dornbush, Economics, 7 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, third edition, Oxford University Press, 1998 This is a good manual for many aspects of public finance and the welfare state. See especially chapter 3: social theory and the state chapter 4: state intervention chapter 12:health and health-care chapter 13: housing

101. Microeconomics Level 2 Sandeep Kapur