Frank Cowell: EC426 Public Economics EC426 MSc Public Economics 2007/8 The Scope of Public Economics 8 October 2007

Frank C

owell:

Frank C

owell: E

C426

EC

426 Public E

conomics

Public E

conomics

EC426 MSc Public Economics 2007/8

http://darp.lse.ac.uk/EC426.htm

The Scope of Public EconomicsThe Scope of Public Economics

8 October 2007

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Public economics

Purpose of this lecturePurpose of this lecture What is the purpose of public economics?What is the purpose of public economics? What does it attempt to do?What does it attempt to do? Introduce the rest of the course.Introduce the rest of the course.

Is PE some special case?Is PE some special case? A minor subset of microeconomic analysis?A minor subset of microeconomic analysis? Particular variants of standard models?Particular variants of standard models?

Is PE some kind of intruder?Is PE some kind of intruder? An aberration from “conventional” economics?An aberration from “conventional” economics? An unnecessary complication?An unnecessary complication?

Begin with something simple…Begin with something simple…

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Overview...The private economy

“Market Failure”

Redistribution

Looking forward

The Scope of Public Economics

The standard story of the microeconomic system. A place for public economics?

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Positive economics

How does the economy work?How does the economy work? Standard story based on a well-known set of modelsStandard story based on a well-known set of models Challenge on functionality?Challenge on functionality?

Do the models work?Do the models work? Do they provide useful predictive power?Do they provide useful predictive power?

Challenge on completeness?Challenge on completeness? Do the models appropriately cover the world as we know it?Do the models appropriately cover the world as we know it? Do they address the appropriate questions?Do they address the appropriate questions?

Let’s look at the standard story…Let’s look at the standard story…

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A standard approach: outline

We use a model of the private economyWe use a model of the private economy Two main features:Two main features:

private internal economic mechanism – the marketprivate internal economic mechanism – the market private external frame of reference – rules of the gameprivate external frame of reference – rules of the game

Competitive marketsCompetitive markets Perfect [?] informationPerfect [?] information No restraint on tradeNo restraint on trade Minimal market powerMinimal market power Effective coverageEffective coverage

Rules of the gameRules of the game Incomes determined by propertyIncomes determined by property Guaranteed private property rightsGuaranteed private property rights

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A standard approach: result

Use the private-economy modelUse the private-economy model Additional assumptions:Additional assumptions:

Small agentsSmall agents Large numbersLarge numbers Convexity?Convexity?

EquilibriumEquilibrium The existence of competitive equilibriaThe existence of competitive equilibria If well-behaved – stability etcIf well-behaved – stability etc

Interpretation:Interpretation: An “Adam Smith” resultAn “Adam Smith” result DecentralisationDecentralisation Each agent max/min with just price guidance Each agent max/min with just price guidance

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Implementation through the market

q2

q1`

p1

—p2

q*f

x2

x1`

p1

—p2

x*h

f

f`

h

h`

f(qf) = 0

Uh(xh) = Uh(x*h)

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A standard approach: implication

Is the private-economy model a good one?Is the private-economy model a good one? What do you mean by “good?”What do you mean by “good?”

Predictive power?Predictive power? Empirical relevance?Empirical relevance? Welfare significance?Welfare significance?

Can consider the model in terms of efficiency:Can consider the model in terms of efficiency: Will the equilibrium be efficient?Will the equilibrium be efficient? Can we use the market to implement any efficient outcome?Can we use the market to implement any efficient outcome?

Focus on two important theoremsFocus on two important theorems One on implicationOne on implication One on implementationOne on implementation

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Welfare theorem 1

Assume a competitive equilibrium.Assume a competitive equilibrium. What is its efficiency property?What is its efficiency property?

THEOREM: if all consumers are greedy and there are THEOREM: if all consumers are greedy and there are no externalities then a competitive equilibrium is no externalities then a competitive equilibrium is efficient.efficient.

Explanation: Explanation: If they are not greedy, there may be no incentive to trade. If they are not greedy, there may be no incentive to trade. If there are externalities the market takes no account of If there are externalities the market takes no account of

spillovers. spillovers.

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Welfare theorem 2 Pick any Pareto-efficient allocationPick any Pareto-efficient allocation Can we find a property distribution Can we find a property distribution dd so that this so that this

allocation is a CE for allocation is a CE for dd??

THEOREM: if, in addition to conditions for theorem 1, THEOREM: if, in addition to conditions for theorem 1, there are no nonconvexities then an arbitrary PE there are no nonconvexities then an arbitrary PE allocation be supported by a competitive equilibrium.allocation be supported by a competitive equilibrium.

Explanation: Explanation: If “lump sum” transfers are possible then we can arbitrarily If “lump sum” transfers are possible then we can arbitrarily

change the initial property distribution.change the initial property distribution. If there are nonconvexities the equilibrium price signals could If there are nonconvexities the equilibrium price signals could

take us away from the efficient allocation... take us away from the efficient allocation...

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Ob

Oa

x1b

x1a

x2a

x2b

Supporting a PE allocation The contract curve

Support the allocation by a CE.

This needs an adjustment of the initial endowment.

Beware: lump-sum transfers may be tricky to implement

Allocations where MRS12

a = MRS12b

Allocations where MRS12

a = MRS12b

An efficient allocation Supporting price ratio = MRS

[x] ^

[R] The property distribution A lump-sum transfer

p1

p2

p1

p2

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Supporting a PE allocation (production)

Firm f’s technology set

0

Supporting price ratio = MRT

f’s net output in the efficient allocation

p1

p2

p1

p2

f’s net output in the allocation is profit-maximising for f.

q2f

q1f

qf^

what if preferences and production

possibilities were different?

what if preferences and production

possibilities were different?

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Private model: limitations

The Adam Smith result is fairly demandingThe Adam Smith result is fairly demanding Not hard to think of practical instances where Not hard to think of practical instances where

these don’t hold.these don’t hold. Should we speak of “market failure”?Should we speak of “market failure”?

A convenient shorthandA convenient shorthand But is it appropriate?But is it appropriate?

Or limits of private economics?Or limits of private economics? Labelling is not so important..Labelling is not so important.. Provides one important route into Public Provides one important route into Public

EconomicsEconomics

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Where the private model doesn’t “work” Useful to look at the separate reasons why… Useful to look at the separate reasons why… A typology of difficultiesA typology of difficulties

Market deficiencyMarket deficiency NonconvexitiesNonconvexities ExternalitiesExternalities Public consumptionPublic consumption

Perhaps only the first two are really “failure”Perhaps only the first two are really “failure” But all provide a normative role for public But all provide a normative role for public

economicseconomics Look at these brieflyLook at these briefly First an important methodological pointFirst an important methodological point

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Competitive Failure and Efficiency The market “failures” raise two classes of problem that The market “failures” raise two classes of problem that

lead to two distinct types of analysis:lead to two distinct types of analysis:

1.1. The characterisation problem The characterisation problem Description of modified efficiency conditions…Description of modified efficiency conditions… ……when conditions for the welfare theorems are not met. when conditions for the welfare theorems are not met.

2.2. The implementation problem The implementation problem Design of a mechanism to achieve the allocation.Design of a mechanism to achieve the allocation.

These two types of problem pervade nearly all of These two types of problem pervade nearly all of modern micro economicsmodern micro economics

It’s important to keep them distinct in one’s mindIt’s important to keep them distinct in one’s mind

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Redistribution

Looking forward


Where markets do not quite do the business…

•Market deficiencies•Nonconvexities•Externalities•Public consumption

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Market deficiencies – 1 A further typology:A further typology: Distorted marketsDistorted markets

MonopolyMonopoly Restrictive practicesRestrictive practices

Missing marketsMissing markets Futures? Risk?Futures? Risk? Highly specialised commoditiesHighly specialised commodities

Thin marketsThin markets Not enough tradersNot enough traders Highly specialised commoditiesHighly specialised commodities

Problems of informationProblems of information Imperfect / incompleteImperfect / incomplete AsymmetricAsymmetric

The role for intervention…? The role for intervention…?

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Market deficiencies – 2 Role for public sector in each of these cases.Role for public sector in each of these cases. Distorted marketsDistorted markets

Monopoly / Anti trust legislationMonopoly / Anti trust legislation Missing marketsMissing markets

Pension / social security provisionsPension / social security provisions Internal markets in healthInternal markets in health

Thin marketsThin markets FranchisingFranchising Private finance initiativesPrivate finance initiatives

Problems of informationProblems of information Regulation Regulation

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Redistribution

Looking forward


Large firms, large projects and infrastructure


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Nonconvexities Nonconvexities: ugly name for a crucial issueNonconvexities: ugly name for a crucial issue Covers many well-known thingsCovers many well-known things

Increasing returnsIncreasing returns Fixed costsFixed costs Weird tastesWeird tastes

But includes other stuff tooBut includes other stuff too Interactions amongst agents…Interactions amongst agents… ……positive externalities positive externalities

The market may not actually fail completelyThe market may not actually fail completely Could still get decentralisationCould still get decentralisation But under what circumstances?But under what circumstances?

Let’s see why the second W-theorem does not work Let’s see why the second W-theorem does not work

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Household h makes “wrong” choice

x2h

0x1

h

xh^

xh~

Household h ’s utility function violates second theorem

Suppose we want to allocate this consumption bundle to h. Introduce prices h's choice given this budget

p1

p2

p1

p2

Nonconvexity leads to “market failure”

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Firm f makes “wrong” choice

q2f

0q1

f

qf^

qf~

Firm f ’s production function violates second theorem Suppose we want to allocate this net output to f. Introduce prices.

f's choice at those prices

p1

p2

p1

p2

Another example of “market failure”

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Nonconvexities: a case for public intervention? The conditions for the second W-theorem are violatedThe conditions for the second W-theorem are violated But this does not automatically mean to say that the But this does not automatically mean to say that the

market won’t “work”market won’t “work” Do nonconvexities require intervention in the market?Do nonconvexities require intervention in the market?

there’s a large-numbers argument there’s a large-numbers argument ““induced” convexityinduced” convexity argument for effective competition laws…argument for effective competition laws… ……for example in the EUfor example in the EU

But what if large-numbers argument doesn’t apply?But what if large-numbers argument doesn’t apply?

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Nonconvexities that won’t go away

Sometimes the large-numbers argument is implausible.Sometimes the large-numbers argument is implausible. Big firmsBig firms

BoeingBoeing MicrosoftMicrosoft

Strategic suppliersStrategic suppliers Network railNetwork rail Electricity / gas distributionElectricity / gas distribution

There may be other cases for a “natural monopoly” There may be other cases for a “natural monopoly” Can see what happens in the case of a large fixed-cost Can see what happens in the case of a large fixed-cost

firmsfirms

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The “infrastructure problem”

Represent the analysis in terms of a two-good model.Represent the analysis in terms of a two-good model. Take something like electricity, highways – good 1Take something like electricity, highways – good 1 To be paid for by sacrifice of all other goods – good 2To be paid for by sacrifice of all other goods – good 2 Basic questions: Basic questions:

Should good 1 be produced at all?Should good 1 be produced at all? If so, how much should be produced?If so, how much should be produced? The answer depends on people's preferencesThe answer depends on people's preferences

A simple diagramA simple diagram

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x1

x2

Efficiency and non-convexities in production: case 1

0

x′

Endowment of good 2Fixed set-up cost to produce good 1Possibilities once fixed-cost has been incurredReservation indifference curveIndifference mapPoint where MRS=MRTEfficient point

x°

Attainable set is shaded area + “spike”

In this case MRS=MRT is not sufficient Utility is higher if x1 = 0

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Efficiency and non-convexities in production: case 2

0

x°

x1

x2

Attainable set as before Indifference map

x′

Consumption if none of good 1 is produced The efficient point

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Nonconvexity: effect of the competitive market

Efficient to produce where MRS=MRT

0

x°

x′

x1

x2

p1

—p2

p1

—p2

Iso-profit-line

Profit-maximisation over the attainable set

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Nonconvexity: efficient fee schedule

Efficient to produce at x'

0

x°

x′

x1

x2

p1

—p2

p1

—p2

MRS=MRT

Fixed charge

Variable charge

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Nonconvexities: the role for public economics Focus on issues raised by the infrastructure problemFocus on issues raised by the infrastructure problem

Generalise to more complex cases Generalise to more complex cases Foundation of large sub-branch of public economicsFoundation of large sub-branch of public economics

Determination of willingness to pay Determination of willingness to pay Often assumed away in private model – consumer Often assumed away in private model – consumer

sovereigntysovereignty But emerges in many applied public problemsBut emerges in many applied public problems Used as the basis of CB analysis…Used as the basis of CB analysis… ……see belowsee below

The science of regulationThe science of regulation Fairly clear for a world of certaintyFairly clear for a world of certainty But tricky if there is uncertainty about costsBut tricky if there is uncertainty about costs Typically the case where there are few producersTypically the case where there are few producers

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Redistribution

Looking forward


Beneficial and harmful spillovers. A special type of transaction?


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The nature of externality

An externality is a kind of “involuntary” An externality is a kind of “involuntary” transaction transaction

A case where market allocation methods don’t A case where market allocation methods don’t workwork Agents cannot be excluded from the transaction Agents cannot be excluded from the transaction

using conventional price mechanismusing conventional price mechanism An example of “market failure”?An example of “market failure”?

Externalities can be detrimental or beneficialExternalities can be detrimental or beneficial Normally concerned with two broad types:Normally concerned with two broad types:

Production externalitiesProduction externalities Consumption externalities Consumption externalities

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Production externality One firm influences another’s production conditionsOne firm influences another’s production conditions

Affects other firms’ cost curves.Affects other firms’ cost curves. Not effect of wage or input price changes…Not effect of wage or input price changes… ……externality is externality is outsideoutside the market mechanism. the market mechanism.

Model this as a parameter shiftModel this as a parameter shift If firm If firm ff’s output produces an externality…’s output produces an externality… ……production function of firm production function of firm kk has has ff’s output as a ’s output as a

parameter…parameter… … … or MC curve of firm or MC curve of firm kk has has ff’s output as a parameter.’s output as a parameter.

Example: networkingExample: networking One firm’s activity creates pool of skilled workers from which One firm’s activity creates pool of skilled workers from which

neighbouring firms may benefit.neighbouring firms may benefit. Example: pollutionExample: pollution

One firm’s activity (glue production) causes emissions to the One firm’s activity (glue production) causes emissions to the detriment of its neighbours (restaurants)detriment of its neighbours (restaurants)

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Externality: Production possibilities

low emissions

by firm f

low emissions

by firm f

q1`k

q2k

high emissions

by firm f

high emissions

by firm f

Production possibilities, firm k

Production possibilities, if firm f’s emissions increase

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Consumption externality One agent’s consumption of a good directly One agent’s consumption of a good directly

affects another affects another A’s consumption of good 1 is an argument of agent A’s consumption of good 1 is an argument of agent

B’s utility functionB’s utility function Related to the analysis of public goods (below)Related to the analysis of public goods (below) Consumption externalities can be seen as Consumption externalities can be seen as

qualitatively differentqualitatively different Formal analysis may Formal analysis may look look similarsimilar But informational problems differBut informational problems differ

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Externalities and the welfare theorems What is the role in the fundamental results?What is the role in the fundamental results? Equilibrium may be inefficient.Equilibrium may be inefficient.

If agents are guided just by pricesIf agents are guided just by prices Then they get misleading signalsThen they get misleading signals

A clear case for public concern?A clear case for public concern? In the case of production, perhaps notIn the case of production, perhaps not

See the externality as special transaction – missing marketSee the externality as special transaction – missing market Perhaps you just need to extend the coverage of marketsPerhaps you just need to extend the coverage of markets Then let trading happen in the extended markets Then let trading happen in the extended markets

But it’s difficult to do this for some types of externality But it’s difficult to do this for some types of externality – particularly consumption – particularly consumption

An essential role for “public” solutions.An essential role for “public” solutions.

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Redistribution

Looking forward


Characteristics of public goods


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Public consumption and public goods

An important instance. An important instance. not so much of market failure…not so much of market failure… ……but of limitations of private modelbut of limitations of private model

A different characteristic of goods and services in the A different characteristic of goods and services in the economyeconomy

Variety of types of institution to provideVariety of types of institution to provide What are the public goods?What are the public goods? Defined by their economic characteristics Defined by their economic characteristics

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Characteristics of public goods Two key properties that we need to distinguish:Two key properties that we need to distinguish: ExcludabilityExcludability

You are producing a good.You are producing a good. A consumer wants some.A consumer wants some. Can you prevent him from getting it if he does not pay?Can you prevent him from getting it if he does not pay?

RivalnessRivalness Consider a population of 999 999 people all consuming 1 unit Consider a population of 999 999 people all consuming 1 unit

of commodity of commodity ii. . Another person comes along, also consuming 1 unit of Another person comes along, also consuming 1 unit of ii. . Will more resources be needed for the 1 000 000?Will more resources be needed for the 1 000 000?

These properties are mutually independentThese properties are mutually independent They interact in an interesting wayThey interact in an interesting way

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Typology of goods: classic definitions

Rival?[ Yes ] [ No ]

pureprivate

[??]

[??] purepublic

[ Yes ]

[ No ]

Exc

lud

able

?

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How the characteristics interact

Private goods are both rival and Private goods are both rival and excludableexcludable

Public goods are nonrival and Public goods are nonrival and nonexcludablenonexcludable

Consumption externalities are non-Consumption externalities are non-excludable but rivalexcludable but rival

Non-rival but excludable goods often Non-rival but excludable goods often characterise large-scale projects.characterise large-scale projects.

Example:defence Example:defence

Example: National defence(E) you can't charge for units of 'defence‘(R) more population doesn't always require more missiles

Example: National defence(E) you can't charge for units of 'defence‘(R) more population doesn't always require more missiles

Example:bread

Example:bread

Example: Bread(E) you can charge a price for bread (R) an extra loaf costs more labour and flour

Example: Bread(E) you can charge a price for bread (R) an extra loaf costs more labour and flour

Example:bridge

Example:bridge

Example: Wide Bridge(E) you can charge a toll for the bridge(R) an extra journey has zero cost

Example: Wide Bridge(E) you can charge a toll for the bridge(R) an extra journey has zero cost

Example:flowers

Example:flowers

Example: Scent from Fresh Flowers(E) you can't charge for the scent(R) more scent requires more flowers

Example: Scent from Fresh Flowers(E) you can't charge for the scent(R) more scent requires more flowers

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Public goods and the welfare theorems Why is implementation likely to be difficult in the case Why is implementation likely to be difficult in the case

of pure public goods?of pure public goods? Private provision will be inefficientPrivate provision will be inefficient We have an extreme form of the externality issue.We have an extreme form of the externality issue. But there is a fundamental difference from private But there is a fundamental difference from private

modelmodel Rationality and self interest: Rationality and self interest:

Unambiguous for the pure private worldUnambiguous for the pure private world Ambiguous hereAmbiguous here

Therefore we may need different solution methodTherefore we may need different solution method

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Example

Good 1 - a pure public goodGood 1 - a pure public good Good 2 - a pure private goodGood 2 - a pure private good Two persons: A and BTwo persons: A and B

Each person has an endowment of good 2Each person has an endowment of good 2 Each contributes to production of good 1Each contributes to production of good 1

Production organised in a single firmProduction organised in a single firm

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[[ –– ]] 1,13,0

0,32,2

[+]

[+]

Alf

Alf

BillBill

[+][+] [[––]]

Public goods: strategic view (1)If Alf reneges [–] then Bill’s best response is [–]

If Bill reneges [–] then Alf’s best response is [–]

Nash equilibrium

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[[ –– ]] 0,03,1

1,32,2

[+]

[+]

Alf

Alf

BillBill

[+][+] [[––]]

Public goods: strategic view (2)If Alf plays [–] then Bill’s best response is [+].

If Bill plays [+] then Alf’s best response is [–].

A Nash equilibrium

By symmetry, another Nash equilibrium

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Which paradigm?

Clearly the two simplified +/Clearly the two simplified +/– – models lead to models lead to rather different outcomes.rather different outcomes.

Which is appropriate? Will we inevitably end up Which is appropriate? Will we inevitably end up at an inefficient outcome?at an inefficient outcome?

The answer depends on the technology of The answer depends on the technology of production.production.

Also on the number of individuals involved in Also on the number of individuals involved in the community.the community.

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Redistribution

Looking forward


Public economics and the rules of the game

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Redistribution

Move away from private-only modelMove away from private-only model Slightly odd preoccupationSlightly odd preoccupation Define public economics as a “complement” Define public economics as a “complement”

Move away also from simple efficiencyMove away also from simple efficiency Pareto criterionPareto criterion Potential ParetoPotential Pareto

An area where private economy approach is (almost) An area where private economy approach is (almost) silentsilent

Two broad areas for considerationTwo broad areas for consideration Motivation Motivation Implementation Implementation

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Redistribution

Looking forward


A framework for analysis?

•Motivation•Implementation

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Normative economics

How should the economy be organised? How should the economy be organised? On what basis make the recommendation?On what basis make the recommendation? Could argue that we’ve already strayed into this Could argue that we’ve already strayed into this

territoryterritory Efficiency is a normative criterion?Efficiency is a normative criterion? Distinguish three approaches:Distinguish three approaches:

ConstitutionConstitution PrinciplesPrinciples SWFSWF

Have use for all three in Public EconomicsHave use for all three in Public Economics

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Constitution approach

Relies on a representation of orderings of social statesRelies on a representation of orderings of social states ““Social will” is some aggregation of individual Social will” is some aggregation of individual

orderings orderings Runs into Arrow “Impossibility Theorem”Runs into Arrow “Impossibility Theorem”

Given a general specificationGiven a general specification And a rich set of alternativesAnd a rich set of alternatives There is no constitution that is not dictatorialThere is no constitution that is not dictatorial

Lesson for usLesson for us Not just a curiosityNot just a curiosity Fundamental to key aspects of Public EconomicsFundamental to key aspects of Public Economics Can’t just assume away issue of social consensusCan’t just assume away issue of social consensus

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Basic principles: approach

Judge outcomes on the basis of (sets of) agreed principlesJudge outcomes on the basis of (sets of) agreed principles EfficiencyEfficiency

Universally endorsed?Universally endorsed? Simply definedSimply defined Rests on principle of Pareto improvementsRests on principle of Pareto improvements

Potential Pareto improvements?Potential Pareto improvements? Potential efficiency Potential efficiency (Harberger 1971) Basis for CB analysis Basis for CB analysis (Adler and Posner 1999)

Direct distributional concern?Direct distributional concern? Fairness Fairness Equity Equity

Key question: Where are these additional principles to come Key question: Where are these additional principles to come from?from?

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SWF approach

Social Welfare Function (SWF) is a convenient deviceSocial Welfare Function (SWF) is a convenient device Commonly invoked in a variety of applied policy Commonly invoked in a variety of applied policy

problemsproblems Restricts normative economics to a more limited fieldRestricts normative economics to a more limited field

imposes much more structure on welfare comparisonsimposes much more structure on welfare comparisons usually provides clear-cut answersusually provides clear-cut answers

Key questions:Key questions: What properties for the SWF?What properties for the SWF? Where does it come from?Where does it come from? How to determine its parameters?How to determine its parameters?

This will receive special attention in our core lecturesThis will receive special attention in our core lectures

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Redistribution

Looking forward


Public economics and the rules of the game

•Motivation•Implementation

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Redistribution: implementation

An aspect of private-economy model that is deceptively simpleAn aspect of private-economy model that is deceptively simple Application of second welfare theoremApplication of second welfare theorem ““Support” requires an adjustment of endowmentsSupport” requires an adjustment of endowments Commonly use the device of “Lump-sum transfers”Commonly use the device of “Lump-sum transfers”

Exogenous reassignment of property rightsExogenous reassignment of property rights Takes place before trading in the private economyTakes place before trading in the private economy A basis for public policy?A basis for public policy?

Why don’t we see more of these in practice?Why don’t we see more of these in practice? Practical difficulties – land expropriation?Practical difficulties – land expropriation? Political difficulties – poll tax?Political difficulties – poll tax?

But there are deep issues associated with implementationBut there are deep issues associated with implementation Design issuesDesign issues Informational problemsInformational problems

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The implementation problem

At the core of public economicsAt the core of public economics Politics is the art of the possiblePolitics is the art of the possible Policy is the art of implementation Policy is the art of implementation

If not lump sum redistribution, then…?If not lump sum redistribution, then…? Design issues cover… Design issues cover…

Economic incentivesEconomic incentives Administrative difficultiesAdministrative difficulties Informational restrictions Informational restrictions

Informational difficulties include… Informational difficulties include… Role of uncertaintyRole of uncertainty Asymmetric informationAsymmetric information Central to interesting questions in public economicsCentral to interesting questions in public economics

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Implementation: asymmetric information Why is asymmetric information so central?Why is asymmetric information so central? Consider the two broad economic categoriesConsider the two broad economic categories Private informationPrivate information

Defines the public/ private boundaryDefines the public/ private boundary What is the State allowed to know about you?What is the State allowed to know about you? Adverse selection problemAdverse selection problem

Hidden actionsHidden actions Defines a boundary of responsibilityDefines a boundary of responsibility How much can/should the State do for you?How much can/should the State do for you? Moral hazardMoral hazard

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Implementation: design

Private information induces incentive problemsPrivate information induces incentive problems May be an incentive to “manipulate” the economic mechanismMay be an incentive to “manipulate” the economic mechanism Mechanism had better be designed to avoid unfortunate effects Mechanism had better be designed to avoid unfortunate effects

of manipulationof manipulation Limitation on private action Limitation on private action Limitation on public policy optionsLimitation on public policy options

Closely related to “constitution” problemClosely related to “constitution” problem ArrowArrow theorem is linked to the incentive problemtheorem is linked to the incentive problem Same issues arise in trying to resolve itSame issues arise in trying to resolve it

Affects whole range of tools available to public sectorAffects whole range of tools available to public sector Social insuranceSocial insurance TaxationTaxation Income supportIncome support Provision of public goodsProvision of public goods

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Redistribution

Looking forward


Connections between parts of the course

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Looking forward This brief summary of public economics…This brief summary of public economics… ……provides an agendaprovides an agenda ……an introduction to the coursean introduction to the course All of the elements presented here play a roleAll of the elements presented here play a role

The main economic issues analysed in detailThe main economic issues analysed in detail And practical examples are examined And practical examples are examined Essential components are done in this termEssential components are done in this term

Let’s briefly look at how they fit togetherLet’s briefly look at how they fit together

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Preview: 1 Begin with motivationBegin with motivation Welfare analysis of redistributionWelfare analysis of redistribution

How do we justify intervention?How do we justify intervention? What’s the philosophical basis?What’s the philosophical basis? How do people feel about redistribution?How do people feel about redistribution?

Equity, social welfare and taxation Equity, social welfare and taxation What do we know about SWFs?What do we know about SWFs? How are these linked to notions of equity?How are these linked to notions of equity? What implications for taxation?What implications for taxation?

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Preview: 2 We make repeated visits to the problem of design We make repeated visits to the problem of design

Policy design: social insurancePolicy design: social insurance An analysis of the basic principles of designAn analysis of the basic principles of design Examination of hidden-action problemExamination of hidden-action problem Application to health and pensionsApplication to health and pensions

Optimal taxationOptimal taxation The problem of private informationThe problem of private information Income tax – the structure of the problemIncome tax – the structure of the problem Commodity taxation – how to use information about Commodity taxation – how to use information about

transactionstransactions

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Preview: 3 Two key areas of applied public economicsTwo key areas of applied public economics Needed to make sense of the theoryNeeded to make sense of the theory

Taxation and individualsTaxation and individuals Taxation and companiesTaxation and companies

Difficult issue of rationalityDifficult issue of rationality Behavioural public economicsBehavioural public economics

Bounded rationality and self-interestBounded rationality and self-interest

Providing public goodsProviding public goods Reconciling the ambiguity in rationalityReconciling the ambiguity in rationality

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Summary: 1

Public economics is not an “intruder” into Public economics is not an “intruder” into microeconomicsmicroeconomics

A role for it follows from fundamental welfare A role for it follows from fundamental welfare theorems theorems

First: where the theorems “break down’’First: where the theorems “break down’’ Whether or not we speak of “market failure”Whether or not we speak of “market failure” Or consider it as limits of the private model Or consider it as limits of the private model

Second: in implementing the support theoremSecond: in implementing the support theorem Mechanisms to guide the private action?Mechanisms to guide the private action? Mechanisms to replace the private action?Mechanisms to replace the private action?

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Summary: 2 Public economics is not just a minor subset of Public economics is not just a minor subset of

microeconomicsmicroeconomics Deals with questions that we would not Deals with questions that we would not

otherwise touchotherwise touch Addresses fundamental questions of economic Addresses fundamental questions of economic

organisationorganisation How to balance conflicting interests – move beyond How to balance conflicting interests – move beyond

the Pareto criterionthe Pareto criterion Lump-sum transfer – harder in practice than might Lump-sum transfer – harder in practice than might

be supposedbe supposed A basis for foundation of economic policyA basis for foundation of economic policy

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References Adler, M. D. and Posner, E. A. (1999)Adler, M. D. and Posner, E. A. (1999) “Rethinking cost- “Rethinking cost-

benefit analysis,” benefit analysis,” The Yale Law JournalThe Yale Law Journal, , 109109, 165-247, 165-247

Cowell, F. A. (2006)Cowell, F. A. (2006) Microeconomics: Principles and Microeconomics: Principles and AnalysisAnalysis, Chapter 13, Chapter 13

Harberger, A. C. (1971) “Three basic postulates for applied welfare economics” Journal of Economic Literature 9, 785.797.

Salanié, B. (2000) Microeconomics of Market Failures Cambridge Massachusetts: MIT Press, Chapter 1.

Documents

Frank Cowell: EC426 Public Economics EC426 MSc Public Economics 2007/8 The Scope of Public Economics 8 October 2007