Using Economic Theory for Policy

E. MaskinInstitute for Advanced Study

25th Anniversary of FEDEAMadrid

November 10, 2010

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• Many economists (including me) attracted to economic theory because

– besides being intellectually fascinating

– thought it could make world a better place

• Will argue that, economic theory has made world better place

• Two distinct contributions

(1) positive

(2) normative

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(1) Positive Economic Theory• economics helps us understand how particular economic

institutions work - - or don’t work

• take the market for navel oranges‒ if you’re in charge of getting navel oranges produced and allocated

to consumers, want to maximize

consumers’ welfare ‒ producers’ cost

• How would you do this?

let consumer 's welfare from consuming 1, ,i i iw x i x i n

producer 's cost of producing 1, ,j j jc y j y j m

max such that i i j j i ji j i j

w x c y x y

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• One way–

–

–

• Another way– set price p

–

–

–

have each consumer report ii w

have each consumer report jj c

compute , y that solve maximizationi ix

adjust until i ji j

p x y

allow each consumer to demand what he wants, , at ix p

allow each producer to supply what it wants, , at jj y p

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• second method is essentially competitive market mechanism– efficient - - solves maximization– requires transmitting a lot less information than first

method• one can show competitive mechanism

– requires less information transmission than any other efficient mechanism

Hayek (1945)Hurwicz (1977)Jordan (1982)

• In fact, can do away with centralized price setter– (unconstrained) bilateral bargaining leads to efficient

outcomeGale (1987)

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• Thus, economic theory gives us great insight into when and how competitive markets work well: if (as in navel orange market)– many agents (consumers and producers)

– no significant externalities

then competitive markets generate efficient outcome

Arrow and Debreu (1954)

affects only i ix w

affects only j jy c

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• Theory also shows when markets don’t work well• Example - - air pollution

‒ for optimum

‒ for equilibrium: p = price of pollution reduction

‒

• so, air pollution not reduced efficiently through market

benefit to customer of reductions i k kk

w x i x

cost to producer of reducing pollution by j j jc y j y

max s.t.i k j j k ji k j

w x c y x y

first-order condition for all i k j j

i k

w x c y j

optimum equilibrium Samuelson (1954)

i k j jk

w x p c y

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Today, more interested in:

(2) Normative Economic Theory• how can economic theory be used to create

better institutions?‒ to formulate good policy?

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2 Examples• drawn from issues I’ve worked on myself• in increasing order of theoretical and empirical

difficulty

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Example 1 – pollution reduction• argued before that competitive market cannot

adequately deal with pollution• But major contemporary problem ‒global

warming‒ is pollution problem (greenhouse gas emissions)

• What to do?

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• several years ago, British government wanted to induce major greenhouse gas-emitting producers to reduce emissions voluntarily

• budget = $500,000,000• Challenge: allocate budget in way that

maximizes emission reduction

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More precisely,• budget B

• for each firm j, j = 1, … , m

–

– good approximation:

• mechanism:

–

– outcome : each firm j assigned

firm 's cost of reducing by unitsj j jc y j y

, 1

, 1

j j j

j j

j

c y yc y

y

ˆeach firm bids jj c

ˆreduction jyˆtransfer jb

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• Transfers must satisfy

•

•

subject to

budget constraint

individual rationality

incentive compatibility

ˆ jb Bˆ ˆ 0 j j jb c y

ˆ in equilibriumj jc c

ˆProbelm: maximize E jy

individual rationality

budget constraint

incentive compatability

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Economic theory gives us:

Solution: (assuming low costs more likely than high costs)• if no bids less than B,

• if, for some k, exactly k bids less than B/k

• if, for some k, more than k bids less than B/k but fewer than k + 1 less than B/(k + 1)

Generalizes to different capacities for different firms

1ˆ ˆ 0my y

ˆ1, /ˆ

ˆ0, /

j

j

j

c B ky

c B k

1 1ˆ ˆ,ˆ0, otherwise

k kj

j

c c cb

ˆ/ , /ˆ

ˆ0, /

j

j

j

B k c B kb

c B k

st1ˆ1, 1 lowest bidˆ

0, otherwise

kj

j

c c ky

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Advantages for economic analyst:

•

•

• government controls mechanism

‒ we (analyst) know what game is

‒ firms know what game is

• no extensive empirical work needed

‒

ˆclear goal maximize iE y limited uncertainty only about jc

except for distribution of jc

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Example 2 ‒ Software Patents

Should software be patentable?• policy issue still open in EU• To answer question

‒ need theoretical framework that incorporates both costs and benefits of patenting

‒ need to formulate policy objective

‒ then asses parameter values empirically

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Benefit: patents encourage innovation• inventor cannot make discovery without

incurring costs• without patent, discovery can be freely imitated• imitation reduces inventor’s revenue from

discovery• so, inventor may not even cover costs• anticipating this, inventor may decide against

incurring costs in first place• society deprived of valuable innovation

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Costs

(1) patents confer monopoly power• but this argument by itself doesn’t outweigh benefit

• can adjust patent horizon

• many significant innovations attributable to patents

e.g., most modern drugs‒ given huge R&D costs, need high-powered incentive schemes

patents or prizes

‒ advantage of patents over prizes: don’t have to know goal in advance

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(2) patents may interfere with innovation• consider

‒ software‒ computers‒ semiconductors

• all highly innovative industries, but‒ weak patent protection (at least in early history)‒ frequent imitation

• Natural experiment in U.S. with software‒ before 1985 software not protected‒ after 1985, courts ensure enforceability‒ but decrease in software R&D per firm‒ similar story in Japan

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What’s different about software (as compared to drugs)?• innovation highly sequential• rather than single big break-through

‒ each innovation is small and builds on previous innovations

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Why does sequentiality make big difference?• suppose I’ve made a discovery (mousetrap) and

put a patent on it• suppose you have idea how to build on my

discovery (better mousetrap) • because you’re using what I’ve discovered, my

patent can block you• so, then my patent reduces innovation

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Not complete argument• if your follow-up R&D so important• then should be profitable• but then why don’t I license discovery to you?• could presumably capture some profit by

charging license fee

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Problem: what fee will I set?• I am a monopolist

‒ have exclusive right to my discovery

• economic theory indicates that monopolist has incentive to set prices too high

• So, I am likely to set license fee so high that‒ significant risk you won’t pay it

‒ so, significant risk your R&D will be blocked

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• So patents can interfere with follow-on innovation• What about original discoveries?

‒ aren’t patents still needed to induce me to invent mousetrap in first place?

• Answer: not as much as in case of non-sequential innovation‒ with sequential innovation, if I decide to incur R&D costs,

raise probability of mouse trap discoveryalso raise probability of follow-on discoveries

‒ so potential benefit of R&D bigger‒ if I capture just fraction of benefit without patents, then patents not

so important

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Thus, in industry with sequential innovation• patents reduce follow-on innovation• although patents still promote original

innovation,‒ not so important as in nonsequential world

• thus, if industry is sequential enough‒ we may be better off without patents

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• This is theoretical argument

• Forms framework for empirical test‒ Bessen and Hunt (2004)‒ suggests that in U.S. software patents have been

detrimental to welfare

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• Use of normative economics more difficult than in carbon mechanism case– don’t know exact game that software inventors are playing– game much less under analyst’s control– many parameters uncertain - - cost of R&D, value of discovery,

degree of sequentiality,...– What is right policy objective? (max consumer + producer

surplus?)

• But theory perhaps even more important in patent case‒ there are so many factors that could be important‒ theory enables us to focus on a few that are truly important, e.g.,

sequentiality

• Economic theory not only useful‒ good policy would be hopeless without it