Economics Workshop
Strategy Unit
25-27 October 2006
Sandeep Kapur
WORKSHOP OBJECTIVES
To provide rigorous but non-mathematical training
in economics, enabling participants to
• develop a simple yet reliable toolkit for
economic analysis
• practise its application using concrete
problems
• apply economic theory to their own work
Introduction to Economics
Concepts and Tools
Basic Concepts
• MICROECONOMICS: study of decisions made
by consumers, producers, and their interaction
in specific markets
• MACROECONOMICS: the big picture –
emphasizes interactions in the economy as a
whole
Basic Concepts
• POSITIVE ECONOMICS
tries to explain behaviour
• NORMATIVE ECONOMICS
prescriptions, usually based on value judgment
The central questions
What goods and service to produce?
How to produce? (choice of technology)
For whom? (income distribution)
FREE MARKET ECONOMY
what, how & for whom decided by prices,
incomes, wealth
COMMAND ECONOMY
central authority directs use of resources
Degrees of government intervention differ..
Cuba - China - Denmark - UK - USA -
Hong Kong
..as does the scale of government
Spending as share of national income (%)
1880
1930
1960
2004
Japan
11
19
18
37
USA
8
10
28
36
UK
10
24
32
43
Germany
10
31
32
47
France
15
19
35
53
Sweden
6
8
31
57
The Production Possibility Frontier
GOOD 2
Maximum quantity of
one good that can be
produced, given
quantity of other goods
being produced
G
. A
B
F
D
E
C
GOOD 1
A, B, C efficient
(on the frontier)
D, E
inefficient
(inside the frontier)
F, G unattainable
(outside the frontier)
Basic Concepts
OPPORTUNITY COST of any good or service
Quantity of other goods sacrificed to get one
more unit of this good
The underlying notion of trade-offs.
Economic Models
MODEL
Deliberate simplification of reality
like a map
DATA
Time Series
Cross-Section
Panel Data
Tools: Visualizing data
A scatter diagram
variable y
+
+
+
+ +
+
+
+ +
+
+
+
+
+
+
variable x
Tools: Interpreting the data
Bus Revenue
+
+
+
+
+
+
+
+
+
Bus fare
It appears that higher bus fares lead to higher revenue…
… but it might not be true
Suppose the two clusters are from two different
time periods – what might that suggest?
Bus Revenue
+
+
+
+
High tube fare
+
+
+
+
+
Low tube fare
Bus fare
Tools: Modelling
Bus revenue depends on bus fares
Revenue = fare x journeys
Number of bus journeys depends on bus fares
But also on other things
• price of other modes of travel (tube fares)
• reliability relative to other modes of travel
• relative comfort and perception of safety
How Markets Work
Demand, Supply, and Price Adjustment
Market
• DEMAND
quantity buyers wish to buy at each price
• SUPPLY
quantity producers wish to sell at each price
• MARKET
any arrangement in which prices adjust to reconcile
buyers and sellers intentions
• EQUILIBRIUM PRICE
the price at which market clears
(i.e. quantity demanded = quantity supplied)
Market
Supply curve
price
Equilibrium
Price
Demand curve
Equilibrium
Quantity
quantity
PRICE ADJUSTMENT
Equilibrium price clears market
Price Controls
Suppose government sets minimum price above market
clearing price
Price
Supply curve
Controlled price
Equilibrium price
Demand curve
Examples incl.
• CAP
• Minimum wages
• Rent control
Equilibrium
quantity
Quantity
DEMAND IN DETAIL
elaborating on the ‘other things’
Demand curve shows relation between price of a
good and quantity demanded of that good.
How does demand change when
1
price of a related good changes?
– substitutes vs complements
2 consumer’s income changes?
– normal goods vs inferior goods
3 tastes change?
– role of fashions and fads
COMPARATIVE STATICS
(effect of changing the ‘other things’)
Suppose income rises, increasing demand
Price
Supply
Equilibrium
price rises
Demand : high income
Demand: low income
Equilibrium quantity rises
Quantity
SUPPLY IN DETAIL
elaborating the ‘other things’
How does SUPPLY of a good vary when
1
technology improves?
2
input prices change?
energy, labour, capital
3
regulation imposes extra costs?
COMPARATIVE STATICS
Suppose technical breakthrough raises supply…
Price
Supply rises
2 but equilibrium
price falls
Demand
1 Equilibrium quantity rises...
Quantity
COMPARATIVE STATICS
An important difference
• If demand shifts, equilibrium price and quantity
move in the SAME DIRECTION
• If supply shifts, equilibrium price and quantity
move in OPPOSITE DIRECTIONS
Introduction to Economics
GROUPWORK
1
Are the following statements positive or normative?
(a)
(b)
(c)
(d)
(e)
(f )
Higher tax rates cut revenue from tobacco taxes
Poor countries get an unfair share of world income
Smoking is antisocial & should be discouraged
The nuclear industry needs public support
The nuclear industry deserves public support
The nuclear industry is a good investment for UK
GROUPWORK
2
(a)
(b)
(c)
(d)
The price of crude oil increased from $2.90 to $9 per
barrel in 1973, in a coordinated move by OPEC
members.
How did the OPEC members manage to raise the
price? Show using a supply-demand diagram for the oil
market.
What happened to the demand for coal and the price of
coal? Show using a supply-demand diagram for the
coal market.
What happened to the demand for fuel-guzzling cars?
What happened to supply and demand for oil
eventually?
GROUPWORK
3
The following data describe price
and output of a product:
(a) Plot a scatter diagram
(b) “Higher prices make firms raise
output.”
“People buy less when prices
are higher”
Does the diagram shed any light
on these statements?
Could both be correct? Explain.
Year
Price
Output
1985
100
101
1986
104
107
1987
108
112
1988
112
122
1989
118
128
1990
117
128
1991
108
118
1992
98
103
Elasticity of Demand and Supply
Price Elasticity of Demand
Measures the price sensitivity of demand
% change in the quantity demanded
% change in price
Elastic demand: sensitive to price changes
Inelastic demand: relatively insensitive
Depends ultimately on substitution possibilities
Implications for Revenue
Price
In demand is elastic,
a fall in price raises the
quantity demanded
by a greater
percentage than the
price. Thus revenue
rises as price falls
Price
In demand is inelastic,
a fall in price raises the
quantity demanded
by a smaller
percentage than the
price. Thus revenue
falls as price falls
Quantity
Quantity
Example
Brazil coffee exports
1993
1994 1995
0.9
2.0
2.1
export quantity (1990 = 100) 113
102
85
Revenue
204
179
price (1995 US $/lb)
102
Other elasticities
Cross price elasticity of demand
for good i with respect to changes in price of good j
% change in the quantity demanded of good i
% change in price of good j
Positive when goods are substitutes
Negative when goods are complements
Other elasticities
Income elasticity of demand
% change in the quantity demanded
% change in real income
Normal good have positive income elasticity of demand
Greater that 1 for luxury goods
Less than 1 for necessities
Inferior good have negative income elasticity
Price Elasticity of Supply
Price Elasticity of Supply
% change in the quantity supplied
% change in price
Supply elasticities are usually positive
Theory of Consumer Choice
Consumers have preferences over different goods and
services
Budget constraint describes the different bundles that a
consumer can afford given prices and income
Consumer makes herself as well off as possible, given
the budget constraint
The Effect of Relative Price Changes
The effect of price changes
• “Substitution effect”: you buy less of things that
have become relatively expensive.
• “Income effect”: the decrease in real income due to
price increase may reduce purchases of all goods.
Impact of wage rates on labour supply
The two effects may work in opposite directions…
As wage rates increase
• workers want to work longer hours because work is
relatively more attractive (substitution effect)
• workers may want to work less because higher
incomes make them want to consume more leisure
(income effect)
The net effect could go either way
What government does
Why intervene?
Government Intervention
Intervention in free markets is usually motivated by
• Equity considerations
• Efficiency considerations
• Ethical or moral arguments
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
Equity of Allocations
Allocation: a description of who gets what
Goods
for Tony
F.
A
E
Goods for Gordon
Starting from A, a move to E or F reflects a decrease in
equity
Efficiency of allocations
Goods
for Tony
F.
B
D
A
C.
E
Goods for Gordon
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
Economic 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.
• There can be more than one Pareto efficient allocation,
and
• even inequitable allocations may be Pareto efficient
Are Markets Pareto Efficient?
Key Questions
• Do free markets lead to efficient outcomes?
Always?
• If sometimes not, why not?
• What are the implications for policy?
Competitive Markets
In competitive markets
• there are many firms, each too small to have any
influence on market price (they are ‘price takers’)
• competition ensures prices are close to the
marginal cost of production
(marginal cost measures opportunity cost of
producing another unit of the good)
• of course, this assumes no tax or other distortions
Competitive Equilibrium & Pareto Efficiency
In undistorted, competitive markets
• consumers align their consumption choices to market
prices
• competition drives prices to marginal cost of
production
• thus prices align consumer benefit to marginal cost
• (implies cannot reallocate resources to generate a
Pareto improvement)
• PUNCH LINE: Competitive equilibrium is efficient
(The Invisible Hand Theorem!)
AN IDEA
If indeed markets are efficient
• rely on markets to achieve efficiency, and
• confine government intervention to redistribution
However markets may not always be efficient
Market Failure: a circumstance in which equilibrium in
free markets fails to achieve an efficient allocation
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.
2.
3.
4.
Income tax
Taxation of petrol
Windfall tax on utilities
Regulating utility prices
…Group Work
5.
6.
7.
8.
9.
10.
11.
12.
Regulating discharge of sewage in the Thames
Legislation against insider trading
Banning the use of cocaine
Unemployment insurance
Making primary school compulsory
Maintaining an army
Running the NHS
Running the Post Office
Is there a trade-off between equity and efficiency?
Correcting Market Failures
Why intervene?
How to intervene?
Sources of Market Failure
• Externalities
• Public goods
• Imperfect competition
• Imperfect information
• Strategic interaction
We will look at each of these in turn
MARKET FAILURE: Externalities
EXTERNALITY
• A circumstance in which an individual's choices
affects others' utility or productivity
• the effect is direct (not through market or prices)
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
Why Externalities Matter
THE ESSENTIAL PROBLEM
• Social cost = private cost + externalities
Social benefit = private benefit + externality
• Externalities imply divergence between social and
private costs (or social and private benefit)
• Market mechanism aligns private costs and benefits
• Efficiency requires alignment of social costs and
benefits
• If divergences exist, should not expect socially
efficient allocations
Adverse Production Externality
F
MSC
G
E
MPC
Demand
Q*
Q
Quantity
For social optimum, social marginal cost = social marginal
benefit
At free market equilibrium E, output is higher than social
optimum Q*
SOLUTION 1 (Pigou). Corrective taxation
Property Rights
MC (for you)
MB (to me)
Q*
Q
Quantity
Efficient quantity
is Q*
Solution 2 (Coase)
• Assign property rights
and let people trade
these rights in ‘pseudomarket’
• Initial assignment affects
distribution but gets an
efficient outcome
• This solution does not
work if there are high
transactions costs or free
riding
MARKET FAILURE: Public Goods
Examples: national defence, 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
Public Goods
CONSEQUENCES
• Free-riding: difficult to make people pay for use
• And may not be efficient to charge for use
In general, markets cannot provide public goods
SOLUTION
• Public provision, financed through taxes
• Note that government needs to ensure right quantity,
but does not need to produce it itself
MARKET FAILURE: Imperfect Competition
The essential problem of monopolies
• with market power, monopoly price exceeds
marginal cost
• and output is restricted below competitive level
• leading to inefficiency
• (importantly, inefficiency lies in the restriction of
output)
• Solution must somehow align price to marginal
costs
MONOPOLY: Solutions
Solution 1. Nationalize (politically not very feasible)
Solution 2. Break monopoly (e.g. anti-trust action in US)
However, no good for ‘natural monopolies’
where strong economies of scale make a case for
preservation of monopoly
and in some sectors monopoly is good for R&D
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?
MARKET FAILURE: Imperfect information
Information is not perfect: often there is asymmetry of
information between buyers and sellers.
This leads to the problems of
• adverse selection
• moral hazard
Resulting in ‘incomplete markets’ or even ‘missing
markets’
Adverse Selection
• Occurs when individuals use private information to
accept or reject a contract or transaction
e.g., those who know themselves to be careless buy
insurance more readily
• If so, insurance company finds itself insuring a
bunch of careless people: an ‘adverse selection’ of
the population rather than an average selection.
• In extreme cases, the market may collapse
altogether, a case of ‘missing markets’
• SOLUTIONS: mitigate informational problems or
provide goods directly
Moral hazard
•
Occurs when the contract itself changes behaviour.
e.g., once you have got insurance, incentive to be
careful is weakened.
• Greater carelessness increases risk of loss to the
insurance company: this is moral hazard
A partial solution
Insurance company forces you to bear some risk
(excess payments or coinsurance) to maintain
incentives to be careful.
In extreme cases, private markets may not provide any
insurance
SOLUTIONS: Regulation, direct provision
Inefficiency due to Strategic Interaction
Individual optimization does not always result in the
best social outcomes
Country 2
No nukes
Country 1
No nukes 8, 8
Nukes
12, 1
Nukes
1, 12
2, 2
More generally, the ‘tragedy of the commons’
SOLUTION: coordinate individual choices through
agreements
Group Work: Pollution control
As the National Rivers Regulator, you must tackle the
problem of a chemical firm 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.
Group Work: Pollution control
b. Instead of 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?
Group Work: Pollution control
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 quotas?
Group Work: Pollution control
d. Lastly, suppose there are two chemical firms polluting
the river, one cleaner than the other. Is it better to
• set a pollution tax? (same rate per unit for both?)
• set each a quota?
• auction pollution quotas?
Public Spending
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
• The big three – social security, healthcare and
education – account for 3/5 of the total.
Health care
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.
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?
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
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
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)
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?
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?
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
Other reasons for intervention
•
Equity arguments
•
Moral and ethical arguments
babies, organs should not be sold
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
Other questions
Macro-economic issue
How much should we spend on health? rising cost of
health care
• ageing population
• more sophisticated (and expensive) treatment
Health care in the UK: case notes
THE PATIENT: NHS
• GPs provide primary care: guide and gatekeeper
• Since 2003, Foundation Trusts, with financial and
managerial autonomy run hospitals
• Primary Care Trusts purchase hospital care,
community services
• Strategic Health Authorities to oversee Primary
Care Trusts and NHS Trusts
• Department of Health
THE CASE HISTORY
•
•
•
•
•
•
Universal and virtually free access
Publicly financed
Good health outcome
Cheap: expenditure is 7-8% of GDP,
But rising (up by 70% in real terms 1979-96, due
to bulges in birth rate in post-war period, ageing
population & new, costly treatments)
A recurrent crisis of confidence: queues, alleged
inefficiencies
Health Spending, 2001
Spending per
head, US$PPP
Spending,
per cent of GDP
Australia
2350
8.9%
France
2561
9.5%
Japan
1984
7.6%
Germany
2808
10.7%
UK
1992
7.6%
USA
4887
13.9%
DIAGNOSIS?
Inefficient or under-funded?
If inefficient, why?
• skills shortages?
• bureaucratic inefficiency?
• absence of choice for patients?
If under-funded,
• more public money or private resources?
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?
SWITCHING PROTOCOL
•
•
•
•
Prior to 1991, central planning
1991-97: quasi markets
1997-2003: move away from markets
2003-: competition and choice
LONG-TERM CARE
•
•
•
More public money or is privatisation inevitable?
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?
Group Discussion: Education
1.
2.
3.
4.
Identify the salient characteristics of education as a
commodity. Do you consider it to be a ‘merit good’?
Do you expect private markets for education to be
efficient? Identify reasons for any market failures.
Private markets for education may well be
inequitable. Should we worry?
‘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.
Government Failure
Government Failure
• Market failures do not always call for action
• We must beware of the possibility of government
failure
• For instance, the possibility that governments may
face the same informational constraints as markets
• They may also face ‘agency problems’
• If so, government intervention could just replace
market failure with government failure
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
Is the public sector inefficient?
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
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
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?
Lessons for policy makers
•
•
•
Market failure does not make an automatic case for
intervention (or a helping hand)
Sometimes government intervention makes matters
worse. Informational problems affect both public and
private sectors.
– regulation may have perverse effects
(fumbling hand)
- vulnerability of civil servants to rent-seeking
behaviour (grabbing hand)
Weigh existing inefficiencies against risk of
government failure
Industrial Policy
Correcting market failures
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
• Circumvent coordination failures, etc.
However, beware the possibility of government failure
Research & Development
PROBLEM: Inventions are a public good, so that
unregulated markets may not produce enough
THREE SOLUTIONS
1. Patents: confer time-bound legal monopoly on the
inventor
2. Procurement: use government research labs
3. Patronage: provide subsidies to universities
New technologies and standards
Problem: uncertainty about new technologies and
standards may cause
• lock-in in to poor standards
• delays in adoption
Solution: guide technological choices?
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
Cost-Benefit Analysis
COST-BENEFIT ANALYSIS
Analysis of costs and benefits: useful for
 Procurement decisions
 Capital projects
 Use or disposal of existing assets
 Regulation: environmental standards, health and
safety
 Policy and programme development
THE PROCESS
 Justify action and set objectives
 Appraise the options including the ‘do minimum’ and socalled politically infeasible ones
Identify costs and benefits of each option
 Adjustments
non-market impacts
risk and optimism
distributional impacts
 Develop and implement solutions
 Evaluation
FORMS OF APPRAISAL
 Financial Appraisal
Compare revenue with costs, as private firm does
 (Social) Cost-Benefit analysis
Evaluate costs and benefits of each option, including
costs and benefits that the market does not value
 Cost-effectiveness analysis
If benefits are hard to evaluate, compare the costs of
achieving some target level of benefits
 Multi-criteria analysis
Computed the weighted score for each option based
on its performance on defined criteria.
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
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
SOCIAL COST-BENEFIT ANALYSIS
 While private sector cares about profits,
government must consider a larger set 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 social NPV could differ
 Social rate of time preference may differ from
market rates of interest
VALUING NON-MARKET IMPACTS
Evaluate non-market consequences
• externalities, including environmental ones
• consumers’ surplus
• saving of time
• saving human life (‘prevented fatality’)
• possibilities of catastrophic risk
Often hard to value these. Can use
• Willingness to Pay (WTP)
• Willingness to Accept (WTA)
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.
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
 see how costs and benefits affect different groups
The effect of the chosen discount rate
Consider stream of positive returns: NPV falls as we
use a higher discount rate
NPV
R
DISCOUNT RATE, r
Choice of too high a discount rate will reject good projects
Choice of too low a discount rate will accept bad ones
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
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.
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
Green Accounting: A Case Study
Costs and Monetized Benefits of of reducing lead from gasoline, 1983 dollars
1985
1986
1987
1988
1989
1990
Children's health
Adult blood pressure
Other pollutants
Maintenance
Fuel economy
Total benefits
-Refining costs
Net Benefits
223
1724
0
102
35
2084
-96
1988
600
5897
222
914
187
7821
-608
7213
547
5675
222
859
170
7474
-558
6916
502
5447
224
818
113
7105
-532
6573
453
5187
226
788
134
6788
-504
6284
414
4966
230
767
139
6517
-471
6045
Children's health: lead in blood is related to IQ-impairment.
Lead causes hypertension and increased heart-attacks: a statistical life was valued at $1 mn
Low lead levels reduce other pollutants, economies in fuel & maintenance
The Welfare State
Supply-side economics
Central idea
Force government OUT of market place, to unleash private
sector dynamism.
Use microeconomic incentives to increase productivity
Origins
• disenchantment with Keynesian, ‘demand-side’
thinking
• tax fatigue of the 1970s
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.
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
In sum
Implications for efficiency
 Claims about likely efficiency gains were exaggerated
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)
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
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
LESSONS OF HISTORY
Is the welfare state viable?
 Thatcher's contribution: linking payments to inflation not
earnings
 Should benefits be targeted or universal?
Further reading


John Kay, The Truth about Markets: their genius, their limits,
their follies, Penguin, 2004
Nicholas Barr, The Economics of the Welfare State, 4th edition,
Oxford University Press, 2004
Economics Workshop
Strategy Unit
Sandeep Kapur