Economic Policy
and Market Regulation
Prof. Dr. Stefan Kooths
BiTS Berlin
(winter term 2014/2015)
www.kooths.de/bits-ep
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Outline
1. Introduction and Overview
2. Market Mechanisms and Government Interventions
3. Externalities and Public Goods
4. Competition Policy and Regulation
5. Ordoliberalism and the Social Market Economy
6. Summary: The Key Lessons Learnt
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Outline
1. Introduction and Overview



Motivation and key aspects
Methodology and general approach
Course scheme
2. Market Mechanisms and Government Interventions
3. Externalities and Public Goods
4. Competition Policy and Regulation
5. Ordoliberalism and the Social Market Economy
6. Summary: The Key Lessons Learnt
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Economics and the key allocation problem
 Human needs
» Subjectively felt uneasiness (reason for action)
» Generally unlimited
 Goods
» Means for (direct or indirect) satisfaction of a need
» Generally limited
 Scarcity (allocation problem)
» Not all needs can be fully satisfied
» Selection inevitable
 Ranking needs
 Matching with disposable means (production possibilities)
» Economic growth: Reduction of „uneasiness “
(more satisfaction by expanding the pool of means)
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Alternative allocation mechanisms

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Violence (military campaigns, robber barons)
Discrimination (Sex, Nationality, Age, …)
Greyhound racing („First come, first served“)
Communism („Each according to his/her need”)
Egalitarianism („Each the same“)
 Market (competitive exchange mechanism)
» Property rights
» Voluntary exchange
 „Each according to his/her preferences and performance“
(ability-to-pay resulting from market income = valuation by others)
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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The market signal system: Profits, Losses, Bankruptcy
 Profits
» Revenues (value creation) > Costs (value destruction)
» Net creation of value
 Agent stays in the game, activity can be expanded
 Losses
» Revenues < Costs
» Net destruction of value
 Yellow card (warning): activity should be reduced/modified
 Bankruptcy
» Revenues << Costs
» Net value destruction ongoing/at large scale
 Red card (sending-off): activity must stop
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Property rights and the primary role of government
 Property rights
» Usus
» Abusus
» Usus fructus (includes: accountability!)
 Role of government:
Defining and guaranteeing property rights (legal framework)
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Fields of economic policy:
Allocation, redistribution and stabilization
 Allocation
» Improving economic efficiency
 Redistribution
» Changing the distribution of disposable income
(primary vs. secondary income distribtuion)
 Stabilization
» Growth, employment, price stability, external equilibrium
(macroeconomic approach)
» Fiscal policy
» Monetary policy (and choice of currency system)
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Levels of economic policy:
Constitutional vs. interventionist approaches
 Constitutional level
» Designing the general institutional framework (economic order)
 Interventional level
» Modifying/interfering with market processes
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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The extended Tinbergen rule for government interventions
 One policy target
 One specific tool (policy instrument)
 One independent authority (in case of target conflicts)
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Incentives and government interventions:
Intention vs. outcome (The Cobra effect)
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The big picture: From Feudalism to Neoliberalism (1/3)
Free market system
(classic liberalism)
Feudalism
liberal
revolution
Feudal power
Constitution
(Democratic) State
Subjects
Economy
Competition
Capitalist economy
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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The big picture: From Feudalism to Neoliberalism (2/3)
„Invisible Hand“/Laissez-faire: Self-interest and public welfare
Adam Smith (1723 – 1790)
„It is not from the benevolence of the butcher, the
brewer, or the baker that we expect our dinner, but
from their regard to their own interest.”
(Wealth of Nations, 1776)
Vincent de Gournay (1712 – 1759)
„Laissez faire, laissez passer,
le monde va de lui-même.”
Bernard de Mondeville (1670 – 1733)
The Fable of the Bees:
or, Private Vices, Public Benefits (1714)
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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The big picture: From Feudalism to Neoliberalism (3/3)
Degenerate
„unfree“ market system
Neoliberal system
Constitution
Constitution
Demokratischer Staat
Influence
Competition
Interventions
(Democratic) State
Regulation
Protection
Competition
Capitalistic economy
Social market economy
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Regulation vs. deregulation: An ongoing debate
 Regulatory design is technology-dependent
 Competing paradigms for economic policy making
 The fundamental organizational question:
Markets vs. hierarchies
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Good and bad economics
(H. Hazlitt: Economics in One Lesson)
The bad economist sees only …
» … what immediately strikes the
eye.
» … the direct consequences of a
proposed course.
» … what the effect of a given
policy has been or will be on
one particular group.
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
The good economist also …
» … looks beyond.
» … looks at the larger and
indirect consequences.
» … inquires what the effect
of the policy will be on all
groups.
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Outline
1. Introduction and Overview



Motivation and key aspects
Methodology and general approach
Course scheme
2. Market Mechanisms and Government Interventions
3. Externalities and Public Goods
4. Competition Policy and Regulation
5. Ordoliberalism and the Social Market Economy
6. Summary: The Key Lessons Learnt
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Methodological individualism
 General method
» Individuals as point of departure for economic analysis
» Explaining social processes via actions of involved persons
 Individuals …
» … are diverse
» … have exogenous preferences
» … are capable of acting on their own
» … follow their vested interest
 Subjectivism
» Individual preferences
» No scientific inter-subjective comparisons of utility
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Human Action
 Subjective uneasiness
 purposeful action
 Action = Influencing circumstances of one’s life
 Humans as universal entrepreneurs
» Decision maker
» Explorer (search for new means)
Ludwig von Mises (1881 – 1973)
Nationalökonomie – Theorie des Handelns und Wirtschaftens (1940)
http://mises.org/document/3250
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“Collective” action and average “behavior” of groups:
Pitfalls of collectivist analysis and the Arrow paradox
Person
Ranking of alternatives A, B, C
1
2
3
A>B>C
B>C>A
C>A>B
Voting
Results
A vs. B
B vs. C
C vs. A
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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The “free-market prejudice”
 Voluntary exchange imply gains from trade
 Markets as reference and default system
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Pareto efficiency and Kaldor-Hicks criterion
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Workable economic coordination: Static and dynamic functions
“What are markets expected to do?”
 Static functions
» Consumer sovereignty
» Efficient factor allocation
» Performance-based income distribution
 Dynamic functions
» Flexible adjustment to changing conditions
» Technological progress/innovations
 Coordination efficiency
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Positive vs. normative analysis
 Positive economics
» Economist as observer
» Explanation of cause and effect
 Normative economics
» Economist as advisor to a “social planner”
» Judgmental knowledge (explicit or implicit assumptions)
» Second-best problems
 Political economics
» Analysis of politicians/bureaucrats/pressure groups
» Public Choice/New Institutional Economics
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Markets vs. politics/morals
 Market system: Coordination mechanism (instrument)
» Usefulness basically open to scientific analysis
» But: Links between personal freedom and market system
 Politics/morals: Definition of targets (normative)
» Legitimation cannot be established by economic science
» Economics: Looking for best means to reach specific targets and
determining opportunity costs/trade-offs
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Transaction costs
 Ex-ante transaction costs
» Search
» Negotiation
» Contracting
 Ex-post transaction costs
» Implementation
» Monitoring
» Adjustment
 Using the market is not for free
(BUT: so is hierarchical/central planning)
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Categories of market failures
 Technological externalities
 Natural monopolies (subadditivity of cost functions)
 Information deficiencies
 Instability (deficient adjustment processes)
 [Non-rationality]
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Potential room for improving social coordination:
The two-stage burden of proof
 Intervention analysis: Market vs. hierarchy (central planning)
(1) Significant market failure?
(2) Market failure > government failure?
(comparing relevant alternatives)
 Information problem
(getting/distributing data, value problem)
 Incentive/bureaucracy problem
(individual utility vs. realization of the plan)
 Financing/spillovers to other fields
(distortions on other markets)
 Intervene only, if (1) and (2)
» Default: Market-based coordination (free-market prejudice)
» Minimally invasive operations (market-compatible solutions)
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Dubai: Is the desert a market failure?
 Ruler of Dubai:
„Market failed to put Dubai on the global map!“
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Outline
1. Introduction and Overview



Motivation and key aspects
Methodology and general approach
Course scheme
2. Market Mechanisms and Government Interventions
3. Externalities and Public Goods
4. Competition Policy and Regulation
5. Ordoliberalism and the Social Market Economy
6. Summary: The Key Lessons Learnt
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Reading
 Literature
» Fritsch, M. (2011): „Marktversagen und Wirtschaftspolitik –
Mikroökonomische Grundlagen des staatlichen Handelns“, 8. Aufl.,
Verlag Vahlen: München.
» Grossekettler, H., A. Hadamitzky and C. Lorenz (2008):
„Volkswirtschaftslehre“; UVK Verlagsgemeinschaft: Konstanz.
» Hazlitt, H. (2008): “Economics in One Lesson”, Ludwig von Mises
Institute: Auburn/Alabama.
» Mankiw, N. G. (2011): „Principles of Economics“, 6th Edition, SouthWestern.
 Course website: www.kooths.de/bits-ep
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Outline
1. Introduction and Overview
2. Market Mechanisms and Government Interventions


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Market-based coordination and welfare economics
Price controls
Taxes
3. Externalities and Public Goods
4. Competition Policy and Regulation
5. Ordoliberalism and the Social Market Economy
6. Summary: The Key Lessons Learnt
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Pareto efficiency
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Conditions for „perfect“ competition (1/2)
 Atomistic market structure
» Infinite number of buyers and sellers (no market power)
» Price taker/autonomous decisions
 Rationality
» Consumers/households: Utility maximization
» Producers/enterprises: Profit maximization
» Self-interest with fair means (no opportunistic behavior)
 Homogenous goods (products and factors)
» No personal/spatial/physical preferences
» No indivisibility
 Stationary world
» Given resources, constant technology
» No growth analysis, no process/product innovations
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Conditions for „perfect“ competition (2/2)
 World without frictions
» Zero transaction costs (no costs for making an exchange of goods)
» Perfect factor mobility (unrestricted market entry/exit)
 Freedom of choice
» No involuntary/compulsory transactions
» No technological external effects
 Perfect information/total transparency
» Full knowledge/free information about alternatives and prices
» No uncertainty
 Infinite speed of response
» Focus on equilibrium analysis
» Transactions only at equilibrium prices (no “false” trading)
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The 2-2-2 model
 Two consumers: A and B
 Two products: X and Y
 Two factors: L and K
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Criteria 1: Efficiency of exchange
(Edgeworth box and contract curve)
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Criteria 2: Efficiency of factor use
(efficiency line and production-possibility frontier)
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Criteria 3: Optimal composition of production
(consumer sovereignty)
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Equilibrium: Market clearing and social welfare
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Fundamental theorems of welfare economics
 Theorem 1:
Competitive markets tend toward an efficient allocation of
resources (= fulfill criteria 1 to 3)
 Theorem 2:
Any particular Pareto-efficient outcome can be achieved via
lump-sum wealth redistributions and then letting the market
take over
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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The markets’ navigation system:
Prices as universal information carriers
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Static and dynamic efficiency
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Primary income distribution
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Flexible adjustment to changing conditions
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Technological progress
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“Perfect” competition and reality:
Nirvana critique and the theory of second best
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Market prices, revealed preferences and the impossibility of
calculation under Socialism (Mises)
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Potential market failures and economic policy
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Outline
1. Introduction and Overview
2. Market Mechanisms and Government Interventions



Market-based coordination and welfare economics
Price controls
Taxes
3. Externalities and Public Goods
4. Competition Policy and Regulation
5. Ordoliberalism and the Social Market Economy
6. Summary: The Key Lessons Learnt
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Price ceilings and market outcomes (example: rent controls)
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Price floors and market outcomes (example: minimum wages)
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Escaping price controls
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Outline
1. Introduction and Overview
2. Market Mechanisms and Government Interventions



Market-based coordination and welfare economics
Price controls
Taxes
3. Externalities and Public Goods
4. Competition Policy and Regulation
5. Ordoliberalism and the Social Market Economy
6. Summary: The Key Lessons Learnt
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Taxes on sellers
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Taxes on buyers
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Elasticity and tax incidence: Who really pays the tax?
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Excess burden (deadweight loss) of taxation
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The Laffer curve: Tax rates vs. tax revenues
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Administrative burden
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Marginal tax rates vs. average tax rates
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Lump-sum taxes
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Principles of taxation: Benefits vs. ability-to-pay
 Benefits principle
 Ability-to-pay principle
» Horizontal equity
» Vertical equity
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Outline
1. Introduction and Overview
2. Market Mechanisms and Government Interventions
3. Externalities and Public Goods


Technological externalities
Public goods and common resources
4. Competition Policy and Regulation
5. Ordoliberalism and the Social Market Economy
6. Summary: The Key Lessons Learnt
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Technological vs. pecuniary externalities
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Positive externalities: Private and social utility
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Negative externalities: Private and social cost
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Policy instruments: Incentive-based vs. command-and-control
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Criteria: Static efficiency, dynamic efficiency, and effectiveness
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Moral suasion
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Nationalization
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Public orders
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Pigou-taxes/subsidies
Arthur Cecil Pigou
(1877—1959)
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Cap-and-trade (example: pollution permits)
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Bargaining: The Coase theorem
Ronald Coase
(1910—2013)
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Outline
1. Introduction and Overview
2. Market Mechanisms and Government Interventions
3. Externalities and Public Goods


Technological externalities
Public goods and common resources
4. Competition Policy and Regulation
5. Ordoliberalism and the Social Market Economy
6. Summary: The Key Lessons Learnt
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Classification of goods: Excludability and rivalry
Rivalry?
Classification matrix
yes
no
yes
Private good
Club good
no
Quasi-public good
Public good
Excludability?
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Private vs. collective goods: Aggregating individual demand
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Non-excludability: The free-rider problem
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Managing collective goods:
Quantities, prices, and willingness to pay
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Providing public goods: Cost-benefit analysis
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The Tragedy of the Commons
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Common resources and property rights
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Outline
1. Introduction and Overview
2. Market Mechanisms and Government Interventions
3. Externalities and Public Goods
4. Competition Policy and Regulation



Competitive markets vs. market power
Anti-competitive behavior and anti-trust policies
Natural monopolies
5. Ordoliberalism and the Social Market Economy
6. Summary: The Key Lessons Learnt
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Monopoly: Price, quantity, and welfare effects
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Price discrimination
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Temporary monopolies (pioneer profits), dynamic efficiency,
and contestable markets
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Cartels: Potential profits and fragility
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Outline
1. Introduction and Overview
2. Market Mechanisms and Government Interventions
3. Externalities and Public Goods
4. Competition Policy and Regulation



Competitive markets vs. market power
Anti-competitive behavior and anti-trust policies
Natural monopolies
5. Ordoliberalism and the Social Market Economy
6. Summary: The Key Lessons Learnt
KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2014/2015)
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Anti-competitive strategies (overview)
 Cartels and collusion
 Abuse of dominant market position
 Mergers and acquisitions
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Anti-trust policy concepts (overview)




Laissez-faire approach
Structure approach
Regulation approach
Ownership approach
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Per se-rule vs. rule of reason
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Ex ante vs. ex post approach
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Problem of the relevant market
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Outline
1. Introduction and Overview
2. Market Mechanisms and Government Interventions
3. Externalities and Public Goods
4. Competition Policy and Regulation



Competitive markets vs. market power
Anti-competitive behavior and anti-trust policies
Natural monopolies
5. Ordoliberalism and the Social Market Economy
6. Summary: The Key Lessons Learnt
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Economies of scale
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Subadditivity of cost functions
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Role of potential competition (contestable markets)
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Regulation: Price-cap vs. rate-of-return
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Auctioning
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