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Title: Economics%20Workshop%20


1
Economics Workshop  Strategy Unit
14-16 March 2007
  • Sandeep Kapur

2
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

3
Introduction to EconomicsConcepts and Tools
4
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

5
Basic Concepts
  • POSITIVE ECONOMICStries to explain behaviour
  • NORMATIVE ECONOMICS prescriptions, usually based
    on value judgment

6
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

7
Degrees of government intervention differ..
Hong Kong
- China - Denmark - UK - USA -
Cuba
8
..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
9
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.

10
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11
Economic Models
  • MODEL
  • Deliberate simplification of reality
  • like a map
  • DATA
  • Time Series
  • Cross-Section
  • Panel Data

12
Tools Visualizing data
  • A scatter diagram

13
Tools Interpreting the data
It appears that higher bus fares lead to higher
revenue
14
but it might not be true
Suppose the two clusters are from two different
time periods what might that suggest?
High tube fare
Low tube fare
15
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

16
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17
How Markets WorkDemand, Supply, and Price
Adjustment
18
Market
  • DEMANDquantity buyers wish to buy at each price
  • SUPPLYquantity producers wish to sell at each
    price
  • MARKET
  • any arrangement in which prices adjust to
    reconcile buyers and sellers intentions
  • EQUILIBRIUM PRICEthe price at which market
    clears (i.e. quantity demanded quantity
    supplied)

19
Market
Supply curve
price
Equilibrium Price
Demand curve
Equilibrium Quantity
quantity
PRICE ADJUSTMENT
Equilibrium price clears market
20
  • 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

Quantity
Equilibrium quantity
21
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 consumers income changes?
  • normal goods vs inferior goods
  • 3 tastes change?
  • role of fashions and fads

22
COMPARATIVE STATICS(effect of changing the
other things)
  • Suppose income rises, increasing demand

23
SUPPLY IN DETAIL elaborating the other things
  • How does SUPPLY of a good vary when
  • technology improves?
  • input prices change? energy, labour, capital
  • 3 regulation imposes extra costs?

24
COMPARATIVE STATICS
  • Suppose technical breakthrough raises supply

25
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

26
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27
Introduction to EconomicsGROUPWORK
  • 1 Are the following statements positive or
    normative?
  • (a) Higher tax rates cut revenue from tobacco
    taxes
  • (b) Poor countries get an unfair share of world
    income
  • (c) Smoking is antisocial should be
    discouraged
  • (d) The nuclear industry needs public support
  • (e) The nuclear industry deserves public support
  • (f ) The nuclear industry is a good investment
    for UK

28
GROUPWORK
  • The price of crude oil increased from 2.90 to 9
    per barrel in 1973, in a coordinated move by OPEC
    members.
  • (a) How did the OPEC members manage to raise the
    price? Show using a supply-demand diagram for the
    oil market.
  • (b) What happened to the demand for coal and the
    price of coal? Show using a supply-demand
    diagram for the coal market.
  • (c) What happened to the demand for fuel-guzzling
    cars?
  • (d) What happened to supply and demand for oil
    eventually?

29
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
30
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31
Elasticity of Demand and Supply
32
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
33
Implications for Revenue
Price
  • If demand is elastic,
  • a fall in price raises the quantity demanded by a
    greater percentage than the price. Thus revenue
    rises as price falls
  • If demand is inelastic,
  • a fall in price raises the quantity demanded by a
    smaller percentage than the price. Thus revenue
    falls as price falls

Price
Quantity
Quantity
34
Example
  • Brazil coffee exports

1993 1994 1995
price (1995 US /lb) 0.9 2.0 2.9
export quantity (1990 100) 113 102 85
Revenue 102 204 179
35
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
36
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
37
Price Elasticity of Supply
  • Price Elasticity of Supply

change in the quantity supplied
change in price
Supply elasticities are usually positive
38
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

39
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.

40
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

41
What government does  Why intervene?
42
Government Intervention
  • Intervention in free markets is usually motivated
    by
  • Equity considerations
  • Efficiency considerations
  • Ethical or moral arguments

43
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

44
Equity of Allocations
Allocation a description of who gets what
  • Starting from A, a move to E or F reflects a
    decrease in equity

45
Efficiency of allocations
  • Relative to initial point A
  • B is better for all (and C is worse)
  • D is better for one, and no worse for other
  • B D are said to be Pareto improvements on A

46
Economic Efficiency
  • An allocation is Pareto efficient if it is
    impossible to find another allocation that makes
    someone better off and nobody worse off.

47
Are Markets Pareto Efficient?
  • Key Questions
  • Do free markets lead to efficient outcomes?
    Always?
  • What are the implications for policy?

48
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

49
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!)

50
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

51
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
  • (Pareto) efficiency considerations?
  • a desire for greater equity?
  • something else?
  1. Income tax
  2. Taxation of petrol
  3. Windfall tax on utilities
  4. Regulating utility prices

52
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53
Group Work
  1. Regulating discharge of sewage in the Thames
  2. Legislation against insider trading
  3. Banning the use of cocaine
  4. Unemployment insurance
  5. Making primary school compulsory
  6. Maintaining an army
  7. Running the NHS
  8. Running the Post Office

54
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55
Correcting Market Failures  Why intervene?How
to intervene?
56
Sources of Market Failure
  • Externalities
  • Public goods
  • Imperfect competition
  • Imperfect information
  • We will look at each of these in turn

57
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)
  • EXAMPLES
  • Adverse externality smoking, pollution
  • Beneficial externality bees and orchards
  • Adverse production externality pollution

58
Why Externalities Matter
  • THE ESSENTIAL PROBLEM
  • Social cost private cost externalitiesSocial
    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

59
Adverse Production Externality
  • 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

60
Property Rights
  • Solution 2 (Coase)
  • Assign property rights and let people trade these
    rights in pseudo-market
  • Initial assignment affects distribution but gets
    an efficient outcome
  • This solution does not work if there are high
    transactions costs or free riding

Efficient quantity is Q
61
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

62
Public Goods
  • CONSEQUENCES
  • Free-riding difficult to make people pay for use
  • And may not be efficient to charge for use
  • Markets do not provide right level of public
    goods
  • SOLUTION
  • Public provision, financed through taxes
  • Note that government needs to ensure right
    quantity, but does not need to produce it itself

63
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

64
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

65
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?

66
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

67
Adverse Selection
  • Occurs when individuals use private information
    to accept or reject a contract or
    transactione.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

68
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

69
Group Work Pollution control
  • As the National Rivers Regulator, you must tackle
    the problem of a chemical firm polluting the
    Thames
  • 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.

70
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?

71
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?

72
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?

73
Public Spending
74
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.

75
Health care
76
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.

77
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?

78
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

79
Why intervene in health care
  • Would a private health care market be efficient?
  • Imperfections in competition
  • Imperfections due to asymmetric information and
    insurance
  • Externalities and public goods aspects
  • In addition to efficiency issues
  • equity issues
  • ethical issues

80
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)

81
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?

82
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?

83
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
84
Other reasons for intervention
  • Equity arguments
  • Moral and ethical arguments
  • babies, organs should not be sold

85
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

86
Other questions
  • Macro-economic issue
  • How much should we spend on health? rising cost
    of health care
  • ageing population
  • more sophisticated (and expensive) treatment

87
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

88
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

89
Health Spending, 2001
Spending per head, USPPP 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
90
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?

91
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?

92
SWITCHING PROTOCOL
  • Prior to 1991, central planning
  • 1991-97 quasi markets
  • 1997-2003 move away from markets
  • 2003- competition and choice

93
LONG-TERM CARE
  • More public money or is privatisation inevitable?
  • Will this create a dual structure, for rich and
    poor? Implications for life expectancy?

94
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95
Discussion Education
  • 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?

96
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97
Government Failure
98
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

99
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

100
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

101
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

102
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?

103
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

104
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105
Industrial Policy  Correcting market failures
106
INDUSTRIAL POLICY
  • Central idea market failure calls for an active
    role for the government
  • Examples intervention can
  • Assist in the diffusion of new technologies
  • Circumvent coordination failures, etc.
  • However, beware the possibility of government
    failure

107
New technologies and standards
Problem uncertainty about new technologies and
standards may cause lock-in in to poor
standards Solution guide technological choices?
108
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

109
Cost-Benefit Analysis
110
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

111
THE PROCESS
  • Justify action and set objectives
  • Appraise the options including the do minimum
    and so-called politically infeasible
    onesIdentify costs and benefits of each option
  • Adjustments
  • non-market impacts
  • risk and optimism
  • distributional impacts
  • Develop and implement solutions
  • Evaluation

112
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.

113
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

114
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

115
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

116
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)

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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.

118
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

119
The effect of the chosen discount rate
  • Consider stream of positive returns NPV falls as
    we use a higher discount rate

Choice of too high a discount rate will reject
good projects Choice of too low a discount rate
will accept bad ones
120
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

121
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.

122
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

123
Green Accounting A Case Study
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125
The Welfare State
126
Supply-side economics
  • Central idea
  • Force government OUT of market place, to unleash
    private sector dynamism.
  • Use microeconomic incentives to increase
    productivity

127
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 a lot, tax
    revenue may even rise
  • Cut taxes on savings, dividends, to reduce
    distortions
  • 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.

128
Evaluation of Supply-side economics
  • did well on the inflation front
  • tax cuts may not induce more workSubstitution
    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
  • budgetary troublesUS government found it easier
    to reduce public investment but not current
    expenditure (wages of civil servants).
  • aggregate investment did not expand much, once
    you correct for the business cycle

129
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)

130
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

131
LESSONS OF HISTORY
  • Is the welfare state viable?
  • Thatcher's contribution linking payments to
    inflation not earnings
  • Should benefits be targeted or universal?

132
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
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