Economics Workshop

 Strategy Unit

Sandeep Kapur

1-3 February 2006

WORKSHOP OBJECTIVES

To provide rigorous but non-mathematical training in economics, enabling participants to• develop a simple but reliable toolkit for

economic analysis• practise its application using concrete

problems• apply economic theory to their own work

Introduction to EconomicsConcepts 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 ECONOMICStries 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 ECONOMYwhat, how & for whom decided by prices, incomes, wealth

COMMAND ECONOMY central authority directs use of resources

Degrees of government intervention differ..

Hong Kong- China - Denmark - UK - USA -Cuba

Scale of government

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

Spending as share of national income (%)

The Production Possibility Frontier

Maximum quantity one good that can be produced, given quantities of other goods being produced

A

B

C

D

E

F

G

.

GOOD 1

GOOD 2

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 realitylike a map

DATA Time SeriesCross-SectionPanel Data

Tools: Visualizing data

A scatter diagram

variable x

variable y

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Tools: Interpreting the data

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Bus fare

Bus Revenue

It appears that higher bus fares lead to higher revenue…

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Bus fare

Bus Revenue

… but it might not be true

Low tube fare

High tube fare

Suppose the two clusters are from two different time periods – what might that suggest?

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 WorkDemand, Supply, and Price Adjustment

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)

Market

Demand curve

quantity

price

EquilibriumQuantity

EquilibriumPrice

PRICE ADJUSTMENT

Equilibrium price clears market

Supply curve

Price Controls

Price

Quantity

Demand curve

Supply curve

Equilibrium price

Equilibrium quantity

Suppose government sets minimum price above market clearing price

Controlled price

Examples incl• CAP• Minimum Wages• Rent Control

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, culture

COMPARATIVE STATICS(effect of changing the ‘other things’)

Suppose income rises, increasing demand

Quantity

Price

Demand: low income

Equilibrium price rises

Equilibrium quantity rises

Demand : high income

Supply

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…

Quantity

Price

Demand

2 but equilibrium price falls

1 Equilibrium quantity rises...

Supply rises

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 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) Airbus needs public support(e) Airbus deserves public support(f ) Airbus is a good investment for Britain

GROUPWORK

2 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?

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 changesInelastic demand: relatively insensitive

Depends ultimately on substitution possibilities

Implications for Revenue

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

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

Price

Quantity

Price

Quantity

Example

Brazil coffee exports

1993 1994 1995

price (1995 US $/lb) 0.9 2.0 2.1

export quantity (1990 = 100) 113 102 85

Revenue 102 204 179

Other elasticities

Cross price elasticity of demandfor 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 demandGreater that 1 for luxury goodsLess 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

A consumer has preferences over different goods and services

Budget constraint describes the different bundles that the 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 oppositive 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

Starting from A, a move to E or F reflects a decrease in equity

Goods for Tony

Goods for Gordon

A

E

F .

Allocation: a description of who gets what

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

Goods for Tony

Goods for Gordon

A

B

C. E

F

D

.

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 Pareto 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 the 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• prices equal the marginal cost of production• so that there is no way to reallocate resources to

generate a Pareto improvement• PUNCH LINE: Competitive equilibrium is Pareto

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. Income tax2. Taxation of petrol3. Windfall tax on utilities4. Regulating utility prices

…Group Work

5. Regulating discharge of sewage in the Thames

6. Legislation against insider trading

7. Banning the use of cocaine

8. Unemployment insurance

9. Making primary school compulsory

10. Maintaining an army

11. Running the NHS

12. Running the Post Office

Is there a trade-off between equity and efficiency?

Market Failures  Why intervene?

How to intervene?

Sources of Market Failure

• Externalities

• Public goods

• Imperfect competition

• Imperfect information

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• Market mechanism aligns private costs and benefits • Externalities imply divergence between social and

private costs (or social and private benefit)• If divergences exist, should not expect socially

efficient allocations

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

Quantity

Demand

MPC

MSC

E

FG

QQ*

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

Quantity

MC (for you)

QQ*

MB (to me)

Efficient quantity is Q*

MARKET FAILURE: Public Goods

Examples: national defence, safe streets, 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 useIn 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,• leading to Pareto 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 (eg 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, or for internal coordination.

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 hazardResulting in ‘incomplete markets’ or even ‘missing

markets’

Adverse Selection

• Occurs when individuals use their 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 changes itself changes behaviour. E.g., once you have bought insurance, the incentive to be careful is weakened.

• Greater carelessness increases risk of loss to the insurance company: this is moral hazard

A partial solutionInsurance 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 (unemployment insurance?)

SOLUTIONS: Regulation, direct provision

Inefficiency due to Strategic Interaction

No nukes Nukes

No nukes 8, 8 1, 12

Nukes 12, 1 2, 2

More generally, the ‘tragedy of the commons’

SOLUTION: coordinate individual choices through agreements

Country 1

Country 2

Individual optimization does not always result in the best social outcomes

Government Failure

• However, we must beware of the possibility of government failure.

• For instance, the possibility that governments may face the same informational constraints as markets.

• If so, government intervention may just replace market failure with government failure

Group Work: Pollution control

You are the National Rivers Regulator, tackling the problem of a chemical firm that is 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.

b. Instead of the 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?

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?

d. Lastly, suppose there are two chemical firms discharging into the river, one cleaner than the other. Is it better to

• set a pollution tax? (same rate per unit polluted 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?

Efficiencymacro: 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 competition2. Imperfections due to asymmetric information and

insurance3. 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 argumentsbabies, 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 autonomyWere 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. Identify the salient characteristics of education as a commodity. Do you consider it to be a ‘merit good’?

2. Do you expect private markets for education to be efficient? Identify reasons for any market failures.

3. Government involve often generates its own inefficiencies. Identify reasons for any government failures.

4. Private markets for education may well be inequitable. Should we worry about this?

5. ‘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

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• Correct for excessive risk aversion• Circumvent coordination failures, etc.

However, the possibility of government failure

Research & Development

PROBLEM: Inventions are a public good, so that unregulated markets may not produce enough

THREE SOLUTIONS1. Patents: confer time-bound legal monopoly on the

inventor2. Procurement: use government research labs e.g.

defence3. 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?

Risk

Problem: Markets may display excessive risk aversionCollectively, society can pool risks across projects &

spread risks across population

Solution: underwrite private sector losses? venture capital?

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 Capital projects Policy and programme development Use or disposal of existing assets Environmental standards, health and safety Procurement decisions

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

Adjustmentsnon-market impactsrisk and optimismdistributional impacts

Develop and implement solutions Evaluation

FORMS OF APPRAISAL

Financial Appraisal Compare revenue with costs, as private firm does

(Social) Cost-Benefit analysisEvaluate costs and benefits of each option, including

costs and benefits that the market does not value

Cost-effectiveness analysisIf benefits are hard to evaluate, compare the costs of

achieving some target level of benefits

Multi-criteria analysisComputed the weighted score for each option based

on its performance on defined criteria.

SOME TECHNICALITIES

TIME PREFERENCEPeople prefer £1 today to £1 tomorrowdemand a premium to postpone consumption

OPPORTUNITY COST OF CAPITAL cost in terms of opportunities foregonerate r at which you borrow

DISCOUNTING AND NET PRESENT VALUE What discount rate should we use?

INFLATION erodes future valueseither 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 RuleONE OPTION: Invest if NPV is positiveMANY 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

DISCOUNT RATE, r

NPV

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

1985 1986 1987 1988 1989 1990

Children's health 223 600 547 502 453 414Adult blood pressure 1724 5897 5675 5447 5187 4966Other pollutants 0 222 222 224 226 230Maintenance 102 914 859 818 788 767Fuel economy 35 187 170 113 134 139Total benefits 2084 7821 7474 7105 6788 6517-Refining costs -96 -608 -558 -532 -504 -471Net Benefits 1988 7213 6916 6573 6284 6045

Costs and Monetized Benefits of of reducing lead from gasoline, 1983 dollars

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 mnLow 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 troublesUS 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

Begg, Fisher and Dornbush, Economics, 8th edition, PART 3 John Kay, The Truth about Markets: their genius, their limits,

their follies, Allen Lane, 2003 Nicholas Barr, The Economics of the Welfare State, 4th edition,

Oxford University Press, 2004

Economics Workshop

 Strategy Unit

Sandeep Kapur