Principles of Policy Analysis

Econ 247

Markets are a good way to organize economic activities

However, the government often plays a role in today’s modern economies

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Overview

Governments often interfere in economic activities:Regulating prices of goodsRestricting trade in certain commoditiesImposing taxes Banning trade or certain activitiesSetting standards

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Examples

Market failures: occur when the market fails to achieve the desired outcome (fails to maximize social welfare).

When does the market fail? ExternalitiesImperfect competitionPublic GoodsImperfect information

Government intervention can potentially correct market failures

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Rationales for public policy

Besides intervention to correct market failures, the government may intervene in markets for

Distributional concernsEthical reasonsPolitical pressures

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Other Rationales for public policy

However, public policies can have unintended consequencesIndividuals react to the policy in a way that

weakens its effectOther decision makers can be affectedTradeoffs involved between different policy

objectives

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Rationales for public policy

Economic Systems, Resource Allocation, and Social Well-Being

The Economic Problem

Resources are used to produce goods and services to satisfy human needs and wants. Resources are limited. Needs and wants are unlimited.

Society has to make a decision

What, How and for Whom?

Society has to decide: What goods will be produced using the scarce

resources.

What, How and For Whom?

Society has to decide: How to produce them

What, How and For Whom?

Society has to decide: Who gets the goods and services produced

Answer

Different possible answersThe answer will determine the type of

economic system.

Answer

Solution 1: Individuals own resources They freely decide how to allocate their

resources in a way that is meaningful to them.

A Pure Market Economy

Answer

Solution 2 The government assumes ownership of

all resources The government decides how to allocate

them

A Pure Command Economy

Answer

Solution 3: A system that combines elements of the pure market

and the pure command system

A Mixed Economy

Resource Allocation in a Command Economy

A state planning commission develops a plan that determines production quantities for each major product

Resources allocated accordingly to each sector

Ministries, bureaus, local and regional planning offices were involved

Resource Allocation in a Command Economy

Workers assigned to positions according to a planning committee. Often the government committed itself to creating a job to each individual

Households allocated a set amount of goods, a system often called a rationing system

Problems of Central Planning18

1. Informational Requirements Planners needed to collect information to

determine the quantities to be produced of each good, the technology to use, which resources to allocate and how to distribute the finished goods.

Often shortages and surpluses existed Problems with pricing Quality of products suffered

Problems of Central Planning

2. Incentives for Efficient Production Production units run by government officials

instead of owners Workers were paid an amount independent of

their true effort No incentives to put extra effort as the resulting

gains will be shared by all workers

Resource Allocation in a Market Economy

Resource owners offer them to the best uses Workers decide how many hours to work. Similarly

landowners and capital owners decide where to put their resources

All decisions are coordinated in markets The market outcome determines the quantity of

resources allocated for each use and the price

Resource Allocation in a Market Economy

Market Structure Purely Competitive Markets

Large number of buyers and sellers Each seller offers standardized product Product prices free to move up or down Buyers and sellers must be mobile Freedom of entry and exit

Purely Monopolistic Markets One seller

Imperfectly Competitive Markets

Market Demand and Supply

5 6 7 8 9 10

5

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7

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Price $

Quantity

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D

D S

S

Surplus

Shortage

Prices as Signals in a Market System

Prices act as signals Prices inform producers of how much to

produce and therefore how much of the resources to be allocated to this use

A change in preferences will result in a price change which guides resource allocation

A higher price results with stronger preferences as the demand curve shifts right. More resources will be allocated to this use