Economic Analysis and Public Policy

Session 1Introduction & Overview

Christopher Grandy6/13/11

Purpose of the Course

• Acquire a working knowledge of economic concepts important to public policy analysis.

• Explore the process and issues related to economic public policy analysis.

• Give you experience: Develop your own analysis of a public policy issue of interest to you.

Course Overview

Syllabus

Readings

• Main Text: Weimer and Vining (WV)• Articles by

– Ronald Coase (Externalities)– Christopher Grandy (efficiency)

Readings on policy method assigned on:

6/13-14 Information Gathering (Ch. 14)

6/21 Goals-Alternatives (Ch. 15)

Assignments/Grades

Project: Conduct a policy analysis on any issue (but approved by me).

– First Report due afternoon of June 16.– Second Report due afternoon of June 24.– Presentation on June 24.

Please submit the two reports electronically at grandy@hawaii.edu.

Main Points for This Session

• Nature of policy analysis– What does a policy analysis usually look like?– The Main elements

• These are the SAME elements you should have in your analysis.

• Example of Outline of assignment

Main Elements of Policy Analysis

• Description of the “problem”• Why is government policy necessary? How have

private markets failed?• History of past policy responses• Policy Goals: What should we be trying to achieve?• Policy Alternatives• How do Alternatives compare with respect to goals?• Recommendation

Main Elements of Canadian Salmon Fishery Example

• Description of the “problem”– Fish catches and stocks have declined. Incomes have fallen. Threats of elimination of

salmon in Canada.– Prior analysis indicates large potential net present value of fishing.

• Why is government policy necessary? How have private arrangements/markets failed?– Open access to fishing areas and difficulty of excluding participants.– Public Good problem: Over use of resource threatens depletion

• History of past policy responses– Early History: Brief, ineffective attempts to license fishers.

• “Overcapitalization”: Too many resources devoted to fishing.– Sinclair/Davis

• Gradually restricting entry through licenses• Unsuccessful buy-back of licenses (led to further investment by incumbents).

– Pearse Commission• Suggested tax on salmon catch to lower return and reduce overcapitalization.• Buy back and auction licenses.

– Mifflin Plan• Voluntary buy back of licenses.• Area licensing—methods of fishing confined to certain areas.

Main Elements of Canadian Salmon Fishery Example(continued)

• Policy Goals: What should we be trying to achieve?– Efficient use of economic resources.– Preservation of fishery.– Equitable distribution

• Current license holders• Aboriginal fishers• Taxpayers

• Policy Alternatives: What might we try?– Adopt Pearse Commission proposals

• Royalty tax (10%)• Buy-back of licenses to reduce capacity by 50%.

– River-Specific Exclusive Ownership• Assign fishing rights to single owner for 25 years.• Compensate existing owners of fishing licenses.

– Individual Transferable Quotas• Fishers allocated quotas as percentage of estimated total catch.• May be transferred (sold) to others.

• How do Alternatives compare with respect to goals?– Table on p. 21 of WV

• Recommendation– Balancing effects on efficiency, fairness and political feasibility: River-Specific Exclusive

Ownership

Notes for Your Project

• Limitations and Responses– Unless already familiar with issue, cannot do extensive

literature review.• Instead, identify potentially useful literature (list).

– Unless already familiar with issue, cannot do extensive history• Instead, outline major history as you understand it (perhaps as

summarized in a previous analysis (cite)).

– Cannot gather data to do cost/benefit analysis• Instead, list the major components of costs and benefits and

indicate possible sources of data/information.

Policy Analysis Compared to Other Approaches• For comparison, consider possible approaches from other analytical

perspectives:– Academic research

• Development of concept of common resource problems• Outcome of public decision process as illustration of class power.

– Policy research• Estimating the behavioral response to taxing fishing licenses.• Surveying fishers about what compensation is considered acceptable.

– Classical planning• Defining societal goals for fishery (and other natural resources?) and rules for

achieving those goals. “Sustainability” guidelines?– Public Administration

• How to efficiently carry out the mandates of decision-makers (e.g. the legislative process)—Managing the process of moving to exclusive river-specific ownership.

• How to participate in, as well as support, the public decision-making process and implement its outcomes.

– Journalism• Telling a good story—identifying victims, heroes, and villains in the public

decision-making process.– Policy Analysis

• Client-oriented assessment of problems and alternatives with goal of coming to a reasoned recommendation.

A Second Example:Traffic Congestion in Khon Kaen

Will use this topic as an example throughout the course.• Description of the “problem”

• Why is government policy necessary? How have private markets/arrangements failed?

• History of past policy responses• Policy Goals: What should we be trying to achieve?• Policy Alternatives• How do Alternatives compare with respect to goals?• Recommendation

Next Time

• Competition & Economic Efficiency• Gathering Information for Policy Analysis

Economic Analysis and Public Policy

Sessions 2 and 3Competition & Efficiency

Gathering Information

Christopher GrandyJune 13-14, 2011

Main Points for These Two Sessions

• Under certain assumptions, competitive markets lead to an “efficient” allocation of resources, and

• Competitive markets maximize “social surplus” (the sum of consumer and producer surpluses).

• Under these assumptions there is relatively little role for public policy to improve social welfare.

• Several critiques of the efficiency of markets worth considering—especially “coercive” relationships.

• Ideas for gathering information to do policy analysis.

Efficiency

• Pareto Efficiency: An allocation is Pareto Efficient if there is no way to reallocate resources so as to make one person better off without hurting another.

• “Better off” means that the person would prefer the new allocation to his/her existing allocation.

Illustration of Pareto Efficiency

Person A

Person B

0

0

Moo Satay

Pad

Tha

i

Set of Pareto Efficient Allocations

Competitive Markets & Efficiency

• Competitive Markets: People take prices as given (they do not act as though they can affect prices).

• Buying and selling in markets at these prices leads to Pareto Efficient allocations of resources.

• A “price” is a rate of exchange of one good in terms of another (e.g. A price of ฿30 means you give up 30 baht in exchange for one dish of pad thai. Or ฿5 for one moo satay. This implies a price of 6 (moo satay for pad thai), meaning that you give up 6 moo satay in exchange for 1 pad thai).

• Can think of a price as the slope of a line in our graphs.

Illustration of Competitive Markets & Pareto Efficiency

Person A

Person B

0

0

Moo Satay

Pad

Tha

i

Bottom Line

Because each person is doing as well as s/he can (each is on the highest indifference curve possible) GIVEN the starting position and the price, there is NO role for policy in improving this allocation of resources without hurting one of the participants.

Exercise

• Get into two groups• Read and discuss the instructions for your

group, making sure that everyone understands.• Do NOT reveal your instructions/information

to the other group.• Discuss possible trades, exchanges with the

other group in an attempt to better your position.

• You may make more than one exchange.

Consumer Surplus

• Useful for later discussion to express some of these ideas in terms of supply and demand curves.

• Look first at demand curves—a relationship between the price of a good and the amount that consumers are willing to purchase.

• Consumer surplus: The value that consumers place on a good in excess of the price they pay for it. Can be represented as the area between the demand curve and the equilibrium price.

Illustration of Consumer Surplus

Price

Quantity

D

P0

Q0

Consumer Surplus

Producer Surplus

• On the producer side, the relationship between price and the amount producers are willing to provide is summarized in the supply curve. The supply curve can be thought of as the cost of providing different amounts of the good.

• Producer Surplus: The value that producers receive in excess of their cost. This is the area above the supply curve but below the price.

Illustration of Producer Surplus

Price

Quantity

P0

Q0

S

Producer Surplus

(also called “rent”)

Social Surplus

• In a particular market, the sum of the two surpluses is called the “social surplus.” It is a measure of the aggregate benefits to individuals on both sides (buyers and sellers) of the market.

Illustration of Social Surplus

Price

Quantity

D

P0

Q0

S

Welfare Implications of a Price Change

• Either an increase or decrease in price will reduce both consumer and producer surplus relative to an initial position.

• The resulting change in social surplus provides a measure of the gain or loss due to the change.

• Useful in beginning to estimate the desirability of a policy that leads to a change in price.

Illustration of Change in Social Surplus Due to Price Reduction

Price

Quantity

D

P0

Q0

S

P1

Q1

Loss in Social Surplus

(Mainly due to loss in producer surplus)

Point

• With competitive markets, the equilibrium prices and quantities tend to maximize social surplus.

• That equilibrium is a Pareto Efficient point.• NOTE: There are many other Pareto Efficient points,

but it will generally be impossible to move from one to another without reducing the welfare of at least one person.

• Again, given the assumptions of a competitive market, there is no role for policy to unambiguously improve the allocations of goods and services.

Exercise: How would we use consumer/producer surplus to analyze market for kai satay?

• What is current price of kai satay?

• At what price would no one purchase kai satay?

• What is the cost of supplying kai satay?

• At what price would no kai satay be supplied?

Pric

e

Quantity

Demand

Supply

Role for Government

• Markets (or, more generally, private arrangements) cannot function without some government (collective action) support:– Enforce property rights

• If it is possible (or not too costly) to simply take property, rather than trade for it, then markets will fail.

– Enforce contracts• Agreements often separated by time—time of delivery of a good or

service may differ from time of payment. If people can violate (renege) on agreements, then no contracts (arrangements/trades) will be made.

– Laws, police, courts are critical societal institutions that allow markets to function.

Example: Traffic Congestion in Khon Kaen

• Goal: To move people and goods efficiently to their destinations.

• For competitive markets (private arrangements) to appropriately handle traffic:– Competitive markets in infrastructure– Vehicles– No congestion

• Develop additional infrastructure?• Given infrastructure

– Could markets improve traffic?– Everyone with “right” to travel that can be traded?

Project: Gathering Information

• Distinction between document research (literature review) and field research (interviews, surveys, etc.)

• For this course you will mainly rely on document research rather than field research.

• Use Ch. 14 to help guide you in looking for resources on potential topics for your project.– Remember: Because of limited time, I do NOT require an

extensive literature review. However, try to identify 4-5 important items that seem relevant to your project.

Next Time

• Market Failures I– Public Goods– Externalities

Economic Analysis and Public Policy

Sessions 4 and 5Market Failures I:

Public Goods & Externalities

Christopher GrandyJune 14-15, 2011

Main Points for These Sessions

• One way to start to think about a policy issue is to ask: Why doesn’t the market allocate this good/service efficiently?– Notice that this assumes that markets are a good way to

allocate goods.

• Two important reasons why markets fail to allocate resources well:– Public Goods– Externalities

• Implied Roles for Policy

Rivalry and Excludability

Two characteristics of many goods and services that make them well-suited to allocation by the market.

• Rivalry: One person’s consumption reduces the amount available for another person to consume. – For example, clothing, housing, food, computers, and so on.– Prevents possibility that a person consume a good that another person

pays for and consumes (“free riding”). • Excludability: Relatively easy to prevent someone from

consuming the good/service. – For example, attempting to take any of the items above from a store

without paying will lead to arrest.– Assures that a private supplier will be paid. Note that this illustrates one role of government in supporting the

allocation of goods and services via the market—enforcing property rights.

Public Goods

Public Goods are those that lack either rivalry (they are nonrivalrous) or excludability (they are nonexcludable) or both.

Consider these examples:

Public Goods: Type IRivalry & Nonexcludability

• Fresh Water: We all need water to live, so there is potentially a huge market for it. – Water is rivalrous: My consumption of a certain quantity

of water reduces the amount available for someone else to consume.

– Water flowing in a river or underground is nonexcludable: In general, it is difficult or impossible to prevent someone from consuming such water.

Leads to the overconsumption of water—the concern that others will use the water if you do not gives people little incentive to conserve and there is insufficient investment in preserving the available supply.

Public Goods: Type IRivalry & Nonexcludability

Quantity of Fresh Water

Price of Fresh Water

D

MPC

Includes the cost of gathering and transporting the water and the reduction in stock of water for this individual only.

MSCIncludes cost of gathering and transporting, but also reflects reduction in stock of water available to all.

QP

PP

QS

PS

Socially optimal consumption Equilibrium private consumption

Potential Policy Response Public Goods: Type I

Rivalry & Nonexcludability• Charge a per unit tax

that equals the difference between MPC and MSC.

• This raises the MPC curve to coincide with the MSC curve.

• Leads people to account for their effects on the total supply—and so, to conserve. D

MPC

MSC

QP

PP

QS

PS

Tax

Type I Public Good (R, NE) as Prisoner’s Dilemma

• Two households sharing a single well.• If both cooperate and conserve water, then each gets 100 Utils (measure of utility

(“happiness”)).• If one conserves while other does not; conserver gets 80 Utils and non-conserver

gets 110 Utils.• If neither conserves, then each gets 90 Utils.

Household 1

Household 2

Conserve

Conserve

Do NotConserve

Do NotConserve

100100

80110

11080

9090

“Do Not Conserve” is a “dominant strategy” for each player.

Socially optimal result is Conserve.

Nash Equilibrium is Do Not Conserve.

Public Goods: Type IINonrivalry & Excludability

• Consider a toll road (without congestion):– Nonrivalrous: In the absence of congestion, your

consumption of the road does not reduce the amount that is available for others to consume.

– Excludable: Access to the road only available if toll paid—preventing consumption.

– Because it doesn’t cost any more to supply another person (no congestion), the marginal price of the lecture “should be” zero. But at that price no one would be willing to supply it.

– If a positive price is charged, then there is underconsumption of the road—another traveler could use the road at no additional cost.

Two Notes on Nonrivalry

• Leads to a distinction between the cost of supplying an additional person versus the cost of supplying an additional unit of the good.– With a private good (rival and excludable), in order to

supply an additional person with the good, one must supply an additional unit of the good.

– With a nonrival good, the same quantity can supply many people. So, an additional person can be supplied at no additional cost.

• Requires a different method of moving from individual to market demand.– With a rival good, we sum over quantity– With a nonrival good, we sum over price

Market Demand for Rival and Nonrival Goods

Rivalrous Good

Q

P

D1 D2D

P

Q

Nonrival Good

D1 D2

D

Market Demand is the horizontal sum (over quantity) of individual demand

Market Demand is the vertical sum (over price) of individual demand

Public Goods: Type IINonrivalry & Excludability

Toll

Number of Travelers

D

S

When toll road is not congested, supply exceeds demand at a zero price. Everyone can travel for free.

But how is the toll road paid for?

Charge a toll and accept underconsumption? Tax everyone & allow all to travel?

0

Public Goods: Type IINonrivalry & Excludability w/ Congestion

Toll

Number of Travelers

D

At some point, each additional traveler imposes costs on others.

A fee reflecting those costs may be appropriate.

But this does NOT solve the problem of how to pay for toll road itself.

0

S

P0

Public Goods: Type IIINonrivalry & Nonexcludability

• Fireworks Display– Nonrivalrous: Ignoring congestion, one person’s

watching the display does not reduce the amount available to others.

– Nonexcludable: Cannot prevent someone from looking at the sky and watching the display.

• At a positive price, there is underconsumption.• Because of nonexcludability, no one is willing

to supply the good.

Public Goods: Type IIINonrivalry & Nonexcludability

Fireworks

Price

D1

D2

D3

Total Demand

Supply

• Optimal provision of fireworks is at Q* where marginal cost (supply) equals total demand.

• If knew each person’s individual demand, then could charge individual prices.

• Since we don’t know individual demand, could tax to supply the good.

• But then some people will be unhappy

• D1 doesn’t want any of the good

• D3 would want much more

Q*

tax

Exercise

Determine whether the following are public goods and, if so, what kind [(R, NE), (NR, E), (NR, NE)]:

1. Information from an online search engine 2. Transportation on a train 3. Fresh air4. Movie in a theatre5. Opihi (small, edible shellfish collected on the shore)6. Tsunami warning system7. The beach8. Bridge across river9. Petroleum in the ground

Example: Traffic Congestion• A congested road possibly the result of an initial Type III

public good (nonrival and nonexcludable).– A newly-built road likely to have enough capacity for all current users.

Thus, nonrival: one person’s use of the road does not reduce the amount available to another (measured in terms of transit time).

– With multiple, public accesses, the road is effectively nonexcludable—difficult, or impossible, to prevent additional travelers.

– Over time, as population grows and/or economy develops, the road becomes congested. Now the road is Type I (rival, nonexcludable).

• Converting the road to a toll road is one option—excludability can reduce congestion.– In New York City (Manhattan) 20 years ago, flat toll to drive into city

across George Washington Bridge.– Today, time-of-day pricing: $8 (฿240) during peak hours and $6

(฿180) during non-peak hours.

Externalities

• A divergence between private and social characteristics of a market:

• A negative externality involves a divergence between private and social cost. Implies overproduction of the good/service.– Pollution from a manufacturing facility.

• A positive externality involves a divergence between private and social benefits. Implies underproduction of the good/service.– Educating children and socialization.

Negative Externality: Manufacturing w/ pollution side-effect

Quantity of Manufactured Goods

Price

Demand

• MPC reflects only the costs recognized by the company. If the company ignores pollution, then these costs will fall below Marginal Social Cost.

• Too much is produced if the firm utilizes MPC.

• May force the firm (or consumers) to bear the cost by imposing a tax on the manufactured good.

MPC

(excluding costs of pollution)

MSC

(including costs of pollution)

QpQ*

Positive Externality: Education

Education

P

S

MPB

MSB

If parents only pay attention to the benefits to them of educating their child, then they are on the Marginal Private Benefit curve, and will choose education level E0.

However, if education has positive socialization effects (encouraging cooperation, less violence, etc.), then there are benefits which accrue to others. And MSB is the relevant curve. The optimal level of education is then E*.

The parents don’t spend enough on education at E0.

May justify public subsidies for education.

E0 E*

Externalities & the Coase Theorem• Ronald Coase won the Nobel Prize in Economics in 1991—in part, for work which

has become known as the Coase Theorem.• Suppose that a farmer and a cattle rancher operate in close proximity to one another

so that occasionally straying cattle will trample some of the crops.• This can be viewed as a negative externality between producers. Traditionally this

has been seen as a situation in which government policy must address the issue—perhaps by imposing a tax on cattle production.

• Coase’s insight: The farmer and the cattle rancher could negotiate a solution—(1) the farmer could pay the cattle rancher to raise fewer cows, (2) the rancher could pay the farmer to plant elsewhere, (3) the two could share the cost of a fence, etc.

• Moreover, Coase argued that the pattern of planting and cattle raising would be the same regardless of the solution negotiated. Indeed, the pattern would be the same irrespective of whether the farmer had the “right” to be free from cattle or the cattle rancher had the right to allow foraging. The “trick” is that the two have an incentive to maximize “joint production.”

• Solution requires low “transaction costs”—the costs associated with bargaining and coming to an agreement.

Exercise: Which of the following are externalities?

• Neighbor paints house (nice color)• Neighbor allows tree to grow, obstructing view• To reduce global warming, national

government joins international treaty committing to end use of petroleum products by 2025.

• New technology for making clothing puts professional tailors out of business.

Example: Traffic Congestion

• On a congested road, each additional traveler imposes an external cost on the travelers behind.– Person decides whether to travel based on cost to him/her

—including delays from congestion ahead.– But typically fails to see cost he/she imposes on those

behind.– Imposing a toll can “internalize” the negative externality.

• Other negative externalities from traffic:– Air pollution in the local neighborhood.– Noise pollution.– CO2 emissions—global warming.

Next Time

• Market Failures II– Natural Monopoly– Asymmetric Information– Other Problems with Markets