Introduction: Thinking Like an Economist 1 CHAPTER CHAPTER 23 Microeconomic Policy, Economic Reasoning, and Beyond If an economist becomes certain of the solution of any problem, he can be equally certain that his solution is wrong. — H. A. Innis Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

1 Microeconomic Policy, Economic Reasoning, and Beyond Chapter Goals  List three reasons why economists sometimes differ and sometimes agree in their views on social policy  Describe three types of failure of market outcomes  Explain the cost/benefit approach the typical economist takes to analyze regulations  Explain why most economists are doubtful government can correct failure of market outcomes

1 Microeconomic Policy, Economic Reasoning, and Beyond Economists’ Differing Views About Social Policy  Economists’ views on social policy differ widely because: They have different underlying values They interpret empirical evidence differently They use different economic models  Any policy proposal must embody both economic analysis and value judgments because the goals of policy reflect value judgments

1 Microeconomic Policy, Economic Reasoning, and Beyond How Economists’ Value Judgments Creep into Policy Analysis Interpretation of the Policymaker’s Values  In practice, social goals are vaguely understood and vaguely expressed  Some economists have argued that economists should recommend only Pareto optimal policies  Pareto optimal policies are policies that benefit some people and hurt no one  Pareto optimal policies don’t exist because all policies make some people better off and some people worse off

1 Microeconomic Policy, Economic Reasoning, and Beyond How Economists’ Value Judgments Creep into Policy Analysis Interpretation of Empirical Evidence  Economists are trained to be as objective as possible, but pure objectivity is impossible  Empirical evidence is almost always imprecise, and inconclusive without further research  Policy debates do not wait for further studies  Economists’ value judgments influence which incomplete study they believe is more accurate

1 Microeconomic Policy, Economic Reasoning, and Beyond How Economists’ Value Judgments Creep into Policy Analysis Choice of Economic Models  An economist’s choice of models, which focus on certain aspects of economic reality, is influenced by value judgments  Some economic models are: Mainstream economic analysis is presented in the text and includes the standard supply/demand model Marxian (radical) focuses on equitable distribution of power, rights, and income. Public choice focuses on economic incentives as applied to politicians

1 Microeconomic Policy, Economic Reasoning, and Beyond Agreements among Economists about Social Policy  Liberal and conservative economists agree on many policy prescriptions  They use the same models, which focus on incentives and individual choice  Economists are often thought of as “coldhearted,” because they look at things in an objective way  Economists consider long-run effects, while the press and politicians tend to focus on short-run effects

1 Microeconomic Policy, Economic Reasoning, and Beyond Economists’ Cost/Benefit Approach to Government Regulation The cost/benefit approach to problems - assigning costs and benefits, and making decisions on the basis of the relevant costs and benefits This requires the determination of a quantitative cost and benefit for everything, including human life Many regulations are formulated for political expediency and do not reflect cost/benefit considerations

1 Microeconomic Policy, Economic Reasoning, and Beyond The Value of Life  Far from regarding human life as priceless, people make decisions every day that reflect the valuations they place on their own lives  It is clear that people place a finite value on life  Economists argue that individuals’ revealed preferences are the best estimate that society can have of the value of life  A policy making society shouldn’t pretend that life is beyond value

1 Microeconomic Policy, Economic Reasoning, and Beyond The Value of Life  These values are calculated by looking at people’s revealed preferences (the choices people make when they must pay the costs) Basis for CalculationValue of Human Life ($) Smoke detector purchases$1,010,000 – 3,380,000 Automobile safety features5,020,000 – 7,130,000 Bicycle helmets1,580,000 – 5,680,000 million Seat belt usage1, 320,000 million Car seats1,100,000 million

1 Microeconomic Policy, Economic Reasoning, and Beyond Comparing Costs and Benefits of Different Dimensions  It is difficult to decide whether the cost of a new regulation will outweigh the benefit  Many of the costs of regulation are small but occur in large numbers  Regulation can appear trivial; its implementation can be very costly  When those costs are compared to the benefits of avoiding a major accident, the dimensions of comparison are often wrong

1 Microeconomic Policy, Economic Reasoning, and Beyond Putting Cost/Benefit Analysis in Perspective  Cost/benefit analysis is often biased toward quantifiable costs or it involves ambiguity as nonquantifiable costs are quantified  Regulations will often change other things, too; minimum wage is an example The subjectivity and ambiguity of costs are reasons why economists differ in their views of regulation If firms replace workers with machines in one industry, employment in the machine industry might rise

1 Microeconomic Policy, Economic Reasoning, and Beyond The Cost/Benefit Approach in Context  In an economist’s framework: Well-intentioned policies often are prevented by individuals’ self-interest seeking activities Policies that relieve immediate suffering often have long-run consequences that create more suffering Politicians have more of an incentive to act fast than to do something that makes sense from a cost/benefit point of view

1 Microeconomic Policy, Economic Reasoning, and Beyond The Cost/Benefit Approach in Context  Cost/benefit analysis is an application of the supply/demand model The supply curve represents marginal costs The demand curve represents marginal benefits  Equilibrium of demand and supply in competitive markets achieves economic efficiency Economic efficiency - achieving a goal; in this case, producing a specified amount of output, at the lowest possible cost

1 Microeconomic Policy, Economic Reasoning, and Beyond Failure of Market Outcomes  Failure of market outcomes occurs when, even though the market is functioning properly (there are no market failures), the market is not achieving society’s goals  Three types of market failure: Failures due to distributional issues Failures due to rationality problems of individuals Failures due to violations of inalienable or at least partially inalienable rights of individuals

1 Microeconomic Policy, Economic Reasoning, and Beyond Failure of Market Outcomes Distribution Issues  The market doesn’t necessarily distribute consumer surplus as we’d like it to: The U.S. has luxury goods but not enough health care for the poor In some African countries, almost 30% of the population has AIDS, but most don’t have the money to get the necessary drugs  The sole purpose of society is not necessarily to maximize consumer and producer surplus; societies integrate other goals into the market

1 Microeconomic Policy, Economic Reasoning, and Beyond Failure of Market Outcomes Consumer Sovereignty and Rationality Problems  The supply/demand framework assumes individuals are rational, that what individuals do is in their own best interest  Rationality failure of individuals is that sometimes we are irrational and do things that aren’t good for us  Governments can intervene to get people to do what’s good for them  Governments levy sin taxes, which are taxes that discourage activities society believes are harmful (sinful)

1 Microeconomic Policy, Economic Reasoning, and Beyond Failure of Market Outcomes Inalienable Rights  By definition, inalienable rights cannot be sold, or given away; there can be no weighing of costs and benefits  If one right conflicts with other rights, society, not the market, must make a moral judgment about which right has priority  Some trades are not allowed because of inalienable rights: Coercive trade such as “your money or your life” Prostitution, selling body parts, and selling babies  Moral judgments underlie all policy prescriptions

1 Microeconomic Policy, Economic Reasoning, and Beyond Government Failure  Failure of market outcomes does not necessarily call for government action  For the government to correct a problem, it must: Recognize the problem Have the will to do something positive about the problem Have the ability to do something positive about the problem  Government seldom can do all three of these well

1 Microeconomic Policy, Economic Reasoning, and Beyond Government Failure Response By Public Choice Economists  Public choice economists point out that politicians are subject to the laws of supply and demand  Politicians’ goal is to provide a policy that their voting constituency likes This can result in larger and larger government  Public choice economists advocate as little government intervention as possible, even in the cases of market failures or failures of market outcomes

1 Microeconomic Policy, Economic Reasoning, and Beyond Chapter Summary  Economists’ views differ because of different underlying value judgments, because empirical evidence is subject to different interpretations, and because their underlying models differ  Economists tend to agree on certain issues because their training is similar; they use models that focus on economic incentives and rationality  The economic approach to analyzing issues is a cost/benefit approach.  The cost/benefit approach and the supply/demand framework deemphasize the possibility that market outcomes may be undesirable to society

1 Microeconomic Policy, Economic Reasoning, and Beyond Chapter Summary  Three failures of market outcomes are failures due to (1) distributional issues, (2) rationality problems of individuals, and (3) violations of inalienable rights  Society does care about how total surplus is distributed  The supply/demand framework assumes that individuals are rational, but individuals are not always rational in practice  Inalienable rights cannot be bought or sold  Economics provides the tools, not the rules, for society