Topic 2 ： Principles for Analyzing Government

Adam Smith （ 1723 ～ 1790 ） noted that in a market economy, individuals pursuing their own self-interests are led as if by an invisible hand to pursue the best interests of the society. –Adam Smith. The Wealth of Nations The market system is based on the principle of voluntary exchange.

Under ideal circumstances the market allocates resources in the most efficient manner possible. Then, why should we have a government?

The Market Economy Resource allocation in a competitive market(figure 2.1)

The Role of Government Firstly, government protects the rights of individuals, which enables them to engage in voluntary market transactions. Secondly, the government can be viewed as an instutution that acts in the public interests.

The priciple underlying the private sector of the economy is voluntary exchange, while in the public sector of the economy, the government forces people to obey its rules and pay for its output. This raises a whole set of questions: –How do we know that we all benefit from the government's programs? –Should someone who never uses a park be forced to pay for it? –If these things really benefit us, why do we have to be forced to pay for it?

The government's activities can be analyzed within the framwork of two general categories. –the first category concerns the scope of governmental activities –the second category concerns how the government finances its activities.

The Market System and Individual Rights The market system presupposes that individuals have the right to the output they produce and have the right to freedom of exchange. –police –national defence –court system

The government as protector of rights –without government protcetion of individual rights, people would have to find ways to protect their own rights, which would greatly reduce the efficiency of an economy. –people would have no incentive to produce any more than they could individually protect.

The government as violator of rights –with too much government, unconstrained in its activies, there is the potential for predation through government.

The Public Interest The government should act in the public interest. But what is the public interest?

Jeremy Bentham(1748 — 1832) the public interest would be served by policies that produced the greatest good for the greatest number. –Jeremy Bentham. An Introduction to the Principles of Morals and Legislation. 1789

Bentham's method of considering the public interest is sometimes referred to as utilitarianism because it attempts to take account of the relative satisfaction, or utility, of everyone in a society.

utilitarianism –the amount of satisfaction or utility that an individual received from consuming goods or services can be measurable. –one way to measure the public interest is to add up the total utility of all the individuals in a society.

John Stuart Mill(1806 － 1873) Principles of Political Economy, 1848

Policy suggestion –Any policy that increased total utility would then be in the public interest because the utility gained by the gainers would be more than sufficient to offset the utility loss to the losers. –the policy of distribution of income

drawbacks: –there is no valid way to compare the utility of one person with the utility of another. –taken to its logical consequences, utilitarianism implies social arrangements that most people would find objectionable.

Michael J.Sandel Justice: What's the Right Thing to Do?

The Pareto Criteria Vilfredo Pareto( ), ecnomics and sociologist He developed two criteria, now known as Pareto optimality and Pareto superiority, for judging the public interest.

Because it is not possible to compare the utilities of two individuals, the only way one can be sure that a change will increase the social welfare is if the change makes at least one person better off, but makes no one worse off. Such a change would be called a Pareto superior move, or a Pareto improvement.

the Pareto criteria(figure 2.2)

Market exchange and the Pareto creteria –Unless people not involved in the exchange are harmed, every market exchange is a Pareto superior move. –With government allacation of resources, there is rarely unanimous agreement, and some people gain while others lose, making it hard to say for sure that the social welfare has been enhanced.

Political exchange and the Pareto creteria –many activities of government produce benefits to some but impose costs on others. –in practical terms it may not be possible to take any action in the public sector if the strict conditions of the Pareto criteria are adhered to.

Other Measures of the Public Interest potential compensation –Hicks-Kaldor cirteria –if a proposed change benefits the gainers by enough that they could take some of their gains and compensate the losers so that everyone could be made better off, then the proposed change is in the public interest.

the social welfare function(figure 2.3) PP: utility possibility frontier UN:social indifference curve

It is really a type of utilitarianism. It is applied to income distribution problems to determine the optimal amount of redistribution through the tax system. By contrast, the Pareto criteria are not well suited to distributional issues.

cost-benefit analysis In actual pracice, it is frequently used to determine whether public sector projects are in the public interest. The main difficulty is to place an accurate dollar value on all the benefits and costs of a particular project.

Positive and Normative Economics Positive economics examines the real world to discover its characteristics and interlationships. Normative economics makes value judgement as to how the world should be.

e.g. the minimum wage law How will the two kinds of economics analyze the law?

normative analysis and the public interest –when studying the public sector, the normative elements necessarily enter into the picture because the government's activities are the result of choices.

Equity and Efficiency: the Goals of Pubic Policy Whether a change allocates resources more efficiently is a positive issue. The goal of equity is fundamentally a normative issue.

Discussion: –Is there a trade-off between equity and efficiency in public policy, or can the two goals be reached simultaneoursly?