Public Policy Analysis MPA 404 Lecture 16

Previous Lecture  A revision of the concepts of equilibrium.  The short run disequilibrium, and the long run adjustment process. The process in the context of IRR.  The identification of consumer and producer surplus in an equilibrium.  The theory behind the rationale for government intervention in lieu of private sector’s shortcomings.

The competitive economy framework  In discussing the rationale for government intervention and then graphing the equilibrium, we discussed perfect competition. Any idealized working of the economy would be something close to the workings of this kind of economic system. The role of a policy analyzer, then, is to sift through the policies and see whether the outcome is directed towards that goal which is the most efficient outcome.  Besides the efficiency criterion, the policy analyzer has also got to take other criteria like distribution(equity), participation and generation of economic opportunities for all into consideration.  The idealized economic system, which distributes resources to various groups (producers and consumers are the two general ones) is a Pareto Efficient system. This concept goes back to the work of Italian economist Wilfredo Pareto, who did work related to welfare economics. The basic premise is that the end outcome of all economic activity should be such that nobody is made worse off by a policy.

 In its philosophical and economic approach, the approach of pareto efficiency is on the same lines as that of IRR for use in decision making processes. What we saw with IRR calculations is that it helps us decide between alternative investments. The pareto optimality and efficiency criteria is along the same lines as it dictates choosing that policy course that helps choose the best economic outcome amongst many.  Graphical demonstration of the concept.

 This kind of analysis falls under the ambit of general equilibrium models, which purports to cover every sector and activity in an economy. But in reality, covering every sector and activity is not possible. Therefore, a more realistic approach revolves around analyzing one sector at a time.  Just like we see IRR as a useful measure of letting us know whether a particular investment is good or not, the measure of social surplus is used to see whether a policy is pareto efficient or not? It lets us guess/calculate which of the alternative policies is good at producing the maximum social surplus. And what is social surplus? The total of producer and consumer surplus that we graphed in the last lecture. Let’s graph it again in terms of change in surplus due to a change in government policy.

 The concept of deadweight loss: loss due to inefficiency of a policy. Depicted in the above graph. The deadweight loss there was the deadweight loss due to the tax policy.  Changes in consumer surplus are usually the basis of measuring the efficacy of relative policies. Since consumer is at a loss here in the sense that he or she cannot purchase the same amount of quantity, therefore consumer is worst off and policy is not pareto efficient (Note: economic theory predicts that consumer is better off with more of a good than less of it because it increases his satisfaction, dubbed utility in econ lingo).  Can the government offset this setback (in the form of loss of utility) to the consumer? Perhaps, if they give back that much amount which will enable the consumer to buy the same amount as before. But that normally does not happen (at least not to all), and there is a deadweight loss anyway since monetary support is not transferred to the affected consumer immediately. If this kind of money-back policy does take place, its called compensating variation.

 The concept of compensating variation is more applicable in terms of the simple demand and supply analysis and production? We can also analyze this kind of change through indifference curves (IC) and budget lines (BL). These then relate to the concept of equivalent variation. But before going to this concept, we need to go through IC’s and BL’s.

 Instead of asking the question that what we will have to do in order to compensate the consumer due to a loss in surplus, the question can be refined as asking what we will have to do to compensate the consumer for the loss of utility due to the absence of a product? That would be equivalent variation.

 The above graphical analysis was the theoretical and graphical part. In practice, when these kinds of issues are discussed, there are two ways to go about this thing. One is to construct a demand schedule by keeping utility constant and track changes in income. The other is to keep income plus all other prices constant, plus track changes according to changes in utility. This second approach is the one used more frequently, and is called the Marshallian demand schedule. As long as price changes and expenditure on a product are small (which usually are for most groups), then these two estimates are pretty close.  Adding up all the individual demand curves would give us the market demand curve that would help us answer the question about what actually happened to total utility, and how is one to restore consumer to the original IC or utility level?  Thus, there arises an opportunity of a pareto improvement through a public policy.