Public Policy Analysis MPA 404 Lecture 15

Previous Lecture Continued on with the examples of IRR and its applications Economic shortages and the effects of regulation on pharmaceutical industry The basics of market economy The simple demand and supply analysis, how disequilibrium is created, and the long run result of disequilibrium analysis Consumer and producer surplus

Before we move any further on graphical stuff, it is very important to go through the rationale of government’s involvement in an economy. Free market advocates do not like government’s presence in an economy. They believe in the working of the ‘price mechanism’, a mechanism through which prices in an economy allocate resources. They are the signals that guide resource allocation. Government’s involvement, they say, can only distort the price allocation mechanism and thus introduce unwanted distortions in the smooth functioning of an economy. However, over time, government has remained as a part and parcel of economic activity. There are many advocates from all backgrounds who advocate government’s active involvement in economic affairs. Today we are going to study the major reasons of why a government has a role to play in the economic affairs of a country. The following have been taken from various sources, including an article on market failures by Joseph Stiglitz, a Nobel prize winning economist.

Conventional market failures: Rests upon few very basic, narrow assumptions like perfect competition, perfect access to information and rationality. However, research over time has shown that markets in many forms may be incomplete, monopolistic, and without imperfect information. There are not many who believe in perfectly well functioning markets today. To be sure, there are examples of badly designed government regulations, but the disasters associated with unfettered markets at least provide a prima facie case for the desirability of some regulation. The actions of one individual (or a group of them) may prove harmful to others. These are known as externalities. The presence of externalities imposes costs upon the society. Indeed, one of the standard arguments for regulation is that it economizes on transactions costs. There are several particular categories of market failures. We have regulations designed to mitigate the extent of externalities. These include, zoning restrictions, environmental regulations, regulations designed to maintain competition and to ensure that natural monopolies do not abuse their monopoly position (utilities regulations). There is a large set of regulations aimed at protecting consumers in areas like financial services, food, safety, etc.

Information is a public good. All individuals want to be assured that if they put money in a bank, the bank will be there when it comes time to withdraw the money. In many instances, private sector tries to hold on to that information from the public. We heard about the establishment of a central bank in a podcast. That was the result of the weakness in the private markets rather than government’s fault. Thus, government’s intervention became necessary. Irrationality: We’ve touched upon this before in a previous lecture. The standard competitive equilibrium model assumed that all individuals are rational in their decision making; it explains why rational individuals (households) interacting with profit (or value) maximizing firms in a competitive marketplace might not result in Pareto efficient allocations. But individuals may not be rational and may deviate from rationality in systematic ways. Individuals (and even more so societies) sometimes end up making a bad decision and have to be saved from themselves. Until the recent work on behavioural economics, economists typically looked with suspicion at such arguments for government intervention. But insights from behavioural economics has changed these views.

Individuals may, in some sense, be better off if they are compelled to undertake some actions. A drug addict may realize that he may be tempted to consume these toxic products and then become addicted. He therefore wants the government (or someone else) to make it impossible, or at least more difficult, to become addicted. Or the government can easily compel him through laws and force to stop using it. In general, five interrelated reasons for government intervention are as follows : (a) ensuring competition; (b) protecting consumers; (c) ensuring the safety and soundness of financial institutions and the financial system; (d) ensuring access to information and ensuring transparency, and (e) promoting macroeconomic stability and growth. The list includes concerns both about efficiency—market failures—and equity (without government regulation, certain groups may not have access to finance and may be exploited).

There are many ways in which the government can deal with the shortcomings in the market. Some of them are as follows. Laws and Regulations: While we typically think of regulations in areas of environment, safety, banking, and utilities, many of the other laws affecting economic activity can be looked at through a regulatory lens. Bankruptcy laws restrict the set of contracts that parties can draw up with each other— no matter what the contract may say about what happens in the event that a debtor cannot meet his obligations, bankruptcy law will prevail if those provisions are in conflict. Similarly, corporate governance laws restrict how corporations may govern themselves. Discussion: Green house gas emissions; did the private sector came up with any good solutions (or a solution at all)?