Principles of Policy Analysis

Markets are a good way to organize economic activities However, the government often plays a role in today’s modern economies 2

Governments often interfere in economic activities: Regulating prices of goods Restricting trade in certain commodities Imposing taxes Banning trade or certain activities Setting standards 3

Market failures: occur when the market fails to achieve the desired outcome (fails to maximize social welfare). When does the market fail? Externalities Imperfect competition Public Goods Imperfect information Government intervention can potentially correct market failures 4

Besides intervention to correct market failures, the government may intervene in markets for Distributional concerns Ethical reasons Political pressures 5

However, public policies can have unintended consequences Individuals react to the policy in a way that weakens its effect Other decision makers can be affected Tradeoffs involved between different policy objectives 6

Economic Systems, Resource Allocation, and Social Well-Being

The Economic Problem Resources are used to produce goods and services to satisfy human needs and wants. Resources are limited. Needs and wants are unlimited. Society has to make a decision

What, How and for Whom? Society has to decide:  What goods will be produced using the scarce resources.

What, How and For Whom? Society has to decide:  How to produce them

What, How and For Whom? Society has to decide:  Who gets the goods and services produced

Answer Different possible answers The answer will determine the type of economic system.

Answer Solution 1:  Individuals own resources  They freely decide how to allocate their resources in a way that is meaningful to them. A Pure Market Economy

Answer Solution 2  The government assumes ownership of all resources  The government decides how to allocate them A Pure Command Economy

Answer Solution 3:  A system that combines elements of the pure market and the pure command system A Mixed Economy

Resource Allocation in a Command Economy A state planning commission develops a plan that determines production quantities for each major product Resources allocated accordingly to each sector Ministries, bureaus, local and regional planning offices were involved

Resource Allocation in a Command Economy Workers assigned to positions according to a planning committee. Often the government committed itself to creating a job to each individual Households allocated a set amount of goods, a system often called a rationing system

Problems of Central Planning Informational Requirements  Planners needed to collect information to determine the quantities to be produced of each good, the technology to use, which resources to allocate and how to distribute the finished goods.  Often shortages and surpluses existed  Problems with pricing  Quality of products suffered

Problems of Central Planning 2. Incentives for Efficient Production  Production units run by government officials instead of owners  Workers were paid an amount independent of their true effort  No incentives to put extra effort as the resulting gains will be shared by all workers

Resource Allocation in a Market Economy Resource owners offer them to the best uses  Workers decide how many hours to work. Similarly landowners and capital owners decide where to put their resources  All decisions are coordinated in markets  The market outcome determines the quantity of resources allocated for each use and the price

Resource Allocation in a Market Economy Market Structure  Purely Competitive Markets  Large number of buyers and sellers  Each seller offers standardized product  Product prices free to move up or down  Buyers and sellers must be mobile  Freedom of entry and exit  Purely Monopolistic Markets  One seller  Imperfectly Competitive Markets

Market Demand and Supply Price $ Quantity 3 4 D D S S Surplus Shortage

Prices as Signals in a Market System Prices act as signals  Prices inform producers of how much to produce and therefore how much of the resources to be allocated to this use  A change in preferences will result in a price change which guides resource allocation  A higher price results with stronger preferences as the demand curve shifts right. More resources will be allocated to this use