econ for public policy week 5

equality of opportunity, pre versus, re distributive policies, education

The equity efficiency trade off

• government want to increase low incomes to increase social welfare, because most people want some redistribution of incomes

• however, there are costs of those policies in terms of reductions in social efficiency that arise due to changes in incentives for work

equity concerns (commodity egalitarianism and equality of opportunity)

policy makers often differ on what redistribution should achieve:

• commodity egalitarianism: society should ensure that individuals meet a set of basic needs, but that beyond that point income distribution is irrelevant

• equality of opportunity: society should ensure that all individuals have equal opportunities for success but not focus on the outcomes of choices made

redistributive policies (means tested out-of-work benefits)

• reduces inequality by increasing the wages of low-incomes households not in work; provides social insurance against the worst economic shocks: these are amongst the poorest households, well targeted, but this is a small group so overall small effect.

• provides negative work incentives for low earners to get into or stay in work

• has to be funded through either cuts to other spending or taxes (reduces social efficiency)

redistributive policies (universal benefits)

• very small reduction in inequality because same amount given to everyone

• small impact on poverty as most money goes to households not in poverty

• large deadweight (a lot of expenditure goes to high income households who benefit little, because their marginal utiltiy of income is low)

• doesn’t distort incentives

• has to be funded through either cuts to other spending or taxes (reduces social efficiency)

which policies lead to equality of opportunity

education: equips people with skills so that outcomes depend more on effort and choices than on family background

redistributive versus pre-distributive policies

redistributive:

• intervene after income is earned

• reduce income of high income households and redistribute to low-income households

• e.g. income taxes, means tested benefits

Pre-redistributive:

• intervene before income is earned (pre-production)

• increase incomes at the bottom

• e.g education

• pre-redistributive policies typically effect lifetime incomes, not incomes today

• pre-distributive policies may have lower efficiency costs (though we still have to raise money to pay for the spending)

• generally better at creating equality of opportunity

pre-distributive policies in education by age

Early childhood interventions (age 0-4)

• Sure Start, childcare credits, Free School Meals, Healthy Start Vouchers

Primary education (age 5-11)

• compulsary education, state provision, national curriculum

Secondary (and further) education (age 12-18)

• compulsary education, apprenticeships, national curriculum

Higher education

• government subsidies to university and specialist training, student loans

Retraining and vocational training

• on the job training, training for specific jobs

Early childhood interventions

sure start centres brought together education, childcare, parental support and employment services in ‘one-stop shops’ for families from disadvantaged backgrounds with young children

• aim to enhance development and life chances of children under 5

• evaluations suggest benefits outweigh costs

other early childhood interventions include: childcare credits, healthy start vouchers- both have pre and redistributive features.

government intervention in education

education makes up 11% of government expenditure

• the main effects of education are to increase an individual’s human capital

• wages in the labour market are a direct function of an individual’s human capital

• this implies that returns to education are largely private

potential market failures in education

externalities

• productivity spillovers, reduce crime, improve citizenship

internalities

• young people might not do what is in their long-term interest due to self control problems or lack of information

family failures

• parent may not be willing or able to make good choices on behalf of their children

borrowing constraints

• poor but talented students or their family may not be able to borrow against future earnings to get an education.

Pre and re distributive effects of education

there are pre and re distributive reasons why the government might want to provide education

• market failures such as borrowing constraints, family failures and internalities likely to be higher for low-income households

• improving someones education will increase their human capital, and increase their life chances and lifetime outcomes.

In the current UK system, there is a strong correlation between

parental education and children's achievement

• children from richer families do much better at school

• 75% children from richest families obtain 5 good GCSEs

• 21% children from poorest families obtain 5 good GCSEs

why do richer students achieve better? and how can the government reduce educational inequality

children from higher income households do better in education mainly because they are far more likley to attend higher performing secondary schools

• poor attainment in secondary schools is more important in explaining lower higher education (HE) participation rates among students from disadvantaged backgrounds than barriers arising at the point of entry into HE

• the government can reduce educational inequality and improve social mobility through policies

education policies for children from low-income households

1. increase spending on early years and primary education

• to improve infrastructure and teaching quality, targeted at improving educational attainment of children from low-income households

2. create opportunities even for those who fall behind

• at all stages of education, improve vocational and on the job training opportunities

3. make sure people are making informed choices

• giving everyone the right to choose (over schools) does not necessarily mean everyone has an equal opportunity to benefit

4. increase teacher pay and incentive

• to improve teaching quality

revisiting adverse selection

adverse selection is a type of market failure that occurs when one side of a market has more information about their characteristics or risk than the other side (asymmetric information)

For e.g., the health insurance market:

• the person has more information about their risk of falling ill than the insurance firm

• leads to private market unravelling

• govt has to intervene to provide subsidised health insurance to all

• primarily because it thinks of health as a basic need

revisiting adverse selection

Suppose you have a job paying £50,000 per year. With a 5% probability, your

income next year will fall to £20,000.

(i) What is your expected income next year?

E(Y) = 0.95 × £50,000 + 0.05 × £20,000 = £47,500 + £1,000 = £48,500

(ii) What would the actuarially fair insurance premium be for fully insuring

against this risk?

A fair premium equals the expected payout = 0.05 × £30,000 = £1,500

Now suppose there are two individuals A and B. A has a 10% probability of

getting sick, and B has a 5% probability of getting sick. If insurance

companies knows their individual risks (symmetric information), what

premium would it charge to A and B?

Individual A (10% risk): Premium = 0.10 × £30,000 = £3,000

Individual B (5% risk): Premium = 0.05 × £30,000 = £1,500

Will A and B buy the insurance?

Depends on their willingness to pay for the insurance. Buy if premium <

willingness to pay

Now suppose there are two individuals A and B. A has a 10% probability of

getting sick, and B has a 5% probability of getting sick. If insurance

companies does not know their individual risks (asymmetric information),

what premium would it charge to A and B?

Pooled Premium = 0.5 × £3,000 + 0.5 × £1,500 = £1,500 + £750 = £2,250

Will A and B buy the insurance?

Depends on their willingness to pay for the insurance.

Likely, A buys, B does not.

What is the expected payout of the firm if only A buys? £3,000

What is the expected premium? £2,250

Will the firm continue to offer insurance? No, makes a loss. Market unravels.