Policy Issues Final

Market

• system where buyers and sellers interact

• decisions are personal and voluntary

• buyers pursue utility / personal benefit

• sellers pursue profit

Prima facie case for the market

• nitial/basic case in favor of markets

• rests on:

  • efficiency

  • economic freedom

  • information availability / information aggregation

Information role of markets

• markets help reveal and aggregate information

• individuals only need to know:

  • their own marginal benefit if they are buyers

  • their own marginal cost if they are sellers

• prices communicate information without central planning

Competitive market w/ one good, cost and benefit graph

• efficiency = max W = B − C

• where B = benefit to buyers

• and C = cost to sellers

• MB = MC

• Q_E = efficient quantity

To prove the efficiency of a competitive market we need to show:

Market assigns goods among buyers to achieve Bmax

Market assigns supply among sellers to achieve Cmin

With Bmax (max benefit) and Cmin (min cost), market chooses the quantity QE that maximizes W =Bmax −Cmin

Buyers in competitive markets

• Buyer equilibrium condition

  • in a competitive market, each buyer chooses consumption where:

    • MB = PB

  • PB = price faced by buyers

• Total benefit maximized among buyers

  • with two buyers, total benefit is maximized when:

    • MB1 = MB2

  • market pricing achieves this because both set marginal benefit equal to the same price:

    • MB1 = PB = MB2

• Market demand

  • horizontal sum of individual buyers’ marginal benefit / demand curves

  • in the slide notation:

    • QB = qb1 + qb2

• Graph intuition for buyers

  • same market price for all buyers

  • each buyer consumes until own MB equals that price

  • this equalizes MB across buyers

  • therefore total buyer benefit is maximized

Sellers in competitive markets

• Seller equilibrium condition

  • in a competitive market, each seller chooses output where:

    • MC = PS

  • PS = price received by sellers

• Total cost minimized among sellers

  • with two sellers, total production cost is minimized when:

    • MC1 = MC2

  • market pricing achieves this because both set MC equal to the same price:

    • MC1 = PS = MC2

• Market supply

  • horizontal sum of individual sellers’ marginal cost / supply curves

  • in the slide notation:

    • QS = qs1 + qs2

• Graph intuition for sellers

  • same price for all sellers

  • each produces until own MC equals that price

  • this equalizes MC across sellers

  • therefore total cost is minimized

The market equilibrium w/ Q_E, P_E, MB^max = MC^min

• Market equilibrium

  • where market demand and market supply intersect

  • determines:

    • equilibrium quantity QE

    • equilibrium price PE

• Efficient market equilibrium

  • in the competitive benchmark:

    • MBmax = PE = MCmin

  • therefore welfare is maximized at equilibrium

• Price equality in equilibrium

  • slide uses:

    • PB = PE = PS

  • buyer price, equilibrium price, and seller price coincide in the no-distortion benchmark

• Graph interpretation of welfare area

  • on the demand-supply graph, welfare is the shaded area

  • this area is maximized at the competitive equilibrium (QE, PE)

How do we know competitive market will achieve that equilibrium?

• Market-adjustment mechanism

  • process by which the market moves toward equilibrium

  • if prices/quantities are away from equilibrium, competitive forces push the market back toward the efficient point

  • this is the slide’s operational version of the invisible hand

• Invisible hand pushes to efficient equilibria

  • shorthand conclusion from the equilibrium slides

  • decentralized self-interested behavior leads to efficient equilibrium under competitive conditions

Competitive markets + efficiency

Competitive markets achieve efficiency, defined as max W = B - C

Centralized allocation

• government replaces decentralized buyer/seller decisions with its own decisions

• slides say this would remove economic freedom

Informational disadvantage of government

• government generally lacks the private information buyers and sellers have

• therefore it cannot directly calculate:

  • Bmax

  • Cmin

  • or overall W = Bmax − Cmin

• Gvt has informational disadvantage compared to markets → Impossible for gvt to achieve efficiency

Asymmetric information

ne party in a transaction possesses greater, more detailed, or better-quality knowledge than the other, creating an imbalance of power

Why markets may outperform centralized planners

• buyers know own preferences / MB

• sellers know own costs / MC

• prices aggregate this decentralized information

• a government can only estimate or guess much of it

Market failure

situation where markets fail to achieve efficiency

Main market failures listed in the slides

• non-competitive markets

• public goods

• externalities

• natural monopoly

• asymmetric information

Monopoly

• one seller dominates the market

• can restrict quantity and raise price above the competitive level

• P = P_M, > P_E

• Monopoly profits maximized when P = P_M and Q = Q_M

Public good

good that can benefit many people simultaneously

Free rider problem

• individuals may want the good but hope others pay for it

• because they can still benefit even if they do not contribute

• leads to underpayment and underprovision

Externalities

• cost or benefit from an action that is not expressed in a market

• affects third parties outside the direct transaction

• can be positive or negative

• market will tend to over-provide goods with negative externalities and under-provide those with positive externalities

Natural monopoly

• industry where competition would wastefully duplicate large fixed costs or infrastructure

• one supplier may be cheaper than many

• Why natural monopoly is a problem

  • efficient production structure may involve one supplier but that creates a non-competitive market

  • regulation becomes necessary

Impact of mobile phones on fish market in Kerala

Key result: mobile phone coverage sharply reduced price dispersion across markets. Prices in different fish markets became much more similar because sellers could respond to where demand was strongest.

Social justice

idea of what makes an outcome fair or just

Why is social justice a separate issue from efficiency?

an outcome can be efficient but still seem unfair; efficiency asks whether total welfare is maximized, while social justice asks whether the distribution/outcome is acceptable morally or politically

Are competitive markets socially just?

no single universal answer; depends on the definition of justice being used and the context; context can change which definition you prefer

Natural right of possession

idea that outcome is socially just if a person’s rightful possessions are respected; people are entitled to what they produce or earn through their own effort

right to compensation

idea that people are entitled to the products of their effort; rewards should reflect personal productive contribution

Do competitive markets satisfy natural right of possession?

yes, in this sense; example: a firm hires labor until marginal cost of labor = marginal benefit of hiring labor, so wages reflect marginal contribution

Problem with natural right of possession as a definition of justice

what people “possess” or can earn is affected by luck, health, education, family background, personal connections, innate ability, or disability; so market rewards may reflect more than just effort or merit

Ex-ante equality

equality of starting opportunity; same opportunity to earn, prosper, and improve in life; no privileged beginnings

people do not necessarily end up equal, but they should begin from a fair starting point with similar opportunity sets

Ex-post equality

equality of final outcomes; “everyone ends up equally”

Pareto improvement

Pareto improvement

Pareto-efficient outcome

an outcome where no further Pareto improvement is possible; you cannot make someone better off without making someone else worse off

Are competitive market outcomes Pareto efficient?

Typically, yes

Must government interventions be Pareto-improving?

No

How does a government make decisions

cost-benefit criterion:

change is efficient if ΔW = ΔB − ΔC > 0; total benefits exceed total costs

How can an efficient change become Pareto-improving in principle?

if gainers compensate losers and still remain better off, then the change could become Pareto-improving

Why is compensation important in government intervention?

because compensation can make a harmful policy change more socially just by addressing the losses imposed on losers

Practical problems with compensation

hard to identify gainers and losers; hard to measure losses; unclear whether gainers should pay directly or whether government should mediate

compensation is socially just, but insisting on it may block efficient change, including even potentially Pareto-efficient change

Trade-off between efficiency and social justice

societies allowing efficient change without compensation may become richer but more unequal; this is the core tension highlighted in the slides

First Fundamental Theorem of Welfare Economics

if all markets are perfectly competitive, the resulting market outcome will be Pareto efficient

under perfect competition, no agent can be made better off without making another worse off, and all gains from trade are exhausted. no market imperfections; the result depends on perfect competition and no distortions/failures

market + perfect competition ⇒ Pareto efficiency

Second Welfare Theorem

any Pareto-efficient allocation can be achieved by the market using lump-sum taxes and subsidies

efficiency and distribution can, in principle, be separated; government can adjust initial endowments, then markets can produce an efficient outcome from there

market + perfect competition + lump-sum taxes/subsidies ⇒ any specific Pareto-efficient allocation

lump-sum tax/subsidy

a transfer that changes a person’s resources/endowment without directly distorting marginal choices in the model used by the theorem

Edgeworth Box

graphical tool showing allocations of two goods between two people; used here to illustrate trade, bargaining, and Pareto-efficient outcomes

• U = Utility of Person 1, Y = Utility of Person 2

• A = initial endowment

• trade occurs until a point on the contract curve is reached

• contract curve = set of allocations where no further mutually beneficial trade is possible; Pareto-efficient set inside the Edgeworth Box

What determines the exact point reached on the contract curve?

bargaining power

the set of possible bargaining outcomes depends on the starting point/endowment

Edgeworth Box and Second Welfare Theorem connection

with lump-sum taxes/subsidies, society can alter endowments so that after bargaining any point on the contract curve is achievable

What do people often say in surveys about equality?

many say: “there should be more equality” and “I feel uncomfortable in having more than you”

Do people always vote for more redistribution if they say they want equality?

no; people often agree with egalitarian statements but do not necessarily support more redistribution politically

Unfairness vs. inequality

people appear more concerned with unfairness than inequality by itself

Rule of law

restriction of the arbitrary exercise of power by subordinating power to well-defined and established laws

what does the rule of law protect us from

from other people and from the government itself

rule of government

he government uses the law as a tool to control the population, but doesn't let the law get in its own way

Why is government especially relevant to rule of law?

because government has a legal monopoly on coercion, so checks and balances are needed

examples of governmental checks and balances

independent judiciary, free press, free speech, freely elected government

equality before the law

everyone should be treated equally before the law; social status or wealth should not matter

economic benefit of rule of law

protects and certifies private property rights, which is essential for markets and efficiency

Why are property rights important for efficiency?

they support market exchange, investment, and productive use of resources; without protection, people may not invest because returns may be taken away

they support market exchange, investment, and productive use of resources; without protection, people may not invest because returns may be taken away

Property rights and credit access

property can serve as collateral, so stronger property rights can improve access to credit

Social justice benefit of rule of law

it protects right of possession and people’s lives

Why do we need rule of law in reality?

incentives often lead people not to behave ethically

Prisoners’ dilemma

strategic setting where individually rational behavior leads to a worse collective outcome; used in the slides to explain why ethical behavior cannot simply be assumed

Efficient outcome = 3,3

Equilibrium outcome = 2,2

Dominant strategy in the prisoners’ dilemma slide = stealing

Nash equilibrium

outcome where no person can gain by changing their own decision given the decisions of others

Efficiency criterion vs Pareto criterion

efficiency / cost-benefit allows winners and losers as long as total gains exceed total losses; Pareto does not allow any loser unless compensated

Ex-ante equality vs ex-post equality

ex-ante = equal starting opportunities; ex-post = equal final outcomes

Rule of law vs rule of government

rule of law limits arbitrary power through established law; rule of government would mean power itself rules, which is precisely what rule of law is meant to prevent

How can the efficient outcome be achieved without formal law?

1. promise not to steal 2. sequential decisions 3. repeated interactions

Condition for reputation to sustain cooperation

interactions must be expected to continue indefinitely or at least long enough for future consequences to matter

Why may private deterrence differ from legal deterrence?

public enforcement under rule of law is not necessarily the same as private retaliation or private protection

causes of underdevelopment

1. physical capital 2. human capital 3. technology

institutions

humanly devised constraints that shape human interactions and structure incentives in political, social, and economic exchange

Economic institutions

institutions that shape economic incentives and contracting possibilities, such as property rights and contract enforcement

Political institutions

institutions that shape political incentives and the distribution of political power, such as the form of government and constraints on politicians and elites

De jure political power

formal political power allocated by official political institutions

De facto political power

actual political power that may come from brutal force, collective action, lobbying, or economic resources, even if not formally assigned by law

Informal institutions

unwritten norms and practices related to how formal rules are actually used, such as social norms

Formal institutions

official, codified rules such as constitutional rules

Institutions vs. development

there is a positive correlation between better institutions and higher economic development

Hierarchy of institutions

political institutions and resource distribution shape political power, which then shapes economic institutions, which then shape economic performance and future resource distribution

Political institutions → what type of power?

they allocate de jure political power

Distribution of resources → what type of power?

it helps determine de facto political power

Power without authority

because economic resources can generate de facto influence through force, lobbying, coordination, or other nonformal channels

Commitment problem

groups in power cannot credibly commit not to later change the distribution of resources in their favor

Why does transient de facto power matter?

because if de facto power may disappear, groups may try to change formal political institutions to make their gains more durable

Acemoglu, Johnson, and Robinson (2001)

paper using a natural experiment related to colonial history to study whether institutions cause development

where Europeans faced high mortality, they were less likely to settle and more likely to establish extractive institutions rather than inclusive ones

if institutions persist over time, colonial institutional differences can have long-run consequences for current development

Political principal-agent problem

• voters/taxpayers = principals

• politicians = agents

• politicians meant to act in public interest

• politicians also have own goals: reelection, career, party success

• core problem: asymmetric information

• if actions perfectly observable, voters could punish/replace bad politicians

• in reality, monitoring weak: budgets complex, aggregated, poorly justified

• information = public good

• result: rational ignorance + weak accountability

Why voters do not fully discipline politicians

• information costly to collect

• private payoff from becoming informed often small

• many free-ride on others becoming informed

• policy details hard to understand

• referendum/election choices can be poorly informed

• gives politicians room to deviate from public interest

Political support, campaign money, and public policy

• politicians want electoral success

• special-interest groups can help through campaign contributions and support → contributions useful for campaigning, advertising, organization

• donors usually expect something in return, can shift policy away from public interest toward donor interests

• special-interest groups often stronger than ordinary voters because: smaller groups, easier collective action, higher stakes in policy outcomes

Can public finance replace private campaign money?

• possible partial fix

• idea: fund politics publicly instead of relying on private donors

• possible designs mentioned:

  • funding by parliamentary representation

  • subsidies matching private funds

  • other institutional designs

• main question: reduce donor influence without creating new distortions

Lithuania study — Baltrunaite (2020)

• question: does banning corporate donations reduce political favoritism?

• setting: Lithuania, focus: public procurement, about 14% of GDP

• test: whether firms making political contributions more likely to win public contracts

• reform: 2012 ban on corporate donations to parties/campaigns

• evidence: donor firms won by narrow margins more often before reform; could fine-tune bids and raise markup

• lesson: campaign finance regulation can reduce special-interest influence, though not eliminate all influence channels

Limits of campaign-finance regulation

• impossible to fully control all influence

• money can be rerouted through other channels

• even if cash donations banned, influence can continue through:

  • legal entities / indirect giving

  • in-kind gifts: cars, holidays, watches

  • media endorsements

  • celebrity endorsements

• takeaway: regulating donations helps, but not complete solution

Role of the media in the principal-agent problem

• media can help voters monitor politicians, reduces asymmetric information

• can strengthen electoral punishment of corruption but media can also worsen the problem if biased

  • biased media can amplify special-interest influence

  • dictators seek media control for this reason

  • even democracies can have biased media environments

Brazil study — Ferraz and Finan (2008)

• setting: Brazil anti-corruption program

• from 2003, federal government randomly audited municipalities using federally transferred funds

• audit findings made public and spread through media \n- identification: compare municipalities audited before vs after 2004 elections, with similar corruption levels

• main result: when violations found, incumbent reelection probability falls by about 17%, effect stronger where local radio existed to spread the informationn

• lesson: voters do punish corruption when they actually receive credible information

Italy study — Barone et al. (2015)

• question: can less biased media change voting?

• background: Italian TV political information seen as biased toward Berlusconi since 1994 \n- 2008–2012: digital TV introduced across Italy

• free channels increased about tenfold, 58 of 78 new channels belonged to firms with no ties to Berlusconi or government

• outcome studied: 2010 regional elections, main result: digital TV switch lowered Berlusconi vote share by about 5.5 to 7.5 percentage points, effect strongest for older and less educated voters

• lesson: more independent/plural media can weaken biased political influence

Non-monetary/media things shaping electoral outcomes

• not just money and media. also:

  • turnout

  • voter attention

  • information

  • politicians

  • political parties

  • interest groups

  • campaign funds

  • bribes/corruption

  • celebrity endorsements

  • weather

Best available tools for reducing the political principal-agent problem

• cannot regulate everything

• goal: improve accountability with available tools

• main tools emphasized in slides:

  • limit/control political donations

  • free and independent media

  • term limits

  • monetary incentives / pay for politicians

Examples of rents in politics

• privileged public spending

• low or zero taxes for selected groups

• targeted public policies \n- favors for family and friends

Rent

• benefit obtained not productively

• gained by influencing decisions of others

• something that would not be earned in a competitive market

• contrast with competition: people paid value of their marginal contribution

Rent creation

• political decision makers create rents because they cannot always use policy directly for personal benefit

• rents let them exchange public money/resources for:

• personal money

  • political support

  • party advantage

  • depends on discretion in public finance and public policy

• discretion exists because voters cannot perfectly observe government behavior

Why rent seeking happens

• individually rational to enter rent-seeking contests

• logic similar to prisoners’ dilemma

• even if socially or privately undesirable overall

• after resources spent, likelihood of getting rent may not change much. still each actor has incentive to compete for it

Prisoners’ dilemma and rent seeking

• if nobody rent-seeks, better collective outcome

• if others rent-seek, each individual wants to rent-seek too

• result: wasteful competition for transfers/favors

• individually rational, collectively inefficient