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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
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 Governments often interfere in economic activities:
 Regulating prices of goods
 Restricting trade in certain commodities
 Imposing taxes
 Banning trade or certain activities
 Setting standards
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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
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Besides intervention to correct market failures, the
government may intervene in markets for
 Distributional concerns
 Ethical reasons
 Political pressures
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 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
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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
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Informational Requirements
1.
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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
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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
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Purely Monopolistic Markets
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One seller
Imperfectly Competitive Markets
Market Demand and Supply
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Surplus
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Shortage
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Quantity
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
Economists’ changing perceptions of
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Government
Optimal balance of markets and government
 Adam Smith and the invisible hand
 Government needs to enforce the law and provide
basic infrastructure
 By 1940 government should play a bigger role
 The great depression
 Concern for inequality
Economists’ changing perceptions of
Government
Government as a benevolent social guardian
when the market fails:
 Decreasing cost industries
 Uncertainties and investment
 Infant Industry
This gave rise to several regulations e.g.,:
• Public sector enterprises
• Anti monopoly laws
Economists’ changing perceptions of
Government
Government Failure: government comprised of
self interested bureaucrats
• Economics of information:
• specific knowledge regarding production
technologies is embodied in market participants
who are in a better position to make production
decisions
• Focus on incentive compatible mechanisms
Economists’ changing perceptions of
Government
• Regulatory capture:
• An agency regulating a particular industry may
end up serving the interests of that industry
• Social ties or a source of jobs
• Collective action
• Lobbies that influence governments decisions are
small groups of particular interests
• Large groups are less likely to organize because
the gains to each individual are small and people
free ride
Economists’ changing perceptions of
Government
• Rent seeking:
• Government regulation may create opportunities
for profit
• Resources can be wasted to get this profit
• Examples: queuing in lines, bribery, excess
investment
• Bureaucratic capture:
• Once an agency to regulate is established it
acquires political power
• Self interest of bureaucrats supported by the
winners from the policy