Preliminary Economic Concepts and Principles:



Government Failure:(“Economics” – Chapter 11)Even in instance of “market failure,” it would be na?ve to conclude that the outcome with government intervention will always be “better” (smaller DWL) than without government interventionGovernment Failure – situations in which total social surplus is decreased by government intervention in a marketTwo broad causes of government failure:Government fails to perform a necessary task efficientlyGovernment fails to do only those tasks that it should do7 specific sources of Government Failure:rmational Problemswhen formulating government policy, it is often necessary to choose a “scope” for government activitye.g., provision of a public good (such as national defense)absent government provision we will have too little2011: U.S. spent $678.1 billion on defense => is this “too little,” “just right,” or “too much”?when buyers and sellers make decisions in markets, they generally have incentives to truthfully reveal their benefits and costshowever, this is not the case when we abandon or cannot rely upon marketseven a well-intentioned government bureaucrat can be led astray when private citizens misrepresent their true benefits or costs from different policiesEconomic Calculation Problem – a system of planning will never be able to achieve efficient outcomes, precisely because under such a system the planners do not have the information generated by market activities available to themArgument first made by Ludwig von Mises and later refined by Friedrich von HayekTo see how markets aggregate and reveal distinct pieces of information, consider artificially created prediction markets“InTrade Prediction Markets” => tradable futures created in such a way so that “price” provides a “reflection of the current aggregate perception of the likelihood of an event”Who will be the 2012 Presidential election? To get an answer, we can “ask the market”!2.Costs of Complying with Government Bureaucracywhen governments impose rules/regulations, individual households and firms need to expend resources to comply with the policiesuse of resources for compliance imposes a cost => the greater the bureaucracy, the higher are these costsif the costs are sufficiently large, they will outweigh any benefits of the regulation“Permit Raj” in India: “a complex, irrational, almost incomprehensible system of controls and licenses” under which “everything needed (government) approval and a stamp.”Recall the “Ease of Doing Business” study. Costs of starting a new business:Chad: 11 procedures, 66+ days, costing 208.5% of annual per capita incomeNew Zealand: 1 procedure, as little as 1 day, costing 0.4% of annual per capita income3.Corruption or KleptocracyCorruption – an environment in which regulations are not enforced and decisions are not made evenly and without biascorruption leads to inefficient decisionse.g., contract for a bridge“Contractor A” has costs of $18 million; “Contractor B” has costs of $21 million => efficiency dictates choosing “Contractor A”“Contractor B” could bribe a corrupt bureaucrat, resulting in higher costs for building the bridgeKleptocracy – an environment of extreme corruption in which government officials unabashedly seek personal gain at the expense of the public interestpresent day Russia: “an ill-governed kleptocracy” in which “corruption is not a happy side effect of power, but the core of the system” and as a consequence “a small group of people wholly above the law has, in the past decade, become rich beyond the wildest dreams of the tsars.”The next three sources of government failure (rent seeking, logrolling, and regulatory capture) can actually occur most easily under a political process in which citizens have a voice in formulating policy…The relevant insights on these next three issues were realized by scholars working in the field of Public ChoicePublic Choice – the academic subfield which uses the tools and framework of economics to analyze issues that historically fall within the domain of political science4.Rent-SeekingRent-Seeking – attempts by individuals and firms to use government action to make themselves better off at the expense of otherse.g., U.S. trade restrictions on imported peanutsvery beneficial to owners and workers of U.S. peanut farms (who therefore have a strong incentive to lobby hard to keep the restrictions in place)peanut producers have an incentive to expend resources to secure these “rents”costly to consumers, foreign peanut producers, and U.S. producers of any goods which use peanuts as an inputresources expended to secure such “rents” (or “surpluses”) are essentially wasted => consider the decision of “Where to have the 2020 Summer Olympics?”5.Logrollingestimated annual impact of U.S. peanut quota:jobs saved = 397cost per job saved = $187,223How does this clearly inefficient subsidy with benefits for so few people get enacted? Why would Congressman from Ohio, California, Oregon, and Wisconsin vote to save 397 jobs in Georgia, Alabama, and Texas at a cost of $187,223 per job!?Logrolling – the process by which a legislator votes to approve one bill in exchange for favorable votes from other members on other billsnot necessarily a “bad thing” => logrolling can be potentially beneficial, since it allows for an expression of “intensity of preference”but, particularly when voters are “rationally ignorant,” the process can give rise to inefficient outcomesrational ignorance – since becoming informed on an issue is costly and the benefits of being informed are typically very small, it is rational for many voters to remain uniformedCongressman from Ohio, California, Oregon, and Wisconsin want similarly inefficient trade protection for machine tools, canned tuna, softwood lumber, and dairy productsNo single proposal would receive majority support based on its own merit. But, when voters are rationally ignorant and representatives engage in vote trading, all the policies get enacted (clearly inefficient).More insights on trade protection for peanuts and other goods:total costs to society = $74,327,531in a society with 310 million people, this comes out to 23.98? per person per year => most people probably do not even notice (or would even care to notice) such a small costaverage annual per person cost of trade protection for… dairy products: $5.25, machine tools: $2.41, softwood lumber: $2.03, canned tuna: 32.41?even though trade protection for peanuts is a “small net loss” for the average person in the U.S., it appears to be a “big net gain” for people in GA, AL, and TX (similar statements apply for these other quotas)voters in GA become informed about and recognize the local benefits of the trade protection for peanuts but remain rationally ignorant of the costs of all the other trade protectionsJames Buchanan (1919-; Noble Prize in 1986; currently at George Mason Univ.) argued that politicians in a democracy often act to maximize the probability of their reelection.it is in the best interest of the representative from GA to engage in logrolling (i.e., vote trading) with other representatives to make sure that the trade protection for peanuts is passed (even if it means passing all the other programs as well)6.Regulatory Capturegovernments often regulate markets in which producers have market power or in which there is a potential for lack of information e.g., in the U.S., all prescription drugs must be approved by the Food and Drug Administration (FDA)presumably, we would want the regulatory agency to conduct a thoughtful cost/benefit analysis based upon the best interest of the publicbut, the regulated industry has a strong incentive to influence the decisions of the regulatory bodyRegulatory Capture – a situation in which firms in a regulated industry influence a regulatory agency to the point where the agency makes decisions that are in the best interest of the firms being regulated (even if the decisions are not in the best interest of the public)regulators often identify more with those in the industry they are regulating than with the general public (perhaps simply because of movement back and forth over time of people between working in the industry and working as a regulator)7.Deadweight-Loss from TaxesGovernment spending must be financed in some manner – commonly by way of taxes.Almost all taxes distort costs and benefits and therefore influence economic choices (often in an inefficient way)Market outcome in the presence of a “per unit” tax:In the presence of a “per unit” (or “quantity”) tax, either: buyers have to pay a certain amount to the government for every unit purchased or sellers have to pay a certain amount to the government for every unit sold (e.g., total per unit taxes on gasoline of roughly $0.628 per gallon)Incidence of a Tax – a measure of “who bears the burden of the tax” in terms of “decreased welfare.”Two environments to consider and compare:per unit tax of $T imposed on buyers (so that buyers must “write the check to the government”)per unit tax of $T imposed on sellers (so that sellers must “write the check to the government”)Focus of analysis:Precisely why will per unit taxes give rise to a positive Deadweight-Loss?Precisely how much revenue would a per unit tax of $T generate?Suppose per unit taxes on gasoline are increased by $1. If 5,000 gallons were being traded per day in this market, how much additional tax revenue would this increase generate?If a per unit tax of $T is going to be imposed, is it “better” to impose it on buyers or sellers? Three perspectives: buyer’s, seller’s, society’s (e.g., would buyers prefer this tax to be “imposed on buyers” or “imposed on sellers”?)Example:consider a market in which a per unit tax of $T=$1 will be imposedDemand = (Buyer’s Res. Price)Supply = (Seller’s Res. Price)00$before the tax is put in place: 5,000 units are traded, each at a price of $3.80quantityPer unit tax of $T imposed on Buyers:Effect on Demand => at the “point of sale” any buyer is now willing to pay exactly $T=$1 less than before => Demand curve shifts down by $T=$1Supply = (Seller’s Res. Price)Demand = (Buyer’s Res. Price)(Buyer’s Res. Price)-(T)00baedf$cquantityOutcome with tax in place:Outcome at “point of sale” determined by focusing on “green curve” and “red curve”4,200 units traded <= unique quantity at which “buyer’s reservation price” (height of blue curve) is exactly $T=$1 above “seller’s reservation price” (height of red curve)Price at the “point of sale” is $3.20Sellers receive $3.20 on each unit soldBuyers must pay $T=$1 on top of the $3.20 purchase price, for a total of $4.20 on each unit purchasedCS decreases by (a)+(b)+(c) <= Incidence for buyersPS decreases by (d)+(e)+(f) <= Incidence for sellersGovernment tax revenue of (a)+(b)+(d)+(e) (equal to ($1)(4,200)=$4,200). Note, government tax revenue is less than $5,000, since they only collect the $1 of tax on units which are traded when the tax is in place.Less than efficient level of trade => DWL of (c)+(f)Per unit tax of $T imposed on Sellers:Demand= (Buyer’s Res. Price)quantity0(Seller’s Res. Price)+(T)Supply= (Seller’s Res. Price)0bcfae$dEffect on Supply => at the “point of sale” any seller must now be paid exactly $T=$1 more than before => Supply curve shifts up by $T=$1Outcome with tax in place:Outcome at “point of sale” determined by focusing on “orange curve” and “blue curve”4,200 units are traded <= unique quantity at which “buyer’s reservation price” (height of blue curve) is exactly $T=$1 greater than “seller’s reservation price” (height of red curve)Since the same quantity is traded with the tax imposed on sellers as when the tax was imposed on buyers, it follows that all other aspects of the two outcomes are identical as well! That is:Sellers receive $3.20 while buyers pay $4.20 on each of the 4,200 units tradedThe decrease in CS, decrease in PS, amount of government tax revenue, and magnitude of DWL are all the same as when the tax was imposed on buyers instead of sellersIt makes NO DIFFERENCE in terms of welfare (to buyers, sellers, or society) if this per unit tax is imposed on buyers or imposed on sellers! ................
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