Microeconomic Policy

Solomon Cohen

• Publisher: Routledge
• Year: 2000
• ISBN:
  9781134562695
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This textbook provides an important and fresh approach to the understanding of microeconomic policy. Microeconomic Policy links principles to settings and shows how theory compliments policy and vice-versa. By linking theory to policies and application, this text will enable students to acquire proficiency and recognise balance in policy analysis a

Chapter 1

Background

1.1 Introduction

Welfare economics is concerned with the evaluation of economic alternatives from the perspective of the well-being of the whole society. It aims at providing a coherent framework for appraising the desirability of economic alternatives. Because decisions on virtually every important public policy issue involve trade-offs between aims, and the reallocation of resources, appraising these divisions within an analytical framework of welfare economic is invaluable.

The basic elements of such an analytical framework were developed with reference to the general economic system in the first half of this century. In this period welfare economists were preoccupied with establishing and applying criteria of social welfare to the general economic system, analysing efficiency conditions and studying their implications for the shaping of real economic systems. This framework formed the basis for evaluating the competitive market economy and variations of the state controlled economy.

Application of welfare economics to the evaluation of the general economic system, mainly in the first part of this century, has been guided by a methodology which can be stylized in four steps:

1. (a) specify the welfare criteria contained in maximum welfare W*,
2. (b) specify the required conditions and underlying assumptions for obtaining maximum welfare W* in an ideal economic system,
3. (c) take the two alternative options of economic systems, competitive markets and state control; study and evaluate the mechanisms of such systems in the real world in realizing W, and
4. (d) study and evaluate the performance of the two systems and the resulting differences between W and W* for each system in the real world.

As more insight was gained in this area and certain conclusions were drawn, attention shifted in the second half of the century to the evaluation of more specific economic policies, projects or actions within the competitive market economy and more recently in state-controlled economies. Applied welfare economics today considers the foundations of the economic system as given, that the total present state of welfare can be described by W and that for the given consumer preferences, production technologies and factor endowments from an economic alternative, the potential welfare could be at a maximum, for example W*. The tasks of welfare economics today are:

1. (e) to show for the given state of welfare that W < W*,
2. (f) track the causes behind the gap,
3. (g) formulate alternative proposals of raising W to W*, and
4. (h) facilitate a choice by appraising benefits, costs and compromise redesigns of the alternative proposals.

This chapter will first deal with the previously stated four steps (a)–(d) in the study of the general economic system and its further elaboration into the mechanisms of competitive markets and state control. These contain the building blocks of the analytical framework which characterize contemporary microeconomic policy making and appraisal. The next chapter outlines the treatment context of the competitive market economy supplemented with state intervention, and gives an overview of the context of each of the following chapters, each of which deals with a specific microeconomic policy problem, along the lines of steps (e)–(h), mainly within the competitive market economy. Brief attention will be given to microeconomic policy making in state-controlled economies.

1.2 Welfare criteria

It is usual to distinguish between welfare criteria, such as economic efficiency, social equity, stability and viability, and performance indicators, such as economic growth rate, indexes of income distribution and poverty incidence, inflation rate and material resources depletion rate.

Our primary attention will go to the two main welfare criteria: (economic) efficiency and (social) equity. Alternative forms of economic organization or economic policies are usually found to have different implications in terms of efficiency and equity. In appraising such alternatives, the economist should be prepared to initially separate but ultimately combine the use of both criteria of efficiency and equity.

Working with both criteria simultaneously is very difficult for it can happen that while alternative A is preferable on efficiency grounds, alternative B is superior on equity grounds, and there is no objective way of weighing the two criteria. Besides, judgements on efficiency grounds can be objective, but those on equity grounds contain subjective elements, and are thus not conclusive. While the economist can set up generally accepted standards of efficiency, neither the economist, nor other scientists, can set up universally accepted standards of equity. Understandably, the economist is inclined in these circumstances to separate economic analysis based on efficiency grounds from that on equity grounds.

But that policy-making economic analysis has to be conducted along both lines of efficiency and equity is obvious and necessary. A functional separation between these two criteria should not be misunderstood for posing one criterion above the other. In particular, there are many problems in real life whose solution is more effective when economic efficiency and social equity are considered simultaneously, and sometimes the combination of both perspectives offers the only possible solution. One society may choose to have firms pay a basic salary to underemployed labour. Another may choose to lay the labour off, tax the firms, and set up a bureaucratic machinery to distribute transfer payments to the laid-off, some of whom may enjoy untaxed earnings in the hidden economy. There can be evidence that the first society, by solving simultaneously for efficiency and equity, is better off than the second society which solves for the two criteria separately.

How do economists deal with the concept of economic efficiency? The objective measure of economic efficiency is conventionally taken to be Pareto-optimality. In view of unresolved difficulties in cardinally measuring, comparing and aggregating individual welfare, economists tend to settle at an ordinal measurement of improvement in welfare. This is found in the Pareto criterion which states that any change that makes at least one individual better off and no one worse-off is an improvement in social welfare. Conversely, a change that makes no one better off and at least one worse off is a decrease in social welfare. Stated otherwise: a situation in which it is impossible to make anyone better off without making someone worse-off is said to be Pareto-optimal or Pareto-efficient.

It should be emphasized that the Pareto criterion is a value judgement as it might not be shared by everybody. For example, someone might want to know something about who will benefit and by how much, but the underlying philosophy of methodological individualism does not permit utility comparisons. Despite its status of a value judgement, the Pareto criterion represents for most economists a workable concept of efficiency based on mutual respect of individual utility.

Next to the Pareto criterion there are other more specific notions of economic efficiency which are relevant in other contexts. For example, the concept of X-efficiency focuses on an organization’s ability to mobilize the use of its inputs and distribute them optimally on the organization’s activities so as to obtain normal output. Furthermore, while static efficiency commonly refers to the optimal allocation of resources over activities for the economy as a whole at a given time, dynamic efficiency refers to such an optimal allocation over time. Dynamic efficiency can be proxied by changes in total factor productivity over time, which in turn is the result of changes in technology, i.e. process and product innovation, demographic composition, income distribution and in the mixture of activities.

How do economists deal with the concept of social equity? In spite of many proposed measurements of social equity there is no consensus on an overall measurement. The minimum what economic analysis can do in these circumstances is to measure what the relevant parties will win and will lose as a result of a policy change. Problems and progress in the measurement of an overall (social) equity effect will be taken up in Chapter 7.

Background

Pareto’s optimality principle . . . and more

Modern economics owes a great deal to Vilfredo Pareto. In his Manuel d’Economie Plitique (1906) and Economie Mathematique (1911) Pareto lays out the conditions for a general equilibrium model which gives the highest satisfaction to consumers and producers. Pareto-optimality is the equilibrium point from which no move can be made that would increase the welfare of a consumer or a producer and make no one worse off. In Paretian economics, an economic equilibrium, where agents are price-taking maximizers of ordinal utility or profit, is Pareto-optimal. Furthermore, Pareto-optimality is in principle obtainable under the same conditions in both a competitive markets-based economy or a socialist state-controlled economy with a more equitable income distribution. Here are the forerunners of the first and second fundamental theorems of welfare economics as were later developed by Arrow and Debreu.

In this chapter we reflect briefly on the value orientations of Pareto-optimality, these being liberalism, methodological individualism and the equality of all individuals. This chapter reflects also on the greater or lesser likelihood of obtaining Pareto-optimality in the real world under the two opposite regimes of competitive markets and state control. Behavioural distortions enter into both regimes to different extents and drive them away from Pareto-optimality.

Understandably, in his writings on an abstract model of the economic system, Pareto could not possibly treat people’s behaviour. As is well known, next to his abstract work, Pareto made major contributions to sociology, politics and statistics with important bearings for the nature and design of economic policy. We mention two of these below.

First, in his Trattato di Sociologia Generale (1916) Pareto sees human behaviour as being determined exclusively by instinctive actions and in-born feelings. People have brains but they use them in giving a false rationalization of an otherwise non-rational and non-controllable behaviour. Practice determines theory, and there are no possibilities for fundamental changes in society. Politics is monopolized by cunning elite groups who replace each other from time to time; most other people are passive. He concludes elsewhere that there cannot be an objective role for the scientist (economist) as a policy advisor. The thoughts are pessimistic regarding human nature and social progress, and hence, negative on policy.

Second, Pareto’s belief in the dominance of instinct, innate capabilities and predeterminate human behaviour is consistent with his interpretation of income distribution statistics, among others. For instance, Pareto’s Law states that there exists an inevitable tendency for income to be distributed in the same way across countries and time, regardless of country institutions. The implication is clear: there is no sense in pursuing an equity policy. The function he estimated is N(x)=A/x^α, where N(x) is the number of people having an income greater than or equal to x. The equation fitted quite a number of countries, particularly at the upper tail of the distribution, giving values of α around 1.6. More recent empirical evidence establishes significant variations in income distributions across countries reflecting different choices as regards institutions and policies. It is generally recognized now that any income distribution is the combined result of inborn capabilities and acquired opportunities as being conditioned by institutions and policies. We shall treat this topic at some length in Chapter 7.

Vilfredo Pareto was born in Paris on 15 July 1848. The family migrated to Italy in 1852. Vilfredo enrolled at the Polytechnical Institute in Turin where he graduated in mathematical and physical sciences in 1867. He worked for a couple of years as a railway engineer after which he combined academic writings with company jobs and policy advice. He fought against state intervention, protection, duties and subsidies. His liberal writings and governmental attacks made him increasingly isolated in Italian politics. The company jobs did not prosper either due to speculative losses. He was a full-time academic from 1890 onwards. In 1893 Pareto followed Walras at University of Luzanne.

Very different from most other thinkers, it was only in 1896, at the age of 48, that he produced his first economic writings on income distribution and economic policy, which were followed by other major works as reviewed above. He was active in writing up to his death in 1923.

1.3 Requirements for obtaining maximum welfare in a general economic system

The circular flow of production, income and expenditures in a general economic system is shown in Figure 1.1. The economy allocates factors among producers, commodities among consumers, and factors among commodities. Assume this economy to be general in the sense that there is as yet no detailed specification of how the economy is particularly organized, and via which mechanisms, such as markets or commands, co-ordination and allocation takes place.

The economy in Figure 1.1 is represented by two consumers, two producers, two commodities and two factors of production. Furthermore, marginal rates of substitution for consumers are denoted by MRS and these apply to commodities they consume and factors of production they own. Marginal rates of transformation for producers are denoted by MRT and these apply to commodities produced and factors deployed. Marginal productivity of labour is denoted by MP.

An economically efficient allocation in the sense of Pareto-efficiency will come into being in such a general economy if ten marginal conditions of maximum welfare will hold. These ten conditions are grouped together into what is called efficiency of consumers, of producers and of consumers with producers. Consumers efficiency relates to the efficient distribution of commodities among consumers. Producers efficiency relates to the efficient distribution of factors among producers. Then there is the conf...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Policy examples
• Preface
• Chapter 1
• Chapter 2
• Chapter 3
• Chapter 4
• Chapter 5
• Chapter 6
• Chapter 7
• Chapter 8
• Chapter 9
• References