KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2015/2016) 1 Economic Policy and...

KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2015/2016) 1

Economic Policy and Market Regulation

Prof. Dr. Stefan KoothsBiTS Berlin

(winter term 2015/2016)www.kooths.de/bits-ep


Contact data

Prof. Dr. Stefan KoothsHead of the Forecasting CenterKiel Institute for the World Economy

Office BerlinIn den Ministergärten 810117 Berlin030/2067-9664

[email protected]

mailto:[email protected]


The Kiel Institute for the World Economy


Outline

1. Introduction and Overview

2. Market Mechanisms and Government Interventions

3. Externalities and Public Goods

4. Competition Policy and Regulation

5. Ordoliberalism and the Social Market Economy

6. Summary: The Key Lessons Learnt


Outline

1. Introduction and Overview Motivation and key aspects Methodology and general approach Course scheme







Economics and the key allocation problem

Human needs» Subjectively felt uneasiness (reason for action)» Generally unlimited

Goods» Means for (direct or indirect) satisfaction of a need» Generally limited

Scarcity (allocation problem)» Not all needs can be fully satisfied» Selection inevitable

- Ranking needs- Matching with disposable means (production possibilities)

» Economic growth: Reduction of „uneasiness “(more satisfaction by expanding the pool of means)


Alternative allocation mechanisms

Violence (military campaigns, robber barons) Discrimination (Sex, Nationality, Age, …) Greyhound racing („First come, first served“) Communism („Each according to his/her need”) Egalitarianism („Each the same“)

Market (competitive exchange mechanism)» Property rights» Voluntary exchange„Each according to his/her preferences and performance“

(ability-to-pay resulting from market income = valuation by others)


Nature of (economic) goods

Human need + Causal connection to satisfy such a need + Human knowledge of this causal connection + Sufficient command of the thing

Subjectivist theory of the good» Good-character depends on human judgment» Quality/value not an objective property of the good

Carl Menger (1840 – 1921)Grundsätze der Volkswirtschaftslehre (1871)

Principles of Economics (1976)


Means, ends, and valuation

Reverse value imputation:The end does not „sanctify “ the means, but it values it!

Limited knowledge: Action under uncertainty (= speculation) Rationality und „homo oeconomicus“:

Humans do not purposefully act against their aims

Means EndEffect

Selection Means EndValuation Subjectivejudgment


The market signal system: Profits, Losses, Bankruptcy

Profits» Revenues (value creation) > Costs (value destruction)» Net creation of valueAgent stays in the game, activity can be expanded

Losses» Revenues < Costs» Net destruction of valueYellow card (warning): activity should be reduced/modified

Bankruptcy» Revenues << Costs» Net value destruction ongoing/at large scaleRed card (sending-off): activity must stop


Property rights and the primary role of government

Property rights» Usus» Abusus» Usus fructus (includes: accountability!)

Role of government:Defining and guaranteeing property rights (legal framework)


Fields of economic policy:Allocation, redistribution and stabilization

Allocation» Improving economic efficiency

Redistribution» Changing the distribution of disposable income

(primary vs. secondary income distribtuion)

Stabilization» Growth, employment, price stability, external equilibrium

(macroeconomic approach)» Fiscal policy» Monetary policy (and choice of currency system)


Levels of economic policy: Constitutional vs. interventionist approaches

Constitutional level» Designing the general institutional framework (economic order)

Interventional level» Modifying/interfering with market processes


The extended Tinbergen rule for government interventions

One policy target One specific tool (policy instrument) One independent authority (in case of target conflicts)


Incentives and government interventions:Intention vs. outcome (The Cobra effect)


The big picture: From Feudalism to Neoliberalism (1/3)

Subjects

Feudal power

Economy

Feudalism

(Democratic) State

Constitution

Capitalist economy

Competition

liberalrevolution

Free market system(classic liberalism)


The big picture: From Feudalism to Neoliberalism (2/3)„Invisible Hand“/Laissez-faire: Self-interest and public welfare

Adam Smith (1723 – 1790)„It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” (Wealth of Nations, 1776)

Vincent de Gournay (1712 – 1759)„Laissez faire, laissez passer,

le monde va de lui-même.”

Bernard de Mondeville (1670 – 1733)The Fable of the Bees:or, Private Vices, Public Benefits (1714)


The big picture: From Feudalism to Neoliberalism (3/3)

(Democratic) State

Constitution

Capitalistic economy

Competition

Inte

rven

tions

Influ

ence

Degenerate„unfree“ market system

Demokratischer Staat

Constitution

Social market economy

Competition

Neoliberal system

Protec-tion

Regu-lation


Regulation vs. deregulation: An ongoing debate

Regulatory design is technology-dependent Competing paradigms for economic policy making

The fundamental organizational question:Markets vs. hierarchies


Scientific social philosophy: Hayek

The Constitution of Liberty (1959)

Law, Legislation and Liberty (1973/1976/1977)A New Statement of the Liberal Principles of Justice and Political Economy

The Fatal Conceit (1988)The Errors of Socialism


World economy (2015) and global civilization

7 320 000 000 people


Spontaneous (= evolutionary) order

“Social structures of all kinds were the result of human action,

but not the execution of any human design.”Adam Ferguson (1782)


Between instincts and rationality

Instincts» Stability of small (non-anonymous) groups» Members: Solidarity, Altruism» Non-members: Exclusion, aggression

Constructionist (naive) rationalism» Legal positivism» Scientism, utilitarianism» Descartes/Hobbes/Rousseau

Evolutionary (critical) rationalism» Limited knowledge of complex sytems» Humans: Means-end-calculus plus rules (customs, conventions, …)» Hume/Smith/Popper


Atavism: Instincts in the anonymous society


„Extended order“

Property Contracts Competition Exchange/money Openness/non-aggression/voluntary interaction Trust/reputation

Efficiency = Use of decentral knowledge Justice (fairness) = Rule of abstract law


Social evolution …

… is» Success of adapted rules» Selection by learning» Dependent on freedom and uncertain (value-free)

… is not» Pursuit of collectively desired ends» „Social Darwinism“» Deterministic (like Comte/Hegel/Marx)


Outline








Good and bad economics(H. Hazlitt: Economics in One Lesson)

The bad economist sees only …» … what immediately strikes the

eye.» … the direct consequences of a

proposed course.» … what the effect of a given

policy has been or will be on one particular group.

The good economist also …» … looks beyond.

» … looks at the larger and indirect consequences.

» … inquires what the effect of the policy will be on all groups.


Methodological individualism

General method» Individuals as point of departure for economic analysis» Explaining social processes via actions of involved persons

Individuals …» … are diverse» … have exogenous preferences» … are capable of acting on their own

» … follow their vested interest

Subjectivism» Individual preferences» No scientific inter-subjective comparisons of utility


Human Action

Subjective uneasiness purposeful action

Action = Influencing circumstances of one’s life Humans as universal entrepreneurs

» Decision maker» Explorer (search for new means)

Ludwig von Mises (1881 – 1973)Nationalökonomie – Theorie des Handelns und Wirtschaftens (1940)

http://mises.org/document/3250


“Collective” action and average “behavior” of groups:Pitfalls of collectivist analysis and the Arrow paradox

Person Ranking of alternatives A, B, C

1 A > B > C2 B > C > A3 C > A > B

Voting Results

A vs. BB vs. CC vs. A


The “free-market prejudice”

Voluntary exchange imply gains from trade Markets as reference and default system


Pareto efficiency and Kaldor-Hicks criterion


Workable economic coordination: Static and dynamic functions

“What are markets expected to do?”

Static functions» Consumer sovereignty» Efficient factor allocation» Performance-based income distribution

Dynamic functions» Flexible adjustment to changing conditions» Technological progress/innovations

Coordination efficiency


Positive vs. normative analysis

Positive economics» Economist as observer» Explanation of cause and effect

Normative economics» Economist as advisor based on fundamental values» Judgmental knowledge (making assumptions explicit)» Second-best problems

Political economics» Analysis of politicians/bureaucrats/pressure groups» Public Choice/New Institutional Economics


Markets vs. politics/morals

Market system: Coordination mechanism (instrument)» Usefulness basically open to scientific analysis» But: Links between personal freedom and market system

Politics/morals: Definition of targets (normative)» Legitimation cannot be established by economic science» Economics: Looking for best means to reach specific targets and

determining opportunity costs/trade-offs


Transaction costs

Ex-ante transaction costs» Search» Negotiation» Contracting

Ex-post transaction costs» Implementation» Monitoring» Adjustment

Using the market is not for free (BUT: so is hierarchical/central planning)


Categories of market failures

Technological externalities

Natural monopolies (subadditivity of cost functions)

Information deficiencies

Instability (deficient adjustment processes)

[Non-rationality]


Potential room for improving social coordination:The two-stage burden of proof

Intervention analysis: Market vs. hierarchy (central planning)(1) Significant market failure?(2) Market failure > government failure?

(comparing relevant alternatives)- Information problem

(getting/distributing data, value problem)- Incentive/bureaucracy problem

(individual utility vs. realization of the plan)- Financing/spillovers to other fields

(distortions on other markets)

Intervene only, if (1) and (2)» Default: Market-based coordination (free-market prejudice)» Minimally invasive operations (market-compatible solutions)


Dubai: Is the desert a market failure?

Ruler of Dubai: „Market failed to put Dubai on the global map!“


Outline








Reading

Literature» Fritsch, M. (2011): „Marktversagen und Wirtschaftspolitik –

Mikroökonomische Grundlagen des staatlichen Handelns“, 8. Aufl., Verlag Vahlen: München.

» Grossekettler, H., A. Hadamitzky and C. Lorenz (2008): „Volkswirtschaftslehre“; UVK Verlagsgemeinschaft: Konstanz.

» Hazlitt, H. (2008): “Economics in One Lesson”, Ludwig von Mises Institute: Auburn/Alabama.

» Mankiw, N. G. (2011): „Principles of Economics“, 6th Edition, South-Western.

Course website: www.kooths.de/bits-ep

http://www.kooths.de/bits-ep


Outline


2. Market Mechanisms and Government Interventions Market-based coordination and welfare

economics Price controls Taxes






Pareto efficiency


Conditions for „perfect“ competition (1/2)

Atomistic market structure» Infinite number of buyers and sellers (no market power)» Price taker/autonomous decisions

Rationality» Consumers/households: Utility maximization» Producers/enterprises: Profit maximization» Self-interest with fair means (no opportunistic behavior)

Homogenous goods (products and factors)» No personal/spatial/physical preferences» No indivisibility

Stationary world» Given resources, constant technology» No growth analysis, no process/product innovations


Conditions for „perfect“ competition (2/2)

World without frictions» Zero transaction costs (no costs for making an exchange of goods)» Perfect factor mobility (unrestricted market entry/exit)

Freedom of choice» No involuntary/compulsory transactions» No technological external effects

Perfect information/total transparency» Full knowledge/free information about alternatives and prices» No uncertainty

Infinite speed of response» Focus on equilibrium analysis» Transactions only at equilibrium prices (no “false” trading)


The 2-2-2 model

Two consumers: A and B Two products: X and Y Two factors: L and K


Criteria 1: Efficiency of exchange(Edgeworth box and contract curve)


Criteria 2: Efficiency of factor use(efficiency line and production-possibility frontier)


Criteria 3: Optimal composition of production(consumer sovereignty)


Equilibrium: Market clearing and social welfare


Fundamental theorems of welfare economics

Theorem 1:Competitive markets tend toward an efficient allocation of resources (= fulfill criteria 1 to 3)

Theorem 2:Any particular Pareto-efficient outcome can be achieved via lump-sum wealth redistributions and then letting the market take over


The markets’ navigation system:Prices as universal information carriers


Static and dynamic efficiency


Primary income distribution


Flexible adjustment to changing conditions


Technological progress


“Perfect” competition and reality:Nirvana critique and the theory of second best


Market prices, revealed preferences and the impossibility of calculation under Socialism (Mises)


Potential market failures and economic policy


Outline


2. Market Mechanisms and Government Interventions Market-based coordination and welfare economics Price controls Taxes






Price ceilings and market outcomes (example: rent controls)


Price floors and market outcomes (example: minimum wages)


Escaping price controls


Outline


2. Market Mechanisms and Government Interventions Market-based coordination and welfare economics Price controls Taxes






Taxes on sellers


Taxes on buyers


Elasticity and tax incidence: Who really pays the tax?


Excess burden (deadweight loss) of taxation


The Laffer curve: Tax rates vs. tax revenues


Administrative burden


Marginal tax rates vs. average tax rates


Lump-sum taxes


Principles of taxation: Benefits vs. ability-to-pay

Benefits principle Ability-to-pay principle

» Horizontal equity» Vertical equity


Outline



3. Externalities and Public Goods Technological externalities Public goods and common resources





Technological vs. pecuniary externalities


Positive externalities: Private and social utility


Negative externalities: Private and social cost


Policy instruments: Incentive-based vs. command-and-control


Criteria: Static efficiency, dynamic efficiency, and effectiveness


Moral suasion


Nationalization


Public orders


Pigou-taxes/subsidies

Arthur Cecil Pigou(1877—1959)

BUT:„It must be confessed, however, that we seldom know enough to decide in what fields and to what extent the State, on account of [the gaps between private and public costs] could usefully interfere with individual freedom of choice.“

(Some Aspects of the Welfare State, 1954)


Cap-and-trade (example: pollution permits)


Bargaining: The Coase theorem

Ronald Coase(1910—2013)


Outline



3. Externalities and Public Goods Technological externalities Public goods and common resources





Classification of goods: Excludability and rivalry

Classification matrixRivalry?

yes no

Excludability?yes Private good Club good

no Quasi-public good Public good


Private vs. collective goods: Aggregating individual demand


Non-excludability: The free-rider problem


Managing collective goods: Quantities, prices, and willingness to pay


Providing public goods: Cost-benefit analysis


The Tragedy of the Commons


Common resources and property rights


Outline




4. Competition Policy and Regulation Competitive markets vs. market power Anti-competitive behavior and anti-trust policies Natural monopolies




Monopoly: Price, quantity, and welfare effects


Price discrimination


Temporary monopolies (pioneer profits), dynamic efficiency, and contestable markets


Cartels: Potential profits and fragility


Outline








Anti-competitive strategies (overview)

Cartels and collusion Abuse of dominant market position Mergers and acquisitions


Anti-trust policy concepts (overview)

Laissez-faire approach Structure approach Regulation approach Ownership approach


Per se-rule vs. rule of reason


Ex ante vs. ex post approach


Problem of the relevant market


Outline








Economies of scale


Subadditivity of cost functions


Role of potential competition (contestable markets)


Regulation: Price-cap vs. rate-of-return


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KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2015/2016) 1 Economic Policy and...

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