Week 3.pdf

01/08/2024 SMU COR2100 Economics and Society Week 3 Dr Lam San Ling 2024-25 Term 1 1...

01/08/2024 SMU COR2100 Economics and Society Week 3 Dr Lam San Ling 2024-25 Term 1 1 Slide 2 Week 3: agenda  The “invisible hand” - Historical context - Market economy as today’s baseline  Market failure - Externalities - Public goods  Role of government - Applying supply and demand tools 2 1  01/08/2024 Slide 3 before we discuss market failure, need to understand the baseline, i.e. market economy “market failure” – failure of what exactly? was market economy always the norm? 3 Slide 4 Adam Smith’s the invisible hand The Wealth of Nations  Father of economics  18th century Scottish moral philosopher and political economist [b 1723, d 1790]  Author of An Inquiry into the Nature and Causes of the Wealth of Nations ("The Wealth of Nations"), 1776 4 2  01/08/2024 Slide 5 The “Invisible Hand” - concept  Invisible hand - Metaphor for the unseen forces that move the free market economy. Through individual self-interest and freedom of production as well as consumption, the best interest of society, as a whole, are fulfilled. [Investopedia] - Economic concept that describes the unintended greater social benefits and public good brought about by individuals acting in their own self- interests. [Wikipedia] - First introduced by Adam Smith in The Theory of Moral Sentiments (1959), elaborated on in The Wealth of Nations (1776). 5 Slide 6 The “Invisible Hand” - concept, quotes  Invisible hand - Adam Smith in The Wealth of Nations (1776): o If people were allowed to trade freely, self interested traders present in the market would compete with each other, leading markets towards the positive output with the help of an invisible hand.  Individuals working in their own self-interest will (unintentionally) lead to the best overall outcome. o Quote: Every individual…neither intends to promote the public interest, nor knows how much he is promoting it…he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. 6 3  01/08/2024 Slide 7 The “Invisible Hand” - concept, quotes  Invisible hand - Adam Smith in The Wealth of Nations (1776): o If people were allowed to trade freely, self interested traders present in the market would compete with each other, leading markets towards the positive output with the help of an invisible hand.  Individuals working in their own self-interest will (unintentionally) lead to the best overall outcome. o Quote: It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regards to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages. 7 Slide 8 The “Invisible Hand” - concept, quotes  Invisible hand - Adam Smith in The Wealth of Nations (1776): o If people were allowed to trade freely, self interested traders present in the market would compete with each other, leading markets towards the positive output with the help of an invisible hand.  Individuals working in their own self-interest will (unintentionally) lead to the best overall outcome.  Historical context: what else was happening in 1776? - The (first) Industrial Revolution, 1760-1830 o Period of rapid technological change, transition to manufacturing processes o From Great Britain to the rest of the world. - United States Declaration of Independence, 4 July 1776 o Assertion of colonial America’s independence from Great Britain 8 4  01/08/2024 Slide 9 today’s baseline: market economy deviations from baseline: market failure 9 Slide 10 Market failure - concepts, definitions  Market failure - Economic situation where free market incentives for rational behaviour (and individuals acting in their self interest) do not lead to a good (optimal) outcomes for the group.  Socially inefficient production and/or distribution of goods and services in the free market.  Individual optimization and social optimization do not coincide - “Broken” invisible hand [AL&L] o Externalities o Public goods o Common pool resources 10 5  01/08/2024 Slide 11 Market failure - externality  Externality - “Spillover from one person’s action to a bystander” [AL&L] o Negative externality = spillover cost o Positive externality = spillover benefit - Examples of negative externality o Pollution: the polluter internalizes the benefits but imposes a spillover cost on others sharing the environment, e.g. noise pollution from construction o Second-hand smoke: spillover costs on (a) “passive smokers” who did not choose to smoke but breathe air in the vicinity; (b) unborn baby of smoker? (c) healthcare costs (and taxes) for society, higher health insurance premiums for non-smokers. o Irresponsible COVID-19 related behaviour by individuals: spreads infection, necessitating lockdowns/restrictions that curb economic activity and growth. o Peeping toms? 11 Slide 12 Market failure - for discussion  Negative externality - Demerit good = goods that carry negative externality o Tobacco o Alcoholic beverages, recreational drugs, junk food, prostitution?  Do you agree?  Other examples? - Poll: If a market insider gives you a stock tip that allows you to trade to your advantage, would you do it? - Poll: If you are a banker, financial advisor, or property agent, would you have any qualms earning commissions from a possibly crooked client?  Does it depend on whether there are penalties if you are found out?  Why should you be penalized? [Just go after market insider, crooked client?] 12 6  01/08/2024 Slide 13 Market failure - for discussion  Positive externality - Merit good = goods that carry positive externality o Education, skills upgrading o Healthcare, vaccination o Safe sex, family planning? Economics, financial literacy? - Merit and demerit goods are typically private goods, i.e. o They can be provided in a market economy - Market failure? – is there basis for government intervention? o Discourage consumption of demerit goods? o Encourage consumption of merit goods? 13 Slide 14 Rivalry and excludability - some more definitions  Rivalry (in consumption) - Rival good o Good whose consumption by one consumer prevents simultaneous consumption by other consumers  Excludability (in consumption) - Excludable good o Good for which it is possible to prevent access to the good (by say, non- paying consumers)  Private good - Rival and excludable good o E.g. Restaurant meals, condos, cars, cupcakes 14 7  01/08/2024 Slide 15 Rivalry and excludability - some more definitions  Public good - Non-rivalry and non-excludable in consumption o E.g. national defence, public health, early warning system  Common pool resource goods - Rival and non-excludable o Fish (and coral reefs) in the sea? Forests? Free food at a function?  Club good - Non-rival and excludable o Private beaches or parks; news subscriptions; cable TV? 15 Slide 16 Rivalry and excludability - some more definitions  Public good  Common pool resource goods  Club good Excludability High Low Rivalry High Private goods Common pool resource Low Club goods Public good Source: AL&L 16 8  01/08/2024 Slide 17 Market failure - public goods  Why is public good an example of market failure? - Non-rivalry and non-excludability in consumption E.g. National defence o Individuals cannot be excluded from enjoying national defence, and thus cannot be charged for this service  Private vendors cannot be incentivized to produce this service in return for payment from consumers  Government to provide? [How to finance?] 17 Slide 18 Market failure - common pool resource  Common pool resource goods - Goods that are rival and non-excludable o Fish in the sea? Coral reefs? Natural forests? - What is the market failure? o Non-excludable: over-consumption, because no payment is charged o Rival: deprives others of use or access.  Government to regulate, deter over-consumption? 18 9  01/08/2024 Slide 19 Market failure - free-rider problem  What do public goods and common pool resource goods have in common? Excludability High Low Rivalry High Private goods Common pool resource Low Club goods Public good Non-excludability  Free-rider problem - Occurs when individual consumers have no incentive to a pay for a good since non-payment does not prevent consumption - Free riders consume more than their fair share or pay less than their fair share  Public policy? - government to provide public goods (financed by tax-payers), and/or to regulate over-consumption? 19 Slide 20 Market failure - club goods  Club goods - Goods that are non-rival but excludable o News subscriptions, cable TV subscriptions, music subscriptions (e.g. Spotify) o “Artificially scarce goods” - What is the market failure? o Non-rivalry (or low rivalry): low or zero MC; but typically high fixed costs o Excludable: possible to deny access to non-payees o Typically provided in non-competitive markets  Government to regulate monopolies? 20 10  01/08/2024 Slide 21 role of Government to address: market failure 21 Slide 22 Role of government - where “socially optimal outcomes” are not achieved  Address market failure - Positive, negative externalities - Public goods  Who decide what is “socially optimal”? - What constitutes positive, negative externality? - What are public goods? - When, how to decide whether to intervene? o Will intervention improve the outcome? o Are there winners and losers of government policy? o Government and civil servants cost money! 22 11  01/08/2024 Slide 23 Role of government - negative externalities  Negative externalities: economy - Country goes into deep recession: who bear the cost? o macroeconomic policies? - business (bakery) fails: who bears the cost? o owner-investors? => no reason for public policy? - Case for public policy?  who decides on public policy, whether government should intervene? 23 Slide 24 Role of government - negative externalities PAUSE  Negative externalities: financial sector - Question: do (should) we care if:  an insurance agent or your stockbroker quits the industry?  a stockbroking company goes out of business?  an insurance company fails?  a bank fails?  a stablecoin (e.g. Terra UST) collapses? 24 12  01/08/2024 Slide 25 Poll Results from week 1 25 Slide 26 role of Government to address: market failure 26 13  01/08/2024 Slide 27 Role of government - positive externalities  Positive externalities - Education [AL&L illustration] P Positive externality for education Socially optimal DD for ed  under-consumption in education P(opt) Q 0 Q(opt) 27 Slide 28 Role of government - positive externalities  Positive externalities - Education [AL&L illustration] P Positive externality for education  under-consumption in education  Deadweight loss P(opt) What can Government do? Q 0 Q(opt) 28 14  01/08/2024 Slide 29 Role of government - positive externalities  Positive externalities - Subsidise consumption (by amount of positive externality) P Positive externality for education  under-consumption in education Mkt DD (w subsidy) DD (with subsidy) shifts up New eqm = Q(opt) P(opt) Q 0 Q(opt) 29 Slide 30 Role of government - positive externalities  Positive externalities - Subsidise consumption (by amount of positive externality) P Positive externality for education  under-consumption in education Mkt DD (w subsidy) Consumers pay P(sub) Producers receive P(opt) P(opt) P(sub) Q 0 Q(opt) 30 15  01/08/2024 Slide 31 Role of government - positive externalities  Positive externalities - Subsidise consumption (by amount of positive externality)  Policy challenges  Incentivise demand for education? - Quantifying the externality (in $) and amount of subsidy o Externality varies for primary, secondary, tertiary education, Skills Future? - Funding, administering the subsidy: through income taxes, GST? o Income tax, GST? Education voucher? Rebate? o May not be worth it if externalities are small? - Assuming nett gains to society, there are still distributional implications o Consumers (of education) benefit o Producers (of education) benefit o Taxpayers who are neither, but pay higher taxes?! 31 Slide 32 Role of government - positive externalities  Positive externalities - Subsidise production? o Advantages, disadvantages over subsidising demand? 32 16  01/08/2024 Slide 33 Role of government - positive externalities Positive externality for education  Positive externalities  under-production in education - Subsidise production? P Socially optimal DD for ed Mkt SS (w subsidy) P(opt) Q 0 Q(opt) 33 Slide 34 Role of government - positive externalities Positive externality for education  Positive externalities  under-production in education - Subsidise production? SS (with subsidy) shifts down New eqm = P Consumers pay P(sub) Producers receive cost = P(sub) + subsidy Socially optimal DD for ed Mkt SS (w subsidy) P(opt) P(sub) Q 0 Q(opt) 34 17  01/08/2024 Slide 35 Role of government - positive externalities  Positive externalities - Subsidise production  Policy challenges  Incentivise supply of education? - Quantifying the externality (in $) and amount of subsidy o Funding, administering the subsidy - Should govt directly supply education? o How to charge for education, at different levels? o Public and private education to co-exist? o National curricula? - Is education a public good? o Rivalry? Excludability? 35 Slide 36 Role of government - public goods  Public goods - Non-excludable => Govt to provide - Non-rival => Govt to figure out the market demand for public good P Private good: Market demand derived by aggregating individual demand curves horizontally At any price, market demand = dd(1) + dd(2) + dd(3) + … Market DD q(1) q(1)+q(2) 0 Q (handbags) 36 18  01/08/2024 Slide 37 Role of government - public goods  Public goods - Non-excludable => Govt to provide - Non-rival => Govt to figure out the market demand for public good P Market DD Public goods: Market demand derived by aggregating individual demand curves vertically p(1)+p(2) At any quantity, willingness to pay = p(1) + p(2) + p(3) + … p(1) 0 Q (roads) 37 Slide 38 Role of government - public goods  Public goods - Non-excludable => Govt to provide - Non-rival => Govt to figure out the market demand for public good P Market DD SS Public goods: DD = SS => Q(opt) public good Public goods o Optimal quantity (subsidized or provided free) is not unlimited o Funded thru’ govt revenue (taxes) 0 Q(opt) Q (roads) 38 19  01/08/2024 Slide 39 Role of government - public goods  Public goods - Provided by government  Policy challenges - Funding and supply of public goods? o Taxes? Reserves? o Can civil servants produce public goods? - Identifying what are truly public goods? o National defence, law & order? o Public infrastructure? Road system, airports?  Is it truly non-rival? Congestion of public infrastructure?  Can consumers be made to pay by making the service excludable? - Public-private partnerships? 39 Slide 40 Role of government - public goods  Policy challenges - Identifying what are truly public goods?  Is it truly non-rival?  Is it truly non-excludable? Excludability High Low Private goods Common pool resource High Rivalry Club goods Public good Low 40 20  01/08/2024 Slide 41 Role of government - public goods  Policy challenges - Public-private partnerships (PPP)? o Collaboration between govt agency and a private sector company to finance, build, and operate projects o Sports Hub: brings together private bank financing for the Sports Hub Consortium to build and manage Singapore’s key national sporting facilities, with an annual payment by the Government for the use of these facilities 41 Slide 42 Role of government? - for discussion  Size of government? - How intrusive? Consumer choice vs paternalism? - Is public policy feasible, cost-effective? Unintended consequences? - Cost of taxation, bureaucracy, regulation?  National priorities? - Equity vs efficiency? - Economic growth, happiness index? - Income, wealth distribution? Poverty (absolute, relative)?  Nations in the global economy? - National sovereignty vs global rules: G7, G-20 consensus? - How much to cede to international organizations? - UK and the Brexit referendum: “Take back control”? 42 21  01/08/2024 Slide 43 Role of government - for discussion  Arguably most important role? - Build or arrive at agreement (social contract?) on what are important? o What individuals are prepared to give up to reach agreed objectives? o To prioritize national objectives? [Assuming they can’t all be achieved.] - Political process and representation to arrive at agreement/consensus? - How should resources be allocated? o Equally? o According to need? o According to “contribution” (ability, ownership)? 43 Slide 44 End of Week 3 Thank you  44 22  01/08/2024 Slide 45 References  AL&L (2021), Economics - Chap 9: externalities and public goods o Chap 9.1 (externalities) o Chap 9.4 (public goods) - Chap 10: the government in the economy o Chap 10.4 (equity vs efficiency) o Chap 10.5 (consumer sovereignty and paternalism) - Quick browse o Chap 7 (the invisible hand) 45 23