Economic Policy and Market Regulation

1. Economic Policy and Market Regulation Prof. Dr. Stefan Kooths BiTS Berlin(winter term 2014/2015) www.kooths.de/bits-ep

2. Outline • Introduction and Overview • Market Mechanisms and Government Interventions • Externalities and Public Goods • Competition Policy and Regulation • Ordoliberalism and the Social Market Economy • Summary: The Key Lessons Learnt

3. Outline • Introduction and Overview • Motivation and key aspects • Methodology and general approach • Course scheme • Market Mechanisms and Government Interventions • Externalities and Public Goods • Competition Policy and Regulation • Ordoliberalism and the Social Market Economy • Summary: The Key Lessons Learnt

4. 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)

5. 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)

6. The market signal system: Profits, Losses, Bankruptcy • Profits • Revenues (value creation) > Costs (value destruction) • Net creation of value • Agent stays in the game, activity can be expanded • Losses • Revenues < Costs • Net destruction of value • Yellow card (warning): activity should be reduced/modified • Bankruptcy • Revenues << Costs • Net value destruction ongoing/at large scale • Red card (sending-off): activity must stop

7. Property rights and the primary role of government • Property rights • Usus • Abusus • Ususfructus (includes: accountability!) • Role of government:Defining and guaranteeing property rights (legal framework)

8. 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)

9. Levels of economic policy: Constitutional vs. interventionist approaches • Constitutional level • Designing the general institutional framework (economic order) • Interventional level • Modifying/interfering with market processes

10. The extended Tinbergen rule for government interventions • One policy target • One specific tool (policy instrument) • One independent authority (in case of target conflicts)

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

12. The big picture: From Feudalism to Neoliberalism (1/3) Free market system(classic liberalism) Feudalism Constitution liberalrevolution (Democratic) State Feudal power Subjects Economy Competition Capitalist economy

13. 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)

14. The big picture: From Feudalism to Neoliberalism (3/3) Degenerate„unfree“ market system Neoliberal system Constitution Constitution Demokratischer Staat (Democratic) State Regu-lation Protec-tion Interventions Influence Competition Capitalistic economy Competition Socialmarketeconomy

15. Regulation vs. deregulation: An ongoing debate • Regulatory design is technology-dependent • Competing paradigms for economic policy making • The fundamental organizational question:Markets vs. hierarchies

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

17. Outline • Introduction and Overview • Motivation and key aspects • Methodology and general approach • Course scheme • Market Mechanisms and Government Interventions • Externalities and Public Goods • Competition Policy and Regulation • Ordoliberalism and the Social Market Economy • Summary: The Key Lessons Learnt

18. 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

19. 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

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

21. The “free-market prejudice” • Voluntary exchange imply gains from trade • Markets as reference and default system

22. Pareto efficiency and Kaldor-Hicks criterion

23. 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

24. Positive vs. normative analysis • Positive economics • Economist as observer • Explanation of cause and effect • Normative economics • Economist as advisor to a “social planner” • Judgmental knowledge (explicit or implicit assumptions) • Second-best problems • Political economics • Analysis of politicians/bureaucrats/pressure groups • Public Choice/New Institutional Economics

25. 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

26. 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)

27. Categories of market failures • Technological externalities • Natural monopolies (subadditivity of cost functions) • Information deficiencies • Instability (deficient adjustment processes) • [Non-rationality]

28. Potential room for improving social coordination:The two-stage burden of proof • Intervention analysis: Market vs. hierarchy (central planning) • Significant market failure? • 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)

29. Dubai: Is the desert a market failure? • Ruler of Dubai: „Market failed to put Dubai on the global map!“

30. Outline • Introduction and Overview • Motivation and key aspects • Methodology and general approach • Course scheme • Market Mechanisms and Government Interventions • Externalities and Public Goods • Competition Policy and Regulation • Ordoliberalism and the Social Market Economy • Summary: The Key Lessons Learnt

31. Reading • Literature • Fritsch, M. (2011): „Marktversagen und Wirtschaftspolitik – MikroökonomischeGrundlagen des staatlichenHandelns“, 8. Aufl., VerlagVahlen: 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

32. Outline • Introduction and Overview • Market Mechanisms and Government Interventions • Market-based coordination and welfare economics • Price controls • Taxes • Externalities and Public Goods • Competition Policy and Regulation • Ordoliberalism and the Social Market Economy • Summary: The Key Lessons Learnt

33. Pareto efficiency

34. 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

35. 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)

36. The 2-2-2 model • Two consumers: A and B • Two products: X and Y • Two factors: L and K

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

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

39. Criteria 3: Optimal composition of production(consumer sovereignty)

40. Equilibrium: Market clearing and social welfare

41. 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

42. The markets’ navigation system:Prices as universal information carriers

43. Static and dynamic efficiency

44. Primary income distribution

45. Flexible adjustment to changing conditions

46. Technological progress

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

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

49. Potential market failures and economic policy

50. Outline • Introduction and Overview • Market Mechanisms and Government Interventions • Market-based coordination and welfare economics • Price controls • Taxes • Externalities and Public Goods • Competition Policy and Regulation • Ordoliberalism and the Social Market Economy • Summary: The Key Lessons Learnt