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

KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2015/2016) 2

Contact data

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

Office BerlinIn den Ministergärten 810117 Berlin030/2067-9664

stefan.kooths@bits-hochschule.dewww.kooths.de

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The Kiel Institute for the World Economy

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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

KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2015/2016) 5

Outline

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

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

KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2015/2016) 6

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)

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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)

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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)

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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

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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

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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)

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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)

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Levels of economic policy: Constitutional vs. interventionist approaches

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

Interventional level» Modifying/interfering with market processes

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The extended Tinbergen rule for government interventions

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

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

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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)

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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)

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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

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Regulation vs. deregulation: An ongoing debate

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

The fundamental organizational question:Markets vs. hierarchies

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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

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World economy (2015) and global civilization

7 320 000 000 people

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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)

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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

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Atavism: Instincts in the anonymous society

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„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

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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)

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Outline

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

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

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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.

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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

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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

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“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

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The “free-market prejudice”

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

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Pareto efficiency and Kaldor-Hicks criterion

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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

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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

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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

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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)

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Categories of market failures

Technological externalities

Natural monopolies (subadditivity of cost functions)

Information deficiencies

Instability (deficient adjustment processes)

[Non-rationality]

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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)

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Dubai: Is the desert a market failure?

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

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Outline

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

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

KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2015/2016) 42

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

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Outline

1. Introduction and Overview

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

economics Price controls Taxes

3. Externalities and Public Goods

4. Competition Policy and Regulation

5. Ordoliberalism and the Social Market Economy

6. Summary: The Key Lessons Learnt

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Pareto efficiency

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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

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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)

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The 2-2-2 model

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

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

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

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Criteria 3: Optimal composition of production(consumer sovereignty)

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Equilibrium: Market clearing and social welfare

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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

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The markets’ navigation system:Prices as universal information carriers

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Static and dynamic efficiency

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Primary income distribution

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Flexible adjustment to changing conditions

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Technological progress

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

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

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Potential market failures and economic policy

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Outline

1. Introduction and Overview

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

3. Externalities and Public Goods

4. Competition Policy and Regulation

5. Ordoliberalism and the Social Market Economy

6. Summary: The Key Lessons Learnt

KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2015/2016) 62

Price ceilings and market outcomes (example: rent controls)

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Price floors and market outcomes (example: minimum wages)

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Escaping price controls

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Outline

1. Introduction and Overview

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

3. Externalities and Public Goods

4. Competition Policy and Regulation

5. Ordoliberalism and the Social Market Economy

6. Summary: The Key Lessons Learnt

KOOTHS | BiTS: Economic Policy and Market Regulation (winter term 2015/2016) 66

Taxes on sellers

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Taxes on buyers

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Elasticity and tax incidence: Who really pays the tax?

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Excess burden (deadweight loss) of taxation

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The Laffer curve: Tax rates vs. tax revenues

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Administrative burden

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Marginal tax rates vs. average tax rates

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Lump-sum taxes

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

Benefits principle Ability-to-pay principle

» Horizontal equity» Vertical equity

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Outline

1. Introduction and Overview

2. Market Mechanisms and Government Interventions

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

4. Competition Policy and Regulation

5. Ordoliberalism and the Social Market Economy

6. Summary: The Key Lessons Learnt

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Technological vs. pecuniary externalities

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Positive externalities: Private and social utility

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Negative externalities: Private and social cost

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

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Criteria: Static efficiency, dynamic efficiency, and effectiveness

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Moral suasion

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Nationalization

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Public orders

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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)

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Cap-and-trade (example: pollution permits)

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Bargaining: The Coase theorem

Ronald Coase(1910—2013)

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Outline

1. Introduction and Overview

2. Market Mechanisms and Government Interventions

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

4. Competition Policy and Regulation

5. Ordoliberalism and the Social Market Economy

6. Summary: The Key Lessons Learnt

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Classification of goods: Excludability and rivalry

Classification matrixRivalry?

yes no

Excludability?yes Private good Club good

no Quasi-public good Public good

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Private vs. collective goods: Aggregating individual demand

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Non-excludability: The free-rider problem

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

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Providing public goods: Cost-benefit analysis

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The Tragedy of the Commons

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Common resources and property rights

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Outline

1. Introduction and Overview

2. Market Mechanisms and Government Interventions

3. Externalities and Public Goods

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

5. Ordoliberalism and the Social Market Economy

6. Summary: The Key Lessons Learnt

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Monopoly: Price, quantity, and welfare effects

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Price discrimination

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

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Cartels: Potential profits and fragility

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Outline

1. Introduction and Overview

2. Market Mechanisms and Government Interventions

3. Externalities and Public Goods

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

5. Ordoliberalism and the Social Market Economy

6. Summary: The Key Lessons Learnt

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Anti-competitive strategies (overview)

Cartels and collusion Abuse of dominant market position Mergers and acquisitions

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Anti-trust policy concepts (overview)

Laissez-faire approach Structure approach Regulation approach Ownership approach

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Per se-rule vs. rule of reason

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Ex ante vs. ex post approach

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Problem of the relevant market

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Outline

1. Introduction and Overview

2. Market Mechanisms and Government Interventions

3. Externalities and Public Goods

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

5. Ordoliberalism and the Social Market Economy

6. Summary: The Key Lessons Learnt

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Economies of scale

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Subadditivity of cost functions

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Role of potential competition (contestable markets)

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

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Auctioning