Choose 1 question from Micro section (block a). Choose 1 question from Macro section (block b). Upto 900 words per question. Define all concepts and key terms Harvard Referencing Give titles to sections of the essays to give clear structure. Use diagrams

SOAS, Uni London Introduction to Economic Analysis Sophie van Huellen Module 153400003 Exercise 9 December 2020

1) Your local authority provides a police station, a fire brigade, and a public library. a. What are the market failures, if any, that each of these seeks to correct? b. Which of these are closest to being public goods? c. Which are furthest from being a public good? d. What would happen if governments were prevented from offering these

services? Answer

Strictly speaking, police stations and fire brigades are not provided by the local

authority in the UK, but by specialist authorities (with local authority representation).

However, this does not affect the question. Note that a decision is needed as to how

far the police station in the question can really be discussed in isolation from the rest

of the police service.

(a) There is no obvious market imperfection that the provision of police stations

seeks to correct, beyond the wider one of the whole police service as a response to

law and order being a public good. Without a public police service, it is difficult to see

how public laws could be generally and equitably enforced. Individuals might (and in

some circumstances currently do) hire private security personnel to protect their

persons and property, but this is not the same thing as a public service provided to

all.

With fire brigades there is an element of public goods but also a more private benefit

which could in principle be solved by private insurance (as indeed it was in the early

days of the fire brigade). However, many people might choose not to insure their

property, and at least where there are children involved the state is likely to feel the

need to step in. There is also a large externality here, in that many people are at risk

from a fire in their neighbour’s property. In densely populated urban areas, the

negative externality from fires is potentially very large (the Great Fire of London is a

good, if rather extreme, example), so that for many purposes, rapid response to fires

is a public good.

Public libraries, or rather the books and other materials they house, have a lot of

potential as imperfect public goods. Although two people cannot easily read the

same book at the same time, a given book can be read many times before it is worn

out. Thus, the marginal cost of making a book available to one more person is very

low, and this is an attribute of public goods. One could easily imagine, however,

private lending libraries that charged a small fee to lenders; again, such libraries

operated more widely in the past than they do now. However, the main argument in

practice for public libraries is probably that their product is widely seen as a merit

good: they promote the social goal of making knowledge generally available to

citizens. This, too, can be thought of as a public good. Finally, the existence of some

SOAS, Uni London Introduction to Economic Analysis Sophie van Huellen Module 153400003 Exercise 9 December 2020 library (for example, the British Library) as a store of knowledge is a nearly pure

public good. But this argues for one central public library, not for many local ones.

(b) In all cases the goods are potentially excludable, although there would be little

point in this for the police station while the rest of the police service remains open to

all. The police station is probably the closest to being a public good, other than

during (short) periods of excess demand, none is rivalrous.

(c) The fire brigade could operate on an insurance basis, and there is an element of

rivalry here insofar as a fire engine attending one call cannot attend another at the

same time. Libraries are clearly excludable, and one person’s borrowing reduces the

service for others, but overall they are probably the furthest from being a public

good.

(d) If governments were prevented from offering all these services, it is likely there

would be extensive private provision (possibly by insurance companies) of a fire

service. Some private libraries might develop, but probably not many. If police

stations were not publicly provided but the rest of the service was then the latter

would be likely to operate much less efficiently. If no police service at all was

provided by the government, one would expect to see some more private security

services instead, at least at the level of local security patrols (where the problem of

free-riding might not be too severe), together with greater investment in burglar

alarms and so on.

SOAS, Uni London Introduction to Economic Analysis Sophie van Huellen Module 153400003 Exercise 9 December 2020

2) What inefficiencies will be caused by a. The personal income tax b. Farm subsidies c. Free elementary education d. Welfare payments to non working persons

Explain why such inefficiencies do not provide sufficient reasons to end the activity. Also explain why one needs neoclassical assumptions about what is the benchmark for comparison in order to suggest that these phenomena are inefficient in the first place. Does neoclassical economic theory introduce a market bias? Answer:

(a) Personal income tax distorts labour supply decisions, as it drives a wedge

between what the employer pays and what the worker receives. As in (a), taxes are

one of life’s certainties, and income may be favoured as a base on distributional

grounds (indirect taxes may be regressive) and because income tax is also relatively

cheap to collect (through the PAYE system in the UK).

(b) Farm subsidies will keep land in agricultural use when the market outcome

would be different or will mean it is used for the “wrong” crop. Prices and quantities

of foods in the shops will also be distorted as a result, and there may well be effects

on trade (such as reducing imports of a subsidized product) with knock-on effects on

producers overseas. There are various possible reasons for maintaining particular

farm subsidies: national security (in case of war), environmental arguments (such as

for hill farms in the Lake District), maintenance of rural employment and populations,

etc.

(c) Free health care might be expected to mean higher resources going into health

care than the private market would provide, but the fact that it is funded by taxation

has tended to keep provision relatively low (the proportion of GDP spent on health

care in the UK is significantly lower than in the USA, for example). Free provision,

particularly for children, may be seen as a social responsibility, or the provision of a

basic (human) right. There are also externality arguments in the case of infectious

diseases, and the relatively low costs of the NHS provide evidence that this may be

an efficient way to provide the service.

(d) Free elementary school education is similar to health care above, although

unless education were to become optional, the main measure of quantity—the

number of children involved—is fixed. Thus, the distortion is probably relatively

small. Again, the need to fund provision by taxes has probably kept costs down.

Again, too, there are social reasons for free, state provision including externality and

paternalism arguments.

SOAS, Uni London Introduction to Economic Analysis Sophie van Huellen Module 153400003 Exercise 9 December 2020 (e) Welfare payments to non-working persons will distort the labour-leisure decisions

of those receiving them, with fewer people choosing to work as a result. The

argument for not stopping the payments is likely to be a social one again: that

society wishes to maintain certain minimum levels of income for all, especially where

there is some good reason for the welfare recipient not being in work (such as

disability or lack of job opportunities) and/or they have children to support.

The inefficiencies do not mean that these interventions should be removed.

Government activities, such as defence, law and order, health and education, have

to be funded somehow. Also, there is an accepted commitment to some level of

redistribution, so that the worst off are provided with a safety net, and this has to be

paid for by the better off (note from the lecture the discussion of the findings of the

Rapporteur of the UN on how thin this safety net currently is). Non-distortionary

taxes (such as the poll tax) have been tried but then rejected on equity grounds.

Second-best arguments also imply that just removing some distortions and not

others cannot be guaranteed to improve things. This means that while there are any

distortions, it may be optimal to retain some others (See Box 13.2 on page 305).

Additionally: You need neoclassical assumptions about what is the ‘normal’, efficient situation. Up to you to argue for or against a market bias, but the case for the bias is clear – markets by themselves are efficient. The Shaikh argument: even if we say there’s pervasive imperfections in competition, we still acknowledge the ‘perfect’ benchmark.

SOAS, Uni London Introduction to Economic Analysis Sophie van Huellen Module 153400003 Exercise 9 December 2020

3) Why is the role of government inevitable even in a market economy? a. Answer from a neoclassical economic point of view. b. Contrast with Ha Joon Chang’s ‘institutional political economy’ point of view

(in his 2002 article on BLE) of a market economy. Does the question make sense from this point of view?

Answer:

(a) There is always the minimal (or “night watchman”) role of maintaining basic law

and order—the ―legal monopoly of violence‖ identified at the start of Chapter 13—

and a properly enforced system of property rights is essential to a well-functioning

market economy. Most modern market economies have laws on fair competition,

monopoly power and so on too (for example, “anti-trust” in the USA), and the

government will have to monitor and enforce these rules. There are also health and

safety concerns in most countries—such as pollution controls and the MOT test for

cars in the UK—and these require government involvement. Finally, even market-

oriented countries generally make some provision for those unable to support

themselves, and this responsibility too often tends to fall on government.

This list is by no means exhaustive, and students will no doubt come up with other

reasons. It is worth noting that even strongly pro-market businesses tend not to want

to invest in countries without an effective government (of which there are several

around the world).

(b) This can draw on Ha Joon Chang’s problem that markets are never really free,

but what is ‘free’ is a relative concept. See in particular section 3.1. Moreover,

somehow markets have to be ‘created’ – they do not spring from the ground like

mushrooms, to paraphrase Hobbes. Government is necessary to create and sustain

markets, especially global ones. (Note: Polanyi, and more recently Mazzucato might

give some ammunition too.)

SOAS, Uni London Introduction to Economic Analysis Sophie van Huellen Module 153400003 Exercise 9 December 2020

4) An industry consists of two firms producing the same product but using different technologies. Each emits 50 tonnes of pollution each year. One can clean up the first tonne at a cost of £1,000 and the cost of each additional tonne cleaned up rises by £1,000 per tonne until the last tonne costs £50,000. The second firm’s cost for the first tonne cleaned up is £20,000 and the costs rises by £1,000 until the fiftieth tonne is cleaned up at a cost of £70,000. The government wishes to cut the industry’s total emissions from 100 to 50 tonnes a year. It gives each firm 25 tradable permits, each one allowing 1 tonne of pollution.

a. What will be the equilibrium price of a permit to pollute by 1 tonne? b. How many permits will be traded? c. By how much will each firm clean up its own pollution? d. What would you infer if, in a subsequent year, the price of a pollution permit

fell by 50%? Answer:

This question is based on Figure 13.5 in your textbook and the discussion there.

Assume initially that each firm uses its 25 permits itself and cleans up the rest of the

pollution. Firm A’s marginal cost of abatement is then £25,000 and Firm B‘s is

£45,000. It makes sense for Firm A to sell permits to Firm B until the two costs come

into line. This will occur when 10 permits have been traded; Firm A will now abate 35

tonnes (i.e. produce 15 tonnes) and Firm B will only abate 15 (and produce 35). Both

now have a marginal abatement cost of £35,000 per tonne, which will equal the price

of a permit. The two firms have moved as shown by the arrows on the diagram

below.

Thus, the answers to the questions are as follows:

SOAS, Uni London Introduction to Economic Analysis Sophie van Huellen Module 153400003 Exercise 9 December 2020 (a) The equilibrium price of a permit to pollute will be £35,000 per tonne.

(b) Ten permits will be traded.

(c) Firm A will clean up 35 tonnes of its own pollution and Firm B 15 tonnes of its

pollution.

(d) If the price of a permit subsequently fell by 50 per cent, the most likely inference

is that

Firm B has improved its technology so that it is closer to Firm A’s. Less likely

alternatives would include the government relaxing its control by issuing more

permits in the first place, so that both firms are lower down in the diagram above.