Assignment 2

2. Why does the operation of a market system presuppose that individual rights are protected?  Describe an economy in which individual rights are not protected.  What institutions of government protect individual rights, and how do they work?

If rights are not protected, people could steal the output of others and voluntary exchange would be undermined.  Such an economy would be bad for everybody (even the tough guys who steal from everybody else) because nobody would produce very much if they believed it would just be stolen from them.  Thus, there wouldn’t even be very much to steal!  The government protects rights through police protection, national defense, and courts.

3. What is utilitarianism?  What are the advantages and disadvantages of using utilitarianism to determine the public interest?  Is some form of utilitarianism currently being used to measure the public interest?  Explain.  Should some form of utilitarianism be used?

Utilitarianism tries to maximize the total amount of social utility in a society.  To do so, there must be some way to compare the gains to the gainers against the losses to the losers.  This is difficult because utility cannot actually be measured (but the dollar value might be approximated through cost-benefit analysis).  Also, it may be unfair to have some people gain at the expense of others.  Ultimately, however, almost every public policy imposes at least some costs on some people, so making the judgment that the gains to the gainers outweigh the losses to the losers is almost unavoidable if the government is to do anything at all.  Because of this, we could say that some form of utilitarianism is used to measure the public interest.

4. Explain the concepts of Pareto optimality and Pareto superiority.  How do the concepts differ?  Would the Pareto criteria or utilitarianism provide a more effective measure of the public interest?

Pareto optimality is the situation where nobody can be made better off without making someone else worse off.  A situation is Pareto superior to another if at least one person is better off and nobody is worse off.  Pareto optimality applies to individual situations.  They either are or are not optimal.  Pareto superiority is used to compare two situations.  The Pareto criteria provide a more effective measure of the public interest than utilitarianism because there is no need to make interpersonal utility comparisons.  (Unfortunately, when there are gainers and losers from a policy, the concept of Pareto superiority cannot be applied, but a situation still could be evaluated to see whether it is Pareto optimal.)

5. Relate the notion of potential compensation to the concept of Pareto superiority.  If the beneficiaries of a change could potentially compensate the losers, is the change in the public interest?  Are there some conditions under which potential compensation would suffice as a measure of the public interest and others under which actual compensation should be demanded?

A change would be Pareto superior if compensation was made.  Whether this would be in the public interest without compensation is a normative issue.  If losses were small, or if over a large number of policies everyone could expect to be net gainers, then potential compensation might be judged a satisfactory measure of the public interest.

6. What is a cost-benefit analysis?  What problems might arise in trying to carry out such an analysis?  Is a cost-benefit analysis more closely related to utilitarianism or to the Pareto criteria?  Given the necessity of determining what is in the public interest, is a cost-benefit analysis a reasonable method of making the determination?  What additional criteria could be used to supplement a cost-benefit analysis?

Cost-benefit analysis tries to convert all gains and losses from a project into dollar amounts so that the gains and losses can be compared directly.  It is an extension of utilitarianism.  It may be reasonable to look at the costs and benefits in this way, but ultimately other criteria must be used to decide whether the project would be in the public interest.  If compensation were paid, any project with net benefits could be a Pareto superior move.  Otherwise, interpersonal utility comparisons would have to be made to judge a program to be in the public interest.

7. What is the distinction between positive and normative economics?  Why is this distinction especially relevant to the study of public finance?

Positive economic analyzes the facts of the world.  Normative economics makes value judgments to determine what is desirable or undesirable.  Facts are either right or wrong, but there is no scientific way to determine whether one person’s values are any more valid than another’s.  This distinction is especially relevant to the study of public finance because we design our governments, so we need to develop criteria to decide when government activity would be desirable or undesirable.

8. Is there a trade-off between equity and efficiency in public policy, or can the two goals be reached simultaneously?  Explain how policies might be designed that are both equitable and efficient.

There may be trade-offs between equity and efficiency.  Programs can be made more equitable if policy makers are cognizant of the distribution of costs and benefits.  Programs might be designed to approximate Pareto superior moves, for example.  Inevitably, trade-offs will sometimes remain, however.

(1)   If the demand curve shows the value of output to those who consume it and the supply curve shows the opportunity cost to the producers of producing output, then the intersection of the supply and demand curves show the optimal level of output.  To the left, demand is greater than supply, so the value of output is greater than its opportunity cost, so we would want to produce more.  To the right, supply is greater than demand, so it costs more to produce output than it is worth to consumers.  Thus, the intersection of supply and demand is optimal.  Because this is the level produced by competitive markets, each individual in a competitive market economy, in pursuing his or her own self-interest, is led as if by an invisible hand to pursue the best interest of the entire society.  This explanation is normative because it argues that the competitive level of output is desirable.