Topic 2：Principles for
Analyzing Government
• Adam Smith （1723～1790）noted that in a
market economy, individuals pursuing their
own self-interests are led as if by an invisible
hand to pursue the best interests of the
society.
– Adam Smith. The Wealth of Nations.1776.
• The market system is based on the principle
of voluntary exchange.
• Under ideal circumstances the market
allacates resources in the most efficient
manner possible.
• Then, why should we have a government?
The Market Economy
• Resource allocation in a competitive market(figure
2.1)
The Role of Government
• Firstly, government protects the rights of
individuals, which enables them to engage in
voluntary market transactions.
• Secondly, the government can be viewed as
an instutution that acts in the public
interests.
• The priciple underlying the private sector of
the economy is voluntary exchange, while in
the public sector of the economy, the
government forces people to obey its rules
and pay for its output.
• This raises a whole set of questions:
– How do we know that we all benefit from the
government's programs?
– Should someone who never uses a park be
forced to pay for it?
– If these things really benefit us, why do we
have to be forced to pay for it?
• The government's activities can be analyzed
within the framwork of two general
categories.
– the first category concerns the scope of
governmental activities
– the second category concerns how the
government finances its activities.
The Market System and Individual Rights
• The market system presupposes that
individuals have the right to the output they
produce and have the right to freedom of
exchange.
– police
– national defence
– court system
• The government as protector of rights
– without government protcetion of individual
rights, people would have to find ways to protect
their own rights, which would greatly reduce the
efficiency of an economy.
– people would have no incentive to produce any
more than they could individually protect.
• The government as violator of rights
– with too much government, unconstrained in its
activies, there is the potential for predation
through government.
The Public Interest
• The government should act in the public
interest. But what is the public interest?
• Jeremy Bentham(1748—
1832)
• the public interest would
be served by policies
that produced the
greatest good for the
greatest number.
– Jeremy Bentham. An
Introduction to the
Principles of Morals and
Legislation. 1789
• Bentham's method of considering the public
interest is sometimes referred to as
utilitarianism because it attempts to take
account of the relative satisfaction, or utility,
of everyone in a society.
• utilitarianism
– the amount of satisfaction or utility that an
individual received from consuming goods
or services can be measurable.
– ony way to measure the public interest is
to add up the total utility of all the
individuals in a society.
• John Stuart
Mill(1806－1873)
• Principles of
Political Economy,
1848
• Policy suggestion
– Any policy that increased total utility would then
be in the public interest because the utility
gained by the gainers would be more than
sufficient to offset the utility loss to the losers.
– the policy of distribution of income
• drawbacks:
– there is no valid way to compare the utility of one
person with the utility of another.
– taken to its logical consequences, utilitarianism
implies social arrangements that most people
would find objectionable.
• Michael J.Sandel
• Justice: What's the Right Thing to Do?
The Pareto Criteria
• Vilfredo Pareto(18481923), ecnomics and
sociologist
• He developed two
criteria, now known as
Pareto optimality and
Pareto superiority, for
judging the public
interest.
• Because it is not possible to compare the
utilities of two individuals, the only way one
can be sure that a change will increase the
social welfare is if the change makes at least
one person better off, but makes no one
worse off.
• Such a change would be called a Pareto
superior move, or a Pareto improvement.
• the Pareto criteria(figure 2.2)
• Market exchange and the Pareto creteria
– Unless people not involved in the exchange are
harmed, every market exchange is a Pareto
superior move.
– With government allacation of resources, there is
rarely unanimous agreement, and some people
gain while others lose, making it hard to say for
sure that the social welfare has been enhanced.
• Political exchange and the Pareto creteria
– many activities of government produce benefits
to some but impose costs on others.
– in practical terms it may not be possible to take
any action in the public sector if the strict
conditions of the Pareto criteria are adhered to.
Other Measures of the Public Interest
• potential compensation
– Hicks-Kaldor cirteria
– if a proposed change benefits the gainers by
enough that they could take some of their gains
and compensate the losers so that everyone
could be made better off, then the proposed
change is in the public interest.
• the social welfare function(figure 2.3)
• It is really a type of utilitarianism. It is
applied to income distribution problems to
determine the optimal amount of
redistribution through the tax system.
• By contrast, the Pareto criteria are not well
suited to distributional issues.
• cost-benefit analysis
• In actual pracice, it is frequently used to
determine whether public sector projects
are in the public interest.
• The main difficulty is to place an accurate
dollar value on all the benefits and costs of a
particular project.
Positive and Normative Economics
• Positive economics examines the real world
to discover its characteristics and
interlationships.
• Normative economics makes value
judgement as to how the world should be.
• e.g. the minimum wage law
• How will the two kinds of economics
analyze the law?
• normative analysis and the public
interest
– when studying the public sector, the
normative elements necessarily enter into
the picture because the government's
activities are the result of choices.
Equity and Efficiency:
the Goals of Pubic Policy
• Whether a change allocates resources more
efficiently is a positive issue.
• The goal of equity is fundamentally a
normative issue.
• Discussion:
– Is there a trade-off between equity and efficiency
in public policy, or can the two goals be reached
simultaneoursly?