Sunday, 7 December 2014
Tuesday, 25 November 2014
There are various concepts of National Income. The main concepts of NI are: GDP, GNP, NNP, NI, PI, DI, and PCI. These different concepts explain about the phenomenon of economic activities of the various sectors of the various sectors of the economy.
Gross Domestic Product (GDP):
The most important concept of national income is Gross Domestic Product. Gross domestic product is the money value of all final goods and services produced within the domestic territory of a country during a year.
Algebraic expression under product method is,
GDP=Gross Domestic Product
P=Price of goods and service
Q=Quantity of goods and service
denotes the summation of all values.
According to expenditure approach, GDP is the sum of consumption, investment, government expenditure, net foreign exports of a country during a year.
Algebraic expression under expenditure approach is,
(X-M)=Export minus import
GDP includes the following types of final goods and services. They are:
Consumer goods and services.
Gross private domestic investment in capital goods.
Exports and imports.
Gross National Product (GNP):
Gross National Product is the total market value of all final goods and services produced annually in a country plus net factor income from abroad. Thus, GNP is the total measure of the flow of goods and services at market value resulting from current production during a year in a country including net factor income from abroad. The GNP can be expressed as the following equation:
GNP=GDP+NFIA (Net Factor Income from Abroad)
Hence, GNP includes the following:
Consumer goods and services.
Gross private domestic investment in capital goods.
Net exports (exports-imports).
Net factor income from abroad.
Net National Product (NNP):
Net National Product is the market value of all final goods and services after allowing for depreciation. It is also called National Income at market price. When charges for depreciation are deducted from the gross national product, we get it. Thus,
National Income (NI):
National Income is also known as National Income at factor cost. National income at factor cost means the sum of all incomes earned by resources suppliers for their contribution of land, labor, capital and organizational ability which go into the years net production. Hence, the sum of the income received by factors of production in the form of rent, wages, interest and profit is called National Income. Symbolically,
Personal Income (PI):
Personal Income i s the total money income received by individuals and households of a country from all possible sources before direct taxes. Therefore, personal income can be expressed as follows:
PI=NI-Corporate Income Taxes-Undistributed Corporate Profits-Social Security Contribution+Transfer Payments
Disposable Income (DI):
The income left after the payment of direct taxes from personal income is called Disposable Income. Disposable income means actual income which can be spent on consumption by individuals and families. Thus, it can be expressed as:
From consumption approach,
Per Capita Income (PCI):
Per Capita Income of a country is derived by dividing the national income of the country by the total population of a country. Thus,
PCI=Total National Income/Total National Population
Monday, 10 November 2014
BURDEN OF PUBLIC DEBT
There are two types of sources of public debt, so that sources are burden i.e burden of internal debt and burden of external debt..
There are two types of sources of public debt, so that sources are burden i.e burden of internal debt and burden of external debt..
Introduction To The Burden of Public Debt :
Over the years, the public debt of the India's Central and that of State government has increased considerably during the planning period. The Government borrows funds by way of public debt to meet the various development and non-development expenses.
Apart from internal debt, there are also internal liabilities of the central government in the form of small savings of the public, provident funds, reserve funds & deposits of Government department.
Both internal and external debt carry a burden on the economy of nation.
The Burden of Internal Public Debt :
1. Internal debt trap:
One of the bad effects of internal debt is the interest paid by the government. Such interest payments increase public expenditure and may become a cause for fiscal deficit. If internal public debt is not checked and kept within limits, it may take the country to the worst position called 'Internal Debt Trap'.
2. More burden on poor and weaker sections:
Internal debt provides opportunities for the rich and higher middle class to earn a higher rate of interest from the state on their lending. At the same time the pobr suffer a lot due to the tax burden. The government levies taxes to repay interest on public debt. But the tax burden does not necessarily fall on the rich unless it is progressive in nature. In the case of indirect taxes, the burden is felt more by the poor than the rich.
3. Increasing interest burden:
Public borrowing may become costlier for the government especially when it resorts to public borrowing by issuing bonds and debentures. Such bonds and debentures carry a high rate of interest to the extent of 15 percent. The impact of such interest payments may develop manifold and still worsen in the future if the government stick to the same policy of borrowing in the years to come.
4. Unjustified transfer:
The servicing of internal debt involves transfers of income from the younger to the older generations and from the active to the inactive enterprises.
The government imposes taxes on enterprises and earnings from productive efforts for the benefit of the idle, inactive, old and leisurely class of bond holders. Hence work and productive risk taking efforts are penalised for the benefit of accumulated wealth. This adds to the net real burden of debts.
5. Indirect real burden:
Internal debt involves an additional indirect real burden on the community. This is because the taxation required for servicing the debts reduces the tax payer's ability to work and save and affects production adversely. The government may also economise social expenditure thereby, reducing the economic welfare of the people.
Taxation will reduce the personal efficiency and desire to work. Thus there would be a net loss in the ability and desire to work. The creditor class will also not have any incentive to work hard due to the prospect of receiving interest on bonds. This would further cause a loss to production and increase the indirect burden of debt.
The Burden of External Public Debt:-
External debt is beneficial in the initial stages as it increases the resources available to the country. But its repayment & servicing creates a burden on the debtor country.
1. External debt trap:
The external debt creates direct money burden. This is because; it involves transfer of funds from the debtor country to foreign citizens. The degree of burden depends upon the interest rate, and the loan amount. The loans are normally to be paid in foreign currency. Therefore, the funds are mostly transferred from export earnings or by raising more funds from foreign markets. Borrowing by way of additional loans would put extra burden on the country. The situation may become so worse, that the country may be caught in the external debt trap. It may have to borrow from foreign markets to repay the interest amount and it would be very difficult to repay the principal amount.
2. Direct real burden:
The external debt may also result in direct real, burden. The citizens of the debtor will have to suffer loss of economic welfare to the extent of repayment of principle amount and interest burden. The foreign currency earned through exports would have been utilized to import better goods and technology. Which would have increased the economic welfare of the citizens of the debtor country. But because of external debt repayment, they have to restrict their welfare which the imported goods would have provided. In other words, the citizens of debtor country are deprived of imported goods and service to the extent till the loans and interest amount is repaid.
3. Decline in expenditure to public welfare programmes:
When the government spends a significant portion of its resources towards the payment of foreign debt it reduces the government expenditure to that extent which otherwise would have been spent for public welfare programmes.
4. Decline in the value of nation's currency:
The repayment of external debt involves an increase in the demand for the currency of the creditor country. This will raise the exchange rate of the creditor country's currency, and aggravate the problem of foreign exchange crisis.
The creditor country may also be adversely affected if it is induced to import more from the debtor country. This may hinder the growth of their domestic industries and cause unemployment.
5. Burden of unproductive foreign debt:
The magnitude of external debt burden depends upon whether the debt is incurred for productive purposes or for unproductive purposes. If it is incurred for unproductive purposes, it will create a greater burden and sacrifice on the citizens of the debtor country.
6. Political exploitation:
In recent years, it was found that the lending countries who dominate international organisations like World Bank & international monetary fund use the lending opportunity as an instrument to exploit the borrowing countries economically & politically.
Sunday, 9 November 2014
TRADE OFF BETWEEN EQUITY AND EFFICIENCY IN TAXATION
A big issue in economics is the trade off between efficiency and equity.
An economic situation in which there is a perceived tradeoff between the equity and efficiency of a given economy. This tradeoff is commonly viewed within the context of the production possibility frontier, where any additional gains in production efficiency must be offset by a reduction in the economy's equity.
Equity is concerned with how resources are distributed throughout society.
Efficiency is concerned with the optimal production and allocation of resources given existing factors of production. There are different types of efficiency
This occurs when firms do not have incentives to cut costs, for example a monopoly which makes supernormal profits may have little incentive to get rid of surplus labour.
Therefore a firms average cost may be higher than necessary.
Increased Inequality and Increased Growth:
Monday, 27 October 2014
Clubs, whether one speaks of the Girl Guides, the All England Lawn Tennis and Croquet Club, a homeowners’ association, or the Republican Party, are private organizations whose members collectively consume (and often produce) at least one good or service that no one person has the capacity unilaterally to finance. Clubs are thus of interest to public choice scholars because they must solve the same kinds of collective action problems government faces in the provision of public goods. Moreover, while there are exceptions to the rule (e.g., closed union shops), clubs solve these problems voluntarily rather than coercively.
This essay summarizes the theory of clubs and assesses its empirical relevance and applicability (more detailed literature reviews are contained in Sandler and Tschirhart, 1980, 1997). The second of these two tasks is not a particularly easy one because there has not been very much in the way of direct empirical testing of the theory of clubs, at least outside the literature on international alliances. However, while the effort here is not intended to be exhaustive, a sufficient number of examples will be provided so that the reader will gain a preliminary understanding of the extremely useful nature of the theory of clubs.
2. An Overview of the Economic Theory of Clubs
As developed in a seminal paper by James Buchanan (1965), the economic theory of clubs applies to goods having three key characteristics:
• Club goods are excludable. Individuals who do not contribute to financing the club can be prevented, at relatively low cost, from gaining access to the benefits of club membership.
• Club goods are congestible. Although consumption is not entirely rivalrous (there is not, as in the case of a private good, a one-to-one relationship between the amount consumed by one person and the amount available for consumption by others), each member of the club imposes a negative externality on his fellows. That negative externality materializes in the form of crowding, which degrades the quality of the benefits consumed by all.
• Club goods are divisible. Once a club’s membership has reached its optimal size, individuals who want to join but have been excluded can form a new club to produce and consume the same good. Clubs can in principle be cloned as the demand for them warrants.
The foregoing assumptions restrict the domain of the theory of club goods to what are commonly called ‘impure’ public goods. A ‘pure’ public good, by contrast, is neither excludable nor congestible. The optimal club size in that case has no upper bound. (Exceptions exist in situations where the club can bundle the provision of a pure public good with an excludable private good, about which more below.)
With this caveat in mind, the determination of the optimal club size is, in theory at least, a straightforward exercise in equating costs and benefits at the margin. That exercise yields three conditions that must be satisfied simultaneously for optimal clubbing. These conditions are (see Mueller, 1989, pp. 150-154; Cornes and Sandler,  1996, pp. 347-56):
• A provision condition, which requires the optimal club size (in terms of capacity) to be determined by setting the summed marginal benefits to members from reducing congestion costs equal to the marginal cost of capacity. Holding membership constant, larger club capacity means less crowding, but supplying additional capacity is costly.
• A utilization condition, which ensures that this capacity is used efficiently. Club theory accordingly contemplates the charging of user fees that equate a member’s marginal benefit from consumption of the club good with the marginal congestion costs the member’s participation imposes on others. If the fee is set too low, the club’s capacity will be overutilized; it will be underutilized if the fee is too high. Optimal capacity utilization therefore requires that the club good be priced to reflect members’ tastes for crowding.
• A membership condition, which dictates that new members be added to the club until the net benefit from membership (in terms of lower pro-rata provision costs for existing members) is equal to the additional congestion costs associated with expanding the club’s size.
These three conditions help explain the prevalence of two-part pricing of club goods. Fixed up-front membership (‘initiation’) fees defray the club’s cost of capacity provision while per-unit charges for use of the club’s facilities ensure optimal utilization. When two-part pricing is not feasible — when the club exists primarily to provide its members with a pure public good such as political lobbying, for instance — clubs may be able to price their services efficiently by bundling them with an excludable private good, furnishing what Olson (1965) calls ‘selective incentives’. Member-only privileges, such as the right to subscribe to the club’s magazine or journal, to buy its calendar, to have access to a group life insurance policy or to group travel packages at favorable rates, and to participate in collective wage bargaining, are examples in this regard.
But in any case, the pricing of club goods is disciplined by a ‘voting-with-the-feet’ mechanism as clubs compete for members (Tiebout, 1956; Hirschman, 1970). As long as clubs can be cloned freely and the members of existing clubs are free to exit, club prices will be kept in line with costs. Voting-with-the-feet also helps overcome preference revelation problems as individuals sort themselves among clubs. Those with high demands for club goods (and a corresponding willingness to pay for them) join clubs that supply high levels of output; low demanders join organizations that offer levels of output (and prices) closer to their liking.
Although the exit option helps prevent clubs from charging prices that are too high, jointness in consumption and shared responsibilities mean that free riding remains the most troublesome economic problem facing club members. Individuals have strong incentives to understate their benefits from joining so as to have their fees lowered appropriately (Laband and Beil, 1999), to ‘shirk’ by opportunistically reducing the effort they supply toward achieving the club’s collective goals, and to otherwise take advantage of their fellow members. Apart from the three conditions for optimal clubbing stated above, the logic of collective action (Olson, 1965; Sandler, 1992) suggests that successful clubs will tend to be relatively small in size and composed of individuals having relatively homogeneous interests. Small club size raises the per-capita benefits of club membership, thereby giving individuals a greater stake in the club’s success; it also lowers the costs of monitoring and controlling free riding. Hence, if the lower costs of coping with free riding in smaller groups more than offset the correspondingly higher per capita costs of club good provision, the optimal club will have fewer members than otherwise.
Small groups also have lower decision-making costs (Buchanan and Tullock, 1962), an outcome that is facilitated by homogeneity of members’ interests. Group heterogeneity creates differences of opinion that make it more difficult to reach agreement on common courses of action and creates opportunities for the membership’s majority to take advantage of the minority (what Buchanan and Tullock call the external costs of collective decision making). Voluntary association, voting-with-the-feet, and the ability to clone organizations as demand warrants means that diversity of tastes and preferences amongst individuals will tend to promote diversity amongst clubs rather than diversity of club membership. People will tend to associate with others who are like-minded in the sense of having similar tastes for crowding and similar demands for club good provision.
As this brief summary indicates, the theory of clubs is, in essence, the study of the private provision of congestible public goods. It differs from the study of public provision of similar goods in ways that are more matters of degree (‘voluntariness’ and absence of coercion) than of kind.
Clubs and government both must grapple with issues of size (capacity provision), utilization, and membership. Careful study of how actual clubs deal in practice with preference revelation, free riding, and pricing can therefore shed considerable light on the public sector’s responses to similar problems. That is the subject to which the essay now turns.
The theory of clubs has been brought to bear in a wide variety of institutional settings. Even so, the surface has only been scratched.
3.1. International Alliances
Perhaps the most intensively investigated application of the theory of clubs is in the realm of international alliances. While the literature on alliances has been extensively and competently reviewed elsewhere (Sandler, 1993; Sandler and Hartley, 2001), it is instructive to summarize the main empirical issues briefly here, given that alliances are in a sense the paradigm for further extensions of the theory of clubs.
In the theory of alliances the observational unit shifts from the individual person to the individual country, thereby suppressing the analysis of collective action problems at the national level (see Frey, 1997). Consistent with the theory, sovereign nation-states voluntarily establish international organizations to achieve goals that are either unattainable or too costly to attain were they to act on their own. These organizations may be created for a wide variety of purposes, including mutual defense, common markets (which might be thought of as multi-product clubs), harmonious legal codes, supranational regulation of the environment, and so on.
Olson and Zeckhauser (1967) provide a cost-sharing analysis of the North Atlantic Treaty Organization (NATO) and identify the conditions under which it would be in the interest of the alliance’s members to increase the size of the ‘club’ (also see Sandler and Forbes, 1980; Hartley and Sandler, 1999; Sandler and Murdoch, 2000). Individual members in a club arrangement bear their pro-rata shares of the costs of operating the club. In the absence of price discrimination, which allows membership prices to be scaled to individual marginal values, cost shares are computed based on the club’s total costs and group size. Given the voluntary nature of club formation, each member plausibly will pay the same price, corresponding roughly to average total cost. In the case of NATO, however, Olson and Zeckhauser point out that the United States is by far the single largest contributor to alliance’s coffers. Can the disparities in members’ shares of NATO’s total costs be viewed as reflective of each member country’s valuation of the good provided by the alliance? Or do the cost shares instead represent an ‘unjust’ or ‘unfair’ distribution of the total costs?
Arguably, the benefits of NATO membership are greater to the citizens of richer nations who stand to lose more if the mutually financed defense umbrella fails to protect them. Smaller European member countries exhibit a greater willingness to participate in infrastructure expenditures, as opposed to operating expenditures, simply because the buildings will remain on their soil after the alliance dissolves (if it does). These considerations suggest that the contributions of each member country are broadly consistent with rational self-interest.
Side payments could, in theory, work to diminish the discrepancies in members’ contributions. If offered by the larger countries, they would encourage the smaller countries to increase their contributions. Side payments only make sense, however, if it is in the interest of larger countries to be party to an alliance characterized by roughly equal contributions. Tollison and Willett (1979) stress the mutual interest basis of ‘issue linkages’. Linking international trade relations and ‘human rights’ or defense assistance and foreign aid, to give two examples, provide opportunities for striking mutually advantageous bargains that move an alliance closer to the aggregate efficiency frontier.
Thus, while the United States may bear a disproportionate share of NATO’s costs, other members of the alliance may contribute relatively more to foreign aid or to humanitarian relief efforts in Africa. Incorporating issue linkages into the theory of alliances promises to shed light on the overall cost-effectiveness of international cooperation. In other words, observed discrepancies in contributions may simply reflect each country’s valuation of membership benefits and of the tradeoffs made on other margins. It is also worth noting, however, that, at least in the case of international trade agreements, issue linkages (between trade liberalization on the one hand and labor and environmental standards on the other) can be ‘used as a pretext for protectionism’ (Lawrence, 2002, p. 284).
3.2. Interest Groups
A special-interest group is the direct analog of a club. The interest group produces a pure public good for its members in the form of political lobbying and, like a club, the interest group faces the fundamental problem of controlling free riding. That is, it must be able to form and to finance its lobbying activities, and to do so, it must find means of reducing to a cost-effective minimum club members’ incentive to shirk. In other words, interest groups must guard against the prospect that an individual will be able to collect his or her share of the collective benefits of group political action without supplying his or her share of the effort required to produce those benefits.
How do groups overcome free-rider problems and organize for economically efficient collective action so as to be able to gain benefits through the political process that exceed the costs of lobbying? One attempt to solve the puzzle is Olson’s (1965) by-product theory of collective action. According to this theory, an association (‘club’) provides a private good or service to its members that cannot be purchased competitively elsewhere. By monopolistically pricing the good or service above cost, the association raises money to finance its lobbying activities.
Indeed, for whatever reason organization is undertaken, lobbying for special-interest legislation becomes a relatively low-cost by-product of being organized. This is because startup costs have already been borne in the process forming the association for some other (non-political) purpose. A business firm is an example of an organization whose resources readily can be redeployed for political lobbying purposes, either unilaterally or in concert with other firms having similar policy interests. Workers may organize to bargain collectively with employers and then find it relatively easy to open an office in Washington to advocate higher minimum wages. Lawyers may agree collectively to a code of ethics to address such matters as attorney-client privilege and then proceed to adopt provisions in their code that, by banning advertising, for example, restrict competition among lawyers.
A handful of studies provide indirect empirical support for Olson’s by-product theory. Kennelly and Murrell (1991), for instance, use observations on 75 industrial sectors in ten countries to show that variations in interest-group formation can be explained by variations in selected economic and political variables. Kimenyi (1989), Kimenyi and Shughart (1989) and Kimenyi and Mbaku (1993) model interest groups as clubs that compete for control of the political machinery of wealth redistribution. They find evidence in cross-sectional international data that governments tend to be less democratic where the competition for wealth transfers is more intense.
Iannaccone (1992, 1997, 1998) has extended the theory of clubs to religious organizations. He starts by noting that religion in modern pluralistic societies is a market phenomenon, and that competing faiths live or die according to how successful they are in convincing potential adherents that they offer a superior ‘product’. This vision of near-perfect competition is seemingly marred, however, by the existence of an obvious anomaly. Although the behavioral burdens most major religious faiths impose on their adherents tend to be relatively light, as the competition for members has become more intense in recent years, the religions that appear to have been most successful, somewhat surprisingly, are the relatively small ones that make the strictest behavioral demands. Fundamentalism is everywhere on the rise.
Iannaccone maintains that the explanation for this seemingly peculiar twist in market dynamics relates to the collective nature of religious activity. He argues that a religion is a kind of club which produces an ‘anticongestible’ club good. By this he means that each member’s participation confers benefits, not costs, on other members; in other words, there are positive returns to crowding. Iannaccone’s point here has an analog in the ‘superstar’ phenomenon, which suggests that the benefits of consumption rise when consumers focus their attention on a small number of sports or entertainment figures.
There remains the problem of ensuring an efficient level of participation among the adherents to a particular faith. If even those who participate minimally can expect to receive full benefits (salvation), the collective good likely will be under-provided. This is the classic free-rider problem. According to Iannacocone, religious clubs may be able to minimize this problem by requiring their members to follow strict rules of behavior. Overt sacrifices (keeping kosher, shunning buttons, wearing turbans, and so on) can more readily be monitored than more subjective indicators of personal participation (i.e., intensity of belief), and this is an important advantage. Additionally, making the required sacrifice public knowledge and the individual adherent subject to the resulting social stigma raises a barrier to free riders. Only those with a high level of motivation and emotional commitment to the ‘club’ will participate.
Iannaccone tests his model using data on denominational characteristics. He finds that sect-like religions, which impose stricter behavioral requirements on their members, indeed seem to induce greater levels of participation. Sect members attend more religious services, contribute more money, and choose more of their closest friends from within the congregation than do otherwise comparable members of more ‘mainstream’ religions.
3.4. Other Applications of the Theory
Cassella and Frey (1992) analyze the problem of determining optimal currency areas. Money as a medium of exchange is a fully non-rivalrous public good, and the optimal currency area is as large as possible. But to the extent that money also serves as a source of public revenue (seigniorage) or as an economic stabilization tool, then the optimal currency area might be much smaller (consistent with the requirement that preferences over the use of money be homogeneous within the club). The recent European monetary unification promises to provide much empirical fodder for studying this issue.
Teams of productive resources, one of the defining hallmarks of the firm as an economic organization (Alchian and Demsetz, 1972), can be thought of as clubs. Leibowitz and Tollison (1980) apply this reasoning to law firms. An optimal number and mix of partners, associates and support staff members must be determined, free riding must be monitored and policed, and access to common-pool resources, such as computers, Xerox machines, and the law library, must be controlled.
Impure public goods characterized by excludability, but only partial rivalry, are at the heart of the theory of clubs. Price-fixing conspiracies, in which cartel rents represent a form of such a good to the members and in which the same basic tension exists between group size and average returns, might also be usefully modeled as clubs. The swimming pool at the country club, the student union on the college campus, condominiums, and many other similar cases (see Foldvary, 1994) suggest that the problem of determining the optimal size of the relevant club can also be related straightforwardly to the issue of federalism. For some public goods, the optimal size of the club is the entire nation; for others, it is a more delimited jurisdiction.
The theory of clubs supplies a rich framework for exploring the inner workings of collective action in private settings. Moreover, further extensions of the theory to additional examples of successful provision of impure public goods seem possible as well. This model will surely be remembered by future historians of economic thought as one of James Buchanan’s key contributions.
Friday, 24 October 2014
PROBLEMS OF AGGREGATION OF PREFERENCES
An aggregate in economics is a summary measure describing a market or economy. The aggregation problem refers to the difficulty of treating an empirical or theoretical aggregate as if it reacted like a less-aggregated measure, say, about behavior of an individual agent as described in general microeconomic theory. micro- and macroeconomics relative to less aggregated counterparts are:
- food vs. apples
- the price level and real GDP vs. the price and quantity of apples
- the capital stock for the economy vs. the value of computers of a certain type and the value of steam shovels
- the money supply vs. paper currency
- the general unemployment rate vs. the unemployment rate of civil engineers.
Standard theory uses simple assumptions to derive general, and commonly accepted, results such as the law of demand to explain market behavior. An example is the abstraction of a composite good. It considers the price of one good changing proportionately to the composite good, that is, all other goods. If this assumption is violated and the agents are subject to aggregated utility functions, restrictions on the latter are necessary to yield the law of demand. The aggregation problem emphasizes:
- how broad such restrictions are in microeconomics
- that use of broad factor inputs ('labor' and 'capital'), real 'output', and 'investment', as if there was only a single such aggregate is without a solid foundation for rigorously deriving analytical results.
Franklin Fisher notes that this has not dissuaded macroeconomists from continuing to use such concepts.
Aggregate consumer demand curve
The aggregate consumer demand curve is the summation of the individual consumer demand curves. The aggregation process preserves only two characteristics of individual consumer preference theory - continuity and homogeneity. Aggregation introduces three additional non price determinants of demand - (1) the number of consumers (2) "the distribution of tastes among the consumers" and (3) "the distribution of incomes among consumers of different taste." Thus if the population of consumers increases ceteris paribus the demand curve will shift out. If the proportion of consumers with a strong preference for a good increases ceteris paribus the demand for the good will change. Finally if the distribution of income changes in favor of those consumer with a strong preference for the good in question the demand will shift out. It is important to remember that factors that affect individual demand can also affect aggregate demand. However, net effects must be considered.
Aggregating individual consumer demand curves presents several problems.
First to sum the demand functions it must be assumed that they are independent - that is that one consumer's demand decisions are not influenced by the decisions of another consumer. Example, A is asked how many pairs of shoes he would buy at a certain price. A says at that price I would be willing and able to buy 2 pairs of shoes. B is asked the same question and says 4 pairs. Questioner goes back to A and says B is willing to buy four pairs of shoes, what do you think about that? A says if B has any interest in those shoes then I have none. Or A, not to be outdone by B says then I'll buy five pairs. And on and on. This problem can be eliminated by assuming that the consumers' tastes are fixed in the short run. This assumption can be expressed as assuming that each consumer is an independent idiosyncratic decision maker.
No interesting properties
This second problem is the most serious. As David Kreps notes is his text, A Course in Microeconomic Theory (Princeton 1990), “...total demand will shift about as a function of how individual incomes are distributed even holding total (societal) income fixed. So it makes no sense to speak of aggregate demand as a function of price and societal income. Since any change in relative prices affects a redistribution of real income the result is that there is a separate demand curve for every relative price. Kreps goes on to say, "So what can we say about aggregate demand based on the hypothesis that individuals are preference/utility maximizers? Unless we are able to make strong assumptions about the distribution of preferences or income throughout the economy (everyone has the same homothetic preferences for example) there is little we can say. ..” The strong assumptions are that everyone has the same tastes and that each person’s taste remain the same as income changes so each additional income is spent exactly the same way as all previous dollars. As Keen notes the first assumption amounts to assuming that there is a single consumer the second that there is a single good. Keen further states that because of the aggregation problem you cannot draw conclusions about social welfare, there is no invisible hand and Adam Smith was wrong. Varian, a leading expert on microeconomic analysis reaches a more muted conclusion, "The aggregate demand function will in general possess no interesting properties..." However Varian went on to say," the neoclassical theory of the consumer places no restriction on aggregate behavior in general." Among other things this means the preference conditions (with the possible exception of continuity) simply don't apply to the aggregate function.
The Preference Revelation Problem
Preference is just another word for "demand"...as in supply and demand. The aggregate of individual preferences (all our preferences added together) is the total demand. For private goods...our spending (time/money) decisions express our true preferences/demand and our demand shapes the supply. For public goods, because of the free-rider problem, we are compelled to pay taxes. But our current method of paying taxes does not convey our true preferences/values for public goods.
There are three main ways of trying to discern people's true preferences...stated preference (contingent valuation), revealed preference and demonstrated preference.
Identification keys are used by biologists to identify species based on their characteristics. Here's a very basic identification key for the three most common "species" in the preference revelation "genera".
- The source discusses the idea that what you say accurately conveys your true preferences/values. Surveys are frequently discussed. Words speak just as loud as actions. See the entry on stated preference
- The source discusses predicting...or guessing..."underlying utility functions" or identifying "independently existing functions". Math is frequently used. Samuelson's theory of revealed preference. See the entry on revealed preference
- The source does not discuss stated preference and it does not discuss Samuelson's theory. But it does discuss the idea that your choices reveal your true preferences. Actions speak louder than words. See the entry on demonstrated preference
How much public funds should be spent on protecting the environment? That would depend on the demand for environmental protection. Here's how the three different "species" would try and determine the demand...
- Survey people and ask them exactly how much they value environmental protection (stated preference - current system)
- Congress guesses/predicts all our preferences (revealed preference - current system)
- Taxpayers choose where their taxes go (demonstrated preference - tax choice system)
Each method would produce a different answer. In other words...each method would indicate a different amount of demand. Therefore, each method would supply a different amount of environmental protection. The less accurate a method was...the greater the disparity between supply and demand...the greater the shortage/surplus of environmental protection...the greater the amount of deadweight loss.
The vast majority of economists agree that our true preferences/values are required to determine the optimal supply of public goods. Because they understand the basic concept of supply and demand, many economists have spent large amounts of time/energy/effort trying to develop accurate preference revelation mechanisms. The more accurate the mechanism...the more efficient the allocation of public funds would be.
For example, Caltech scientists even developed a way to try and read your mind in order to try and accurately determine exactly how much you value public goods.
|Nevertheless, the classic solution to the problem of underprovision of public goods has been government funding - through compulsory taxation - and government production of the good or service in question. Although this may substantially alleviate the problem of numerous free-riders that refuse to pay for the benefits they receive, it should be noted that the policy process does not provide any very plausible method for determining what the optimal or best level of provision of a public good actually is. When it is impossible to observe what individuals are willing to give up in order to get the public good, how can policymakers access how urgently they really want more or less of it, given the other possible uses of their money? There is a whole economic literature dealing with the willingness-to-pay methods and contingent valuation techniques to try and divine such preference in the absence of a market price doing so, but even the most optimistic proponents of such devices tend to concede that public goods will still most likely be underprovided or overprovided under government stewardship. - Patricia Kennett, Governance, globalization and public policy|