Economic Principles

1. SIO 295 Summer 2007 Economic Principles

2. Economic Principles: From the seminar this morning 1. Fundamental Economic Principle: Every alternative involves "Trade-offs" or a weighing of Costs and Benefits 2. Fundamental Economic Principle: All economic consequences (costs and benefits) can be measured (in principle) in monetary units 3. Fundamental Economic Principle: An Optimal or Best economic choice is always one that maximizes the (Net) Total Economic Value (the sum of all benefits less the sum of all costs). 4. Fundamental Economic Principle: For every sub-optimal economic choice, there is an optimal economic choice that (in principle) everyone (currently alive or who will be alive sometime in the future) would prefer to the sub-optimal choice. (This Principle is a Proposition -- not an assumption)

3. 5. Fundamental Economic Principle: Identical consequences occuring at different dates (e.g. now vs. in the future) do not have the same economic value. In general, any given benefit is worth more if received sooner and any cost is less burdensome if incurred later. 6. Fundamental Economic Principle: To the extent that an individual is "risk-averse", the value of an uncertain (future) benefit is smaller than the "expected" value of (the distribution of) the (future) benefit. (Analogously for costs -- an uncertain cost is more burdensome than its expected value.) This afternoon I want to discuss these principles in more detail...

4. 1. Economics is fundamentally about scarcity -- the human use of scarce resources for human benefit. Scarcity means that choices must be made among alternative uses of resources. Since every meaningful economic alternative involves consequences that matter to humans, to choose alternative A over alternative B means that the consequences of A are viewed as more desirable than the consequences of alternative B. Since consequences may be desireable or undesireable -- and most real alternatives involve some of both kinds ("no pain, no gain") -- choice among alternatives inherently involves making trade-offs -- weighing desirable consequences ("benefits") against undesirable ones ("costs"). This is just FEP 1.

5. 2. In order to have a metric -- a "yardstick" -- by which to compare costs and benefits of different alternatives, economists use a reference commodity -- called "money". It suffices for our purposes here to consider the reference commodity real money -- that is, US dollars, or euros, or whatever currency you care to use. For simplicity, let's just use US dollars. • Our second FEP is that all economic consequences can be measured in money. What we mean precisely is that when faced with an alternative A, which has a bundle of associated consequences -- both benefits and costs -- an individual is able to compare alternative A with any fixed amount of money X and choose either to accept A or take the money X. By comparing choices of A with various amounts of money X, we assume that for very small amounts of X, our chooser will take A but for very large amounts of money X, our chooser will take the money instead of alternative A. In fact, we assume there is a unique amount of X, say X(A), such that for any amount greater than X(A), s/he will choose the money and for any amount less than X(A) s/he will choose alternative A. We call X(A) then the monetary value (to our chooser) of A. This assumption is only consistent if more money is preferred to less money. • Note: The value of X(A) may be positive or negative. If negative, we say that alternative A is a "bad" and interpret X(A) as the amount of money our chooser would pay to avoid having to endure alternative A.

6. A perhaps over-simplified analogy: Economics claims that whatever other values society may have, society should strive to make the economic "pie" as large as possible. Economics does not say what the optimal or best division of the economic "pie" is. • However, economics does analyze how different economic arrangements -- political systems and economic institutions -- leads to different distributions of economic welfare, in addition to just the size of total economic value. In addition, drawing on theories of moral philosophy (e.g. Rawls, Nozick, etc.) economics does analyze different equity criteria (e.g. "fairness", maximin individual welfare, etc.) and how they might or might not be achieved through various political systems and economic institutions. • Since nearly all individual economic activity is directed at securing private economic benefits -- in effect, determining how economic value is distributed in society -- there is no guarantee that the outcome of all this individual economic activity maximizes Total Economic Value. It is a profound result of economic analysis that conditions under which this is true have been identified, including the political system and economic instituitions that are sufficient. However, nothing in these results claims that the resulting distribution of Total Economic Value achieved under these conditions is desireable or "equitable".

7. 3. Suppose an alternative A is a social alternative -- a choice that society may make -- whose consequences affect all individuals in society. Each individual, by FEP 2, has a value X(A) of the alternative. We define the Social Value or Total Economic Value of the alternative A to be the sum of all the individual values. This is just a definition. • FEP 3 claims that any "best" economic choice is one that maximizes the Total Economic Value and we noted that this is never unique. Thus, the criterion of Maximizing Total Economic Value is only a partial criterion and leaves much to be determined. In particular, how the Total Economic Value should be divided amongst all individuals in society (how "welfare" is to be distributed or the "equity" issue) is left undetermined. This question is for many the most important question, yet is not one that economics answers definitively. Nor, for that matter, can any "science".

8. 4. The justification, such as it is, for focusing on the criterion of maximizing Total Economic Value is that contained in FEP 4 -- namely that if Total Economic Value is NOT maximized, there exists other possible sets of economic arrangements/choices that EVERYONE in society would prefer to the current arrangement. • This result is so important that it is embodied in the all-important economic concept of "Efficiency" (or "Pareto Efficiency").

9. Definition: A given economic arrangement (i.e. a full distribution of Total Economic Value to all individuals) is ”efficient" if and only if it is not possible to find another arrangement that everyone would prefer to the given arrangement. • This definition gives rise to related notions of "productive efficiency" -- i.e. a given use of inputs to produce specific amounts of outputs is productively efficient if it is not possible to use the given amount of inputs in some other way to produce more of all outputs -- and "distributive efficiency" -- i.e. a given distribution of all goods in society is distributionally efficient if it is not possible to rearrange the distribution of the fixed amount of goods to make everyone better off (i.e. give everyone a different amount of goods that everyone would prefer).

10. The focus on efficiency, at the expense of ignoring the distribution, points to both the difficulty and challenge of achieving efficient outcomes. • (a) Since a choice that would lead to an efficient choice (or just an increase in Total Economic Value) may not make everyone better off, the losers might be expected to object to that choice. If the losers possess sufficient political power, they may, in fact, prevent the choice from being made. • (b) If the current situation is not efficient, then there are other decisions involving possibly some compensation or "side-payments” that would, if the compensations are made to the "losers", that would make everyone better off. The challenge is then to identify such a decision and obtain agreement from sufficient number of individuals (possibly all of them) to accept the proposed compensation. This is a non-trivial problem.

11. An Illustration of the Point: Global Warming/Climate Change We may suppose that Total Economic Value would be increases by the immediate reduction in emission of GHGs. Suppose the overall reduction that maximizes Total Economic Value is a 10% reduction over the next five years. How is this to be achieved? Every individual country would be better off with no reduction, assuming all the remaining countries collectively reduce GHGs by the required aggregate of 10%. The Kyoto treaty suggests a particular distribution of the burden of reducing GHG emissions that requires only the developed economies to reduce their emissions while excluding, in particular, India and China from any obligation to reduce their emissions. The Bush administration rejected this distribution of the burden. • The Bush administration also, evidently, also rejected the proposition that the particular total reductions in GHGs would result in an increase in Total Economic Value. • Others have argued (cf. Lomberg, Copenhagen Consensus) that reducing GHGs at this point is not efficient use of resources -- i.e. that other decisions -- e.g investments in health care -- AIDS, education, economic growth, etc. -- would increase Total Economic Value more than GHG emission reduction.

12. 5. Evaluating streams of Total Economic Value over time: Discounting The simple math of discounting: Suppose you can deposit $X in a bank and receive (simple) interest of r% (e.g. 4%) per year. Then, at date 1 (i.e. 1 year from now), the value of your deposit (denoted, X(0)) is: X(1) = (1.04)*X(0) = (1+r)*X(0) and at date 2 (2 years from now): X(2) = (1.04)*X(1) = (1.04)(1.04)*X(0) = (1.04)^2 * X(0) = (1+r)^2 *X(0) ... and at date t (t years from now): X(t) = (1.04)^t *X(0) = (1+r)^t * X(0) (1)

13. We can use equation (1) to answer the question: How much would a promise to pay $Y t years from now be worth today? Setting Y = X(t) and solving equation (1) for X(0), the amount which, if deposited today, would be worth exactly $Y t years from now: X(0) = {1/[(1+r)^t]}*X(t) = [1/(1+r)^t]*Y (2) Thus, equation (2) can be used to calculate the Present Value (i.e. the value today) of any amount X(t) received t years from now. Given, then, a stream of values (or, net benefits) {X(0),X(1),X(2),...,X(t),...} that will be received in each year, t = 0,1,2,...,t,..., the Present Value of the stream is just: PV{X(0),X(1),X(2),...,X(t),...} = X(0) + [1/(1+r)]*X(1) + [1/(1+r)^2]*X(2) + ... + [1/(1+r)^t]*X(t) + ... = Sum (t=0,1,2,...,t,...) [1/(1+r)^t]*X(t) (3) Equation (3) is the formula for calculating the Present Value of any decision, A, that yields the stream of net benefits {X(0),X(1),X(2),...,X(t),...} over time.

14. 6. Dealing with Uncertainty: Risk Aversion and the Certainty Equivalent Consider an individual with an asset worth $X that may be destroyed (e.g. by a hurricane) and suppose the likelihood of the event that it will be destroyed anytime in the future is p. If an insurance policy is available at a cost of r per dollar of coverage (e.g. 1% so that if X = 100,000, the insurance cost is $1000), then for a low enough cost, the asset owner will purchase the insurance. (If the insurance cost is too high, the owner will not buy the insurance.) Since the insurance premium R = r*X is paid at the beginning, whether or not the loss occurs, and (for full insurance) the owner is paid X in the event his asset is destroyed, the owner who purchases the insurance is guaranteed the value: X - R = X - r*X = (1-r)*X

15. If r' is value such that at any cost r > r' the owner will not buy the insurance and at any cost r < r' he will, then the guaranteed value X - R' = (1-r')*X is called the Certainty Equivalent of the uninsured asset's value. The uncertain value -- $X with probability 1- p (i.e. the asset is not destroyed) and $0 with probability p (i.e. the asset is destroyed) is worth exactly Y = X - R'. Thus, in principle, any uncertain value (i.e. a distribution of values) is equivalent to a single fixed value -- its Certainty Equivalent.

16. Given the distribution of values -- {X with probability 1-p, 0 with probability p} -- we can calculate the mathematical Expected Value of the distribution: • EV = X*(1-p) + 0*p = X - p*X • and the Expected Loss: • EL = X - EV = p*X • If the insurance premium, R, is equal to the Expected Loss -- equivalently, the insurance cost r equals the probability of the loss -- then the insurance is called "fair" (i.e. a "fair gamble").

17. If the asset owner would always buy insurance as long as its cost is no greater than r (is at least "fair"), then the individual is called "risk averse" and his Certainty Equivalent is less than the Expected Value of the asset. • If, on the other hand, the asset owner would only buy the insurance if it is strictly less than r, (the insurance is more than "fair"), then the individual is called "risk loving" and his Certainty Equivalent is greater than the Expected Value of the asset. • In the "knife-edge" case in which the Certainty Equivalent is equal to the Expected Value of the asset, the owner is neither risk averse nor risk loving, but "risk neutral".

18. For small risks, maximizing expected value is nearly equivalent to maximizing certainty equivalent, but for large risks, there may be a considerable difference for risk averse (or risk loving) individuals. • Adjusted for Net Benefits occurring over time and for uncertainty of future benefits, the efficiency criterion of Maximizing Total Economic Value can be stated as: Maximization of Present Value of Future Certainty Equivalents.

19. If society is risk averse, the Certainty Equivalent of a future uncertain benefit is less than its Expected Value, and the present value of the Certainty Equivalent is equal to the discounted Expected Value for a higher discount rate. Thus, maximizing the present value of future Certainty Equivalents is equivalent to maximizing the present expected values using a risk-adjusted (higher) discount rate.

20. 7. Sustainability: An alternative criterion to Maximizing Total Economic Value • As defined by economists (as opposed to, say, biologists or ecologists) sustainability means to provide future generations with a standard of living at least as high at that enjoyed by the current generation. • If Total Economic Value (per capita) is identified as the standard of living, then this criterion implies that Total Economic Value should never decrease from one generation to the next.

21. 8. A Note on the "Precautionary Principle" • The Precautionary Principle suggest that actions that may lead to undesirable outcomes (e.g. low Total Economic Value) even though they may also have a high probability of yielding desirable outcomes should be avoided. • The principle has been embodied in European Union legislation and is often invoked by environmentalists who see "doom and gloom" in some development project that might threaten some environmental resource. • It has also been invoked by defenders of the Bush Administration's policy towards Global Warming who claim that it would be very expensive for the US economy to meet the Kyoto targets in reducing GHG emissions without possibly yielding any discernable benefits (because, for example, China will continue to emit GHGs). Thus a precautionary approach would not subject the US economy to such potential costs.

22. As stated, the precautionary principle is an extreme form of societal risk-aversion and has been derided as the "Never-do-anything for-the-first time" principle. Most economists suggest that using a more realistic measure of risk-aversion and then maximizing the Total Economic Value (of the Certainty Equivalents) is the better justified criterion.