Lecture 2: The Economic Exchange Logic
Economic policy design
The aim of rational economic policy is the design of welfare enhancing institutions (legal
rules) within a consistent system of policy-goals. Tinbergen considers rational economic
policy a way of maximising social welfare. The economy only functions through institutions
and rules, it is invisible, but it affects behaviour through constraints.
Rational economic policy must meet certain conditions:
Complete and systematic recognition of the initial situation (status quo). Policy
makers must have an empirical overview of what the initial situation is.
Knowledge about the interrelation of policy-goals (neutral, complementary, conflict).
Policy makers must have a theoretical understanding of policy goals, including how
they (may) affect each other based on theory and data
The policy-goal is unambiguous, there cannot be multiple interpretations of the
policy-goal (e.g. the goal is to increase competitiveness, what does this mean?) Goals
must be defined and accepted in society
Knowledge (theory and empirical evidence) about the impact of economic policy
instruments/institutions/legal rules
Knowledge about the appropriate agencies and organisations which can implement
the economic policy. Theory and data are associated with an organisation who can
implement these policies and the correct tool sets (governance)
Economic policy is very demanding which is why it often fails in real life. Policy goals are
proposed to the relevant agencies and organisations (governance) who develop the economic
policy instruments, institutions and legal rules
A “wise and benevolent dictator” is the precondition for the proper implementation of
economic policy what is the importance of democracy and public choice in economic policy?
Wise refers to knowing everything: in economic policy, governments must conduct
extensive research to acquire knowledge regarding the status quo, policy goals,
impact of policies and the potential actors involved
Benevolent dictator refers to an authoritarian leader who acts only in the interest of
the people (common good) and is not self-interested: in economic policy, if we have a
benevolent dictator then democracy is a waste of time
In the case that a ruler is not benevolent, systems of checks and balances must be
developed (which is what exists in real life)
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,Modus operandi (mode of operating) of analyses in welfare economics
Welfare economics focuses on the optimal allocation of resources and goods and how the
allocation these resources affects social welfare (= the well-being of an individual or society).
In economics, welfare can be analysed by defining the conditions (e.g. perfect
competition, free trade) which, with the help of microeconomic tools, (e.g. marginal
analysis, rationality) will maximise the society’s welfare (i.e. Pareto-criterion)
Economic interventions and social welfare
In the case of deviations from the normative yardstick of welfare economics (e.g.
market failures), economic policy measures (e.g. legal rules, intervention) are in
order. Thus, economic policies may be implemented in the case that it may lead to
improved social welfare
However, deviations from the normative yardstick of welfare maximisation may also
be a result of unjustified political intervention into market processes (e.g. tariffs, trade
barriers). In this case, deregulation, liberalisation and free trade are necessary to
improve social welfare.
When is welfare maximised?
Several economists proposed the use of the law of diminishing marginal utility (= marginal
utility declines as supply increases) to measure welfare.
The cardinal metering of utility proposes that social welfare is maximised if income is
equally distributed to all members of the society. However, the flaw here is that it
assumes that all individuals have identical utility functions for money, so that with an
equal income distribution all would have the same marginal utility of money.
Individuals differ in their preferences and attitudes; thus, utility cannot be compared
interpersonally.
Paretian welfare economics: Vilfredo Pareto (1848-1923) was an engineer, economist
and socialist who tackled the problem of measuring utility. He proposed the ordinal
concept of utility, where no interpersonal comparisons of utility are made.
o Pareto-optimal: a situation in which it is impossible to make anyone better-
off without making someone worse-off
Any change that makes at least one individual better-off and no one
worse-off is an improvement in social welfare
Any change that makes no one better-off and at least one worse-off is a
decrease in social welfare
Pareto optimum may not be a sufficient condition for attaining
maximum social welfare, but it is a necessary condition for it
Level of utility if two individuals/countries
interact In order to analyse welfare, we must
first look at the initial condition (Point
C).
If we look at Point D, we notice that
both Utility A and B increase in
Quadrant IV, which means that the
policy should be accepted because it
improves welfare for both.
Welfare decreases in Quadrant II;
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, therefore, the policy should not be
accepted.
No assessment is possible in Quadrants
I and III.
The model of perfect competition and its features
Perfect competition refers to the most competitive market imaginable, where any individual
buyer or seller has a negligible impact on the market price.
This model provides the conditions when rational individuals attain Pareto-optimality.
1. Resources are given (there is no room for discovering new resources)
2. Constant production technology and constant array of products (there is no innovation
which may lead to monopolisation)
3. Preferences of individuals are given and constant
4. Individuals are free to choose between alternatives
5. Products are homogenous (cannot be distinguished from competing products,
consumers only compare prices)
6. Atomistic market structure, where firms are so numerous that the market represents
perfect competition (no monopoly, firms are price takers). In the case of a monopoly,
we need policies to protect suppliers i.e. competition law.
7. Markets are fully transparent (full access to information, consumer protection)
8. Unlimited mobility, to make good choices we need reduced or no transaction costs for
making choices (make choices more feasible)
9. Unrestricted divisibility of goods and factors (in real life, we have public goods and
utilities which lead to natural monopolies e.g. railways which must be regulated)
10. Immediate reactions
11. No involuntary exchanges, no externalities (e.g. environmental costs, accidents and
damages) in real life, production occurs without considering the environmental costs
The perfect competition model is a static one: the assumption of immediate reactions allows
only to make comparisons between equilibria. The assumptions of given technologies,
resources and products do not allow for an analysis of dynamic phenomena (e.g. innovation
and development).
The self-organisation of the market system: the emergence of pattern and order in a system
by internal processes (interactions), rather than external constraints or forces.
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, Lecture 3: History of European Integration
Formation of the European Union
European integration must be understood within the post-WWII context, driven by political
factors (e.g. prevent another European war, share the fruit of integration with the new
democratic nations in central and eastern Europe). These goals were always political, but the
means were always economic.
The present-day European Union (EU) is a political and economic union of 28 Member
States. These Member States delegate some decision-making power to the shared institutions
that they have created, this ensures that states are not making decisions that might hurt others
who don’t have a say in the matter. Many global problems today (e.g. climate change, forced
migration) are issues that cross borders that can only be solved through cooperation between
states.
“The EU is a place to manage the interdependence of States in Europe. This mission is
underpinned by a democratic understanding, in the sense that the EU restrains States
from taking decisions that impose costs on nationals of other States who have no political
voice in the first State’s decision-making process, as well as a more crude sense that
Europe operating collectively is able to exert influence and power that exceeds the sum of
its parts.” - Stephen Weatherill, Law and Values in the European Union (OUP 2016) 20.
The development of European integration
The Benelux Treaty was a customs agreement that initiated the Benelux
union. This treaty established a common policy regarding foreign trade and
1944 set forth the free movement of persons, goods, capital and services within
Belgium, the Netherlands and Luxembourg.
1948 The Marshall Plan was an American initiative passed to aid Western Europe.
George Marshall announced that the USA would give financial assistance to
all European nations ‘west of the Urals’, if they could agree to a joint
programme for economic reconstruction.
The Organisation for European Economic Cooperation (OOEC) emerged
from the Marshall Plan and was a permanent organisation that worked
towards a joint recovery programme, the distribution of aid and further
European economic integration.
European economic integration was achieved by reducing intra-
European trade barriers and improving the intra-European system of
payments by establishing the European Payments Union (EPU).
Prior to WWII, economic growth was seen as a competition between
nations which led to increased barriers. In contrast, trade liberalisation
among western European nations allowed for economic growth and
expansion of intra-European imports and exports.
The Treaty of Brussels was an agreement signed by Britain, France,
Belgium, the Netherlands and Luxembourg, creating a collective defence
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