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Market Versus Government: Welfare-Economic and Mesoeconomic Perspectives by Ng Yew-Kwang1

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Market Versus Government: Welfare-Economic and Mesoeconomic Perspectives by Ng Yew-Kwang1 Special Feature 93 Special Feature D Market Versus Government: Welfare-Economic and Mesoeconomic Perspectives by Ng Yew-Kwang1 This Feature discusses the central issue of free markets versus government intervention in both the micro and macroeconomic domains. From the first welfare theorem, the market is efficient under certain conditions. However, in the presence of important external effects like pollution and greenhouse gas emissions, government intervention in the form of Pigovian taxation may be desirable. Poverty reduction and equality promotion may also be appropriate. Nevertheless, in the absence of considerations for efficiency, this promotion should be in terms of overall incomes. The mesoeconomic analysis that combines elements of micro, macro and simplified general equilibrium is then used to show that a change in nominal aggregate demand (possibly from money supply) may affect either the price level alone, or also aggregate output, making both the Monetarists and the Keynesians correct in different situations. Factors affecting this include whether firms are perfectly competitive, how the costs of firms respond to prices, and aggregate output. Though justified by mathematical models elsewhere, these results are illustrated with simple diagrams of marginal revenue equalling marginal cost. Introduction A major, if not the main, theme of disagreement Next, I will offer a way to bridge the micro and between different economists, policymakers, and macroeconomic domains based on my earlier at times the lay public, is that of free markets contributions to mesoeconomics (explained versus government intervention. Should society below). The focus is on why changes in nominal leave economic matters to be decided by free aggregate demand, including changes in money market forces or should the government supply, may or may not affect aggregate output intervene in various areas to achieve under various conditions. This perspective also improvements? Although some intervention is partly explains why we have big differences present in all economies, the extent, degree and between two major groups—the believers methods of desired intervention are still subject (including the Monetarists) in free markets, to much debate. In this Special Feature, I will do laissez-faire and/or rules, and those (including the two things quickly. First, I will outline my thoughts Keynesians) that favour government discretion regarding this central issue in the area of and intervention. I believe that both sides are microeconomics, drawing some main conclusions, differently correct in important aspects, but lack and referring readers to my previous writings for the full picture. further details. 1 Ng Yew-Kwang is a Professor of Economics at Nanyang Technological University, Singapore. The views in this article are solely those of the author and should not be attributed to MAS. Monetary Authority of Singapore Economic Policy Group 94 Macroeconomic Review, October 2018 Insights From The First Theorem In Welfare Economics In the area of microeconomics, the most The first welfare theorem specifies only efficiency; important result in economics is, in my view, the thus, another possible area of government first theorem in welfare economics. This theorem intervention is to reduce poverty and inequality. states that the general equilibrium of a market However, unless justified by some efficiency economy under perfect competition results in a considerations (such as external effects), equality most efficient allocation of resources, inputs, or should be pursued in terms of overall incomes, factors of production, and of final goods (taken to leaving specific issues to be determined by the include services), as exposited in Ng (2015). principle of efficiency supremacy or “a dollar is a Conditions needed for the theorem to hold dollar irrespective of rich or poor”, as argued in include the absence of external effects like Ng (1984). If a good produces external pollution and serious ignorance that justifies benefits/costs, it may be subsidised/taxed on the things like food safety regulation. These efficiency grounds of its external effects. In the conditions, as well as the requirement for perfect absence of such efficiency considerations, a good competition, are very strict and never fully should not be taxed/subsidised for being satisfied in any real economy. Nevertheless, the predominantly consumed by the rich/poor, as theorem is important as it explains why the taxing/subsidising their incomes directly is more invisible hand of the market works (even if not efficient. Thus, while progressive and negative perfectly) and it serves as a benchmark to guide income taxation may be justified, inadequate us in locating areas that might need government pricing of petrol, electricity, and water cannot. In intervention. the presence of second- and third-best considerations (on which see Lipsey and For example, where there is serious Lancaster, 1956; Lipsey, 2017; Ng, 1977a; Ng, environmental disruption, efficiency may be 2017), complications may arise. For example, it is seriously violated and government intervention, if best to tax the driving of cars heavily and the use not too inefficient, may help to mitigate the of public transport such as buses, trains, and devastating effects. Pigovian taxes on pollution MRTs slightly, on environmental grounds. and greenhouse gas emissions may be needed. However, if it is not feasible (technically or Although Nobel laureate Ronald Coase (1960) politically) to tax private driving, it may be better argued against Pigovian taxation, his argument is to subsidise (instead of taxing) bus/train/MRT based on ignoring the asymmetry between the riding as this is a close substitute to driving. costs of reducing pollution/emission which are infinitesimal at the margin of free-pollution Of course, even in areas where the market fails equilibrium, and the benefits of such reduction and government intervention may be indicated, which are high (Ng, 2007). These (marginal) the results of intervention may yet be worse if it is damages are difficult to estimate, making the too inefficient. Thus, we tell students the mistake amount of Pigovian taxes (which should ideally of the Roman emperor who awarded the trophy equal these damages) difficult to determine. to the second singer after just hearing the first However, for most cases where abatement singer. This consideration is less important in the investment to reduce environmental disruption is case of Singapore, which has a good track record being undertaken, it can be shown that the of efficient public policy formulation and Pigovian taxes should at least equal the marginal implementation, and it is overwhelmed by the costs of this investment, which are much easier to compelling importance of the issue of estimate. Moreover, the amount of tax revenues environmental disruption which may threaten so collected will be more than enough to fund the human survival. We cannot just wait to die. optimal amount of abatement investment (Ng, 2004). Monetary Authority of Singapore Economic Policy Group Special Feature 95 Does Money Affect Real Output Or Price Level? A Mesoeconomic Perspective Friedman (1970) regarded the most important illusion or other frictions. Then, it can be shown problem in macroeconomics to be how a change that, if we assume in addition that firms are in nominal aggregate demand (as may be effected perfect competitors, we have the result of money by a change in money supply or other factors) neutrality, where nominal aggregate demand only affects the price level or aggregate output. affects prices, but not output or employment. This Economics students also learn that, ignoring time result is consistent with the fact that all models lags, money is neutral (i.e., affecting only the price correctly producing neutrality are explicitly or level, not real variables). This important problem implicitly based on perfect competition, as may involves many aspects beyond the scope of this be cross-checked.3 The micro foundation of this Feature. Here, I only shed some light on one neutrality is shown in Figure 1 for the short-run important aspect using the method of case, with a given number of firms. The aggregate mesoeconomic analysis I have developed over the output Y is then represented by the output of the last few decades (Ng, 1977b, 1980, 1982, 1986, representative firm on the horizontal axis. The 1992), with the latest perspective in Ng (2014). initial equilibrium point A is at the intersection of This is a general equilibrium analysis (but the initial demand curve (horizontal due to simplified to abstract away changes in relative perfect competition) for the output of the firm d prices and allow the use of the representative with its marginal cost curve MC. A change (say an firm methodology) that takes into account the increase) in nominal aggregate demand shifts the responses in both the cost side (effects of changes demand curve upward to d’. As a higher price for in aggregate output and the price level on the the representative firm also means a higher costs of the firm) and demand side (effects of average price or price level, the MC curve also changes in aggregate output, aggregate shifts up by the same proportion, in the absence income/demand, and the price level on the of time lags in adjustments in the input markets. demand for the firm’s product), as well as the The new intersection point of d’ and MC’ at B interaction of the firm with other firms as a whole shows only an
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