The economics of fund allocation in public policy

A very difficult question a government faces when deciding a budget is how to allocate public funds in the best possible way. The arguments often revolve around social, economic and environmental objectives; objectives in which can often tear at each other’s throats.

Social themes generally direct funding to those with special needs and lower incomes, and those saddled with serious diseases in which research is still being undertaken in the hope of finding better treatment options. Funding to support these people is very important, and it is heartwarming to know a decent number of individuals offering these support services often do so as volunteers. The most challenging decision for a government is how much to set aside for these endeavours.

The most basic principle in economics is to invest in an activity until the Marginal Revenue (MR) derived from that extra investment unit equates the Marginal Cost (MC) of instilling that unit of investment. The costs are often not difficult to compute – it is the sum of expected salaries (and other employment costs), overheads and the opportunity cost of having diverted funds to these causes rather than the next best alternative. One might argue valuing the opportunity cost borne by volunteers is material to a complete analysis but that step is precluded for this post. 

The benefits are devilishly tricky to compute. Take for example research into the management of serious diseases. Research to find more viable options to treat cancer, muscular dystrophy, Alzheimer’s and cerebral palsy often take many, many years to come to fruition. How can an incumbent government measure the benefits of such programs when results only show in a period when they are no longer the government? A connected issues is how to quantify those benefits even they do arise. How is one expected to value the joy a young child experiences when they start walking after successful treatment for muscular dystrophy? How does one value a grandmother’s significantly-reduced pain after a new drug is developed to manage the wrath of cancer?

-to be completed-

Minimum Wage in Australia

Fair Work Australia (FWA) today announced a $19.40 increase in the weekly minimum wage for Australian workers. The new minimum weekly salary is $589.30. Section 62 of the Fair Work Act indicates the rate be based on a 38-hour work week, which effectively translates to the hourly wage being just below $15.51.

I’m certain policy-makers at FWA don’t appreciate that they are just sustaining the wage-price spiral in Australia. A wage-price spiral refers to the increasing of business costs caused by higher wages which push prices higher, which in turn results in higher wages being demanded and the story is repeated. It is ridiculous that the lowest-skilled workers make a wage above $15.50 per hour. Consider other modern economies like the US, UK and Singapore. The federal minimum wage in the US is $7.25 , while that of the UK is GBP 6.08.  Singapore does not even have a minimum wage. But these countries are nowhere near as costly as Australia. The standard-of-living (at least in my opinion) for middle-class families is higher than here and this can be measured by the cost of living, cultural variety, education and efficiency of public transport. These three countries do compare very strongly with Australia when considering those elements, though I do acknowledge that congestion (on the road and off) is much less of a problem in Australia (with the exception of Sydney certainly).

Ultimately, wage-price spirals destroy the attractiveness of an economy to current and potential investors. The detrimental impact on tourism and education is another issue that policy-makers have to contend with. FWA needs to recognise higher minimum wages spill over to all parts of the economy and necessarily make everything else more expensive.

The Australian economy is leveraging off its resource-rich environment but what will happen when that comes to an end? The world currently needs Australia’s resources to fuel the ballooning demand of the hungry nations of China and India among others, but the gradual switch to cleaner energy may compromise this source of foreign income. I recognise that a forte of Australia is professional services but the wage-price spiral is going to make these services very unappealing to foreigners who will look to the US, UK and Singapore for similar expertise. Australians will still seek Australian services due to cultural and locational elements, but their demand is insufficient to sustain Australia in the long term. Fresh produce is another active export item but that too is suffering the consequences of inflation. Dark fiscal times will begin when Australia realises it has priced its products and services out of the international market.

There is an equity argument for having a relatively higher minimum wage, but at what cost? I’m sure an individual on the minimum wage would be able to make ends meet quite comfortably given they didn’t have to support a family. Of course, they wouldn’t be able to afford luxuries like a large home, powerful car and Giorgio Armani suits. But they certainly could rent a nice room, buy a reasonable second-hand car and take a short trip to Bali (which I must emphasise are options that cannot be enjoyed by many people in this world). It’s the lack of appreciation and taking-things-for-granted mentality that make some people here feel they are entitled to so much, even though their jobs don’t require decent skills or much responsibility.

By continuing to increase the highly-inflated minimum wage, FWA is endorsing this undesirable attitude among low-income earners. The focus should be on managing finances responsibly and encouraging them to accept the appropriate kind of lifestyle they can lead which is commensurate with their level of income. Cost pressures should never be the sole driving factor in determining minimum wages. Let the market decide what wage should be set. Equity will always have a role in this debate but right now, it is a big bully on the efforts of small and large businesses everywhere in Australia. Big problems loom ahead if FWA continues to increase the minimum wage

So what do microeconomists really do?

I found that not many students knew what exactly economists could do in the workforce. I will take this opportunity to shed some light on what consulting microeconomists do. Such economists are engaged by law firms,  regulators, utilities and other private companies.

Electricity and other octopoid industries

Electricity prices have always been a big concern in Australia.  According to the Australian Bureau of Statistics, electricity prices have soared by 59.1% from 2005 to 2010 in Victoria alone. The electricity sector can be broken down into four components:

• generation (wholesale)
• transmission
• distribution
• retail

Economists in the electricity (or more broadly the energy) sector advise on pricing and investment policy for each of these components. Not many people know that the National Electricity Market (NEM) in Australia is fundamentally based on a Price = Marginal Cost mechanism. Electricity generating companies (gencos) submit bids to the Market Operator (AEMO) every 5 minutes; they indicate a price and quantity they want to sell electricity at. When many of the bids are submitted, AEMO derives a supply curve based on these price-quantity combinations from the gencos. The level of demand at that point is equated with the supply curve to determine a price.

There is also a high demand to understand the economics of other octopoid industries;

• the water;
• telecommunications;
• public transport; and
• garbage collection sectors

require careful economic regulation.

Legal and Competition sector

The Trade Practices Act 1974 addresses the level of competition in the different markets. Often, we hear of a merger or acquisition that could reduce competition. The ACCC sometimes engages economists to determine whether the proposed MA activity would substantially lessen competition. There are specific rules that are abided by when addressing these concerns.

Australia has strict laws on cartels. In cases of cartels, economists are asked to ascertain the value of damages that a firm can be compensated for it had purchased inputs from a cartelised industry. A very recent example is the company Jarra Creek claiming compensation from an alleged cardboard box cartel comprising Visy and Amcor in Australia.

The interesting thing about the Legal and Competition field is that economists (and econometricians!) find themselves working on issues faced in very different industries. Disputes arise in the building industry, telecommunications industry, music industry and even lead ingots industry which require scrutiny from the ACCC. So the possibilities are endless for economists in this field.

Modelling and econometrics

As key advisors and valuers, consulting economists know that data management and analysis are imperative to finding solutions. Energy modelling, economy-wide modelling and developing regulatory models form the crux of economic analysis in Australia. Such economists need to be well-versed in statistical software such as Stata, R, SAP and Microsoft Excel. Others need to be familiar with spreadsheet models, especially when government bodies usually prefer spreadsheet-oriented models.

 

 

I hope this post has enlightened you on the many opportunities economists can have in the consulting industry.

Going back to the past

Rather than seeing a psychologist, what do economists use to bring them back to the past?

A: Regression analysis.

And the modifications:

What do economists use to bring them back to the past again and again?
A: Multiple regression analysis.

What do economists use to bring them straight back to the past?
A: Linear regression analysis.

//GK

Fun with DE and GK

Our email exchange:

Subject: Fun for you
DE: Give a demand function for which the point PED is always constant. You have 1 minute
GK: P = 0*Q
DE: The function doesn’t have to be linear! Hmm, I can see what you mean but the problem is the elasticity would then be undefined.. ∆P/P would always be 0 in the PED equation and since that’s the denominator of that equation, the PED is undefined rather than being constant
GK:  It would be CONSTANTLY undefined P = Q
DE: It would be P=k/Q where k is any positive number. The PED would be always 1 for such an equation. Or in very simple terms P x Q = k which means revenue is always constant!
GK: Smart! My economic capabilities are depreciating rapidly… :-( sigh

A beautiful function

Q: What do you call a beautiful function in math and economics?

A: Affine function.

//GK, inspired by DE.

Point Price Elasticity of Demand Faux Pas perhaps?

Could the point price elasticity of demand (PED) interpretation be wrong?

Revenue = Price (P) X Quantity (Q)

Suppose P = $1 and Q = 100

When I reduce P by 10% (P becomes $0.90), suppose my affine demand function tells me Q increases by 11% to 111 units.

What is the PED? It is the (absolute value of the) percentage change in quantity over percentage change in price.

PED = 0.11/0.1=1.1

This indicates demand for this good is elastic; I would expect a price reduction of this good to more than proportionately increase the quantity demanded – translating to higher revenue yes? Hell no.

When P=$1.00 and Q = 100, revenue is $100.00
When P=$0.90 and Q = 111, revenue is $99.90

Have economists got the maths incorrect?

 

NB: The arc PED would give the correct result. However, some universities prefer using the point PED approach as it is simpler.