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Microeconomics of Public Policy Analysis (ISE)

by Lee S Friedman Princeton University Press
Pub Date:
Hbk 784 pages
AU$84.00 NZ$86.09
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This book shows, from start to finish, how microeconomics can and should be used in the analysis of public policy problems. It is an exciting new way to learn microeconomics, motivated by its application to important, real-world issues. Lee Friedman's modern replacement for his influential 1984 work not only brings the issues addressed into the present but develops all intermediate microeconomic theory to make this book accessible to a much wider audience. Friedman offers the microeconomic tools necessary to understand policy analysis of a wide range of matters of public concern--including the recent California electricity crisis, welfare reform, public school finance, global warming, health insurance, day care, tax policies, college loans, and mass transit pricing. These issues are scrutinized through microeconomic models that identify policy strengths, weaknesses, and ideas for improvements. Each chapter begins with explanations of several fundamental microeconomic principles and then develops models that use and probe them in analyzing specific public policies. The book has two primary and complimentary goals. One is to develop skills of economic policy analysis: to design, predict the effects of, and evaluate public policies. The other is to develop a deep understanding of microeconomics as an analytic tool for application--its strengths and extensions into such advanced techniques as general equilibrium models and pricing methods for natural monopolies and its weaknesses, such as behavioral inconsistencies with utility-maximalization models and its limits in comparing institutional alternatives. The result is an invaluable professional and academic reference, one whose clear explanation of principles and analytic techniques, and wealth of constructive applications, will ensure it a prominent place not only on the bookshelves but also on the desks of students and professionals alike.

Endorsements: 'An important book. It should have a major impact in schools of policy, planning, and administration, and even in some economics departments. Friedman does a great job of applying the theory to important real-world problems.'--David Howell, New School University 'The Microeconomics of Public Policy Analysis will quickly become the most widely used text in graduate schools of public affairs and will be an attractive text for use in advanced undergraduate economics courses. This is one of the few books I know of that a non-economist can skim through and end up with a reasonable understanding of the key economic concepts central to the study of policy analysis.'--Samuel L. Myers, Jr., Roy Wilkins Professor of Human Relations and Social Justice, University of Minnesota

(S = Supplementary Section, O = Optional Section with Calculus)





Chapter 1: Introduction to Microeconomic Policy Analysis 3

Policy Analysis and Resource Allocation 3

The Diverse Economic Activities of Governments 6

Policy-Making and the Roles of Microeconomic Policy Analysis 9

Organization of the Book 15

Conclusion 18

Chapter 2: An Introduction to Modeling: Demand, Supply, and Benefit-Cost Reasoning 19

Modeling: A Basic Tool of Microeconomic Policy Analysis 19

Demand, Supply, and Benefit-Cost Reasoning 25

Monday Morning, 6:45 A.M.

Monday Morning, 9:00 A.M.

Summary 33

Discussion Questions 35

Chapter 3: Utility Maximization, Efficiency, and Equity 36

A Model of Individual Resource Allocation 37

Efficiency 45

The General Concept

Efficiency with an Individualistic Interpretation

Efficiency in a Model of an Exchange Economy

A Geometric Representation of the Model

Relative Efficiency

Equity 58

Equality of Outcome Is One Concept of Equity

Equality of Opportunity Is Another Concept of Equity

Integrating Equity-Efficiency Evaluation in a Social Welfare Function (S)

Summary 66

Exercises 68

Appendix: Calculus Models of Consumer Exchange O 69


Chapter 4: The Specification of Individual Choice Models for the Analysis of Welfare Programs 79

Standard Argument: In-Kind Welfare Transfers Are Inefficient 81

Responses to Income and Price Changes 85

Response to Income Changes

Response to Changes in a Good's Price

Response to Price Changes of Related Goods

Choice Restrictions Imposed by Policy 94

Food Stamp Choice Restriction: The Maximum Allotment

Food Stamp Choice Restriction: The Resale Prohibition

Public Housing Choice Restrictions S

Income Maintenance and Work Efforts

The Labor-Leisure Choice

Work Disincentives of Current Welfare Programs

The Earned Income Tax Credit (EITC)

Interdependent Preference Arguments: In-Kind Transfers May Be Efficient S 113

Summary 118

Exercises 120

Appendix: The Mathematics of Income and Substitution Effects O 121

Chapter 5: The Analysis of Equity Standards: An Intergovernmental Grant Application 124

Equity Objectives 124

Intergovernmental Grants 135

Design Features of a Grant Program 136

Income Effects and Nonmatching Grants

Price Effects and Matching Grants

The Role of Choice Restrictions

Alternative Specifications of Recipient Choice-Making

Equity in School Finance 146

The Equity Defects Identified in Serrano

The Design of Wealth-Neutral Systems

Other Issues of School Finance Equity

Summary 158

Exercises 160

Appendix: An Exercise in the Use of a Social Welfare Function as an Aid in Evaluating School Finance Policies O 162

Chapter 6: The Compensation Principle of Benefit-Cost Reasoning: Benefit Measures and Market Demands 169

The Compensation Principle of Relative Efficiency 171

The Purpose of a Relative Efficiency Standard

The Hicks-Kaldor Compensation Principle

Controversy over the Use of the Compensation Principle

Measuring Benefits and Costs: Market Statistics and Consumer Surplus 179

An Illustrative Application: Model Specification for Consumer Protection Legislation S 193

Problems with Measuring Individual Benefit S 197

Three Measures of Individual Welfare Change

Empirical Evidence: Large Differences among the Measures

Summary 208

Exercises 210

Appendix: Duality, the Cobb-Douglas Expenditure Function, and Measures of Individual Welfare O 212

Chapter 7: Uncertainty and Public Policy 220

Expected Value and Expected Utility 222

Risk Control and Risk-Shifting Mechanisms 235

Risk-Pooling and Risk-Spreading

Policy Aspects of Risk-Shifting and Risk Control

Alternative Models of Individual Behavior under Uncertainty 243

The Slumlord's Dilemma and Strategic Behavior

Bounded Rationality

Moral Hazard and Medical Care Insurance 254

Information Asymmetry and Hidden Action: The Savings and Loan Crisis of the 1980s and Involuntary Unemployment 260

Summary 263

Exercises 266

Appendix: Evaluating the Costs of Uncertainty 267

Chapter 8: Allocation over Time and Indexation 278

Intertemporal Allocation and Capital Markets 279

Individual Consumption Choice with Savings Opportunities

Individual Consumption Choice with Borrowing and Savings Opportunities

Individual Investment and Consumption Choices

The Demand and Supply of Resources for Investment

Individual Choices in Multiperiod Models

Choosing a Discount Rate

Uncertain Future Prices and Index Construction 299

Summary 307

Exercises 309

Appendix: Discounting over Continuous Intervals O 310


Chapter 9: The Cost Side of Policy Analysis: Technical Limits, Productive Possibilities, and Cost Concepts 317

Technical Possibilities and the Production Function 320

The Production Function Is a Summary of Technological Possibilities

Efficiency, Not Productivity, Is the Objective

Characterizing Different Production Functions

Costs 335

Social Opportunity Cost and Benefit-Cost Analysis

Accounting Cost and Private Opportunity Cost

An Application in a Benefit-Cost Analysis

Cost-Output Relations

Joint Costs and Peak-Load Pricing S

Summary 362

Exercises 363

Appendix: Duality-Some Mathematical Relations between Production and Cost Functions O 365

Chapter 10: Private Profit-Making Organizations: Objectives, Capabilities, and Policy Implications 373

The Concept of a Firm 374

The Private Profit-Maximizing Firm 377

Profit Maximization Requires that Marginal Revenue Equal Marginal Cost

The Profit-Maximizing Monopolist

Types of Monopolistic Price Discrimination

Normative Consequences of Price Discrimination

The Robinson-Patman Act and the Sherman Antitrust Act

Predicting Price Discrimination

Alternative Models of Organizational Objectives and Capabilities S 397

Objectives Other than Profit Maximization

Limited Maximization Capabilities

Summary 411

Exercises 414

Chapter 11: Public and Nonprofit Organizations: Objectives, Capabilities, and Policy Implications 417

Nonprofit Organizations: Models of Hospital Resource Allocation 419

Public Bureaus and Enterprises 429

Empirical Prediction of Public Enterprise Behavior: The Pricing Decisions of BART 432

A Normative Model of Public Enterprise Pricing: The Efficient Fare Structure 440

Summary 449

Exercises 450

Apppendix: The Mathematics of Ramsey Pricing O 452


Chapter 12: Efficiency, Distribution, and General Competitive Analysis: Consequences of Taxation 461

Economic Efficiency and General Competitive Equilibrium 462

Efficiency in an Economy with Production

Competitive Equilibrium in One Industry

The Twin Theorems Relating Competition and Efficiency

General Competitive Analysis and Efficiency 481

Partial Equilibrium Analysis: The Excise Tax

General Equilibrium Analysis: Perfect Competition and the Excise Tax

Lump-Sum Taxes Are Efficient and Most Real Taxes Are Inefficient

Summary 499

Exercises 500

Appendix: Derivation of the Competitive General Equilibrium Model 502

Chapter 13: The Control of Prices to Achieve Equity in Specific Markets 507

Price Support for Agriculture 508

Apartment Rent Control 514

Preview: Economic Justice and Economic Rent

Dissatisfaction with Market Pricing during Temporary Shortage of a Necessity

A Standard Explanation of the Inefficiency of Rent Control

Rent Control as the Control of Long-Run Economic Rent

The Relation between Rent Control and Capitalized Property Values

The Supply Responses to Rent Control

The Effects of Rent Control on Apartment Exchange

Recent Issues of Rent Control

A Windfall Profits Tax as Rent Control 542

Summary 544

Exercises 547

Chapter 14: Distributional Control with Rations and Vouchers 550

Ration Coupons 551

Vouchers and Ration-Vouchers 557

Rationing Military Service 561

The Utility Value of Work

Conscription versus the All-Volunteer Military

Income Effects of Rationing Methods S

Rationing Gasoline during a Shortage 572

Other Rationing Policies 583

Summary 586

Exercises 588


Chapter 15: Allocative Difficulties in Markets and Governments 593

Market Failures 595

Limited Competition Owing to Scale and Scope Economies over the Relevant Range of Demand

Public Goods


Imperfect Information

Second-Best Failures

Government Failures 606

Direct Democracy

Representative Democracy

Public Producers

Summary 613

Exercises 615

Chapter 16: The Problem of Public Goods 617

The Efficient Level of a Public Good 617

The Problem of Demand Revelation 619

The Housing Survey Example 621

Mechanisms of Demand Revelation 623

The Public Television Example 626

Summary 631

Exercises 633

Chapter 17: Externalities and Policies to Internalize Them 635

A Standard Critique of Air Pollution Control Efforts 637

The Coase Theorem 638

Efficient Organizational Design and the Degree of Centralized

Decision-Making 641

Reconsidering Methods for the Control of Air Pollution 647

Summary 657

Exercise 658

Chapter 18: Industry Regulation 660

Oligopoly and Natural Monopoly 661

Rate-of-Return Regulation 671

Franchise Bidding: The Case of Cable Television 677

Incentive Regulation 687

Summary 692

Exercise 695

Chapter 19: Policy Problems of Allocating Resources over Time 696

Perfectly Competitive and Actual Capital Markets 698

The Social Rate of Discount 700

Education as a Capital Investment 702

The Market Failures in Financing Higher Education Investments

Income-Contingent Loan Plans for Financing Higher Education

The Allocation of Natural Resources 707

Renewable Resources: Tree Models

A Note on Investment Time and Interest Rates: Switching and Reswitching

The Allocation of Exhaustible Resources Such as Oil

Summary 721

Exercises 723

Chapter 20: Imperfect Information and Institutional Choices 724

Asymmetric Information 725

Adverse Selection, Market Signals, and Discrimination in the Labor Market

Moral Hazard and Contracting

The Nonprofit Supplier as a Response to Moral Hazard

Nonprofit Organizations and the Delivery of Day-Care Services 734

The Value of Trust 746

Summary 747

Exercises 751



Teachers and students alike will be thanking Lee Friedman for accomplishing what all too few textbook authors do: breathing the vibrant life of practical examples into the abstract principles of economic analysis. This book links sound economic theory to scores of policy problems, presented in rich institutional detail. It will engage, enlighten, and captivate participants in both public policy and mainline economics courses for years to come. Henry J. Aaron, Brookings Institution Getting the economics right is one of the first tasks to getting public policy right. In Lee Friedman's new text, we now have the thorough and thoughtful treatment we need to train the next generation of policymakers and their advisors. Friedman makes sure the student sees the strengths and weaknesses of each tool in the economist's kit. To Harry Truman's chagrin each application and substantive topic gets a balanced 'pro vs. con' presentation. And today's policy analysts, myself included, need this book within easy reach, on the shelf between Varian and Rawls. Robert P. Inman, University of Pennsylvania An important book. It should have a major impact in schools of policy, planning, and administration, and even in some economics departments. Friedman does a great job of applying the theory to important real-world problems. David Howell, New School University The Microeconomics of Public Policy Analysis will quickly become the most widely used text in graduate schools of public affairs and will be an attractive text for use in advanced undergraduate economics courses. The main argument is that microeconomic theory provides a strong and persuasive foundation for designing policies to achieve efficiency and equity in market and nonmarket settings. This text is significant . . . the best to bring together economic rigor and policy applications. Samuel L. Myers, Jr., Roy Wilkins Professor of Human Relations and Social Justice, Hubert H. Humphrey Institute of Public Affairs, University of Minnesota Lee Friedman's new text is just what's needed to prepare the next generation of policy analysts for the challenges ahead. It provides a strong foundation for a public-policy course that could serve either as a complement or substitute for a traditional intermediate microeconomics course. Friedman is superb at developing extended real-world examples that provide a grounded sense of both the power and the limitations of economic analysis. Philip J. Cook, Duke University
Lee S. Friedman is an economist and Professor of Public Policy at the Goldman School of Public Policy, University of California, Berkeley. A recipient of the David N. Kershaw Award for distinguished public policy research, he is the author of Microeconomic Policy Analysis (McGraw-Hill) and numerous articles in scholarly journals. He is the former editor of the Journal of Policy Analysis and Management, the official journal of the Association for Public Policy Analysis and Management, whose presidency he also held.