Karachi University has announced results of M.A. (Previous) External Annual Examination 2011.

Karachi University has announced results of M.A. (Previous) External Annual Examination 2011.

http://www.uok.edu.pk/ann_results/docs/2012/mapext11c.pdf

MA-EXTERNAL REGISTRATION FROM 5TH NOVEMBER 2012

MA-EXTERNAL REGISTRATION FROM 5TH NOVEMBER 2012

Binomial Distribution

Definition: 

 The Binomial Distribution is one of the discrete probability distribution. It is used when there are exactly two mutually exclusive outcomes of a trial. These outcomes are appropriately labeled Successand Failure. The Binomial Distribution is used to obtain the probability of observing r successes in n trials, with the probability of success on a single trial denoted by p.


Formula:

P(X = r) = _nC_r p ^r (1-p)^n-r
where,
             n = Number of events
             r = Number of successful events.
             p = Probability of success on a single trial.
             _nC_r = ( n! / (n-r)! ) / r!
             1-p = Probability of failure.


Example: Toss a coin for 12 times. What is the probability of getting exactly 7 heads.


  Step 1: Here, 
                Number of trials n = 12
                Number of success r = 7 since we define getting a head as success
                Probability of success on any single trial p = 0.5

  Step 2: To Calculate _nC_r formula is used. 
           _nC_r = ( n! / (n-r)! ) / r!
                = ( 12! / (12-7)! ) / 7!
                = ( 12! / 5! ) / 7!
                = ( 479001600 / 120 ) / 5040
                = ( 3991680 / 5040 )
                = 792

  Step 3: Find p^r.
            p^r = 0.5⁷
               = 0.0078125

  Step 4: To Find (1-p)^n-r Calculate 1-p and n-r.
            1-p = 1-0.5 = 0.5
            n-r = 12-7 = 5

  Step 5: Find (1-p)^n-r.
            = 0.5⁵ = 0.03125

  Step 6: Solve P(X = r) = _nC_r p ^r (1-p)^n-r
            = 792 * 0.0078125 * 0.03125
            = 0.193359375


The probability of getting exactly 7 heads is 0.19

Binomial Distribution Problems

(1)  A company owns 400 laptops.  Each laptop has an 8% probability of not working.  You randomly select 20 laptops for your salespeople.

(a) What is the likelihood that 5 will be broken?         (b) What is the likelihood that they will all work?

(c) What is the likelihood that they will all be broken?

(2) A study indicates that 4% of American teenagers have tattoos.   You randomly sample 30 teenagers.   What is the likelihood that exactly 3 will have a tattoo?

(3)  An XYZ cell phone is made from 55 components.  Each component has a .002 probability of being defective. What is the probability that an XYZ  cell phone will not work perfectly?

(4)  The ABC Company manufactures toy robots.    About 1 toy robot per 100 does not work.  You purchase 35 ABC toy robots. What is the probability that exactly 4 do not work?

(5)  The LMB Company manufactures tires.  They claim that only .007 of LMB tires are defective.  What is the probability of finding 2 defective tires in a random sample of 50 LMB tires?

(6)  An HDTV is made from 100 components.  Each component has a .005 probability of being defective. What is the probability that an HDTV will not work perfectly?

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(1) (a)  20C5 (.08)⁵ (.92)¹⁵ = .0145   (b) 20C0 (.08)⁰(.92)²⁰ = .1887 
(c) 20C20 (.08)²⁰(.92)⁰ = .0000000000000000000001 (note ^-22 means move the decimal 22 places to the left)

(2) 30C3 (.04)³ (.96)²⁷ = .0863

(3) Probability that it will work (0 defective components) 55C0 (.002)⁰ (.998)⁵⁵ = .896

Probability that it will not work perfectly is 1 - .896 = .104   or 10.4%

(4) 35C4 (.01)⁴ (.99)³¹ = .00038

(5) 50C2 (.007)² (.993)⁴⁸ = .0428 
(6) Probability that it will work (0 defective components) 100C0 (.005)⁰ (.995)¹⁰⁰ = .606

Probability that it will not work perfectly is 1 - .606 = .394   or 39.40%

Pigovian tax

A Pigovian tax (also spelled Pigouvian tax) is a tax levied on a market activity that generatesnegative externalities. The tax is intended to correct the market outcome. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product. A Pigovian tax equal to the negative externality is thought to correct the market outcome back to efficiency.

In the presence of positive externalities, i.e., public benefits from a market activity, those who receive the benefit do not pay for it and the market may under-supply the product. Similar logic suggests the creation of Pigovian subsidies to make the users pay for the extra benefit and spur more production.

Pigovian taxes are named after economist Arthur Pigou who also developed the concept ofeconomic externalities. William Baumol was instrumental in framing Pigou's work in modern economics.

Arthur C. Pigou's original argument

In 1920, British economist Arthur C. Pigou wrote The Economics of Welfare.. In it, Pigou argues that industrialists seek their own marginal private interest. When the marginal social interest diverges from the marginal private interest, the industrialist has no incentive to internalize the cost of the marginal social cost. On the flip side, Pigou argues, if an industry produces a marginal social benefit, the individuals receiving the benefit have no incentive to pay for that service. Pigou refers to these situations as incidental uncharged services and incidental uncharged disservices.

Pigou provides numerous illustrations of incidental uncharged disservices. For example, if a contractor builds a factory in the middle of a crowded neighborhood, the factory causes these incidental uncharged disservices: higher congestion, loss of light, and a loss of health for the neighbors (Pigou 1920). He also references businesses that sell alcohol. The sale of alcohol necessitates higher costs in policemen and prisons, Pigou argues, because of the crime associated with alcohol. In other words, the net private product of alcohol businesses is peculiarly large relative to the net social product of the same business. He suggests that this is why most countries tax alcohol businesses (Pigou 1920).

The divergence between the marginal private interest and the marginal social interest produces two primary results. First, as already noted, the party receiving the social benefit does not pay for it, and the one creating the social harm does not pay for it. Second, when the marginal social cost exceeds the private marginal benefit, the cost-creator over-produces the product. Ultimately, because non-pecuniary externalities over-estimate the social value, they are over-produced.

To deal with over-production, Pigou recommends a tax placed on the offending producer. If the government can accurately gauge the social cost, the tax could equalize the marginal private cost and the marginal social cost. In more specific terms, the producer would have to pay for the non-pecuniary externality that it created. This would effectively reduce the quantity of the product produced, moving the economy back to a healthy equilibrium.

[edit]Working of the Pigovian tax

Pigovian tax effect on output.

The diagram illustrates the working of a Pigovian tax. A tax shifts the marginal private cost curve up by the amount of the tax. If the tax is placed on the quantity of emissions from the factory, the producers have an incentive to reduce output to the socially optimum level. If the tax is placed on the percentage of emissions per unit of production, the factory has the incentive to change to cleaner processes or technology.

[edit]Lump-sum tax subsidy

In 1980, a new critique of Pigouvian taxes emerged from Dennis Carlton and Glenn Loury.They argued that Pigouvian taxes alone would not create an efficient outcome in the long-run, because the taxes controlled only the scale of the individual firms, not the amount of firms in the particular industry. In the case of pollution, if the firms each produced a fraction of what they produced before, but the number of firms increased exponentially, the amount of pollution would still increase. To prevent this, Carlton and Loury recommend a policy with the potential to regulate the number of firms in an industry: lump-sum taxes or lump-sum subsidies.

Carlton and Loury present four basic arguments in their article. First, Pigouvian taxes work in the short-term, because the number of firms cannot vary. Second, Pigouvian taxes do not work in the long-term because the number of firms can vary. Third, an industry with a specific number of firms and scale can achieve the long-run social optimum (LRSO). The best option is to add an entry tax for potential firms and a subsidy for current firms to restrict a movement in the number of firms. Fourth, it is possible for a tax policy to create a LRSO.

Robert Kohn responded to this article in “The Limitations of Pigouvian Taxes as a Long-Rum Remedy for Externalities: Comment,” saying that a Pigouvian tax on pollution emissions can, in fact, create the long-run social optimum without a lump-sum tax-subsidy.Carlton and Loury responded the same month, clarifying that they were discussing a Pigouvian tax on output; whereas, Kohn was discussing a Pigouvian tax on emissions.^[5] Carlton and Loury provide numerical proofs as to why these are different. Ultimately, they argue that there are some cases in which a single tax on emissions will produce the LRSO and others in which a single tax on output will attain the LRSO. Either case only works with the taxes properly determined.

[edit]Double dividend hypothesis

In 1998, Don Fullerton and Gilbert E. Metcalf evaluated the double dividend hypothesis in “Environmental Taxes and the Double-Dividend Hypothesis: Did You Really Expect Something for Nothing?”. This article defines the double-dividend hypothesis as the theory that environmental taxes can improve the environment and increase economic efficiency simultaneously. Either motivation can legitimately support a tax reform. The first dividend intuitively makes sense: decreasing pollutant emissions improves the environment. The improvement in economic efficiency results from a shift away from distorting taxes such as the income tax. Fullerton and Metcalf note that for every $1 extracted in taxes, a $1.35 burden falls on the economy. In a sense, the private sector must swallow a 35 cent excess burden for no particular reason. The second dividend aims to eliminate some of this excess burden.

Tempting as it may be to try, Fullerton and Metcalf argue, the validity of the double-dividend theory cannot be established as a whole. An observer must evaluate each circumstance individually. Fullerton and Metcalf do provide guidelines for this analysis. Two questions help shape this analysis: what is the status quo? What are the specifics of the reform? The amount and nature of the current taxes, permits, and regulations greatly influence the results of the additional tax. Also, where the tax revenue goes greatly affects the success of the tax.

Secondly, Fullerton and Metcalf say the previous literature on Pigouvian taxes focused too heavily on the revenue dividend and too lightly on the environmental dividend of environmental taxes. His predecessors naively value revenue too much, Fullerton and Metcalf argue, because they fail to recognize that all taxes impose costs on someone. These taxes could outweigh the environmental benefit. Thus, the government must use the Pigouvian tax revenue to lower another tax if it wants to minimize the economic damage of a tax.

Fullerton and Metcalf also mention that the effectiveness of any sort of Pigouvian tax depends on whether it supplements or replaces an existing pollution regulation. If the tax replaces a pollution regulation, it will most likely be environmentally neutral, even if it is revenue-positive. If it supplements the regulation, it may or may not be environmentally and revenue-neutral, depending on the effectiveness of the original regulation. The status quo substantially affects the outcome of a proposed tax.

[edit]Pigouvian tax and distortionary taxation

A. Lans Bovenberg and Ruud A. Mooij argue that there is a first-best case scenario and a second-best case scenario in their article “Environmental Levies and Distortionary Taxation." In the first-best case, the government does not need to get revenue from distortionary taxes such as the income tax, and the Pigouvian tax can create the long-run social optimum. In the real world, second-best case, the status quo includes an income tax that distorts the labor supply. In this situation, Bovenberg and Mooij write that the best tax comes in below the level of the Pigouvian tax.

Bovenberg and Mooij establish that households consume a dirty good (D) and a clean good (C). If the government taxes D, it can use the earned revenue to lower the labor income tax. At the same time, the tax levied on the firm will increase the price of D. The lowered income tax and the higher consumer prices even each other out, stabilizing the real net wage. But because C’s price has not changed and it can substitute for D, consumers will buy C instead of D. Suddenly the government’s environmental tax base has eroded and its revenue with it. The government then cannot afford to keep the labor income tax down. Bovenberg and Mooij posit that the increase in the price of goods will outweigh the slight decrease in the income tax. Labor and leisure become more interchangeable the lower the real net wage (or after-tax wage) falls. With this decrease in the real net wage, more people leave the job market. Ultimately, labor bears the cost of all public goods.

Goulder, Parry, and Burtraw agree that that the net social welfare after the implementation of a tax hinges on the preexisting tax rate. Don Fullerton agreed with this analysis in 1997 in his article “Environmental Levies and Distortionary Taxation: Comment.” He added that lowering the income tax and taxing the dirty good equates with raising the labor tax and subsidizing the clean product. These two polices create the same effects, Fullerton says.

In 1998, Fullerton and Gilbert E. Metcalf explain this theory more thoroughly. He begins by defining terms. The gross wage reflects the pre-tax wage a laborer receives^[8]. The simplest form of the net wage is the pre-tax wage minus the income tax. In reality, however, the net wage is the gross wage times one minus the tax rate, all divided by the price of consumption goods. With the status quo income tax, deadweight loss exists. Any addition to the price of consumption goods or an increase in the income tax extends the deadweight loss further. Either of these scenarios lowers the net wage, reducing the supply of labor offered. Supply of labor decreases because of the labor/leisure interchange. If someone gets paid very little, he or she may decide it is no longer worth his or her time to continue in that job. Thus, employment decreases. If the Pigouvian tax, which increases the price of consumption goods also decreases the income tax, replaces the income tax, Fullerton argues that the net wage is not affected.

[edit]Alternatives

[edit]No intervention (direct negotiation between parties)

Economist Ronald Coase argued that individuals can come to an agreement with an efficient result without the interference of a third party when transaction costs are low^[9]. He says it is less expensive and less difficult for two neighbors to come to an agreement about a fence, the amount of noise, or the amount of smoke than it is for these two neighbors to approach a third party to solve the situation for them. Even when several parties are involved, outside interference could result in an inefficient outcome.

[edit]Firm limits

Instead of taxing the negative externality producer, the government could simply regulate the production of that negative externality. Fullerton and Metcalf argue that restricting the amount of pollution that all firms in an industry can produce will indirectly reduce the output of all firms. This comprehensive supply reduction will automatically raise the consumption price of the good. These types of command-and-control restrictions simulate a cartel, which businessmen typically see as beneficial to profits. Fullerton remarks that production cost per unit does not change, meaning the company can earn profits over and above what it earned before the regulations even with selling a lower quantity of goods. If the production cost of all firms increased simultaneously due to a regulation, the firms may be able to increase the price uniformly. They do not consider the elasticity of products and that's effect on the quantity of demand and the industry's final profits.

[edit]Cap and trade

Another alternative to applying Pigouvian taxation is for government to place a limit on the total amount of the negative externality and create a market for rights to generate this specific negative externality. In the United States since the late 1970s, and in other developed nations since the 1980s, the concept of a market for "pollution rights" has arisen. Giving out the rights for free (or at less than market price) allows polluters to lose less profit or even gain profits (by selling their rights) relative to the unaltered market case.

Goulder, Perry, and Burtraw suggest that selling permits to firms is the best option, but recognize that many firms in the status quo are grandfathered in, meaning they are given exemptions^[11]. The authors include an example of the U.S. regulations in coal-fired electrical power plants that require the reduction of 10 million tons of sulfur dioxide emissions. They estimate that more than half of the $907 million preexisting taxes could have been eliminated by auctioning off the permits rather than grandfathering them.

[edit]Criticisms

Most of the criticism of the Pigouvian tax relate to the determination of the tax and the implementation. Pigou and Friedrich Hayek point out that the assumption that the government can determine the marginal social cost of a negative externality and convert that amount into a monetary value is a weakness of the Pigouvian tax. William Baumol suggests that the measurement of social cost is almost impossible. Ronald Coase argues that all social costs are reciprocal in nature, so, once the tax is set, it must not be changed. Others assert that political factors can complicate the implementation of a Pigouvian tax.

[edit]Measurement problem

Arthur Pigou said in "It must be confessed, however, that we seldom know enough to decide in what fields and to what extent the State, on account of [the gaps between private and public costs] could interfere with individual choice." In other words, the economist's blackboard "model" assumes knowledge we don't possess — it's a model with assumed "givens" which are in fact not given to anyone.Friedrich Hayek would argue that this is knowledge which could not be provided as a "given" by any "method" yet discovered, due to insuperable cognitive limits.

William Baumol argues that it is extraordinary difficult to measure the social costs of any externality, especially because many costs are psychological and individual. Even if a measurement of the psychological effect of some externality did exist, it would be impossible to collect that data for all individuals affected and then find the optimum output level. If experts could find the optimum output level, it would be easier to find the optimum Pigouvian tax level to achieve that optimum. In the end, Baumol argues that the best solution is to set a minimum standard of acceptability for negative externalities, and create tax systems to achieve those minimum standards. Baumol points out that government committees have a tradition of agreeing on minimum standards, so the practicality of this solution is reasonable.

[edit]Reciprocal cost problem

Ronald Coase argues that the tax placed on an industry creating a negative externality should not be changed after it is implemented. The crux of his argument is that all social costs are reciprocal in nature. Coase argues that a factory emitting smoke is not entirely responsible for the social harm of smoky air. If the factory were not there, no one would suffer from smoky air, and if the people were not there, no one would suffer from smoky air. Because of this reciprocity of harm, Coase argues that neither party bears sole responsibility for the social harm, so neither party should pay the full cost.

The social harm gets worse, Coase argues, if only one offender pays for the social harm. If the smoke-emitting factory must pay dearly for all its smoke, it will reduce its quantity of production or buy the necessary technology to reduce its smoke rate. With the advent of clean air, neighbors may move into the area. This immediately increases the marginal social cost of smoke, which would require a tax increase on the factory. Essentially, each time the tax increases, the population increases and the marginal cost of the status quo increases again, so the factory is punished for making conditions good enough that people want to move there.

One complexity of this situation is the multiple local maxima, or the interchangeable best-case scenarios. It all hinges on the numbers. If the cost of abating all smoke is more than the cost to move the neighbors out, the neighbors should move out and let the factory continue emitting smoke. On the other hand, if it costs less to abate the smoke than to move the neighbors, then the factory ought to pay the tax or buy the clean technology to provide clean air for the surrounding residents. Once the optimum solution is implemented, Coase argues that the tax should not change, regardless of changing circumstances. In this case, if a tax is imposed on the factory and some more neighbors move in, the factory tax should not increase.

[edit]Political problem

Political factors such as lobbying of government by polluters may also tend to reduce the level of the tax levied, which will tend to reduce the mitigating effect of the tax; lobbying of government by special interests who calculate the negative utility of the externality higher than others may also tend to increase the level of the tax levied, which will tend to result in a sub-optimal level of production.

In their article “On Taxation and the Control of Externalities: Comment,” Earl A. Thompson and Ronald Batchelder noted one political problem with Pigouvian taxes. If a firm can influence the tax rate or regulations put on it, the results will not be as certain as Pigou and Baumol suggested. Baumol responded to this, saying that almost all discussions on Pigouvian taxes include the assumption of pure competition. This certainly does alter the scenario, but the literature had not ignored it; it had merely used a different set of assumptions.

Thomas A. Barthold argues in 1994 that actual policy decisions often come from budget requirements, not concern for the environment. The taxes do not always parallel raw economic theory because social benefits and costs are hard to measure. He uses the 1989 Montreal Protocol as an example. President George H. W. Bush signed this protocol that allowed either a permit auction or a tax on ozone-depleting chemicals. Barthold attributes the decision to implement the tax to the pressure on the Ways and Means committee to come up with more consistent revenue.

The tax policy also did not accord with basic common sense economic principles. For one, it makes sense to impose a tax on the industry that creates the pollution problem, on the activity that emits the harmful chemicals. This particular activity happened to be the use of automobiles with leaky compressor systems, but because of the high administration cost of taxing that many people, the government decided to tax the producers of those chemicals, though they contributed nothing to the actual problems of chlorofluorocarbons in the atmosphere.

Another evidence of the alternative motivations for this policy is the fact that the base tax increases annually. Does the harm from chlorofluorocarbons increase every year and in the same increment? Who is to say that $1.37 per pound of chlorofluorocarbons is an accurate description of the marginal social cost of pollution? The conspicuous hike in the tax in 1992 that equalized the Energy Policy Act’s budget ignited Barthold’s suspicions. Additionally, exporting firms should not receive exemptions from environmental taxes simply because they are exporting goods. If the motivation for this tax was simply the first dividend, environmental improvement, then all firms, whether or not they export, would be taxed.

Aside from this frustration, Barthold noted that politicians often prefer regulations with obvious benefits and hidden costs to regulations with hidden benefits and obvious costs. This is one reason why politicians often prefer to hand out permits to firms rather than impose a tax on them, even though the tax is more economically efficient. Free permits create winners of grandfathered firms and losers of the consumer who has to pay more for the same product. According to Barthold, taxation makes losers of the factory producers and indirect winners of the consumers.

[edit]

The Coase theorem

The Coase theorem states that where there is a conflict of property rights, the involved parties can bargain or negotiate terms that are more beneficial to both parties than the outcome of any assigned property rights. The theorem also asserts that in order for this to occur, bargaining must be costless; if there are costs associated with bargaining (such as meetings or enforcement), it will affect the outcome. The Coase theorem shows that where property rights are concerned, involved parties do not necessarily consider how the property rights are granted if they can trade to produce a mutually advantageous outcome.  

This theorem was developed by Ronald Coase when considering the regulation of radio frequencies. He posited that regulating frequencies was not required because stations with the most to gain by broadcasting on a particular frequency would have an incentive to pay other broadcasters not to interfere.

The Coase Theorem: Controlling Externalities through assigning property rights

  If transactions costs don't overwhelm gains, saleable property rights will bring social resources to their socially efficient uses, even when there are externalities. Social welfare will be maximized. This is a simple variant on the pollution permit auction.

            Ronald Coase is an economist but he is currently on the faculty of the University of Chicago Law School. He won the Nobel Prize in Economics in 1991 for his work, which included what is known as the Coase Theorem. It is quite shocking in that is suggests that under certain conditions, externalities don't cause any inefficiency or DWL at all. So no government action is needed. Furthermore, the legal assignment of property rights will have nothing to do with how economic production is ordered. Legal rights will only determine who receives what economic rents.

            A famous Coase example is the following. Consider a railroad that passes through wheat fields. The passing trains let off sparks which can burn the wheat. If the legal rights are on the side of the farmers, then they could require the trains to buy and install spark catchers to eliminate these fires. However, if that is expensive (i.e. more than the value of the burned wheat), the train owners may just pay the farmers for the damage done to the crops. If the legal rights are with the trains, the farmers may just put up with burned crops or (if that is expensive) they could pay the trains to put on spark catchers. Either way, the socially efficient outcome (install spark catchers or burn crops) is what happens and the legal rights just determine who has to pay.

            Consider the Dow Chemical (and Ben & Jerry's) example. If the initial legal framework gives the right to clean air to people, they could make Dow produce less or nothing at all. However, Dow is willing to pay up to $5 per unit for the right to pollute enough to produce its output. If that is more than people value clean air (and the graph suggests that it is), then people will take the money and put up with (the economically optimal level of) pollution. On the other hand, if the right to pollute lies with the firms, people could pay firms to pollute less. With pollution, the assignment of vendible property rights is much more difficult. For a simpler case, consider the following example.

            Another way of thinking about this is from the standpoint of "internalization." With the Pigouvian solution to externalities, firms are forced to internalize the externality though the tax (or subsidy) they face. With the Coase solution (and sufficiently low transactions costs), the parties behave as though they are run by a single agent. That is, they maximize their joint welfare or profits because that maximized the size of the possible transfer and individual payments.

            Concert tickets and NU dorm rooms are often assigned by other than market means. However, it is often the case that people who value the good more than its (scalper) price get the good and those who have the initial property right but don't value the good as much as the price it commands, get the money.

Simple Coase Example

            I dug out my treasured copy of "The Problem of Social Cost" from The Journal of Law and Economics (October, 1960), which contains the following example to which I have added numbers.

            Consider two business that are next door to one another. One is a doctor's office, the other a candy maker. The candy maker uses machinery which grind up sugar and other ingredients and which produce a low rumbling noise. The doctor needs to be able to hear quiet sounds like heartbeats and joint movements. For years these two got along fine until one day one of two things happened (it doesn't matter which). Either the doctor desired to start treating patients in the room right next to the wall between her office and the candy maker or the candy maker started running a grinder right next to a wall adjoining one of the doctor's treatment rooms. Either way, the grinding noise made it difficult for the doctor to carry on her business in that one room.

            Whichever one of the two parties who felt aggravated could take this matter to court and see how the law would be applied. The law might state that it is impermissible for noises to pass from one establishment to another and so tell the candy maker to shut down that grinder. On the other hand, the law might say that the candy maker is allowed to do anything he wants on his own property as long as it doesn't endanger the health of anyone else. In this case, the doctor would be told to do without that treatment room.

            Coase points out that whichever way the decision goes, it serves a rather arbitrary notion of fairness and fails to serve the perhaps more important goal of serving the larger social welfare. What would be better for society? It would be optimal if the scarce resource (in this case a location where sound is important) went to producing the more valuable (socially desired) output. Rather than forcing one or the other to give up trying to produce in a given location, they should be allowed and encourage to work out some mutually advantageous agreement.

            Suppose that value of output produced by the candy maker in the disputed location is $20,000 per year and that the doctor would produce value of $15,000. Here a judicial decision that would force the candy maker to shut down would clearly create an inefficient allocation of resources. However, the cost to society of lost output is bourn by the doctor in the form of the opportunity cost she faces by using that room. She might realize that it is worth any amount up to $20,000 to the candy maker for the right to run a grinding machine near that area. Thus her using that room to treat patients costs her and society $5,000.

            Suppose still that the candy maker would make more profitable use of the scarce resource and that the doctor and the candy maker can bargain with each other. From a social standpoint, it does not matter with whom the law sides. Either way the scare resource should go to the candy maker. The only difference the decision of the law makes is which of the two, the doctor or the candy maker, is relatively advantaged. If the law supports the candy maker, the doctor is annoyed and the candy maker is delighted and much candy is made. If the law supports the doctor, the doctor is delighted and the candy maker is annoyed. However, the candy maker buys the right from the doctor and again, much candy is made.

            This can be broken down even further.  Suppose that it would cost the candy maker $20,000 to shut down or move to where noise wouldn’t be a problem, it would cost $12,000 to improve the candy maker’s machine to be very quiet, it would cost $10,000 to buy the physician high-powered instruments that can overcome the noise, and it would cost $15,000 to the physician to shut down or move to a quieter location.  Socially, the best outcome is to get the physician new instruments.  Who should pay for it?  Socially, that’s just a matter of a transfer.  As long as transactions costs are low enough, the socially optimal outcome will prevail regardless of how the law stands, the only question that law bears on here is which party has to pay off the other. 

            But what about the question of transactions costs?  If the cost of working out a deal where something low like $100, and the law favored the candy maker, the physician would buy new instruments.  If the law favored the physician, then the candy maker would pay for the instruments.  Either way, we get to the social optimum.  On the other hand, if we lived in a world where it cost $25,000 for the parties to negotiate, then we might not reach the socially optimal outcome.  If the law favors the candy maker, the physician will buy the better instruments for $10,000.  On the other hand, if the transactions costs are that high and the law favors the physician, the candy maker will end up paying $12,000 to buy a quieter candy machine, resulting in a social dead weight loss of $2,000.

            Coase makes the point that which ever way the law interprets the property rights, as long as these rights are well defined and the transactions costs of enforcing and transferring them are not too great, society's resources will be used most efficiently by just letting private agents work out these problems to their own mutual benefit.

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Budget 2012-13

Budget 2012-13 by Dr Ashfaque H Khan The present government will be presenting its fifth and the last budget on June 1, 2012. Given the persistence of political tension throughout the tenure, deterioration of security environment, unfolding of multiple epoch making events and intensification of the war on terror, presenting the fifth budget is in itself nothing short of a big achievement for the government. Budget 2012-13 is being prepared in an inhospitable economic environment, both domestically and externally. The domestic economic environment is largely a creation of the government itself. In fact, there is general consensus within and outside the country that the economy of Pakistan has never been in a state such as this until now. Pakistan has faced serious economic difficulties in the past, but has managed to sail through because of a strong and committed leadership and competent economic team. There is widespread scepticism as to the strength and effectiveness of both the leadership and the economic team which has rendered the people of Pakistan nervous about their own futures. It is well known that the budget is not only an account of resources and expenditure of the government but that it also reflects the policy of the government to address the challenges facing the economy. Declining investment and slowing economic growth, shrinking capacity of the economy to create jobs, rising poverty, persisting double digit inflation, mounting debt burden, depreciating exchange rate, emerging debt payment crisis, higher budget deficit, crippling effects of power sector mismanagement, and waning confidence of the private sector on the country’s economic management are some of the critical challenges currently confronting Pakistan. Budget 2012-13 must address these challenges. Expecting a serious, meaningful and reform-oriented budget in the tail end of the government’s tenure is too much. Fiscal indiscipline continues to this day, and as such the country has paid and is still paying a heavy price. Investment rate (investment-to-GDP ratio) has declined to 12.5 percent in 2011-12, which is the lowest in sixty years as against 22.5 percent in 2006-07. A 10 percentage point reduction in investment in such a short period has caused irreparable damage to the economy. Foreign private investment on the other hand has simply collapsed from as high as $8.4 billion in 2006-07 to $ 0.5 billion in the current fiscal year. More worrisome is the fact that domestic saving has declined to 5.8 percent of the GDP in 2011-12, which is perhaps the lowest in the country’s history (15.6 percent in 2006-07). Can a developing country like Pakistan achieve a higher economic growth with such dismally low saving and investment rates? It is not unsurprising to see Pakistan’s economic growth slowing to an average of three percent per annum over the last five years. All major components of economic growth have also exhibited a dismal performance. For example, despite criminal increase in support prices of various agricultural commodities, agriculture growth averaged 2.2 percent per annum, almost equal to the country’s population growth. Large scale manufacturing grew by 0.7 percent, on average, and services sector registered a growth of 3.8 percent per annum during the same period. Such low economic growth is bound to create less jobs thereby increasing unemployment and poverty. Persistence of large fiscal deficit is one of the principal reasons for the above mentioned ailments. Fiscal deficit has thus far averaged 6.5 percent of the GDP. However, the current fiscal year may see budget deficit touching 8 percent of the GDP (including the so-called one-off elements of 1.9 percent of the GDP). Such a development on the fiscal front has damaged monetary policy credibility and as such has emerged as one of the principal reasons for the persistence of double digit inflation. Large budget deficit will also add to public debt, which may reach Rs13 trillion in June 2012. It may be noted that the total stock of public debt stood at Rs6.0 trillion in June 2008, which has, since then, more than doubled in just five years. Higher public debt is bound to increase interest payment, which is likely to cross Rs1.0 trillion, thereby leaving little resources to be spent on education, health and physical infrastructure. Pakistan is sure to face serious payment difficulties on its external debt obligation in the next two years. Unless we receive huge capital inflows during this period, Pakistan will not be able to service its external debt payment. Making a budget for the next year under such financial constraints will be a gigantic task for the government. The crippling effects of power sector mismanagement and the waning confidence of the private sector on the country’s economic management have contributed immensely to declining investment and growth. Can budget 2012-13 address such issues? Budget 2012-13 will be a non-serious and politically motivated budget, directed only at ‘winning’ the election. None of the issues discussed above will be addressed in this budget. Had the government been serious in improving the health of the economy, it could have taken difficult decisions in the past four budgets. At the moment, I am more worried about the fallout of such a non-serious budget. If things go as indicated by the stance of the government, I am certain that the budget 2012-13 will not touch upon agricultural income coming under the direct tax net, implementing of the RGST, reform in petroleum sector taxation, provincial governments improving their fiscal efforts, resolution of rotten PSEs and circular debt and strengthening of tax administration. It is safe to predict that in sidestepping these thorny issues, the forthcoming budget is likely to be as out of tune with economic realities as earlier budgets. The cost as always will be borne by those not at the helm of the country but by the already economically crippled common man whose hopes for a better future lie all but shattered.

Liquidity trap

A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

In its original conception, a liquidity trap refers to the phenomenon when increased money supply fails to lower interest rates. Usually central banks try to lower interest rates by buying bonds with newly created cash. In a liquidity trap, bonds pay little to no interest, which makes them nearly equivalent to cash. Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy affects the economy only through its effect on interest rates. Thus, if an economy enters a liquidity trap, further increases in the money stock will fail to further lower interest rates and, therefore, fail to stimulate. In the wake of the Keynesian revolution in the 1930s and 1940s, various neoclassical economists sought to minimize the concept of a liquidity trap by specifying conditions in which expansive monetary policy would affect the economy even if interest rates failed to decline.

Don Patinkin and Lloyd Metzler specified the existence of a "Pigou effect," named after English economist Arthur Cecil Pigou, in which the stock of real money balances is an element of the aggregate demand function for goods, so that the money stock would directly affect the "investment saving" curve in an IS/LM analysis, and monetary policy would thus be able to stimulate the economy even during the existence of a liquidity trap. While many economists had serious doubts about the existence or significance of this Pigou Effect, by the 1960s academic economists gave little credence to the concept of a liquidity trap. The neoclassical economists asserted that, even in a liquidity trap, expansive monetary policy could still stimulate the economy via the direct effects of increased money stocks on aggregate demand. This was essentially the hope of the Bank of Japan in the 1990s, when it embarked upon quantitative easing. Similarly it was the hope of the central banks of the United States and Europe in 2008–2009, with their foray into quantitative easing. These policy initiatives tried to stimulate the economy through methods other than the reduction of short-term interest rates. When the Japanese economy fell into a period of prolonged stagnation despite near-zero interest rates, the concept of a liquidity trap returned to prominence.[1] However, while Keynes's formulation of a liquidity trap refers to the existence of a horizontal demand curve for money at some positive level of interest rates, the liquidity trap invoked in the 1990s referred merely to the presence of zero interest rates (ZIRP), the assertion being that since interest rates could not fall below zero, monetary policy would prove impotent in those conditions, just as it was asserted to be in a proper exposition of a liquidity trap. While this later conception differed from that asserted by Keynes, both views have in common first the assertion that monetary policy affects the economy only via interest rates, and second the conclusion that monetary policy cannot stimulate an economy in a liquidity trap.

Declines in monetary velocity offset injections of short term liquidity. Much the same furor has emerged in the United States and Europe in 2008–2010, as short-term policy rates for the various central banks have moved close to zero. Paul Krugman argued repeatedly in 2008-11 that much of the developed world, including the United States, Europe, and Japan, was in a liquidity trap.[2] He noted that tripling of the U.S. monetary base between 2008 and 2011 failed to produce any significant effect on U.S. domestic price indices or dollar-denominated commodity prices.[3][4] Criticisms Austrian School economists generally argue that a lack of investment during periods of low interest rates are the result of malinvestment and time preference instead of liquidity preference.[5][6] Most Austrian economists have rejected Keynes' theory of liquidity preference altogether. In his book America's Great Depression, Murray Rothbard argued that interest rates are determined by time preference. Says Rothbard, "Increased hoarding can either come from funds formerly consumed, from funds formerly invested, or from a mixture of both that leaves the old consumption-investment proportion unchanged. Unless time preferences change, the last alternative will be the one adopted. Thus, the rate of interest depends solely on time preference, and not at all on "liquidity preference." In fact, if the increased hoards come mainly out of consumption, an increased demand for money will cause interest rates to fall—because time preferences have fallen."[7]

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Aggregate Demand and Aggregate Supply

ISLM aggregates the economy into a market for money balances, a market for goods and services, and a residual market that it ignores by invoking Walras' Law. Since part of the residual market is the labor market, and because adjustment in this market is slow, ISLM would be a better model if it could capture what is happening in the resource markets. Aggregate supply-aggregate demand analysis makes this incorporation. The aggregate demand curve is derived from the ISLM model. In the illustration below, equilibrium income is Y1 when the price level is P1. Let the price level rise to a higher level, from P1 to P2. At the higher level, with a constant amount of money, purchasing power is cut. The fixed number of dollars no longer buys as much. The effects on the LM curve are identical to what happens when prices remain fixed and the amount of money falls. The LM curve, in either case, shifts left, interest rates rise, and income falls. The output levels at both P1 and P2 are shown in the bottom part of the illustration. The aggregate demand curve connects them with points that other price levels generate.

The aggregate supply curve comes from the resource market. Though these markets may adjust slowly, when they finally do fully adjust, price level should have little or no effect on the amount of resources supplied. If a doubling of all prices and wages results in more or less output, someone is suffering from money illusion. The person believes either that he is better off at a higher nominal (but same real) wage, or that he is worse off with higher prices that have been fully compensated with higher wages. If people realize that money is merely an intermediary, and ultimately goods trade for goods, price level should not matter. The point of the last paragraph is important enough to explain in a more concrete manner. Suppose Edward has a paper route and at the end of each week his income is $25.00. He spends his entire income on 15 hamburgers that cost $1.00 each and 20 soft drinks that cost $.50 each. One day Edward wakes up and finds that his weekly income has doubled to $50, but all prices have also doubled. Is he any better or worse off? Clearly he is not. A week of delivering newspapers still trades for 15 hamburgers and 20 soft drinks. He has no reason to work either more or less. If behavior does not change when price level does, output will not depend on price level. The result will be the perfectly vertical aggregate supply curve shown in the illustration above. In the long run, when prices and wages fully adjust to any change in total spending, resources and output determine output. In the short-run, however, an adjustment process that is not instantaneous seems more appropriate. Prices can be sticky, especially in resource markets. Expected rates of inflation can affect the way prices are set. Once we allow these possibilities, we have a system in which it may take years to reach long-run equilibrium. It is even possible that the system will never reach equilibrium, but, as the business-cycle writers thought, will fluctuate forever in the adjustment process. Once we add stickiness to prices and give a role to expected inflation, a change in spending will not simply move the economy up or down a vertical aggregate-supply curve. The upward-sloping curve below shows what is likely in the short run. A change in spending will move the aggregate-demand curve. If the short-run aggregate-supply curve is fairly flat, there will be a large change in output and a small change in price level.

Aggregate supply and aggregate demand is an attractive framework because it is simple, with the same structure as supply and demand. However, the assumptions behind aggregate supply and aggregate demand are totally different from those behind supply and demand, that is, aggregate supply and aggregate demand curves are not obtained by adding up all the supply and demand curves in an economy. If they were, one would expect that the long-run aggregate-supply curve would be flatter than the short-run aggregate-supply curve, as is the case with a normal supply curve. But the aggregate supply curve grows steeper the longer the time for adjustment. Aggregate supply and aggregate demand is more general than ISLM, and overcomes some of the limitations of ISLM. It includes price level as a variable, and it shows that resource markets matter. It also lets one consider cases in which disturbances originate in a resource market, such as a disruption of oil supplies, which ISLM cannot handle. Aggregate supply and aggregate demand gives insight into the adjustment process. Observation of the real world tells us that when spending suddenly changes, output changes initially more than prices, and only after considerable delay do prices change more than output. Aggregate supply and aggregate demand yields this pattern. Aggregate demand and aggregate supply show an adjustment process. It does this with a series of short-run equilibria. Alfred Marshall originated this technique with regular supply and demand. He had three periods: the market period or the very short run, in which output was fixed; the short run, in which capital was fixed but utilization of capital was not; and the long run, in which nothing was fixed. So far the expositions of aggregate supply and aggregate demand have been fuzzy about what is fixed in the short run that is not fixed in the long run. This fuzziness remains as a problem of aggregate demand and aggregate supply.