Good policy making – in the development field or in any field for that matter – involves three steps. First, a problem must be identified or a goal needs to be set. Second, policy measures that can take us to the stated goal need to be identified. The third step is to find the “least costly” policy measure, or what is called the “first-best” policy for achieving the goal.
This last step is usually the hardest one and often neglected in policy debates. For example, a recent study by Aghion et al. (2009) shows that a low level of trust in society promotes uncivic behavior by entrepreneurs and therefore greater demand by the public for regulation of businesses. Interestingly, the study also notes that parental education to children is a strong predictor of civic behavior and trust. Nevertheless, a comparison of the costs and benefits of regulation vs. a civic-education subsidy is missing.
In the true general equilibrium spirit, any given variable of interest (say, corruption) is typically connected to a large number of other variables (court efficiency, income levels, education, etc). So, in principle, a policy response could involve changing either one (or a combination) of the latter. This gives us a myriad of policy choices. However, not all these policy choices are the same – they impose different costs and therefore lead to different levels of national welfare. The trick is to find the policy tool that is sharp enough to achieve the objective but does not affect economic behavior in the rest of economy; otherwise, it will introduce unnecessary distortions in economic activity.
A classic example of what I’m suggesting is the infant industry argument. The objective here is to increase the production level in a domestic industry. This requires more favorable prices for the domestic producers. One way of achieving such favorable prices is a tariff on imports of the good. Another way is a subsidy to the producers.
Both these policy measures achieve the same goal – a given level of production by domestic firms. However, they have different welfare implications. A tariff is a blunt tool in that apart from giving more favorable prices to domestic producers, it creates a wedge between the price of the good faced by consumers in the domestic market and the true opportunity cost of consumption to the country (the world price of the good). This wedge distorts consumption choices and reduces national welfare – a “consumption distortion”. In contrast, the production subsidy does not create any such wedge and is therefore superior to the tariff.
Identifying the first best policy tool for any given objective is not easy and often requires detailed research – what are the sorts of distortions that different policy tools entail and which of these is least harmful for national welfare? Notwithstanding the complexity of the task, the search must go on.
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