Appunti del corso di Economic Assessment of Urban Transformation (Prof. Caragliu)

Economic assessment of urban transformation (Caragliu)

Lesson: 10/3 - Slide 1 “Intro and introductory public economics”.

Many methodologies for the economic appraisal of urban transformations, both from the planner’s perspective as well as the private investor’s.

Reading list

• Campbell, H., and Brown, R. (2007). “Benefit cost analysis”, Cambridge (UK): Cambridge University Press.
• Rosen S. H., Gayer T., “Public Finance”, McGraw-Hill, ISBN: 0073511358.
• Capello, R. (2015). “Regional economics”, London (UK): Routledge.

Esercitazione

Scientific paper, drafting short essay (3-4 pages, summarising the context of a scientific paper).

May the 5th.

Select a case study, find the date, applied the method chosen.

Methods is chosen linked to the case.

Why some methods are better than other?

Summary

• The course offers a wide perspective on many methodologies for the economic appraisal of urban transformations, both from the planner’s perspective (collective benefits of large urban transformation projects) as well as from the private investor’s (financial return from large real estate projects).
• The first part of the course will deal with the Economics principles needed for a sound framing of appraisal techniques. This first part will summarise the main theories explaining urban land rent formation and the main principles in public economics, with particular attention being paid to the two welfare theorems and the notion of externality.
• The second part will instead introduce the main methods for evaluating urban transformations, i.e. cost-benefit analysis, multi-criteria analysis, the hedonic price method, contingent evaluation, and Territorial Impact Assessment.
• Lastly, in the third part of the course applied case studies will be presented, with an active role played by students carrying out empirical take-homes aiming at getting oneself familiar with the methodologies seen in class.
• The final goal of the course is to expose students to the various approaches to the evaluation of urban transformations, applied to different case studies.
• Given the advanced nature of the course, the course is oriented towards methodological applications, without however overlooking the economic theory needed in order to understand analytical techniques.

Fundamental points

1. Fundamental theorems of Welfare Economics.
2. Assumptions of the perfect competition model:
   • Excludability.
   • Price system as a vehicle of market signals.
   • Price-taking behaviour.
   • Perfect information.

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Welfare economics

Welfare: Quality of life.

Why economic welfare increase in a given country?

Try to provide policy makers.

The object of welfare economics is the analysis of the main determinants of economic welfare in a given Country.

Researchers in this field try and provide policy advice (consulenza politica) for Country and local authorities with the final goal to maximise economic welfare (Pigou, 1920).

“The economics of welfare” - Pigou (guidance book).

Three principles of utilitarism theory

1. Evaluating alternative circumstances/conditions: the only criterion for a correct evaluation is the welfare or satisfaction derived from people doing what they prefer - Welfarism. So, we evaluate alternative options on the basis of individual welfare level change. (Valutare le opzioni alternative sulla base del cambiamento del livello di benessere individuale).
2. Reason for the choice of actions: (Ragione/Motivazione per la scelta delle azioni) Actions must be compared only in terms of the consequences they engender. Consequentialism. It suggest that actions must be decided related to consequences that they (the actions) create.
3. Sum-ranking: Aggregation criterion must be the sum of individual welfare levels.

Policy option.

A fundamental criterion underlying the Utilitarism Theory is the principle of Pareto-efficiency.

(Efficienza Paretiana: Nella ri-allocazione delle risorse => tutti guadagnano o rimangono uguali, ma nessuno perde).

Efficienza paretiana (o Pareto-efficienza).

Allocation of resources

• It is Pareto-efficient a resource allocation that cannot be modified, such that the welfare level of everyone is improved. (even though someone is damaged by that resource allocation).
• In other words, a welfare state is Pareto-optimal if and only if there is no alternative state of the world in which an individual is better off and no one is worse off.
• Pareto efficiency: an allocation is efficient if there is no alternative allocation such that an individual is better off and no one is worse off.

Un’allocazione è efficiente se non esiste un'allocazione alternativa tale che un individuo stia meglio e nessuno stia peggio.

Una situazione S Pareto-efficiente (o efficiente in senso paretiano) se non possibile accrescere il benessere di alcuno dei soggetti coinvolti, se non riducendo il benessere di qualcun altro di loro.

Una situazione S′ un miglioramento paretiano rispetto alla situazione S, se possibile trasformare S in S′, dove il benessere di almeno uno dei soggetti coinvolti maggiore in S′ che in S e nessuno ha minor benessere in S′ piuttosto che in S.

Un miglioramento paretiano debole se nella nuova situazione il benessere, qualcuno dei soggetti coinvolti lo stesso di prima (ma non escluso che, invece, tutti godano di un miglioramento).

È invece forte se c’è un incremento di benessere per tutti i soggetti coinvolti.

Possiamo, pertanto, riformulare la definizione precedente come segue:

Una situazione S Pareto-efficiente se non esistono miglioramenti paretiani deboli rispetto ad essa.

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Fundamental theorems of welfare economics

• The First Fundamental Theorem of Welfare Economics states/says that a competitive equilibrium is Pareto-efficient (remember the definition of Pareto efficiency: an allocation (una quota) is efficient if there is no alternative allocation such that an individual is better off and no one is worse off).
• The Second Fundamental Theorem of Welfare Economics states/says that a Pareto Efficient allocation can be obtained through a competitive equilibrium, with the intervention of the actor called Social Planner (Local planner, Government, Policies, etc) and the actions of this person goes thru the market.

Social Planner, act toward re-instating the equilibrium if some of the theorems was violating.

(It complements the first theorem).

• Taken together, these two theorems have important policy implications and provide the rationale for the free market and competition among economic actors.

Questi 2 teoremi presi insieme hanno importanti implicazioni politiche e forniscono la logica per il libero mercato e la concorrenza fra attori economici.

Then why do we have the public sector?

The main arguments justifying public intervention in the economy are twofold (duplici):

1. Efficiency: is related to the aggregate level (livello complessivo) of economic activity.
2. Equity: is related to the distribution of the benefits stemming from economic activity.

Efficiency

Can an economy without public sector be efficient?

An economy could not work without:

1. Property rights: (diritti di proprietà) Rules defining legitimate possession. (Hobbes: government as a form of social contract allowing men to avoid the anarchic state of nature).
2. Contract regulation: (regolamentazione contrattuale) The set of rules governing trade (commercio). (Fostering exchange eliminating uncertainties typically associated to economic transactions). (Agreement so that people commit to perform an act that aims an economic transaction).

Accordi che vedono le persone impegnate a compiere un atto che miri a una transazione economica.

Imperfect competition: is a contract violation!

Equity

Many of the policy option we select, we have redistributive effects —> Opportunity cost.

• A further reason for motivating public intervention in the economy is related to income, opportunities, or wealth inequality (just think of why public schools or social welfare programs exist).
• Therefore, whenever a government decides which policy must be undertaken, it faces two conflicting goals:
  1. Make the best use of available economic resources;
  2. Pay attention to the distribution of these resources and to the effects of the policies.

No one is wanted to be left behind!

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Efficiency and equity

Q: What relation exists between efficiency and equity? The two are linked by a trade-off mechanism.

Problem: is there trade-off between these two objectives (efficiency and equity)?

Esiste un compromesso tra questi due obbiettivi?

Are there other circumstances in which public intervention is justified?

• Public intervention as a reaction to market failures (MF* exists whenever we have any assumption of the competition model is fully or partially violating) is justified on the basis of the principle of efficiency.
• A market failure exists whenever any of the assumptions underlying the perfect competition model is violated, and, as a consequence, the economy does not reach an efficient allocation.
• Before delving into the possible cases of market failure, we can get back to the question above. In the figure we have seen that European public expenditure over the last 20 years has constantly increased in terms of ratio to GDP. How can that be?

Q: What are the two fundamental reasons for the government to step in in the economy? Explain how the two concepts differ.

R. The main arguments justifying public intervention in the economy are twofold: Efficiency and Equity.

Efficiency is related to the aggregate level of economic activity.

Equity is related to the distribution of the benefits stemming from economic activity.

So Public Intervention is justified in case we have a Market Failure (whenever any assumption of the competition model is violated) and, as a consequence, the economy does not reach an efficient allocation.

Wagner law

Bear in mind that a similar process affects most advanced economies, both European and non-European.

Wagner’s law tries to explain the increase in public expenditure on the basis of 3 mechanisms:

1. Economic growth create an increase in the system’s complexity. (= when Economic or GDP grow it means that this increase the complexity of the system). Societies have a growing need for laws and more complex regulations);
2. The urbanisation process causes new costs (infrastructure, pollution); (cities are hot spots! There are more complex objects to handle!)
3. Economic growth produces and increase in demand for specific goods that are typically produced and distributed by the public sector (education, healthcare).

How to imply the money we earn/own?

Strong evidence: this type of decision (or portfolio of choices) change as the level of income also change.

Assumption of perfect competition model

1. Excludability: Goods cannot be consumed by more than an individual simultaneously (if Adam eats an apple, the same apple can no longer be eaten by Eve).
2. Price system as a vehicle of market signals: The actions of an individual (or firm) have no direct effect on other individuals, other than through the price system; (quantity availability and demanded).
3. Price-taking behaviour: Consumers and firms act as price-takers (Individual consumer are price taker). Crucial assumption both firms and individual cannot influenced the price.
4. Perfect information: Consumers and firms have full information about the quality and availability of goods on the market, as well as about relative prices.

When I do have a violation (fully or partially) of one or more of the 4 assumption for perfect completion model I would have a Market Failure.*

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Competition model

Market failures: assumption 1 (public goods)

1. Excludability: Goods cannot be consumed by more than an individual simultaneously (if Adam eats an apple, the same apple can no longer be eaten by Eve);

Public goods are those goods that allow simultaneous consumption by more consumer.

Defence: all citizens of a given Country are simultaneously protected.

Radio waves: simultaneously received by anyone located within signal reach.

These are two examples of public goods: whenever more than one consumer benefits from the consumption of a unit of the same good, welfare theorems are violated.

Q:Which fundamental conditions characterise a public good? As a consequence, which characteristics does a private good display?

Perfect public goods

Perfect public goods satisfies 2 conditions:

1. Non excludable (or Non excludability). If a public good is produced, no individual can be prevented from its consumption.
2. Non rivalry: the consumption of a public good from an individual does not exclude others from consuming the same good.

When are rival good? Scarcity for example. (ex. water, beaches) —> As a consequence a private good is both rival and excludable in consumption.

Types of goods: they can be characterised by a different combination of rivalry and excludability in consumption:

Technically I cannot exclude anyone, but if too many people simultaneously consume the good, the quality of consumption decrease.

In the case of a pure public good, the marginal cost (MC), i.e. the cost to provide it to an additional person, is equal to zero and it is not possible to exclude any individual from its consumption.

NB: several goods provided by the public sector are actually impure public goods!

Example. The cost for an additional traveller on an empty road is very low, but it is not exactly equal to zero.

Besides, whenever the road is jammed, the marginal cost of an additional traveller increases dramatically.

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Why can the private sector not sell public goods?

Example:

We have a large ship-maker (A) and several smaller ship owners (from 1 to n; e.g., fishermen), using the same harbour.

Everyone would need a lighthouse. A evaluates her costs and benefits before deciding whether or not to build the lighthouse. Let’s assume that CA > BA. Consequently, A will decide not to build the lighthouse.

However, this investment would be profitable if we took all benefits into account:

CA < BA + B1 + B2 + ... + Bn.

Therefore, a single individual is not willing to pay for the public good, but what would happen if all ship-makers/users would form a union and would jointly build the lighthouse sharing the bill?

SO:

Free riding problem: some ship-owners will refuse to pay (example: contribution campaign).

Free ride: you get the benefits without paying the costs for this good.

ex White house: public good. Why no private sector? No individual will pay this public good by itself.

In general, we can conclude that:

Even if there could be some form of supply of public goods even in the absence of the public sector, in general we need public intervention in order to supply public goods, because the government can force taxpayers to contribute for them.

Example: Major Public Good: Health.

Common resources

Common resources (Rival in consumption – Non-Excludable):

• They encompass those goods that cannot be privately consumed and that, once consumed, are no longer available.
• While it is in the interest of everyone that these resources are not spoiled, everyone faces an incentive to over-exploit them. Ex.: pastures, office copying machines.

Club goods

Club goods (non rival in consumption - excludable).

A club good is non-rival in consumption, or only partially rival, but the supplier can exclude someone from its consumption. The excludability issue can also be interpreted literally (ex. request of a membership card).

Ex.: pay-TV, gyms.

Local public goods

Local public goods: (Local: geographical bounded) (no-rival and no excludable).

Only residents of a particular area can benefit from a local public good. This good can be non-rival or partially rival within that specific geographical context. You can think of a local community much like a club.

Ex.: access to limited traffic areas within a city.

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Competition model

Market failures: assumption 2 (externalities)

2. Price system as a vehicle of market signals: The actions of an individual (or firm) have no direct effect on other individuals, if not through the price system.

Q: Define the concept of externality. On which elements do externalities exert their effect?

An externality of the price system is an interaction between economic agents (*) taking place outside the market economy. There is an externality any time the utility or profit (welfare) of some economic agents are directly influenced by the way other agents (consumers or producers) behave in the economy.

Externalities not influence price but rather the quantities.

Externalities = External to the price system!

(Economic Agents* una persona, azienda o organizzazione che ha un'influenza sull'economia producendo, acquistando o vendendo: il corretto funzionamento dell'economia di mercato è influenzato principalmente dall'interazione dello stato con l'agente economico).

With “directly” we exclude any effect that is mediated by the price system.

The test of the efficiency

The test of the efficiency of the market is based on two assumptions:

1. The welfare of each consumer depends only on her consumption level (Adam is not interested in what Eve is doing). Externality: I’m eating a sandwich while my neighbour is smoking;
2. The production of each firm depends only on its on decisions about production factors (inputs) to be used and the quantity (output) to produce. Externality: production of fishermen on a lake is influenced by how much pollution the refinery located upstream generates.

Ex. 1 - Traffic jams

Train: how much time to commute (fare il pendolare) by train? Whatever traffic exists, trains are better, and travel time remains the same.

Car: Positive incentive, more people you have traveling the more traffic you have, the more time you get to travel.

Individual consumers travel by car if beyond level of e.

e: equilibrium: is reached in e; however, o is more efficient than e.

• Time travel by car increases with the number of cars travelling on the highway.
• Equilibrium is reached in ‘e’; however, ‘o’ is more efficient than ‘e’.

He