Expectations and Policy Outcomes: Model

Expectations and Policy Outcomes Model

The following model shows that the benefits from government policy can be affected by differences between entrepreneurs' expectations for government policy and the actual policy enacted. This model is not meant to represent a real economy in all its complexity; rather, it illustrates an idea using a few simple, standard tools of economic analysis.

Suppose that entrepreneurs in an economy can invest in either capital for producing consumer goods or capital for producing machinery. Since resources are limited, the economy faces a tradeoff between the production of consumer goods and the production of machinery. This tradeoff is captured in a production possibility frontier. In the graph above, the production possibility frontier (PPF) is the curved boundary of the green region.

Suppose that entrepreneurs' investments in production must be made before government policy is actually enacted, and these investments, once made, cannot be changed. To determine whether to invest in producing machinery or consumer goods, entrepreneurs need to make a judgement about the future price of machinery relative to consumers goods. Given his or her expectation for this price and his or her particular skills, each entrepreneur will decide what kind of investment to make. Thus entrepreneurs' expectations about policy will determine investments.

Consumption choices also depend on the price of machinery relative to consumer goods. Assuming that consumer goods and machinery can be freely traded, the consumption point will be the utility-maximizing point on a budget line passing through the production point and having slope equal to the world price (net of any tariffs or duties) of machinery relative to consumer goods. The ability to consume at points on this line that are beyond the production possibility frontier indicates the potential benefits of trade opportunities.

A policy initiative to liberalize tariffs on consumer goods represents a shift in the price of consumer goods relative to machinery. If the government fails to communicate to entrepreneurs what the new policy will be, or if entrepreneurs do not believe the government's policy pronouncement (perhaps because they have been deceived in the past), the policy initiative will not deliver the full benefits that it might have. In particular a reduction in the price of consumer goods relative to machinery means that the slope of the budget line in the diagram above will increase. Utility will increase if the production of machinery increases. But the production of machinery may not increase to the optimal extent if entrepreneurs had not expected the government to pursue the policy that it actually did.

An Algebraic Example

Suppose the PPF for machinery (M) and consumer goods (C) is
(1) C=a-b*M*M
where a and b are constants.
Suppose that a representative consumer's utility function (the social welfare function) is
(2) U=M*C
Let p be the price of machinery relative to consumer goods. Then the production point is given by maximizing the value of production subject to the PPF (1):
(3) Max over {M,C} p*M+C subject to C=a-b*M*M
Let y=p*M'+C', where M' and C' are the solutions to (3) above. Then the consumption point is given by maximizing utility (2) constrained by the budget line:
(4) Max over {M,C} M*C subject to y=p*M+C

Numeric Solution to the Expectations and Policy Outcomes Model

The policy scenario is based on the model above. For the numerical values, the algebraic example of the model is solved for p varying from 2 to 3, and a=100 and b=0.03.

Policy Credibility Learning Module