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Economic policy analysts typically specify a model that describes an optimal outcome-for example, an efficient allocation of resources, an optimal distribution of income, an optimal growth path, or an optimal macroeconomic outcome of stability with full employment and low inflation. Because economic models can become complex when they account for many things, all models employ simplifying assumptions to focus on one particular issue. Models that analyze policies to promote economic growth, for example, differ from models that describe the optimal distribution of income or the optimal policy for internalizing an externality (see Holcombe 1989). Nevertheless, the methodology is the same: develop a model that incorporates the particular issue, then show in the model the optimal result and identify what keeps the economy from producing the optimum. The recommended policy is one that should move the economy from a nonoptimal position to thc optimal one by removing impediments to the attainment of an optimal outcome, by changing the incentive structure so that market participants trade to a Pareto optimum, or, where markets pose more difficult problems, by imposing regulations, government mandates, or government production to allocate resources optimally.
When the invisible hand of the market fails, economic policy recommendations typically do not go beyond advising that the visible hand of government move the economy to the optimal outcome, without any detailed discussion of whether government action can achieve this outcome or whether public-sector actors have an incentive to implement the optimal outcome. Government is modeled as if it is an omniscient benevolent dictator. To make economics policy relevant, however, this omniscient benevolent dictator must be deposed. Government in contemporary Western countries is neither omniscient nor benevolent nor dictatorial.
The Planner's Problem
The omniscient benevolent dictator is often represented in economic analysis as the planner's problem. The analyst derives the conditions required for an optimal allocation of resources, and the planner's problem is to create those conditions. The policy problem is couched entirely in comparative-static terms, identifying the optimal outcome and the status quo, with policy recommendations intended to change the situation from the latter to the former. The comparative-statics methodology for evaluating economic policy measures goes back at least to A. C. Pigou (1920, chap. 1), who lays out a methodology for evaluating policy measures by...