Chapter 2
Efficiency, Markets and
Government
1
Positive and Normative Economics
Positive Economics explains “what is,”
without making judgments about the
appropriateness of “what is.”
Normative Economics: designed to
formulate recommendations about
what “should be.”
2
Normative Evaluation of Resource Use:
The Efficiency Criterion/Criterion of Pareto
Optimality
Criterion of Pareto Optimality/ efficiency criterion
The efficiency criterion is satisfied when resources
are used over any given period of time in such a
way as to make it impossible to increase any one
person’s well-being without reducing any other
person’s well-being.
Efficiency
means producing a desired result with a
minimum of effort or expense.
3
Marginal Conditions for Efficiency
Total Social Benefit
Total Social Cost
Net Benefit = TSB – TSC
Maximum Net Benefit occurs where
MSB = MSC
4
Marginal Conditions for Efficiency
Analysis of the benefits and costs of making additional amounts of a
good available is required to determine whether the existing allocation
of resources to its production is efficient.
total social benefit imply that any given quantity of an economic good
available, say per month, will provide a certain amount of satisfaction
to those who consume it.
The marginal social benefit of a good is the extra benefit obtained by
making one more unit of that good available per month (or over any
other period).
The marginal social benefit can be measured as the maximum amount
of money given up by people to obtain the extra unit of the good. For
example, if the marginal social benefit of bread is $2 per loaf, some
consumers would give up $2 worth of expenditure on other goods to
obtain that loaf and be neither worse nor better off by doing so.
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Marginal Conditions for Efficiency
The total social cost of a good is the value
of all resources necessary to make a given
amount of the good available per month.
The marginal social cost of a good is the
minimum sum of money required to
compensate the owners of inputs used in
producing the good for making an extra
unit of the good available.
6
Figure 2.1 Efficient Output
A
Price, Benefit, and MSC
Cost (Dollars) 2.00 = P B
C
E
1.50 = P*
1.00 = P2 A D
MSB
Q1 = 10,000 Q2 = 20,000
Q* = 15,000 TSC
B TSB
Total Social Benefit
Z
and Cost
TSB – TSC
0 Q*
Loaves of Bread per Month 7
Conditions under which the
Market is Pareto Optimal
All productive resources are privately owned.
All transactions take place in markets, and in each
separate market many competing sellers offer a
standardized product to many competing buyers.
Economic power is dispersed in the sense that no
buyers or sellers alone can influence prices.
All relevant information is freely available to buyers
and sellers.
Resources are mobile and may be freely employed
in any enterprise.
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Markets, prices, and efficiency
conditions
Assume that both buyers and sellers seek to maximize their gains
from trading in such a system.
Accordingly, buyers maximize the satisfaction they obtain from
exchanging their money for goods and services in markets and sellers
maximize the profits they earn from making goods and services
available to consumers.
The market prices that emerge reflect the free interplay of supply and
demand.
Neither businesses nor buyers can control prices; they can only react
to them.
When deciding how much of a good to purchase, buyers consider
their own marginal private benefit (MPB), which is the dollar value
placed on additional units of the good by individual consumers.
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Markets, prices, and efficiency
conditions
Producers maximize their gains from trading each month when they
maximize profits.
When it is no longer possible to add any gain by selling one more
unit, profits are maximized.
The firm will increase profits whenever the revenue obtained from
selling an additional unit exceeds the cost of producing and selling
that extra unit.
The marginal private cost (MPC) of output is the cost incurred by
sellers to make an additional unit of output available for sale.
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If These Conditions are Met
P = MPB = MSB
and
P = MPC = MSC
so
P = MSB = MSC
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When Does Market Interaction Fail to Achieve
Efficiency?
markets operating under conditions of perfect competition
produce efficient outcomes.
competitive markets are economic institutions that have
evolved to allow maximum gains from the exchange of
goods and services.
The basic problem that causes inefficiency in competitive
markets is that prices do not always fully reflect the
marginal social benefits or marginal social costs of
output.
12
When Does Market Interaction Fail to
Achieve Efficiency?
Monopolistic Power
Markets will also fail to result in efficient levels of output
when monopolistic power is exercised. A firm exercises
monopolistic power when it influences the price of the
product it sells by reducing output to a level at which the
price it sets exceeds marginal cost of production. A
monopolist maximizes profits at a level of output per
month (or year) at which marginal revenue (MR) equals
its marginal private cost.
13
Figure 2.2 Loss in Net Benefits Due to Monopolies
Price, Benefit, and
MSB = P B
MSC
Cost (Dollars)
E
Loss in Net Benefits
MSCM A
D = MSB
MR
0 QM Q*
Output per Month 14
When Does Market Interaction Fail to
Achieve Efficiency?
Taxes
When a product or a service is taxed, the amount that is traded is influenced by
the tax paid per unit, as well as by the marginal social benefit and marginal
social cost of the item. The tax distorts the decisions of market participants.
For example, income taxes influence the decision workers make about the
allocation of their time between work and leisure. Workers consider not only
the amount of extra income they can get from more work, but also the extra
taxes they must pay on that income when deciding how many hours per week
or year to devote to work. When you work more hours, you receive less than
the gross amount of wages paid to you. In deciding whether to work more
when you have the opportunity to do so, you weigh the extra income after
taxes against the value of the leisure time you give up. Taxes influence your
decision to work by reducing the net gain from working.
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Figure 2.3 Taxes and Efficiency
New Supply = MPC + T > MSC
Supply = MSC = MPC
6 E'
Price (Cents per
Message Unit)
5 E
4 B
Demand = MSB
0 3 4
Billions of Message Units per Month 16
When Does Market Interaction Fail to Achieve
Efficiency?
Subsidies
Governments often subsidize private
enterprises or operate their own enterprises
at a loss, using taxpayer funds to make up
the difference. Taxes can impair market
efficiency, and so can subsidies.
Eg: effects of agricultural subsidies and the
operation of agricultural markets.
17
Figure 2.4 Subsidies and Efficiency
Supply = MSC
Price (Dollars per Bushel)
5 A
E
4
3 C
Demand = MSB
0 Q* QS
Bushels of Wheat per Year
18
Market Failure: A Preview of the Basis for
Government Activity
Government intervention may be warranted if a market
exhibits:
1) Monopoly power by one supplier.
When markets are dominated by only a few firms or by a single firm,
Firms exercising monopoly power can add to their profits by adjusting
prices to the point at which marginal revenue equals their marginal private
costs without fear of new entrants into the market.
To prevent monopoly control over price, governments typically monitor
markets to ensure that barriers to entry do not encourage the exercise of
monopoly power.
Governments also often regulate the pricing policies of monopoly
producers of such services as electric power, natural gas, and water.
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Market Failure: A Preview of the Basis for
Government Activity
2. Effects of market transactions on third parties
When market transactions result in damaging or beneficial
effects on third parties who do not participate in the decision,
the result will be inefficiency.
When the effects are negative, people demand government
policies to reduce the damaging or beneficial effects of market
transactions on third parties who do not participate in such
decisions.
For example, exhaust fumes from cars, trucks, buses, heating
systems, factories, and power plants decrease air quality and
impair public health.
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Market Failure: A Preview of the Basis for
Government Activity
3. Lack of a market for a good where MSB>MSC (i.e. a
public good)
In many cases, useful goods and services cannot be provided efficiently
through markets because it is impossible or difficult to sell the good by
the unit.
Benefits of such goods can be shared only. These goods
are called “public” goods to distinguish them from private goods, which
are consumed by individuals and whose benefits are not shared with
others who do not make the purchase.
A distinguishing characteristic of public goods is that a given quantity of
such goods can be enjoyed by additional consumers at no reduction in
benefits to existing consumers.
Eg: National defense.
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Market Failure: A Preview of the Basis for
Government Activity
4. Incomplete information about goods being sold
Always demand that government intervene in markets
because having incomplete information about the risks of
purchasing
certain products or working in certain occupations.
For example, we rely testing new drugs and to prevent
hazardous products from being sold.
also rely on government to establish standards for safety in
the workplace.
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Market Failure: A Preview of the Basis for
Government Activity
5. An unstable market
Market imperfections, such as downwardly rigid wages,
give rise to excessive unemployment in response to
decreases in aggregate demand.
Governments engage in monetary and fiscal policies in an
effort to stabilize the economy to correct for these market
failures to ensure full employment.
Governments also seek to avoid excessive and erratic
inflation that can erode purchasing power and can impair
the functioning of financial markets.
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Equity vs. Efficiency
Equity: perceived fairness of an outcome.
Horizontal equity is achieved when equal
people are treated equally.
Vertical equity is achieved when people are
treated fairly along the socio-economic
continuum.
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Figure 2.5 Utility Possibility Curve
Annual Well-Being of A UA
E1 Z
UA2
X E2
UA1
E3
0 UB1 UB2 UB
Annual Well-Being of B 25
Positive Analysis Trade-off Between
Equity and Efficiency
When making choices about public policy
issues, we are usually faced with the
inevitable situation that you make one
person worse off while making another better
off. (Taxes must be paid by some in order
that public goods can be purchased; these
benefits accrue to people other than
taxpayers.) Some economists attempt to
overcome this with the Compensation
Criteria.
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Compensation Criteria
An attempt is made to compare the dollar
value of the gain to the gainers and the dollar
value of the loss to the losers.
If the gainers gain more than the losers lose,
then the gainers can pay the losers enough
to compensate the losers for their loss.
Everyone can be made at least as well off as
they were without the change as long as
compensation is paid.
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