Chapter 2

Efficiency, Markets and Governments

POSITIVE AND NORMATIVE ECONOMICS
When considering economic issues, we must carefully distinguish
questions of fact and questions on fairness. Positive economics
describes the facts of an economy, while normative economics
involves value judgements.
Positive Economics:
Establishes cause-and-effect relationships among economic
variables. Formulates hypotheses of the “If … then” variety that
can be checked against facts.

For example:

• A proposal to widen a road can be used to predict how the

road will benefit users by reducing the time and money costs
involved in getting between two locations.

• The impact of a food subsidy to low-income persons can be

used to estimate the effect of the subsidy on the price of food
and the quantity available to the recipients.

• Why do doctors earn more than janitors?

• Do high interest rates slow the economy and lower inflation?

Although these questions are difficult to answer, they can be

resolved by reference to analysis and empirical evidence.

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 Normative Economics: what should or ought to be
- Is based on value judgments about what is desirable or what
should be done to achieve the desired outcome.

- Normative economics is designed to formulate recommendations

as to what should be accomplished.

- It can evaluate alternative policies and actions only on the basis of

the underlying value judgments.

For example:
• Should the US negotiate further agreements to lower tariffs
on imports?

• Has the distribution of income in the US become too unequal?

There are no right or wrong answers to these questions because
they involve ethics and values rather than facts.
➢ While economic analysis can examine the likely consequences of
alternative policies, the answers can only be resolved by
discussions and debates.

➢ Discussions around public policies and welfare typically involve

normative economic statements because a higher degree of
disagreements persists in such discussions because neither party
can clearly prove their correctness.

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 Positive Economics Normative Economics
Based on facts Based on value judgements
Objective Subjective
It’s a specific economic Leaves the door open for
statement strictly states the future changes, eliminates
facts that are known to be true absolute statements and
at a given moment provide an avenue for
discussion.
Statements are precise, Originates from personal
descriptive and clearly perspectives, feelings or
measurable. opinions involved in the
decision-making process.
Can be tested or proved Can’t be tested or proved

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Examples:
Taxes must be cut in half to increase disposable income levels.
Positive
Tax cuts would improve the quality of life for every citizen.
Normative
Government-provided healthcare increases government
expenditures.
Positive
The government should provide basic healthcare to all citizens.
Normative
When prices fall, people can delay their purchases.
Positive
Subsidies should be removed.
Normative
Removing subsidies will raise prices in developing countries.
Positive
How the growth of money supply influences inflation.
Positive
Increase in government spending will reduce the unemployment
rate.
Positive

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 NORMATIVE EVALUATION OF RESOURCE USE: THE
EFFICIENCY CRITERION
- Efficiency is a normative criterion for evaluating the effects of
resource use on the well-being of individuals.

- The efficiency criterion (Pareto optimality): is satisfied when

resources are used in such a way as to make it impossible to
increase the well-being of any one person without reducing the
well-being of another.
There are 2 aspects of efficiency:
1. Efficiency means avoidance of waste in achieving any useful
objective.
Given available amounts of productive resources and the existing
state of technical knowledge in an economy, elimination of wasted
effort will allow more production from available resources.

2. Exchange (freedom to trade) is an important aspect of efficiency.

Even when production is accomplished without waste, additional
net gains are usually possible through mutually agreeable
exchanges. If you are free to engage in transactions for gain, you
can obtain more satisfaction out of your income.

If there are constraints that prevent resources from being used and
traded in such a way as to allow mutual gains, this will prevent
achievement of efficiency.

The criterion of efficiency is based on an underlying value judgment

and therefore, is not acceptable to all persons. That’s why
efficiency in considered normative economics.
Marginal Conditions for Efficiency:

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• These are the conditions required for the efficient output of a
particular good over a period of time.

• In order to determine whether resources used to produce

additional amounts of good are used efficiently, we need to
analyze the costs and benefits.

1. Total social benefit (TSB): Amount of satisfaction provided to

consumers by any given quantity of a good available over a
given period of time.

2. Marginal social benefit (MSB): The extra benefit obtained by

making one more unit of a good available over a given period of
time.
➢ 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.

➢ If these consumers could obtain the bread for less than $2 per
loaf, they would be made better off.

➢ The marginal social benefit of a good is assumed to decline as

more of that good is made available each month.
➢ The marginal social benefit = Δ TSB/ Δ Q.
• Δ TSB: is the change in the social benefit of the good
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 • Δ Q is a one-unit increase in the output of bread in a given
period of time.

➢ The marginal social benefit is measured by the slope of the total

social benefit curve at any point.

3. Total social cost (TSC): The value of all resources necessary

to make a given amount of the good available over a given
period of time.

4. Marginal social cost (MSC): The minimum amount of money

required to compensate the owners of inputs for making an extra
unit of the good available. (The cost to society from producing
one extra unit).

➢ It is assumed that output is produced at minimum possible cost,

given available technology.

➢ If the marginal social cost of bread is $1 per loaf, this is the

minimum dollar amount necessary to compensate input owners
for the use of their inputs without making them worse off.
➢ If they were to receive more than $1 per loaf, they would be
made better off.
➢ If they were to receive less than $1 per loaf, they would be made
worse off by making that extra unit available.

➢ The marginal social cost= Δ TSC/ Δ Q

➢ MSC is measured by the slope of the total social cost curve at

any point.

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 The efficient output of bread can be determined by comparing its
marginal social benefit and marginal social cost at various levels of
output.

At Q1= 10,000 loaves of bread.

- Consumers (buyers) are willing to pay $2/loaf (MSB=$2) as a

maximum amount to give for the bread, and input owners
(suppliers) require $1/loaf (MSC=$1) as a minimum amount in
compensation for the use of their inputs to produce that bread.

- If input owners were to receive $2 from each buyer, they would

be made better off because $2 exceeds the minimum amount they
require in compensation for the use of their inputs to produce that
bread.

- Therefore, suppliers of bread can be made better off without

harming any consumer by making more bread available.

- Similarly, the consumer who obtains the loaf of bread for $1 is

better off, because that is less than the maximum amount the
consumer would be willing to sacrifice for the bread, and if
suppliers of bread were to receive $1 for that loaf, they would be
no worse off because their marginal costs would be covered.

- Therefore, at least one buyer can be made better off without

making the suppliers of bread worse off.

- This demonstrates that the output of 10,000 loaves is inefficient,

because some people can be made better off without making
anyone else worse off.

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The marginal net benefit of a good = MSB-MSC.

- When marginal net benefits are positive (MSB> MSC), it will be

possible to make at least one person better off without harming
another by producing more of the good.

- Net gains from allocating resources to additional production of

the good continue just up to the point at which the marginal
social benefit equals the marginal social cost.

- If additional resources were allocated to produce more of the

good beyond that point, marginal social costs would exceed
marginal social benefits and the marginal net benefit would be
negative.

- In other words, if output were increased beyond the Q*=

15,000, consumers would be unwilling to sacrifice enough to
compensate input owners for all the costs involved in making the
extra units of bread available.

So, the marginal conditions for efficient resource allocation

require that resources be allocated to the production of a good over
a given period of time so that

MSB = MSC

The efficient output corresponds to the point at which the MSB and
MSC curves intersect. This efficient output is Q*= 15,000. (Optimal
point is at E)

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- If MSB >MSC (at Q1), additional net gains from allocating more
resources to production of the good will be possible. The extra
net gains possible from increasing output from Q1 to Q* are
represented by the area ABE.

- When MSC >MSB (at Q2), the additional net gains would be
possible by reducing output from Q2 to Q* loaves. This is
represented by the area of the triangle CED.

- At the output Q* at which MSB = MSC, the total net satisfaction

(total net benefits = TSB less TSC) from using resources to
produce the good is maximized.

- At output Q*, the slope of the TSC curve equals the slope of the
TSB curve and the difference between the two curves is at its
maximum.

- This difference (TSB – TSC) represents the surplus of the total

social benefit of the good over its total social cost. This is the
net total benefit of the good.

- Producing more of the good until TSB equals TSC (at point Z )
would decrease the total net satisfaction. This is because the
difference between total social benefits and total social costs
declines as more than Q* units are produced.

- At the point (Z) where TSB = TSC, the total net benefit of the
good is actually zero!

The efficiency occurs when the (MSB=MSC) and the net benefit
(TSB-TSC) reaches the maximum level.

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