CHAPTER 2
EFFICIENCY, MARKETS, AND
GOVERNMENTS
LEARNING OBJECTIVES
• • Discuss the difference between positive and normative economics.
• • Define the efficiency criterion and show how the marginal
conditions for efficiency can be used to identify the efficient output
of a good or service.
• • Explain how a system of perfectly competitive markets can achieve
efficiency.
• • Show how the exercise of monopoly power can prevent markets
from achieving efficient levels of output.
• • Demonstrate how taxes and subsidies affect incentives and how
they can prevent competitive markets from achieving efficient
outcomes.
• • Use a utility-possibility curve to illustrate the trade-off between
efficiency and equity.
Introduction
• Decades of poor Performance in central planned economies e.g.
Soviet republics, formerly communist nations of central and
eastern Europe
• Industrialized nations in which private ownership of productive
resources and free markets have prevailed enjoyed high
standards of living
• Important questions on the functioning of the free market
economies
• After we evaluate free market performance, we can then discuss
possible defects of markets and examine how these defects give
rise to demands for government goods and services
• How markets functioned efficiently
POSITIVE AND NORMATIVE ECONOMICS
• Positive economics is a scientific approach to analysis that
establishes cause-and-effect relationships among economic
variables.
• Positive theory attempts to be objective, making no
presuppositions about what is good or bad or what should be
accomplished.
• Normative economics The normative approach is based on
value judgments about what is desirable or what should be
done to achieve the desired outcome.
• Normative theory begins with predetermined criteria and is
used to prescribe policies that best achieve those criteria.
POSITIVE AND NORMATIVE ECONOMICS
• For example, suppose you support government-
supplied housing with very heavily subsidized
rents for poor families because you believe that
such policies will enable them to enjoy better
and larger apartments. If positive analysis can
show that some persons might actually be
induced to move into small, publicly provided
housing units from larger apartments, you might
reconsider your support of the public-housing
program
NORMATIVE EVALUATION OF RESOURCE
USE: THE EFFICIENCY CRITERION
Developed by the Italian economist Vilfredo Pareto (1848–1923), it is often referred to as the criterion of
Pareto optimality
• Efficiency is a normative criterion for evaluating the effects of resource use on the
well-being of individuals
• 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 the well-being of any one
person without reducing the well-being of any other person
• The criterion of efficiency is based on an underlying value judgment that individuals
should be allowed to pursue their self-interest as they see fit, provided that no one is
harmed in the process
• Other object to this criteion
. 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.
Marginal Conditions for Efficiency
• Total social benefit any given quantity of an economic good
available, say per month, will provide a certain amount of
satisfaction to those who consume it
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 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). Figure 2.1
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.
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
• The marginal net benefit of a good is the difference between its
marginal social benefit and its marginal social cost.
• When marginal net benefits are positive, additional gains from
allocating more resources to the production of a good are possible
• Whenever the marginal social benefit of a good exceeds its
marginal social cost, it will be possible to make at least one person
better off without harming another by producing more of the
good
• The marginal conditions for efficient resource allocation require
that resources be allocated to the production of each good over
each period so that MSB= MSC
Marginal Conditions for Efficiency
.
Marginal Conditions for Efficiency
• The marginal conditions for efficient resource allocation require that
. resources be allocated to the production of each good over each period so
that
MARKETS, PRICES, AND EFFICIENCY
CONDITIONS
1.
. All productive resources are privately owned.
2. All transactions take place in markets, and in each separate
market many competing sellers offer a standardized product to
many competing buyers.
3. Economic power is dispersed in the sense that no buyers or
sellers alone can influence prices.
4. All relevant information is freely available to buyers and sellers.
5. 5. Resources are mobile and may be freely employed in any
enterprise.
MARKETS, PRICES, AND EFFICIENCY
CONDITIONS
• 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.
• Therefore, they maximize their gains from trading by adjusting
the amount of any good they consume per month (or any other
period of time) until the marginal private benefit, MPB, received
is just equal to the price, P:
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 marginal private cost (MPC) of output is the cost incurred
by sellers to make an additional unit of output available for sale.
• The extra revenue obtained from selling one more unit is its
price, assuming that the firm can sell as much as it likes at the
going market price
• If marginal private cost exceeds price, the gains from trade
(profit) would decline. It follows that producers maximize gains
from trade at the point for which
MARKETS, PRICES, AND EFFICIENCY
CONDITIONS
• A perfectly competitive market, in which both buyers and sellers
.
maximize their net gains from trade, will result in a level of
output for which marginal private benefit equals marginal
private cost
• If consumers are the only recipients of benefits when a good is
sold, and sellers bear all the cost of making that good available,
• The market equilibrium will achieve the efficient output.
• If this condition is met in all markets and all goods are tradable
in markets, the overall allocation of resources in the economy
will satisfy the efficiency criterion.
• When the prices of all goods and services equal the marginal
social benefits and marginal social costs of these items, the
market system achieves an efficient outcome
where MPBi is the marginal private benefit received by any given consumer
When Does Market Interaction Fail to Achieve
Efficiency?
• 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.
• This often occurs because of the nature of certain goods, which
makes them difficult to package and trade easily in markets.
• example, the services of such environmental resources as air
and water are often used for disposal of wastes without
adequate consideration of the benefits these resources have in
alternative uses.
• The failure of markets to price and make available certain
goods, such as national defense and environmental protection,
gives rise to demands for government production and regula