Public Finance, 10th Edition

David N. Hyman Chapter 2

THE EFFICIENCY
CRITERION

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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 & 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.
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Learning Objectives (cont.)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Positive Economics
• Scientific approach to analysis that establishes
cause-and-effect relationships among economic
variables
• Attempts to be objective
• Formulates “If…then” hypotheses that can be
checked against facts.
• E.g. predict how road widening might benefit the
users, the impact of food subsidy to low-income
people, etc.
• Useful to the normative approach
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Normative Economics
• Based on value judgments
• Designed to formulate recommendations as to
what should be accomplished
• Not objective
• Can evaluate alternative policies and actions only
on the basis of value judgments.
• Begins with predetermined criteria and is used to
prescribe policies that best achieve those criteria
• Useful to the positive approach in that it defines
relevant issues. Both approaches are useful.
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Normative Evaluation of Resource Use:
The Efficiency Criterion

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Marginal Conditions for Efficiency
• Total social benefit (TSB)– any given quantity of an
economic good available in a give time period will provide
satisfaction to those who consume it.
• Marginal social benefit (MSB) – slope of TSB
• the extra benefit by making one more unit of that good
available in a given time period  ( TSB / Q).
• Total social cost (TSC) – the value of all resources
necessary to make a given amount of the good available.
• Marginal social cost (MSC) – slope of TSC
• minimum sum required to compensate the owners of
inputs used for making an extra unit of the good available
 ( TSC / Q).
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Marginal Conditions for Efficiency (cont.)

• Whenever the MSB > MSC, it will be possible to

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

• Whenever the MSC > MSB , consumers cannot

be made better off without harming producers.

• The marginal conditions for efficient resource

allocation require that resources be allocated to
the production so that MSB = MSC (total net
satisfaction is maximized).

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Efficient Output

MSC > MSB

MSB > MSC

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Efficient Output

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Markets, Prices & Efficiency Conditions

• An efficient economic system allocates resources

so as to set the MSB = MSC.

• A system of perfectly competitive markets can

result in efficient resource use in an economy.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Markets, Prices & Efficiency Conditions

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Markets, Prices & Efficiency Conditions (cont.)

Buyers:

• When deciding how much of good to purchase,

buyers consider their own marginal private
benefit (MPB)
• MPB – dollar value placed on additional units of the
good by individual consumers.

• Maximize their gains from trading by adjusting

the amount of any good they consume until

• P = MPB = MSB
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Markets, Prices & Efficiency Conditions (cont.)

Producers:
• Firm increase profits whenever the revenue >
costs.
• Marginal private cost (MPC) – the cost incurred
by sellers to make an additional unit of output
available for sale
• Maximize profits when adjust its output to the
point which P = MPC. If MPC > P, profit would
decline. Producers maximize gains at
• P = MPC = MSC
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Markets, Prices & Efficiency Conditions (cont.)

• A system of competitive markets achieves an

efficient allocation of resources when P* = MPB
= MSB = MSC is satisfied in each market and all
goods & services are sold in markets.

• Also implies that the overall allocation of

resources in the economy will satisfy the
efficiency criterion.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 When Does Market Interaction Fail to Achieve
Efficiency?
• Markets operating under conditions of perfect
competition produce efficient outcomes.
• In some cases, there is a possibility that markets
and prices fail to result in the efficient outputs
• Government activity itself can cause inefficiency.
• Basic problem that causes inefficiency in
competitive markets is that prices do not always
fully reflect marginal social benefits/costs of output.
• Due to nature of certain goods, e.g. environmental
resources as air & water (often used for disposal of
waste)
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 When Does Market Interaction Fail to Achieve
Efficiency? (cont.)
• Means other than markets needed to make social
benefits of certain goods available.
• Failure of markets to make available certain goods
(national defense, environmental protection) gives
rise to demand for government production and
regulation.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Market Failures
• Market failure is a concept within economic theory
wherein the allocation of goods and services by a free
market is not efficient.

• Often associated with information asymmetric, non-

competitive markets, externalities, or public goods.

• Used as a justification for government intervention in a

particular market.

• However, some types of government policy interventions,

such as taxes, subsidies, bailouts, wage and price
controls, and regulations, including attempts to correct
market failure, may also lead to an inefficient allocation of
resources, (sometimes called government failures)
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Loss of Efficiency Due to Monopolistic Power

• Occurs when a firm influences the price of a

product by reducing output to a level at which P >
MC of production.
• Because a monopolist’s MR < P, MSC < P. At Qm,
P = MSB > MSC.
• Causes failure of markets to result in inefficient
levels of output because MSB > MSC at Qm.
• Normative economists would prescribe government
intervention to increase output (Q*) in order to
attain efficiency (MSB=MSC).

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Monopolistic Power

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Loss of Efficiency Due to Taxes

• Tax causes the amount of a good or service that is

traded to be influenced by tax paid per unit, not
only marginal social benefit/cost.
• Therefore, the tax distorts decisions of market
participants.
• Income taxes influence the decision workers make about
the allocation of their time between work and leisure.
More work, more income but also extra taxes need to be
paid.
• Taxes influence decisions to work by reducing the
net gain from working.
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Loss of Efficiency Due to Taxes

Tax = 2 cent per message

(equilibrium efficient output MSB =MSC)

(Loss in net benefits called excess burden of the tax = EE’B)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Loss of Efficiency Due to Taxes (cont.)

• When evaluating the marginal cost of a new

government program, must add any loss in net
benefit to the additional tax revenue required to
finance the program.

• Government spending programs can provide net

benefits only when the MSB > tax revenue
collected & loss in efficiency (the excess burden).

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Loss of Efficiency Due to Government Subsidies

• Subsidy reform in Malaysia was initiated in July 2010

via a reduction in subsidies for fuel and sugar.
• cuts in the subsidies for vehicle fuel, sugar, and gas for cooking
that took effect on 15 July 2010.
• RON95 and RON97 grades of petrol was subject to a price
increase .
• The price of liquified petroleum gas (LPG), was raised.
• The price of diesel was fixed at RM1.75 per litre.
• Sugar increased in price.
• Prices for cooking gas have increased
• Further cuts in subsidies for these and other products are
planned over a 3-5 year period in order to strengthen
government finances and improve economic efficiency.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Loss of Efficiency Due to Government Subsidies

• Subsidies also can impair market efficiency.

• Suppose govt. guarantees farmers a certain

price for their crops. When market price fall
below the “target” price guaranteed by the govt.,
the govt. will pay subsidy equal to the difference
between the market price and target price.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Loss of Efficiency Due to Government Subsidies

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Loss of Efficiency Due to Government Subsidies
(cont.)

• In addition to loss in net benefits, the target price

program costs the govt. = $2 X Qs.

• Overproduction relative to efficient level

depresses the market price to $3 per bushel
(point C).

• Consumer end up paying $3, while MC is $5.

The $2 difference between the P and MC is paid
by the govt.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Basis for Government Intervention in Markets

Various form of market failure are commonly used as

a basis for recommending govt. intervention in
markets or govt. provision of services.
1. Exercise of monopoly power in markets
2. Effects of market transactions on third parties
3. Lack of a market for a good with a marginal social
benefit that exceeds its marginal social cost
4. Incomplete information
5. Economic stabilization

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Basis for Government Intervention in Markets (cont.)

1. Exercise of monopoly power in markets

• When markets are dominated by only a few firms or by
single firm.
• To prevent monopoly control over price, govt. monitor
markets & regulate the pricing policies
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  inefficiency.
• Negative effects – people demand govt.
intervention/policies to reduce the damage and vice
versa.
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Basis for Government Intervention in Markets
(cont.)

3. Lack of a market for a good with a MSB that

exceeds its MSC.
• In most of the cases, useful goods & services cannot be
provided efficiently through markets because it is
impossible/ difficult to sell the good by unit.
• Benefits of such goods can be shared only – public good.
• E.g. national defense, education, fire protection,
healthcare, etc

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Basis for Government Intervention in Markets
(cont.)
4. Incomplete information
• Incomplete information about the risks of purchasing
certain products or working in certain occupations. E.g.
• Rely on govt. to test new drugs and to prevent
hazardous products from being sold
• Establish standards for safety in workplace.
5. Economic stabilization
• Govt. engage in monetary and fiscal policies to stabile the
economy to correct market failures that lead to rising
unemployment, inflation, deficit, exchange rate
depreciation, etc.
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Equity Versus Efficiency
• Many argue that resource allocation should also be
evaluated in terms of equity, or perceived fairness of the
outcome.
• People differ in their ideas about fairness.
• Analysts usually try to determine the effects of government
actions on both resource allocation and the distribution of
well-being.
• The trade-off between improvements in efficiency and
changes in the distribution of welfare can be illustrated with
utility-possibility curve.
• Utility-possibility curve  the maximum attainable level of
well-being (utility) for one individual, given the utility level of
others in the economy, their tastes, resource availability, and
technology.
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Utility-Possibility Curve

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Equity Versus Efficiency in Competitive Markets

• Perfectly competitive market system - capable of

achieving efficiency (a point on the utility-possibility
curve).
• Many argue that the market system does not fulfill
the equity criteria – because many participants
cannot satisfy basic needs ( they cannot pay for
goods and services).
• Market system caters to those with the ability to
pay, which depends on earnings.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Equity Versus Efficiency in Competitive Markets (cont.)

• Critics of the market system argue that the poor

should receive transfers financed by taxes on the
more fortunate.
• However, taxes and subsidies used to alter the
distribution of income distort incentives to produce,
preventing achievement of efficiency.
• Thus, equity versus efficiency causes conflict for
policy makers.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Equity Versus Efficiency in Competitive Markets
(cont.)

Effects
• Government policies often cause conflict between equity and
efficiency.
• E.g. progressive income tax system - requires people who
earn more money to pay higher tax rates to support
government operations (unemployment compensation and
welfare benefits to the poor).
• Policy strive to achieve greater economic equity, but at a cost
of reduced efficiency.
• Higher tax rates on high incomes reduce the reward for
working hard and may result in people working and producing
less.
• Less output shrinks the overall size of the economic growth.
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Equity Versus Efficiency in Competitive Markets

Significance
• Much of the debate over the competing values of efficiency
and equity in economics centers on tax policy.
• Tax policy can increase efficiency at a cost of reduced
equity, or provide greater equity at a loss of efficiency.
• The most contentious debates usually center on the
question of equity rather than efficiency.
• Opponents of higher taxes often condemn proposed tax
hikes as socialist measures which intended to redistribute
income.
• While critics of tax cuts view them as benefiting the rich at
the expense of the poor and middle class.
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Equity Versus Efficiency in Competitive Markets

• Historical example
• Former President Ronald Reagan emphasized using the
U.S. tax system to increase economic efficiency.
• In 1980, the year Reagan was elected, the richest
Americans faced top marginal tax rates of 70 percent.
• Reagan argued the high rates acted as disincentives to
work and invest (reduced efficiency).
• By the time Reagan left office, the top marginal rates were
below 30 percent.
• Reagan's critics contended the president cut taxes for the
wealthy, taking away government benefits for the poor (tax
policy reduced economic equity).

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Equity Versus Efficiency: Positive Analysis
• Positive analysis:
• can be used to evaluate the effectiveness of alternative
policies in achieving any given change in the distribution
of income.
• Positive approach attempts to explain why efficient
outcomes are, or are not, achieved
• Can also used to predict how government intervention in
private affairs affects likelihood of achieving efficiency.
• Attempts to predict whether changes in government policy
will be agreed upon through political institutions,
regardless of an efficient outcome
• Improvements in efficiency are often opposed by special-
interest groups that would suffer loses by the
improvements.
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Summary

Key Concepts:
• Efficiency Criterion
• Equity
• Marginal Conditions for Efficient Resource
Allocation
• Total Social Benefit & Total Social Cost
• Marginal Social Benefit & Marginal Social Cost
• Marginal Private Benefit & Marginal Private Cost
• Positive & Normative Economics
• Utility-Possibility Curve
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.