Public Finance,

12e
Chapter 2: Efficiency, Markets, and
Government

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 About this chapter
• A useful starting point for analyzing government activities is the study
of the role of markets in allocating resources. Markets facilitate
exchanges of goods and services and inputs. Free exchange between
buyers and sellers in unregulated, competitive markets often achieves
outcomes that rate high in terms of the standards of economic
performance used by many economists.
• However, markets cannot be relied upon to supply all useful goods
and services, and sometimes market transactions have undesirable
side effects, such as pollution. In those circumstances, government
supply of goods and services through political institutions can result in
net gains to citizens’ well-being.

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 About this chapter… ctd
• In this chapter, we begin by defining the concept of efficiency.
• We then discuss conditions under which markets operate efficiently
and examine some instances in which they fail to do so.
• We also show how government subsidies and taxes can distort
resource allocation and cause losses in output and efficiency in
markets.
• In the next two chapters, we show how government programs can
result in improvements in resource use and provide additional benefits
to individuals that outweigh any additional costs.

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 Efficiency

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 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.
• Useful to the normative approach in that it cannot make recommendations to
achieve certain outcomes without an underlying theory of human behavior.

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 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
• Designed to formulate recommendations as to what should be accomplished.
• Not objective.
• 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.

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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 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
• Often referred to as the criterion of Pareto optimality.
• Efficiency means producing a desired result with a minimum of effort or expense

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 The Efficiency Criterion

• Normative criterion for evaluating effects of resource use on individual well-

being.
• 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.
• Often referred to as the criterion of Pareto optimality.

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 Marginal Conditions for Efficiency
• Total social benefit – any given quantity of an economic good available in a give
time period will provide satisfaction to those who consume it.
• Marginal social benefit – the extra benefit by making one more unit of that good
available in a given time period.
• Total social cost – the value of all resources necessary to make a given amount
of the good available.
• Marginal social cost – minimum sum required to compensate the owners of
inputs used for making an extra unit of the good available.

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 Efficient Output

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 Efficient Output (1 of 2)

the social benefits from

producing an additional unit
of the good are exactly
balanced with the social
costs. This means that the
allocation of resources is
optimal in the sense that no
further gains in overall
welfare can be achieved by
producing more or less of
that particular good

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 Efficient Output (2 of 2)

The efficient level of output, Q*, occurs at point E. At

that monthly output, MSB = MSC. The monthly
output Q* maximizes the difference between TSB
and TSC as shown in B.

Resources are efficiently allocated when the well-

being of any one person cannot be increased without
harming another. This condition is attained when all
goods are consumed over any period up to the point
at which the marginal social benefit of each good
equals its marginal social cost

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The marginal conditions for efficient resource
allocation
• 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

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 Markets

• In a perfectly competitive market:

• All productive resources are privately owned.
• All transactions take place in markets, in which competing sellers offer a
standardized product to many buyers.
• Economic power is dispersed in that no single buyer or seller can influence
prices.
• All relevant information is available to buyers and sellers.
• Resources are mobile and may be freely employed in any enterprise.

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When Does Market Interaction Fail to Achieve
Efficiency?
• It is not surprising that markets operating under conditions of perfect competition produce
efficient outcomes. After all, competitive markets are economic institutions that have evolved to
allow maximum gains from the exchange of goods and services, and that is what efficiency is all
about.

• In perfectly competitive markets at the equilibrium point P* = MSB = MSC

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 Inefficiency in Competitive Markets
• Prices do not always fully reflect marginal social benefits/costs of output.
• This often occurs because of the nature of certain goods, which makes them difficult to
package and trade easily in markets.
• 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.
• In cases for which interaction between buyers and sellers in competitive
markets does not result in an efficient outcome, government intervention can be
prescribed to help achieve efficiency
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 Loss of Efficiency Due to Taxes (1 of 2)

• 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.
• Taxes influence decisions to work by reducing the net gain from working.

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Loss of Efficiency Due to Taxes (2 of 2)

A tax on the sale of a product affects

incentives to supply that product. In the
graph above, a tax on telephone
service decreases the supply of the
product. The price of a message unit
increases from 5 to 6 cents. There is a
loss in net benefits from telephone
service because the marginal social
cost of the new equilibrium output
(corresponding to point E') is less than
its marginal social benefit. The loss in
net benefits is represented by the
triangular area E'EB. The tax costs
more than the $0.06 billion in revenue
collected when the loss in net benefits
is added to the amount of revenue
collected.
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Loss of Efficiency Due to Government
Subsidies
A target price of $5 per bushel is set by
the government. Because this price
exceeds the market price of $4 per
bushel, the wheat farmers produce Qs
bushels per year instead of Q*. Qs is more
than the efficient amount of wheat
because its marginal social cost is greater
than its marginal social benefit. The loss in
net benefits from resource use is
represented by the area EAC. The
subsidy the government pays is $2 per
bushel multiplied by the Qs bushels
produced annually. After the subsidy, the
market price of wheat falls to $3, which is
less than the marginal social cost of
producing it.
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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 the price it sets exceeds marginal cost of production.
• Causes failure of markets to result in inefficient levels of output.
• Normative economists would prescribe government intervention to increase
output in order to attain efficiency.

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 Monopolistic Power

The monopolistic firm maximizes profits by

producing QM units per month. At that output level,
the marginal social benefit of the good exceeds its
marginal social cost. Additional net benefits equal to
the area ABE are possible if output were increased
to Q* units per month.

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Basis for Government Intervention in Markets

• We cannot rely on markets to provide all goods in efficient amounts.

• Market failure to make goods and services available in cases for which the
marginal social benefits of the goods outweigh the marginal social costs of
those goods or services often results in demands for government action.

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Basis for Government Intervention in Markets

• Exercise of monopoly power in markets.

• Effects of market transactions on third parties other than sellers and buyers.
• Lack of a market for a good with a marginal social benefit that exceeds its
marginal social cost.
• Incomplete information.
• Economic stabilization.

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 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 utility-possibility curve presents 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.

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 Utility-Possibility Curve
Points on the utility-possibility curve
indicate the maximum level of well-
being for any one person, A, given the
level of well-being of any other
person, B. Points, E1, E2, and E3 are
efficient. Because, at that point, it is
impossible to increase either A’s or B’s
utility without reducing the
other’sPoint.

Z is unattainable. Point X is
inefficient. However, a movement from
X to E3 will be opposed by A because
it would make him or her worse off.

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 Equity Versus Efficiency in Competitive
Markets
• Critics of the market system argue that many participants cannot satisfy basic
needs because they cannot pay for goods and services.
• Critics of the market system argue that the poor should receive transfers
financed by taxes on the more fortunate.
• However, taxes used to alter the distribution of income distort incentives to
produce, preventing achievement of efficiency.
• Thus, equity versus efficiency causes conflict for policy makers.

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 Equity Versus Efficiency: Positive Analysis

• Positive approach attempts to explain why efficient outcomes are, or are not,
achieved.
• Can also 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.

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 Appendix 2 – Welfare Economics

• Welfare economics is the normative analysis of economic interaction that seeks

to determine the conditions for efficient resource use.
• Productive efficiency exists if it is not possible to reallocate inputs to alternative
uses in such a manner as to increase the output of any one good without
reducing the output of some alternative good.

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 Productive Efficiency

Use of the Edgeworth box to determine the condition that will lead to productive efficiency in the
use of inputs.

All input allocations corresponding to

tangencies of the food and clothing isoquants
satisfy the conditions for productive efficiency.
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 The Production-Possibility Curve

Alternative way to summarize the economic information displayed in the efficiency locus:

The curve TT’ gives all the

efficient combinations of food and
clothing per year that can be
produced in the economy, given
the resource constraints and
technology.

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 Efficient Allocation

An efficient allocation of the two goods requires

that the marginal rate of substitution of food for
clothing be the same for both consumers.
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 Pure Market Economy & Productive
Efficiency
• Efficiency criterion can be used to evaluate resource allocation in a pure market
economy operating under conditions of perfect competition in all markets.
• Price of any given commodity assumed to be identical for all buyers and sellers.
• Producers take the prices of labor and capital as fixed.
• Firms minimize the cost of producing any output:

C PK K  PL L

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Pure Market Economy & Productive
Efficiency

Competitive firms maximizing profits choose the efficient input allocation.

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Pure Market Economy & Pareto Efficiency
The tangency between two
people’s budget constraint lines
and an indifference curve in their
indifference maps defines the
market basket of goods they
choose in order to maximize their
utility.

In equilibrium, each consumer

purchases food and clothing in
markets to satisfy the following
condition:
PC
MRSCF 
PF

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 Market Imperfections

• Monopolists might influence the price of their output by manipulating their

production.
• Price is no longer a given.
• To reach output level that maximizes profits, must restrict the amount of
production per time period to a level below that which would prevail if the
monopoly were a perfectly competitive industry
• Monopolist produces less than what a perfectly competitive industry producing
the same good would.
• Prevents the market from attaining an efficient resource allocation.

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