Copyright © 2002 by Thomson Learning, Inc. Efficiency Markets and Government Chapter 2 Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN X

Copyright © 2002 by Thomson Learning, Inc. Positive and Normative Economics  Positive Economics explains “what is” without making judgments about the appropriateness of “what is.”  Normative Economics: designed to formulate recommendations on what should be.

Copyright © 2002 by Thomson Learning, Inc. Normative Evaluation of Resource Use: The Efficiency Criterion  Pareto Optimality  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.

Copyright © 2002 by Thomson Learning, Inc. Marginal Conditions for Efficiency  Total Social Benefit  Total Social Cost  Net Benefit = TSB – TSC  Maximum Net Benefit occurs where MSB = MSC

Copyright © 2002 by Thomson Learning, Inc. Figure 2.1 Efficient Output Price, Benefit, and Cost (Dollars) Loaves of Bread per Month 0 A B Total Social Benefit and Cost MSC MSB TSC TSB 2.00 = P 1.50 = P* 1.00 = P 2 Q* Q 1 = 10,000Q* = 15,000Q 2 = 20,000 B C E A D Z TSB – TSC

Copyright © 2002 by Thomson Learning, Inc. 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.

Copyright © 2002 by Thomson Learning, Inc. If These Conditions are Met P = MPB = MSB P = MPC = MSC P = MSB = MSC and so

Copyright © 2002 by Thomson Learning, Inc. When Does the Market Interaction Fail to Achieve Efficiency?  Monopoly  Taxes  Subsidies

Copyright © 2002 by Thomson Learning, Inc. Figure 2.2 Loss in Net Benefits Due to Monopolies Price, Benefit, and Cost (Dollars) Loss in Net Benefits Output per Month 0 QMQM MSB = P MSC M D = MSB MSC MR A E B Q*

Copyright © 2002 by Thomson Learning, Inc. Figure 2.3 Taxes and Efficiency Price (Cents per Message Unit) Billions of Message Units per Month E' E B Demand = MSB New Supply = MPC + T > MSC Supply = MSC = MPC 034

Copyright © 2002 by Thomson Learning, Inc. Figure 2.4 Subsidies and Efficiency Price (Dollars per Bushel) Bushels of Wheat per Year A E C Demand = MSB Q* Supply = MSC QSQS

Copyright © 2002 by Thomson Learning, Inc. Market Failure: A Preview of the Basis for Government Activity Government intervention may be warranted if there is:  Monopoly power.  Effects of market transactions on third parties.  Lack of a market for a good where MSB>MSC (i.e. a public good).  Incomplete information about goods being sold.  An unstable market.

Copyright © 2002 by Thomson Learning, Inc. 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 a socio-economic continuum.

Copyright © 2002 by Thomson Learning, Inc. Figure 2.5 Utility Possibility Curve Annual Well-Being of A 0 UAUA UA2UA2 UA1UA1 Annual Well-Being of B Z X UBUB E1E1 E2E2 E3E3 UB1UB1 UB2UB2

Copyright © 2002 by Thomson Learning, Inc. 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 and these benefits accrue to others.) Some economists attempt to overcome this with the Compensation Criteria.

Copyright © 2002 by Thomson Learning, Inc. 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 there is compensation.

Copyright © 2002 by Thomson Learning, Inc. International View: Agricultural Subsidies, International Trade Restrictions and Global Efficiency  Many nations subsidize farmers with  Production subsidies  Export subsidies  Import constraints  This results in reduced agricultural efficiency  Since WTO agreements, such subsidies and import constraints have been reduced