Efficient Markets and Government Chapter 2 Efficient Markets and Government

Positive and Normative Economics Positive Economics explains “what is,” without making judgments about the appropriateness of “what is.” Normative Economics: designed to formulate recommendations about what “should be.”

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 any one person’s well-being without reducing any other person’s well-being.

Figure 2.1 Efficient Output Price, Benefit, and Cost (Dollars) Loaves of Bread per Month A B Total Social Benefit and Cost MSC Q1 = 10,000 2.00 = P 1.00 = P2 B A MSB Q2 = 20,000 C D 1.50 = P* Q* Q* = 15,000 E TSC Z TSB TSB – TSC

Conditions under which a Perfectly Competitive Market System Exists 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.

If These Conditions are Met P = MPB = MSB and P = MPC = MSC so P = MSB = MSC

Figure 2.2 Loss in Net Benefits Due to Monopolies Price, Benefit, and Cost (Dollars) Output per Month MR D = MSB MSC QM MSB = P MSCM A B Loss in Net Benefits E Q*

Figure 2.3 Taxes and Efficiency New Supply = MPC + T > MSC Price (Cents per Message Unit) Billions of Message Units per Month 5 E Demand = MSB Supply = MSC = MPC 4 E' B 6 4 3

Figure 2.4 Subsidies and Efficiency Price (Dollars per Bushel) Bushels of Wheat per Year 4 E Demand = MSB Q* Supply = MSC 5 3 A C QS

Market Failure: A Preview of the Basis for Government Activity Government intervention may be warranted if a market exhibits: Monopoly power by one supplier 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

Figure 2.5 Utility Possibility Curve UA Z E1 UA2 Annual Well-Being of A X E2 UA1 E3 UB1 UB2 UB Annual Well-Being of B

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.

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 compensation is paid.