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Chapter 5: The Public Sector

Economic and technical


Technical efficiency no unemployed or

underemployed resources (i.e., operating on
Economic efficiency (also known as Pareto
optimality) it is not possible to benefit one
or more individuals without harming someone
Technical efficiency is a prerequisite for
economic efficiency (but does not guarantee
economic efficiency)

Markets and economic efficiency

voluntary trade in markets benefits

each trading partner
under ideal conditions, markets attain a
state of economic efficiency (Pareto

Market failure

Markets may fail to achieve economic

efficiency as a result of:

imperfect information
public goods
the absence of property rights
monopoly, or
macroeconomic instability

Imperfect information

One party may not benefit from a market

transaction if there is imperfect information
about the item being sold
Possible corrective action:

product labeling requirements (listing ingredients

or including warnings)
requiring guarantees (such as lemon laws)
requiring truth in advertising
licensing workers in certain professions
providing public information about products


Externalities are side effects of production or

consumption that affect individuals not
directly involved in the activity or transaction
Positive externalities occur when one or more
parties not involved in the transaction benefit
from the activity
Negative externalities occur when third
parties are harmed.

Positive externalities

Those engaged in the transaction do

not take the external benefits into
account in their decision making
This results in underproduction
Possible remedies:


Negative externalities

Negative externalities result in social

costs that are not borne by the parties
involved in the transaction.
results in overproduction
Possible solutions:


Internalizing externalities

The use of taxes or subsidies to correct

for an externality is sometimes referred
to as internalizing the externality.

Public goods

nonrival in consumption (one persons

consumption does not affect the
quantity or the quality of the good
available to others)
free-rider problem results in
Possible solutions: government
production or subsidization

Common property resources

problem of the commons - resources

are commonly owned

benefits are received by those who use the

costs are shared by all

government regulation


higher prices and lower output

antitrust law, regulation, or public

Macroeconomic instability

economic inefficiency caused by

unemployment during recessions
government policies designed to
stabilize the economy

Public choice theory

government policy is constructed by selfinterested individuals

participants in policy formation are concerned
about their own self interest, not the public
economic rent - a payment in excess of
opportunity costs
rent-seeking behavior on the part of specialinterest groups

Economic policy

Microeconomic policy - designed to

correct for:

imperfect information,
public goods,
the absence of property rights, and

Macroeconomic policy - designed to

enhance macroeconomic stability and
encourage economic growth.