Chapter 2

Efficient Markets and

Government

1
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.”

2
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.

3
Marginal Conditions for
Efficiency
 Total Social Benefit
 Total Social Cost
 Net Benefit = TSB – TSC
 Maximum Net Benefit occurs where
MSB = MSC

4
 Figure 2.1 Efficient Output
A
Price, Benefit, and MSC
Cost (Dollars) 2.00 = P B
C
E
1.50 = P*

1.00 = P2 A D
MSB

Q1 = 10,000 Q2 = 20,000
Q* = 15,000 TSC
B TSB
Total Social Benefit

Z
and Cost

TSB – TSC

0 Q*
Loaves of Bread per Month 5
 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.

6
If These Conditions are Met
P = MPB = MSB
and

P = MPC = MSC
so

P = MSB = MSC

7
When Does Market Interaction Fail
to Achieve Efficiency?

 Monopoly

 Taxes

 Subsidies

8
 Figure 2.2 Loss in Net Benefits Due to Monopolies
Price, Benefit, and

MSB = P B
MSC
Cost (Dollars)

E
Loss in Net Benefits
MSCM A

D = MSB
MR
0 QM Q*
Output per Month 9
 Figure 2.3 Taxes and Efficiency
New Supply = MPC + T > MSC
Supply = MSC = MPC
6 E'
Price (Cents per
Message Unit)

5 E

4 B

Demand = MSB

0 3 4
Billions of Message Units per Month 10
 Figure 2.4 Subsidies and Efficiency
Supply = MSC
Price (Dollars per Bushel)

5 A
E
4

3 C

Demand = MSB

0 Q* QS
Bushels of Wheat per Year
11
 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

12
The Tax System and the Birth Rate
 Families with children pay less tax than
families without children:
 personal exemption
 child tax credit
 Historical data shows that an increase in
the real value of the personal exemption is
associated with increases in the birth rate.

13
 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 the socio-economic
continuum.

14
Figure 2.5 Utility Possibility Curve

Annual Well-Being of A UA

E1 Z
UA2
X E2
UA1

E3

0 UB1 UB2 UB
Annual Well-Being of B 15
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; these
benefits accrue to people other than
taxpayers.) Some economists attempt to
overcome this with the Compensation
Criteria.

16
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.

17
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. 18