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Lecture 3

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8 views

Lecture 3

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aligama917
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Public Finance

Lecture 3

Efficiency and Markets

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Main Points

1. The Concept of Economic Efficiency.


2. Positive and Normative Approaches.
3. Pareto Optimality and Efficiency Criterion.
4. Allocative and Productive Efficiency.
5. Equity versus Efficiency.

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1. The Concept of Economic Efficiency

 Economic efficiency is the benchmark by which both market outcomes and


government intervention are judged.
 Economic efficiency requires all actions to be generating more social benefits than
social costs.
 If this condition is met, then we will have a free market economy with no government
intervention.
 The unobservable market force that helps the demand and supply of goods in a free
market to reach equilibrium automatically is the invisible hand.
 The concept of efficiency is considered to be one of the topics studied under
normative economics.

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2. Positive and Normative Approaches
Positive Analysis Normative Analysis
 Explains “What is?” without making  Designed to formulate recommendations on
judgments. “what should be?”
 Objective and fact based.  Is subjective and value based (i.e value
 Are able to be tested and proved or judgment).
disproved.  Are opinion based, so they cannot be
 Cause and effect relationship. proved or disproved.
For example, the impact of a widening a  Efficiency is a normative criterion for
road on individuals by reducing the time evaluating the effects of resource use on the
and money costs involved in getting well-being of individuals. (Pareto optimality).
between two locations.
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3. Pareto Optimality and the Efficiency Criterion

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.

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 The economy will be Pareto Optimal when markets are
perfectly competitive and the economy is in a state of general
equilibrium.
 This also happens when prices reflect economic values.
 When this price system is in equilibrium, the marginal revenue
product, the opportunity cost, and the price of a resource or asset
will all be equal.
 Therefore, each unit of every good and service is in its most
productive use or best consumption use. No transfer of resources
could result in greater output or satisfaction.
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Market Conditions for Pareto Optimality
1. All productive resources are privately owned.
2. All transactions take place in markets and in each separate market
many competing sellers offer a standardized product to many
competing buyers.
3. Economic Power is dispersed so that no single buyer or seller can
influence prices.
4. All relevant information is freely available to buyers and sellers.
5. Resources are mobile and may be freely employed in any
enterprise.
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4. Allocative and Productive Efficiency

a. The Allocative Efficiency:

 Allocative efficiency happens when consumers


maximize their satisfaction and producers maximize
their profits.
 Allocative efficiency requires two different types of
efficiency →

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1. Efficiency in consumption:
 Allocative efficiency happens when consumers get the maximum possible
satisfaction from the current combination of goods and services produced and
sold.
 In other words, the level of satisfaction that consumers receive will not increase
even if the consumers change their pattern of consumption and buy different
quantities of goods and services.
2. Efficiency in specialization and exchange:
 Allocative efficiency requires efficient markets where firms specialize in producing
and selling the products that they can produce with minimum cost to maximize
their profits.
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• The consumer surplus is the net
benefit (satisfaction) that
consumers obtain from a good.

• This is represented graphically by


the triangular area BCD.

• Producer surplus measures the difference between the market price and the
minimum amount of money that producer would accept for the product.

• This is represented graphically through the triangular area ABD.


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 The combination of both these types of efficiency results in allocative
efficiency.
 Allocative efficiency will be increased as long as doing more of something
results in a greater marginal benefit to society than marginal cost.
 As long as this process continues, allocative efficiency will increase.

The optimum level of allocative efficiency is determined when:


marginal benefit = marginal cost.

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b. The Productive Efficiency:

 Productive efficiency occurs when the available factors of production are


allocated between products in such a way that it is not possible to reallocate
the production factors to raise the output of one product without reducing
the output of another product.

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 There are many situations in which it is possible to raise the total
output in an economy by simply reallocating factors of production
at no additional cost (i.e. if the factors of production were
misallocated).
 This is because factors of production are more productive in some
uses than they are in others.
 In a perfectly competitive economy, producers continue reallocating
factors of production until they are reach their most productive
use.
 Example: reallocating labor from agricultural to industrial sector.
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5. Equity versus Efficiency

 The socially efficient level of production or consumption occurs when social


marginal benefit is equal to social marginal cost.

 “Equity” concerns the distribution of resources and is inevitably linked with


concepts of fairness and social justice.

 In the case of efficient market equilibrium, the reallocation of productive


resources to produce goods or services will inevitably hurt someone.

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We must distinguish between horizontal and vertical
equity;

 Horizontal equity is achieved when equal people are treated equally.


 Vertical equity is achieved when people are treated fairly along a socio-
economic continuum.

The problem involved with applying criteria of equity is that persons differ in
their ideas about fairness.

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