Public finance chapter 2 efficiency, equity hyman chapter 2 (1)

EFFICIENCY, MARKETS, AND

GOVERNMENTS

Positive Economics

scientific approach analysis that establishes

cause-and-effect relationshios among economic

variables

Attempts to be objective

Formulates “lf then” hypotheses that can be

checked against facts

Useful to the normative approach in that it cannot

make recommendations to achieve certain

outcomes without an underlying theory of human

behavior

Normative Economics

¢ Designed to formulate recommendations as to what should be accomplished

¢ Not objective

¢ Begins with predetermined criteria and is used to

prescribe policies that best achieve those criteria

¢ Useful to the positive approach in that it defines relevant issues

The Efficiency Criterion

¢ Normative criterion for evaluating effects of

resource use on individual well-being

¢ Satisfied when resources are used in such a way

as to make it impossible to increase the well-being

of any one person without reducing the well-being

of another

¢ Often referred to as the criterion of Pareto

optimality

The Efficiency Criterion

Avoiding waste in production helps to achieve

efficiency

Freedom to trade

However, not all mutually gainful trades should be

allowed Government should prevent exchanges

that are morally objectionable (e.g gambling,

prostitute, certain drugs )

The individualistic ethnic underlying the efficiency

criterion: Individuals should be allowed to pursue

their self-interest, provided that no one is harmed

in the process

TOOLS OF NORMATIVE

ANALYSIS

Welfare Economics

Concerned with the social desirability of alternative

economic states

Consumption Economy

¢ Edgeworth Box - an analytical device used to

model welfare economic theory

¢ Depicts distribution of goods in a 2-good/2-person economy

¢ Pareto Efficiency — an allocation of resources

such that no person can be made better off

without making another person worse off

¢ Pareto Improvement -— a reallocation of

resources that makes at least one person better

off without making anyone else worse off

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3 apples and figs do

Indifference curves in Edgeworth Box

Beginning at Point g, how to make Adam better

off without Eve becoming worse off

Beginning at Point g, how to make Eve better off

without Adam becoming worse off

0

Adam ‹ Apples per year >

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Beginning at Point g how to make both Adam

and Eve better off

Starting from a different initial point: Point k

Pareto Efficiency in Consumption

MRS = MRS,

Where MRS:

-is the rate at which an individual is willing to

trade one good for another

-is the absolute value of the slope of an

indifference curve

Production Economy

¢ Analysis when supplies of 2 goods (applies and

figs) are variable rather than fixed

¢ Production Possibilities Curve

— Graph to model production economy

— Maximum quantity of one output that can be

produced given the amount of the other output

Production Possibilities Curve

Marginal Rate of Transformation

MRT., = Marginal rate of transformation of

apples for fig leaves MRT., = rate at which the economy can

transform one good into another MRT., = Absolute value of slope of

Production Possibilities Frontier MRT = MC./MC,

Pareto Efficiency Conditions with

The First Fundamental Theorem of

Welfare Economics

¢ Given:

— All producers and consumers are perfect competitors

— A market exists for every commodity

¢ Then a Pareto Efficient allocation of resources

emerges

— A competitive economy allocates resources efficiently without any need for centralized direction

The First Fundamental Theorem of

EXERCISE

Xuan 1s willing to exchange 3 shirts for 1 box of food and still feels satisfied as before Meanwhile, Thu is willing to trade 2 boxes of food for 3 shirts

- Has the allocation between shirts and food for these two individuals reached

Pareto efficiency? If not, why not?

- In case Pareto efficiency has not been achieved, suggest a way of exchange

between these two individuals so that Xuan gains without Thu losing; or Thu

gains without Xuan losing; or both gain.

EXERCISE

During the restructuring process, it 1s calculated that in order to maintain the output

of the industrial sector while reducing one unit of investment capital, it 1s necessary

to supplement with 8 labor units At the same time, to keep the output of the

agricultural sector unchanged while reducing one labor unit, it 1s necessary to

compensate with 1/3 unit of capital

- How can the output of the industrial sector be increased without affecting the output

of the agricultural sector?

- How can the output of the agricultural sector be increased without affecting the

industrial sector?

EXERCISE

Both Minh and Hai have plenty of notebooks and erasers The exchange options between

them are as follows:

(a) Minh is willing to exchange | notebook for 3 erasers, while Hai is willing to exchange 3 erasers for 1 notebook

(b) Minh is willing to exchange | notebook for 3 erasers, while Hai 1s only willing to

exchange 2 erasers for | notebook

(c ) Minh is willing to exchange 2 erasers for 1 notebook, while Hai is willing to exchange 3 erasers for 2 notebooks

Has the allocation of notebooks and erasers between these two individuals reached Pareto

efficiency in each case? If Pareto efficiency has not been achieved, suggest a redistribution

so that one of the two individuals gains more without the other being worse off.

Marginal Conditions for Efficiency

Total social benefit — any given quantity of an economic

good available in a given time period will provide

satisfaction to those who consume it

Marginal social benefit — the extra benefit by making one

more unit of that good available in a given time period

make a given amount of the good available

Marginal social cost — minimum sum required to

compensate the owners of inputs used for making an extra

unit of the good available

Loaves of Bread per Month

The efficient level of output, Q*, occurs at point E At that monthly output, MSB = MSC The monthly output Q* maximizes the difference between TSB and TSC, as shown in B Extension of monthly output to the level corresponding to equality of

TSB and TSC would involve losses in net benefits Similarly, output levels Q; and Qz

are inefficient

All productive resources are privately owned

All transactions take place in markets, in which competing

sellers offer a standardized product to many buyers

Economic power is dispersed in that no single buyer or

seller can influence prices

All relevant information is available to buyers and sellers

Resources are mobile and may be freely employed in any

enterprise.

Inefficiency in Competitive Markets

¢ Prices do not always fully reflect marginal social

benefits/costs of output

¢ Means other than markets needed to make social

benefits of certain goods available

¢ Failure of markets to make available certain goods

(national defense, environmental protection) gives

rise to demand tor government production and

regulation

Loss of Efficiency Due to Monopolistic Power

¢ Occurs when a firm influences the price of a

oroduct by reducing output to a level at which the

price it sets exceeds marginal cost of production

¢ Causes failure of markets to result in inefficient

levels of output

¢ Normative economists would prescribe

government intervention to increase output in order

to attain efficiency

Monopolistic Power

FIGURE 2.2 : : — _FIGURE2.2 ĐH in Net Benefits Due to Monopolistic Power

Output per Month

The monopolistic firm maximizes profits by producing Qy units per month At that output level, the marginal social benefit of the good exceeds its marginal social cost

Additional net benefits equal to the area ABE are possible if output were increased to Q* units per month

Loss of Efficiency Due to Taxes

¢ Tax causes the amount of a good or service that is

traded to be influenced by tax paid per unit, not

only marginal social benefit/cost

¢ Therefore, the tax distorts decisions of market

participants

¢ Taxes influence decisions to work by reducing the

net gain from working

Loss of Efficiency Due to Taxes

Billions of Message Units per Month

A tax on the sale of a product affects incentives to supply that product In the graph above, a tax on telephone service decreases the supply of the product The price of a message unit increases from 5 to 6 cents There is a loss in net benefits from tele-

phone service because the marginal social cost of the new equilibrium output (corre-

sponding to point E’) is less than its marginal social benefit The loss in net benefits is represented by the triangular area E’EB The tax costs more than the $0.06 billion in revenue collected when the loss in net benefits is added to the amount of revenue collected

Loss of Efficiency Due to Government Subsidies

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Bushels of Wheat per Year

A target price of $5 per bushel is set by the government Because this price exceeds

the market price of $4 per bushel, the wheat farmers produce Q, bushels per year in- stead of Q* Q, is more than the efficient amount of wheat because its marginal social cost is greater than its marginal social benefit The loss in net benefits from resource use is represented by the area EAC The subsidy the government pays is $2 per

bushel multiplied by the Q, bushels produced annually After the subsidy, the market

price of wheat falls to $3, which is less than the marginal social cost of producing it

Basis for Government Intervention in Markets

1 Exercise of monopoly power in markets

2 Etfects of market transactions on third parties

3 Lack of a market for a good with a marginal social

benefit that exceeds its marginal social cost

4 Incomplete information

5 Economic stabilization

Equity Versus Efficiency

Many argue that resource allocation should also be

evaluated in terms of equity, or perceived fairness of the

outcome

People differ in their ideas about fairness

Analysts usually try to determine the effects of government

actions on both resource allocation and the distribution of

well-being

The utility-possibility curve presents the maximum

attainable level of well-being (utility) for one individual,

given the utility level of others in the economy, their tastes,

resource availability, and technology.

Fairness and Second Fundamental

Theory of Welfare Economics

° Addresses equity concerns in allocations of goods

¢ Second Fundamental Theory of Welfare

Economics states that society can attain any

Pareto efficient allocation of resources — one that

is more equitable — by redistributing the initial

allocation of resources and then letting people

Efficiency versus Equity

Utility Possibilities Curve

Maximum amount of one person’s utility given each level of

another person’s utility

Social Indifference Curve

Society’s willingness to trade off one person’s utility for another’s

Maximizing Social Welfare

, equitable distribution of goods -

embodied in Social Indifference Curves, fairness and efficiency are possible (iii)

Market Failures: Causes of Inefficiency

Buying into Welfare Economics: The

Controversies

¢ Underlying outlook is individualistic

— Merit goods: commodities that output to be provided

even if people do not demand it

¢ Results orientation rather than the process used

to arrive at the results

¢ However, coherent framework for analyzing

policy

— Will it have desirable distributional consequences?

— Will it enhance efficiency?

— Can it be done at a reasonable cost?

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Equity Versus Efficiency in Competitive Markets

¢ Critics of the market system argue that many

participants cannot satisfy basic needs because

they cannot pay for goods and services

¢ Critics of the market system argue that the poor

should receive transfers financed by taxes on the

more fortunate

¢ However, taxes used to alter the distribution of

income distort incentives to produce, preventing

achievement of efficiency

¢ Thus, equity versus efficiency causes conflict for

policy makers

Positive approach attempts to explain why efficient

outcomes are, or are not, achieved

Can also predict how government intervention in private affairs affects likelihood of achieving

efficiency

Attempts to predict whether changes in

government policy will be agreed upon through

political institutions, regardless of an efficient

outcome

Improvements in efficiency are often opposed by

special-interest groups that would suffer loses by

the improvements

Chapter 2 Summary

Welfare economics is the study of the desirability of

different economic states

— Based on individualist social philosophy

Pareto efficiency occurs when no person can be made

better off without making another person worse off

— MRS! = MRT,,, i=persons i n

First Fundamental Theory of Welfare Economics:

Competitive markets result in Pareto efficiency

Second Fundamental Theory of Welfare Economics:

Society can attain any Pareto Efficient outcome with

reassignment of initial endowments and free trade

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ExercIse

The following table shows how the total social

benefit and total social cost of summer outdoor concerts in Central City vary with the number of

performances What is the efficient number of

A prominent senator has calculated the total social

benefit of the current amount of space exploration

at $3 billion per year The total social cost of soace

exploration is currently only $2 billion The senator

argues that a net gain to society would result by

increasing the amount of space exploration until

total costs rise enough to equal total benefits Is

the senator's logic correct’?