Lecture Public economics (5th edition) - Chapter 2: Benchmark model of the economy: positive and normative approaches

Learning outcome of this chapter 2: Identify the critical assumptions of the two-sector model, define what is meant by a Pareto-optimal allocation of resources; articulate the three conditions for a general equilibrium; distinguish between allocative efficiency, X-efficiency, and ‘dynamic’ efficiency (or economic growth); discuss the broad categories of market failure; explain the allocative, distributive, and stabilisation functions of government; distinguish between direct and indirect forms of government intervention.

• Identify the critical assumptions of the two-sector model

• Define what is meant by a Pareto-optimal allocation of

resources

• Articulate the three conditions for a general equilibrium

• Distinguish between allocative efficiency, X-efficiency, and

‘dynamic’ efficiency (or economic growth)

• Discuss the broad categories of market failure

• Explain the allocative, distributive, and stabilisation

functions of government

• Distinguish between direct and indirect forms of

government intervention.

• Individual consumer or producer is:

– Fully informed about the economy

– Unaffected by the actions of other consumers or producers

– Completely mobile

– Always striving to maximise his/her own utility of profit

• Disturbances will cause instantaneous adjustments

to return the system to a stable equilibrium.

• Optimal mix of commodities

• Interaction between:

– Consumption activities of consumers

– Production activities of producers

• Simultaneous concurrence of 3 conditions:

– Pareto optimality

– Maximising utility subject to budget constraints

– Producers and consumers achieve equilibrium

simultaneously

Allocative efficiency refers to a situation in which the limited resources of a

country are allocated in accordance with the wishes of its consumers.

Technical efficiency or X-efficiency refers to a situation in which existing resources are utilised in the most

efficient manner

• Lack of information

• Friction and lags in adjustments

• Incomplete markets

• Non-competitive markets

• Macroeconomic instability

• Distribution of income.

• Market failures distort the allocation of resources in

the economy

• Incomplete markets

– Characteristics of goods and services prevent efficient

supply

– Existence of externalities

• Fairness

• Inequality in income distribution

• Criteria for evaluation

• Macro-economic objectives

• 3 premises of stabilisation (Keynes):

– The market economy is inherently unstable

– Macroeconomic instability is a form of market failure that is highly costly to an economy

– Governments are able to stabilise the economy by means of appropriate macroeconomic policies

• New Classical Macroeconomics

• Neo-Keynsian theory.

Direct government intervention refers to the actual

participation of government in the economy

Indirect government intervention to the regulatory

function of government

• Actual participation in the

economy

• Tax individuals and

companies

• Borrow on financial markets

• Execute budgeted spending

• Examples:

– National defence

– Electricity

– Infrastructure

– Provision of school text

books

• Regulatory function

• Enacting law or proclaiming legally binding rule

• Indirect taxes and subsidies

• Examples:

– Labour laws

– Anti-tobacco laws