Public Finance (MPA405) Dr. Khurrum S. Mughal

Lecture 2: Efficiency: Criterion and Government Public Finance

Positive and Normative Economics Positive Economics explains “what is” without making judgments about the appropriateness of “what is.” Normative Economics: designed to formulate recommendations on what should be.

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 the well- being of any one person without reducing the well-being of any other person.

Welfare Economics

Efficiency Resource Use Assumptions 2 inputs (capital and labor) 2 outputs (food and clothing)

Production Functions F = F(L F,K F ) C = C(L C,K C ) Where F = food production C = clothing production L i = labor devoted to the production of good i K i = capital devoted to the production of good i

Constraints L = L F + L K K = K F + L F

Productive Efficiency It is not possible to reallocate inputs to alternative uses in such a manner as to increase the output of any good without reducing the output of some alternative good.

Figure Productive Efficiency F3F3 E* F6F6 F5F5 Z* F3F3 F1F1 F4F4 Z1Z1 C2C2 C3C3 C4C4 C5C5 C6C6 C1C1 D 0 K* F K L C KFKF LFLF LCLC KCKC L* F C 0'

Efficiency Condition MRTS F LK = MRTS C LK The Marginal Rate of Technical substitution of Labor for Capital in each good are equal

Figure The Production-Possibility Curve A D E 1 E 2 Food per Year Clothing per Year 0 T F CT'

Pareto Efficiency Preferences on Consumption U A = U(F A,C A ) U B = U(F B,C B ) Where U i = the utility of person i F i = food consumed by person i C i = clothing consumed by person i

Constraints F = F A + F B C = C A + C B

Food per Year Clothing per Year T T’ F C D FAFA CACA CBCB FBFB Figure Efficient Allocation of A Given Amount of Food and Clothing per Year For Two Consumers UB1UB1 UB2UB2 UB3UB3 UB4UB4 UB5UB5 UB6UB6 UB7UB7 UA5UA5 UA4UA4 UA2UA2 UA1UA1 UA6UA6 FA*FA* FB*FB* CB*CB* CA*CA* E* E** UA3UA3 UA7UA7 0

Efficiency Criterion on Consumption and Production MRS A CF = MRS B CF = MRT CF

Interpretation of Efficiency Criterion Suppose we say that the “price of a unit of clothing is $1.” Then clothing is the same as “money.” We can then say that MRS A CF is A’s willingness to substitute clothing for money, which is their marginal benefit of clothing, MB A C. The same is true for B. If these are equal to the MRT CF then this represents the capability of turning money into clothing as well. Thus it reflects the costs of production. Lastly if there are no other people who gain from either A or B consuming clothing or food then: MSB = MB A C = MB B C = MSC C

Efficiency and Economic Institutions Given the conditions for a market rendering a Pareto Optimal outcome in perfect markets: C = P K K + P L L then production of a particular amount of a good is efficient if the slope of the production function for each good is equal to the slope of the isocost line.

Figure Cost Minimization and Productive Efficiency Capital Labor F = F 1 per Year 0 K L E

Implications of Figure MRTS F LK = P L /P K MRTS C LK = P L /P K MRTS F LK = MRTS C LK = P L /P K

Pure Market Economy and Pareto Efficiency Step 1 So far we know that P F = MC F and P C = MC C from perfect competition dividing one by the other we get It can be shown that this ratio of MCs is equal to MRT P C MC C P F MC F =

Pure Market Economy and Pareto Efficiency Step 2 MC F is the amount of other resources that must be given up to produce more Food. We will denote this fact by saying: MC F =  C. It is the forgone clothing to produce more Food. The same applies the other way around MC C =  F.

Pure Market Economy and Pareto Efficiency Step 3 Dividing these by each other we get : MC C  F MC F  C =

Pure Market Economy and Pareto Efficiency Step 4 = MRT CF FF CC Since And MRT CF = PCPC PFPF Then = MRT CF = PCPC PFPF FF CC MC C MC F =

Figure 2A.5 Consumer Choice E UA3UA3 UA2UA2 UA1UA1 Food per Year Clothing per Year 0 FAFA A BCACA

Pure Market Economy and Pareto Efficiency Step 5 As just seen the slopes of the individual’s indifference curves are equal to the ratio of the prices. So MRS CF = PCPC PFPF A PCPC PFPF B

Pure Market Economy and Pareto Efficiency Final MRS CF = MRS CF = MRT CF = PCPC PFPF AB

Market Imperfections Monopoly P > MC