1 Efficient Markets and Government Chapter 2

2 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.”

3 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.

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

5 Figure 2.1 Efficient Output TSB MSC MSB Price, Benefit, and Cost (Dollars) Loaves of Bread per Month 0 A B Total Social Benefit and Cost 1.50 = P* Q* Q* = 15,000 E Q 1 = 10, = P 1.00 = P 2 B A Q 2 = 20,000 C D TSC Z TSB – TSC

6 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.

7 If These Conditions are Met P = MPB = MSB P = MPC = MSC P = MSB = MSC and so

8 When Does Market Interaction Fail to Achieve Efficiency? Monopoly Taxes Subsidies

9 Figure 2.2 Loss in Net Benefits Due to Monopolies Price, Benefit, and Cost (Dollars) Output per Month 0 D = MSB MR MSC E Q* QMQM MSB = P MSC M A B Loss in Net Benefits

10 Figure 2.3 Taxes and Efficiency New Supply = MPC + T > MSC Price (Cents per Message Unit) Billions of Message Units per Month 0 E' B E Demand = MSB Supply = MSC = MPC 4

11 Figure 2.4 Subsidies and Efficiency Price (Dollars per Bushel) Bushels of Wheat per Year 0 4 E Demand = MSB Q* Supply = MSC 5 3 A C QSQS

12 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

13 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.

14 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.

15 Figure 2.5 Utility Possibility Curve Annual Well-Being of A 0 UAUA UA2UA2 UA1UA1 Annual Well-Being of B Z X UBUB E1E1 E2E2 E3E3 UB1UB1 UB2UB2

16 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.

17 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.

18 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.