The Market Economy Process of voluntary exchange Specialization Gains from trade

Economic Efficiency and the Competitive Market Demand Curve – value of output produced Supply Curve – opportunity cost of producing output Intersection of supply and demand curves determine level of output maximizing value of economy’s resources

Economic Efficiency and the Competitive Market

Role of Government Private Sector – voluntary exchanges Public Sector – government activity typically financed by mandatory taxes monopoly on legitimate coercion and force

Why is the Public Sector Necessary? Failure of market system Government may be more efficient than market Equity

Market System and Individual Rights Right to freedom of exchange Rights protected by: police national defense court system Protection of rights creates incentives to produce goods

Government as Protector of Rights Primary function of government is protection of individual rights Proper level of protection is debatable Many rights can be protected through private provision

The Government as Violator of Rights Any government powerful enough to protect rights is strong enough to violate rights Public sector institutions should be designed so as to act in public interest

The Public Interest What does it mean to act in the public interest? Greatest good for the greatest number Utilitarianism – public interest measured by total utility of society Contemporary Utilitarianism – weigh benefits and costs

Pareto Criteria Pareto superiority – change makes at least one person better off; no one worse off compares two possible situations Pareto optimality – no one can be made better off without making one person worse off applied to a single situation

The Pareto Criteria

The Pareto Criteria Market Exchange and Pareto Criteria Satisfies utilitarian criterion Satisfies Pareto superiority (in absence of negative externalities) Political Exchange and Pareto Criteria Political process – if all agree to a change, change is Pareto superior

Limitations of Pareto Criteria Not possible to adhere strictly to Pareto criteria Lends legitimacy to status quo Does not rank all possible states of the world

Other Measures of the Public Interest Potential compensation – gainers value gains more than losers value losses Cost-benefit analysis – dollar value placed on costs/benefits of a project Social welfare function – indifference curves depicting welfare of entire society

Other Measures of the Public Interest

Positive and Normative Economics Positive economics – what is conclusions will be either right or wrong Normative economics – what should be involves value judgments

Normative Analysis and Public Interest Positive analysis evaluates effects of policy Pareto criteria useful to evaluate public interest Public sector involves normative analysis

Goals of Public Policy Reallocate resources efficiently – positive analysis Equity – normative analysis