Chapter 5: The Public Sector

Economic and technical efficiency Technical efficiency – no unemployed or underemployed resources (i.e., operating on PPC). Economic efficiency (also known as Pareto optimality) – it is not possible to benefit one or more individuals without harming someone else Technical efficiency is a prerequisite for economic efficiency (but does not guarantee economic efficiency)

Markets and economic efficiency voluntary trade in markets benefits each trading partner under ideal conditions, markets attain a state of economic efficiency (Pareto optimality)

Market failure Markets may fail to achieve economic efficiency as a result of: imperfect information externalities public goods the absence of property rights monopoly, or macroeconomic instability

Imperfect information One party may not benefit from a market transaction if there is imperfect information about the item being sold Possible corrective action: product labeling requirements (listing ingredients or including warnings) requiring guarantees (such as “lemon laws”) requiring “truth in advertising” licensing workers in certain professions providing public information about products

Externalities Externalities are side effects of production or consumption that affect individuals not directly involved in the activity or transaction Positive externalities occur when one or more parties not involved in the transaction benefit from the activity Negative externalities occur when third parties are harmed.

Positive externalities Those engaged in the transaction do not take the external benefits into account in their decision making This results in underproduction Possible remedies: subsidy regulation

Negative externalities Negative externalities result in social costs that are not borne by the parties involved in the transaction. results in overproduction Possible solutions: taxation regulation

Internalizing externalities The use of taxes or subsidies to correct for an externality is sometimes referred to as “internalizing” the externality.

Public goods nonrival in consumption (one person’s consumption does not affect the quantity or the quality of the good available to others) free-rider problem results in underproduction Possible solutions: government production or subsidization

Common property resources problem of the commons - resources are commonly owned benefits are received by those who use the resource costs are shared by all overutilization government regulation

Monopolies higher prices and lower output antitrust law, regulation, or public production

Macroeconomic instability economic inefficiency caused by unemployment during recessions government policies designed to stabilize the economy

Public choice theory government policy is constructed by self- interested individuals participants in policy formation are concerned about their own self interest, not the “public interest” economic rent - a payment in excess of opportunity costs rent-seeking behavior on the part of special- interest groups

Economic policy Microeconomic policy - designed to correct for: imperfect information, externalities, public goods, the absence of property rights, and monopolies. Macroeconomic policy - designed to enhance macroeconomic stability and encourage economic growth.