1. Efficient Markets and Government
Chapter 2
Efficient Markets and Government

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
Price, Benefit, and
Cost (Dollars)
Loaves of Bread per Month A B
Total Social Benefit
and Cost
MSC
Q1 = 10,000
2.00 = P
1.00 = P2 B A
MSB
Q2 = 20,000 C D
1.50 = P* Q*
Q* = 15,000 E
TSC Z
TSB
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
and
P = MPC = MSC so
P = MSB = MSC

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 MR
D = MSB
MSC QM
MSB = P
MSCM A B
Loss in Net Benefits E Q*

10. Figure 2.3 Taxes and Efficiency
New Supply =
MPC + T > MSC
Price (Cents per
Message Unit)
Billions of Message Units per Month 5 E
Demand =
MSB
Supply =
MSC = MPC 4 E' B 6 4 3

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

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 CurveUA Z E1
UA2
Annual Well-Being of A X E2
UA1 E3
UB1
UB2 UB
Annual Well-Being of B

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. Many nations subsidize farmers with:
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.