Public Finance Lecture 3 - Efficiency and Markets PDF

# Public Finance: Lecture 3 - Efficiency and Markets ## Main Points: 1. The Concept of Economic Efficiency. 2. Positive and Normative Approaches. 3. Pareto Optimality and Efficiency Criterion. 4. Allocative and Productive Efficiency. 5. Equity versus Efficiency. ## 1. The Concept of Economic Eff...

# Public Finance: Lecture 3 - Efficiency and Markets ## Main Points: 1. The Concept of Economic Efficiency. 2. Positive and Normative Approaches. 3. Pareto Optimality and Efficiency Criterion. 4. Allocative and Productive Efficiency. 5. Equity versus Efficiency. ## 1. The Concept of Economic Efficiency: - Economic efficiency is the benchmark by which both market outcomes and government intervention are judged. - Economic efficiency requires all actions to be generating more social benefits than social costs. - If this condition is met (social benefit > social costs), then we will have a free market economy with no government intervention. - The unobservable market force that helps the demand and supply of goods in a free market to reach equilibrium automatically is the invisible hand. - The concept of efficiency is considered to be one of the topics studied under normative economics. ## 2. Positive and Normative Approaches ### Positive Analysis - Explains "What is?" without making judgments. - Objective and fact-based. - Are able to be tested and proved or disproved. - Cause and effect relationship. **For example:** The positive relationship between price and quantity supply - when P↑ → Qs↑ **For example:** The impact of a widening a road on individuals by reducing the time and money costs involved in getting between two locations. ### Normative Analysis - Designed to formulate recommendations on "what should be?". - Is subjective and value based (i.e., value judgment). - Are opinion-based, so they cannot be proved or disproved. **For example:** Students of faculty of commerce English section should start with salary $7000 (this is my opinion; it is not a fact). - Efficiency is a normative criterion for evaluating the effects of resource use on the well-being of individuals (Pareto optimality). ## 3. Pareto Optimality and the Efficiency - 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. - The economy will be Pareto Optimal when markets are perfectly competitive and the economy in a state of general equilibrium. - This also happens when prices reflect economic values. - When this price system is in equilibrium, the marginal revenue product, the opportunity cost, and the price of a resource or asset will all be equal. - Therefore, each unit of every good and service is in its most productive use or best consumption use. No transfer of resources could result in greater output or satisfaction. ### Market Conditions for Pareto Optimality - All productive resources are privately owned (no government intervention). - 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 so that no single buyer or seller can influence prices. - All relevant information is freely available to buyers and sellers. - Resources are mobile and may be freely employed in any enterprise. ## 4. Allocative and Productive Efficiency ### A) The Allocative Efficiency - Allocative efficiency happens when consumers maximize their satisfaction and producers maximize their profits. - Allocative efficiency requires two different types of efficiency: 1. **Efficiency in consumption:** - Allocative efficiency happens when consumers get the maximum possible satisfaction from the current combination of goods and services produced and sold. 2. **Efficiency in specialization and exchange:** - Allocative efficiency requires efficient markets where firms specialize in producing and selling the products that they can produce with minimum cost to maximize their profits. - **Consumer surplus and producer surplus:** - The consumer surplus is the net benefit (satisfaction) that consumers obtain from a good. - This is represented graphically by the triangular area BCD. - Producer surplus measures the difference between the market price and the minimum amount of money that the producer would accept for the product (point A). - This is represented graphically through the triangular area ABD. - The combination of both these types of efficiency results in allocative efficiency. - Allocative efficiency will be increased as long as doing more of something results in a greater marginal benefit to society than marginal cost. - As long as this process continues, allocative efficiency will increase. - The optimum level of allocative efficiency is determined when: **Marginal benefit = Marginal cost.** **Note:** - **Marginal cost:** Cost of producing one additional unit. - **Marginal benefit:** The additional satisfaction that a consumer receives when the additional good or service purchased. ### B) The Productive Efficiency - Production efficiency occurs when the available factors of production are allocated between products in such a way that it is not possible to reallocate the production factors to raise the output of one product without reducing the output of another product. - There are many situations in which it is possible to raise the total output in an economy by simply reallocating factors of production at no additional cost (i.e. if the factors of production were misallocated.) - This is because factors of production are more productive in some uses than they are in others. - In a perfectly competitive economy, producers continue reallocating factors of production until they reach their most productive use. - **Example:** Reallocating labor from agricultural to industrial sector. ## 5. Equity Versus Efficiency - The socially efficient level of production or consumption occurs when social marginal benefit is equal to social marginal cost. (This will be explained in more detail in the next lecture ISA). - "Equity" concerns the distribution of resources and is inevitably linked with concepts of fairness and social justice. - In the case of efficient market equilibrium, the reallocation of productive resources to produce goods or services will inevitably hurt someone. ### Horizontal Equity - We must distinguish between horizontal and vertical equity. - Horizontal equity is achieved when equal people are treated equally. ### Vertical Equity - Vertical equity is achieved when people are treated fairly along a socio-economic continuum. - The problem involved with applying criteria of equity is that people differ in their ideas about fairness.