Efficient Markets and Government

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 A MSC B 2.00 = P C E Price, Benefit, and Cost (Dollars) 1.50 = P* 1.00 = P2 D A MSB Q1 = 10,000 Q2 = 20,000 TSC Q* = 15,000 B TSB Z Total Social Benefit and Cost TSB – TSC 0 Q* Loaves of Bread per Month

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 B MSB = P MSC E Price, Benefit, and Cost (Dollars) Loss in Net Benefits MSCM A D = MSB MR QM Q* 0 Output per Month

10. Figure 2.3 Taxes and Efficiency MPC + T > MSC New Supply = MSC = MPC Supply = E' 6 E 5 Price (Cents per Message Unit) 4 B MSB Demand = 0 3 4 Billions of Message Units per Month

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

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 UA Z E1 UA2 Annual Well-Being of A X E2 UA1 E3 UB1 UB2 UB 0 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. 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.