EFFICIENCY, MARKETS, AND GOVERNMENTS

EFFICIENCY, MARKETS, AND GOVERNMENTSLEARNING OBJECTIVESDiscuss the difference between positive and normative economicsDefine the efficiency criterion and show how the marginal conditions for efficiency can be used to identify the efficient output of a good or serviceExplain how a system of perfectly competitive markets can achieve efficiencyShow how the exercise of monopoly power can prevent markets from achieving efficient levels of outputDemonstrate how taxes and subsidies affect incentives and how they can prevent competitive markets from achieving efficient outcomesUse a utility-possibility curve to illustrate the trade-off between efficiency and equity I. POSITIVE AND NORMATIVE ECONOMICSA useful starting point for analyzing government activities is the study of the role of markets in allocating resources

POSITIVE ECONOMICS is a scientific approach to analysis that establishes cause-and-effect relationships among economic variables.

Attempts to be objective, making no presuppositions about what is good or bad or what should be accomplished.

NORMATIVE ECONOMICS is based on value judgments about what is desirable or what should be done to achieve the desired outcome.

Begins with predetermined criteria and is used to prescribe policies that best achieve those criteria.

Because it is based on underlying values, this approach is not objective.POSITIVE ECONOMICSPositive economics is a branch of economics that focuses on the description and explanation of phenomena, as well as their casual relationships including developing and testing economic theories

Positive economics clearly states an economic issue

The what is of economics

Clearly states an economic issue

NORMATIVE ECONOMICSNormative economics is a branch of economics that expresses value or normative judgments about economic fairness. It focuses on what the outcome of the economy or goals of public policy should be.

It focuses on what the outcome of the economy or goals of public policyshouldbe

normative economics provides the value-based solution for the issue.

Economic thought in which one applies moral beliefs, or judgment, claiming that an outcome is "good" or "bad".

The what ought to be in economics

Provides the value-based solutions for the issue

II. NORMATIVE EVALUATION OF RESOURCE USE: THE EFFICIENCY CRITERION

EFFICIENCY is a normative criterion for evaluating the effects of resource use on the well-being of individuals

- Producing a desired result with a minimum effort or expense or the minimization of wasted effort.

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 the well-being of any one person without reducing the well-being of any other person. (by Vilfredo Pareto)Marginal Conditions for EfficiencyMARGINAL SOCIAL BENEFIT of a good is the extra benefit obtained by making one more unit of that good available over any given period.

Can be measured as the maximum amount of money given up by people to obtain the extra unit of the good.

MARGINAL SOCIAL COST of a good is the minimum sum of money required to compensate the owners of inputs used in producing the good for making an extra unit of good available.

THE MARGINAL NET BENEFIT of a good is the difference between its marginal social benefit (MSB) and its marginal social cost (MSC)

Note:When MNBs are positive, additional gains from allocating more resources to the production of a good are possible

THE TOTAL SOCIAL COST of a good is the value of all resources necessary to make a given amount of the good available per month.III. MARKETS, PRICES, AND EFFICIENCY CONDITIONSEFFICIENT ECONOMIC SYSTEM

Allocates resources so as to set MSB of each good or service = MSCMarkets are organized for the purpose of allowing mutually gainful trades between buyers and sellers.

A PERFECTLY COMPETITIVE MARKET SYSTEMCan result in efficient resource use in an economy. It exists when:

All productive resources are privately ownedAll 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 the prices.All relevant information is freely available to buyers and sellers.Resources are mobile and may be freely employed in any enterprise.

When does market interaction fail to achieve efficiency?2. Prices do not always fully reflect the marginal social costs of output. This occurs because of the nature of certain goods, which makes them difficult to package and trade easily in markets.

2. For services with collective or shared benefits, it might be difficult to package the benefits flowing from outputs into units that can be sold to individuals. When packaging into salable units is difficult so is pricing.

The failure of markets to price and make available certain goods, such national defense and environmental protection, gives rise to demands for governmental protection and regulation.3. When Monopolistic Power is exercised. (Figure 2.2) - A firm exercises monopolistic power when it influences the price of the product it sells by reducing output to a level at which the price it sets exceeds marginal cost of production.

4. Taxes It distorts the decisions of market participants. For example, taxes influence your decision to work by reducing the net gain from working. (Figure 2.3)

5. Government Subsidies IV. MARKET FAILURE: A PREVIEW OF THE BASIS FOR GOVT ACTIVITYExercise of monopoly power in markets Damaging effect of the market (exhaust fumes from cars, trucks, factories and power plants)Public goods (national defense)Incomplete information (e.g. drugs and hazardous products)Economic stabilization (unemployment)V. EQUITY VS. EFFICIENCYEQUITY - Perceived fairness in the resource allocation

VI. POSITIVE ANALYSIS TRADE-OFF BETWEEN EQUITY AND EFFICIENCY