Public Finance (MPA405)

Dr. Khurrum S. Mughal

Lecture 3

Public Finance

Efficiency, Markets and Government

Marginal Conditions for Efficiency

• Total Social Benefit • Total Social Cost • Net Benefit = TSB – TSC • Maximum Net Benefit occurs where MSB

= MSC

Figure 2.1 Efficient Output

Pri

ce,

Ben

efit

, an

d C

ost

(D

oll

ars)

Loaves of Bread per Month 0

A

B

Tota

l S

oci

al B

enef

it a

nd

Co

st

MSC

MSB

TSC TSB

2.00 = P

1.50 = P*

1.00 = P2

Q*

Q1 = 10,000 Q* = 15,000 Q2 = 20,000

B C E

A D

Z

TSB – TSC

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.

If These Conditions are Met

P = MPB = MSB

P = MPC = MSC

P = MSB = MSC

and

so

When Does the Market Interaction Fail to Achieve Efficiency?

• Monopoly

• Taxes

• Subsidies

Figure 2.2 Loss in Net Benefits Due to MonopoliesP

ric

e, B

en

efi

t, a

nd

C

os

t (D

olla

rs)

Loss in Net Benefits

Output per Month 0 QM

MSB = P

MSCM

D = MSB

MSC

MR

A

E B

Q*

Figure 2.3 Taxes and EfficiencyP

ric

e (

Ce

nts

pe

r M

es

sa

ge

Un

it)

Billions of Message Units per Month

6

5

4

E'

E

B

Demand = MSB

New Supply = MPC + T > MSC

Supply = MSC = MPC

0 3 4

Figure 2.4 Subsidies and EfficiencyP

ric

e (

Do

llars

pe

r B

us

he

l)

Bushels of Wheat per Year 0

5

4

3

A E

C

Demand = MSB

Q*

Supply = MSC

QS

Market Failure: A Preview of the Basis for Government Activity

Government intervention may be warranted if there is:

• Monopoly power. • 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.

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 a socio-economic continuum.

Figure 2.5 Utility Possibility Curve

An

nu

al W

ell-

Be

ing

of

A

0

UA

UA2

UA1

Annual Well-Being of B

Z

X

UB

E1

E2

E3

UB1 UB2

Trade-off Between Equity and Efficiency in Competitive Markets

• Each individual’s money income depends on amount of productive resources owned

• Poverty is equitable

• Poor lack resources

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.

• People still vote for such policies even if the outcome is inefficient

• (Taxes must be paid by some in order that public goods can be purchased and these benefits accrue to others.) Some economists attempt to overcome this with the Compensation Criteria.

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 there is compensation.

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