EFFICIENCY,

MARKETS, AND
GOVERNMENT
S

LEARNING OBJECTIVES

Discuss the difference between positive and normative

economics

Define the efficiency criterion and show how the

marginal conditions for efficiency can be used to
identify the efficient output of a good or service

Explain how a system of perfectly competitive markets

can achieve efficiency

Show how the exercise of monopoly power can

prevent markets from achieving efficient levels of
output

Demonstrate how taxes and subsidies affect

incentives and how they can prevent competitive
markets from achieving efficient outcomes

Use a utility-possibility curve to illustrate the trade-off

between efficiency and equity

I. POSITIVE AND
NORMATIVE ECONOMICS

A 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
ECONOMICS

Positive 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

NORMATIVE
ECONOMICS

Normative 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

Positive economics clearly

states an economic issue

The what is of economics

Clearly states an economic 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

Efficiency
MARGINAL 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 CONDITIONS
EFFICIENT ECONOMIC SYSTEM
1.

Allocates resources so as to set

MSB of each good or service =
MSC

2.

Markets are organized for the

purpose of allowing mutually
gainful trades between buyers
and sellers.

A PERFECTLY COMPETITIVE MARKET SYSTEM

Can result in efficient resource use in an

economy. It exists when:

1.

All productive resources are privately owned

2.

All transactions take place in markets, and in

each separate market many competing sellers
offer a standardized product to many
competing buyers.

3.

Economic power is dispersed in the sense that

no buyers or sellers alone can influence the
prices.

4.

All relevant information is freely available to

buyers and sellers.

5.

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
ACTIVITY
1. Exercise of monopoly power in
markets
2.

Damaging effect of the market

(exhaust fumes from cars,
trucks, factories and power
plants)

3.

Public goods (national defense)

4.

Incomplete information (e.g.

drugs and hazardous products)

5.

Economic stabilization

V. EQUITY VS. EFFICIENCY

EQUITY - Perceived fairness in
the resource allocation

VI. POSITIVE ANALYSIS

TRADE-OFF BETWEEN
EQUITY AND EFFICIENCY