Economics of the Public Sector

1
Economics of the Public Sector

• FUNDAMENTALS OF WELFARE ECONOMICS
• Market efficiency
• 2.1. The invisible hand of competitive markets
• 2.2. Welfare economics and Pareto efficiency
• 2.3. Analyzing economic efficiency

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Market efficiency welfare economics and Pareto
efficiency

• WELFARE ECONOMICS is the branch of economics that
  focuses on normative issues
• what should be produced,
• how it should be produced,
• for whom,
• who should make these decisions.
• PARETO EFFICIENCY
• Resource allocations that have the property that
  no one can be made better off without someone
  being made worse off are said to be Pareto
  efficient, or Pareto optimal.

3
Market efficiency welfare economics and Pareto
efficiency

• Pareto efficiency and individualism
• The criterion of Pareto efficiency is concerned
  only with each individuals welfare, not with the
  relative well-being of different individuals.
• It is each individuals perception of her own
  welfare function that counts. This is consistent
  with the general principle of CONSUMER
  SOVEREIGNTY, which holds that individuals are the
  best judge of their own needs and wants, of what
  is in their best interest.

4
Market efficiency welfare economics and Pareto
efficiency

• FUNDAMENTAL THEOREMS
• OF WELFARE ECONOMICS
• Every competitive economy is Pareto efficient
• Every Pareto efficient resource allocation can be
  attained through a competitive market mechanism,
  with the appropriate initial redistributions.

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Market efficiency welfare economics and Pareto
efficiency

• EFFICIENCY FROM THE
• PERSPECTIVE OD A SINGLE
• MARKET
• In deciding how much to demand, individuals
  equate the marginal benefit they receive from
  consuming an extra unit with the marginal cost,
  the price they have to pay.
• In deciding how much to supply, firms equate the
  marginal benefit they receive, which is just the
  price, with the marginal cost.
• At the market equilibrium, where supply equals
  demand, the marginal benefit (to consumers) is
  equal to the marginal cost to firms and each
  equals the price

Price
Supply curve
E
Demand curve
Quantity
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Market efficiency analyzing economic efficiency

• THE UTILITY POSSIBILITY CURVE
• The UPC gives the maximum level of utility that
  one individual (Friday) can achieve, given the
  level of utility of other individual (Crusoe).
• Along the frontier, it is not possible for Crusoe
  to consume more unless Friday consumes less.
• Therefore, the UPC is downward-sloping the
  higher Crusoes utility, the lower the maximum
  level of Fridays utility.

Crusoes utility
A
Fridays utility
7
Market efficiency analyzing economic efficiency

• EXCHANGE EFFICIENCY
• concerns the distribution of goods,
• means that, given the set of goods available in
  the economy, no one can be made better off
  without someone else being made worse off.
• It requires that there is no scope for trades, or
  exchanges that would make both parties better
  off.
• It requires that all individuals have the same
  marginal rate of substitution between any pair of
  commodities.
• Competitive markets in which all individuals face
  the same prices always have exchange efficiency.

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Market efficiency analyzing economic efficiency

• Robinsons Budget Constraint
• Given income of 100, the price of oranges of 2,
  and the price of apples of 1, an individual can
  purchase any combination of apples and oranges
  along or to the left the budget constraint.
• The slope of the budget constraint is based on
  the relative price of oranges and apples.

Apples
100
Budget constraint
50
Oranges
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Market efficiency analyzing economic efficiency

• THE CONSUMERS
• CHOICE PROBLEM
• The budget constraint gives the combinations of
  apples oranges that Robinson can buy, given his
  income given the price of apples oranges.
• The indifference curve gives those combinations
  of apples oranges among which Robinson is
  indifferent.
• Robinson chooses the point along the budget
  constraint which he most prefers, that is, the
  point where the indifference curve I0 is tangent
  to the budget constraint (point E).

Apples
100
B
89
A
80
E
F
I1
D
C
18
17
I0
Oranges
50
59
60
17
18
10
Fridays consumption of oranges
A
0
Apples
Fridays indifference curves
Fridays indifference curve
Fridays consumption of apples
E
B
B
Crusoes indifference curve
Crusoes consumption of apples
A
0
Oranges
Crusoes consumption of oranges

• EXCHANGE EFFICIENCY
• The sides of this Edgeworth-Bowley Box give the
  available supplies of apples oranges.
• Pareto efficiency requires the tangency of the
  two indifference curves (point E), where the MRS
  of apples for oranges are equal.

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Market efficiency analyzing economic efficiency

• PRODUCTION EFFICIENCY
• It requires that, given the set of resources, the
  economy not be able to produce more of one
  commodity without reducing the output of some
  other commodity.
• The economy must be operating along its
  production possibility curve.
• It requires that all firms have the same marginal
  rate of technical substitution (MRTS) between any
  pair of inputs.
• Competitive markets in which firms face the same
  prices always have production efficiency.

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Market efficiency analyzing economic efficiency

• PRODUCTION EFFICIENCY
• THE PRODUCTION POSSIBILITIES FRONTIER
• Points inside the frontier are attainable but
  inefficient.
• Points along the frontier are feasible
  efficient.
• Points outside the frontier are unattainable,
  given the resources of the economy.

Production Possibilities Frontier
Apples
Oranges
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Market efficiency analyzing economic efficiency

• ISOQUANTS ISOCOST LINES
• An isoquant gives combinations of inputs (land
  labor) which yeald the same output.
• The slope of the isoquant is the MRTS.
• The isocost line gives those combinations of
  inputs which cost the same amount.
• The slope of the isocost line is given by the
  relative prices of the two inputs.
• The firm maximizes its output, given a particular
  level of expenditures on inputs, at the point
  where the isoquant is tangent to the isocost
  line.
• At that point, the MRTS equals the relative
  price.

Land
Isoquants
Q1
Q0
Isocost line
Labor
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Labor input into apples
A
0
Land
Apple isoquants
Land input into apples
Q0
C
D
Q1
E
B
B
Q2
Land input into oranges
Orange isoquant
Apple isoquants
0
A
Labor
Labor input into oranges

• PRODUCTION EFFICIENCY
• The sides of this Edgeworth-Bowley Box give the
  available supplies of resources land labor.
• It requires the tangency of the isoquants.
• At tangency points (such as E) MRTS of land for
  labor is the same in the production of apples
  oranges.

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Market efficiency analyzing economic efficiency

• PRODUCT MIX EFFICIENCY
• It requires that the marginal rate of
  transformation (MRT) the slope of the
  production possibilities curve equal
  individuals marginal rate of substitution (MRS)
• Competitive markets have product mix efficiency.

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Market efficiency analyzing economic efficiency

• PRODUCT MIX EFFICIENCY requires that MRT equal
  consumers MRS
• In order to reach the highest level of consumers
  utility, the indifference curve the production
  possibilities schedule must be tangent (point E).

Indifference curves
Apples
E
E
Production Possibilities Curve
Oranges
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Market efficiency analyzing economic efficiency

• Basic conditions for Pareto efficiency
• EXCHANGE EFFICIENCY MRS between any two goods
  must be the same for all individuals.
• PRODUCTION EFICIENCY MRTS between any two
  inputs must be the same for all firms.
• PRODUCT MIX EFFICIENCY MRT must equal MRS.
• Competitive economies satisfy all three conditions