BBAF 406: Public Finance

Overview of Public Finance

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 Overview of Public Finance
• Public finance is a course that deals with economic analysis of
government activities and public policy. It discusses issues about role of
government, justification of government roles, public expenditures and
revenue issues and the impact of public sector activities on the economy
as a whole. Public finance also studies public policy by exploring how the
effectiveness of policy formulation and application can be improved.
• Various economic arguments have been raised about whether there is
need for government activities in the economy given that the forces of
demand and supply (the invisible hands) are the prime tools that
determine how resources should be allocated.

• Historical perspective:
• Classical economists conclude that government intervention is not
necessary because market will work efficiently in the allocation of
resources. Therefore, government activities will bring distortions into the
market. They also state that Aggregate Supply (AS) creates its own
demand (Aggregate Demand) therefore no need for government
activities. Besides, they believe that every economy has the mechanism
to self-correct or make re-adjustments to be in optimum position hence
the economy should not be induced by any government activities to
correct temporary distortions or deviations from optimum. 2
 Overview of Public Finance
• Keynesian Economists' observation of the problems that
bedevilled the economy in the 1930s Great Depression recognized
the fact that supply was not able to create its own demand as a
result of high unemployment and recession. They therefore
proposed the Aggregate Expenditure framework which basically
explains that the Aggregate Demand is what determines Aggregate
Supply.
• Besides, Keynesians believe that the economy will take time to
correct itself or self-adjust to optimum. If the time it takes is
eternity, then the economy would have collapse then. They
therefore make a strong case for government activities to expedite
or induce the self-adjustments to solve economic problems.
• Keynesians made a strong case for the public sector or
government activities in the economy to achieve optimum. For
instance, if there is a recession then expansionary government
activities would be required to induce the economy to achieve
optimum. If there is an inflationary boom then contractionary
activities required to stabilize the economy.
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 Overview of Public Finance
• Chicago School:
• This school of thought believes that a government
intervention must improve market efficiency,
otherwise no need for it.
• Government intervention through taxes might not
then (Deadweight loss).
• Summary:
• Classicals: No need for govt intervention
• Keynesians: Strong need for government activities
• Chicago School: Conditional; only if government
intervention improves market efficiency. 4
 Overview of Public Finance
• Public finance also examines the efficiency of the market
(market mechanism in efficient allocation of resources) and
identifies that private markets can fail in efficiently allocating
resources based on the failure of conditions that make the
market work. Conditions which make the market fail include
the case of public goods, externalities, information
asymmetry, increasing returns arguments etc.
• It also recognizes that even if a private market does not fail,
government activities might also be necessary to set
regulatory framework for the market to work. This framework
involves defining and enforcing property rights to facilitate
rules of conduct in private markets. Market mechanism alone
cannot perform all economic functions. Public policy or
government activity is needed to guide, correct and
supplement it in certain respects.
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 Overview of Public Finance
• It is worthy to note that though the market may fail,
government intervention or activities might not
necessarily resolve market failure because of issues of
government failure as well.
• Some of the conditions which make the market fail can
also make government to fail. Besides, certain peculiar
problems associated with government activities can
also make the government fail i.e rent seeking
behaviours, corruption, government monopolies,
agency problems etc.
• Why are government activities or intervention common
in developing countries on the basis of the overview of
public finance? Discuss this among yourselves! 6
•
Question
Market mechanism alone cannot perform all economic functions. Public policy
and/or government activity is needed to guide, correct and supplement it in
certain respects. Explain.
• Market mechanism involves the interaction between the forces of demand and
supply in allocation resources. For the market mechanism to perform its economic
functions of allocating resources efficiently, the market itself must be efficient. The
efficiency of the market requires that there is efficiency in consumption, in
production and in product composition. These conditions do break down in certain
respects especially in the case of public goods, externalities, information
asymmetry, incomplete markets etc. Therefore in principle, whenever such
conditions break down (or the market fails), public policy or government activity is
required in those respects. Public policy is therefore required in such circumstances
to guide (in terms of defining and assigning property rights), correct (in terms of
regulation, taxes, subsidies etc as in the case of externalities) and supplement (in
terms of providing goods which the private market will not provide based on
efficiency reasons eg. public goods). If public policy or government activity is able
to perform these, then the efficiency of the market will be improved. Therefore
public policy can improve the efficiency of the market in certain respects but not
always because of issues of government failure due to inability of consumers to
reveal true preferences, rent seeking activities, monopoly bureaucracy, agency
problems etc.
• In conclusion, the statement means public policy or government activity can
improve market economic functions.
• NB: (A property right is a legal rule that describes what economic agents can do 7
with an object or idea).
 Overview of Public Finance
• Tools of Public Finance:
• Positive analysis: What must be. E.g. If price increases, quantity
demanded will fall for normal goods, etc.
• Normative Analysis: Subjective view. E.g. Equity issues, questions of
what should be produced, how it should be produced, for whom and
who should make these decisions, etc.
• Economic theory: Demand, supply, market equilibrium, etc.

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 Economic objectives/functions of government
• For government to intervene in situations of market
failure, government needs to set objectives and tailor
its functions in line with achieving the objectives.
• The economic objectives of government basically
include:
✓ Macroeconomic stability
✓ Equitable distribution of income
✓ Economic growth
• Government attempts to achieve these objectives by
carrying out Allocation Functions, Distribution or
redistribution functions and Stabilization functions.
• All these functions are executed through the
budgetary process where government expenditures,
revenues and policies are outlined.
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 Economic objectives/functions of government
• Allocation function involves the provision of social
goods or the process by which total resource use is
divided between private and social goods, and by
which a mix of social goods is chosen.
• Distribution function: The adjustment of income and
wealth to ensure conformity with what society
considers “fair” or “just” state of distribution. This
plays a key role in tax and transfer policies.
• Stabilization or Macroeconomic stability Function:
The use of budget as a means of maintaining high
employment, a reasonable degree of price level
stability and an appropriate rate of economic growth,
with allowances for effects of trade and Balance of
Payments (BOP). 10
 Economic objectives/functions of government
• Allocation function:
• Due the xtics of social or public goods, the market
system or mechanism (transactions between
individual consumers and producers or
interaction between demand and supply) may fail
to bring about optimal provision of these goods
or may produce inefficient levels (of merit goods)
which will not benefit society.
• Government or public policy is required to
facilitate efficient provision and production.

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 Economic objectives/functions of government
• Distribution function:
• Competitively, distribution of income requires that factor endowments
(personal earning abilities and ownership of accumulated and inherited
wealth) should fetch prices in line with their marginal product. But this
manner of distribution of income may not be what society considers
“fair” because it can bring substantial degree of inequality; total
satisfaction or happiness of society might not be maximized; utility of
income to various individuals differs markedly.
• This therefore calls for public policy or government activity towards
ensuring socially acceptable income distribution.
• There is therefore need for redistribution by
➢ tax-transfer schemes: combining progressive taxation of high-income
with a subsidy to low-income households
➢ Progressive taxes to finance public services like public housing which
benefit low-income households
➢ a combination of taxes on goods purchased largely by high-income
consumers with subsidies to other goods which are used mainly by low-
income consumers.
This may have efficiency losses but is it not worth it? Discuss.
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 Economic objectives/functions of government
• Stabilization function:
• Economic targets or goals like high employment,
reasonable price level stability, soundness of foreign
accounts (BOP), and acceptable economic growth rate do
conflict one another as economic relationships indicate eg
Philip’s Curve; stagflation (sustained high unemployment
coupled with high inflation)
• There is need for a balance of one target with an
acceptable or healthy allowance for other targets.
• Given the private markets are driven purely by profits or
quest for higher returns; such markets might act to
maximize one target to the detriment of the other.
• Public policy is therefore required to set jointly achievable
targets to better the lots of all market actors.
• This is usually done through fiscal policy instruments and
monetary policy instrument on behalf of the government.
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 Concept of EQUITY
• Equity is a social construct that examine fairness in
distributing resources among the population. It looks not
only at fairness in distributing income but also wealth,
opportunities and even public projects. Need for Cost-
Benefit Analysis (CBA) important.
• Equity is the fairness of distribution of well-being (resources,
wealth, income etc) among the population.
• Equity does not in any way mean equality, rather, it is a call
for fairness or justice in the distribution of resources.
• Govt. should, therefore, design socially desirable policies to
achieve fairness in the distribution of resources
• Equity or fairness in government activities is achieved
through taxation and provision of public goods.
• As regards taxation, Benefit principle is crucial: thus taxing
in line with the benefits received from government activity.
• Ability-to-pay principle: Fairness in determining the capacity
of an individual to handle a financial burden. 14
 Equity Issues
Welfare economist identified horizontal and vertical equity in income
distribution
• Horizontal equity means when people in similar circumstances are
treated similarly in matters of remuneration and taxation. Eg :
People with similar abilities or income pay similar tax amounts.
People doing same work must receive same salary according to
their ranks. Eg SSSS. Horizontal equity can be alluded to by the
phrase “Equals must be treated equally”
• Vertical equity means different treatment of people in different
situations in order to reduce inequality in the society. Thus
“Unequals must be treated unequally”. This means tax system
should be based on ability-to-pay principle. Example is the income
tax structure.
• Which of these equity types inure to the benefit of the poor in
society? Discuss!
• Although this has its own efficiency problems and may be inimical
to growth, the objective of attaining equity is very crucial. Thus,
equity should be seen as an end, while efficiency a means to an
end. 15
 Equity: Applications
• Discussion:
• Taxation: Progressive taxation; VAT, NHIS.
• Which kinds of equity are they meant to
achieve? Why?

• Remuneration: SSSS, Article 71 Remuneration,

Allowances, Social security.
• Which kinds of equity are they meant to
achieve? Why?
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 Social Interest and Market Efficiency
• Much like the competitive market, government or
public sector performs various economic functions
in order to achieve an ultimate goal of improving
social or public interest, collectively referred to as
social welfare.
• While the market achieves this objective by
assuming that maximization of private welfare (self
interests) will together improve social welfare,
public sector activities aim at achieving this together
or collectively.
• It is therefore necessary to understand the concept
of social welfare function in order to appreciate
private market vs public sector. 17
 Social Welfare Function Analysis
• Social Welfare encompasses the well-being of the society
as a whole rather than the welfare of individuals. But the
society is made up of individuals hence we can construct a
social welfare function (SWF) as a function of individual
well-being.
• If well-being can be measured (say using utility) and
interpersonal comparisons of well-being is allowed, then
SWF=W= f(U1, U2, …, Un) where n is the population, U is
utility (benefit, satisfaction) then 3 properties can be
drawn:
i. Pareto principle: If Ui rises then W rises.
ii. Individualism: Social Welfare is only a function of
individual well-being.
iii. Social welfare function can provide some basis for social
choice. (Choice of projects with CBA based on welfare).
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 Social Welfare Function Types
• Utilitarian SWF: It says Social Welfare is the sum of
individual well-being. W=U1+U2+ … +Un. This type is
however pregnant with strong inequality and equity
problems. Why?
• Rawlsian SWF: Social Welfare is the welfare of the worst-
off member of the society. W= min (U1, U2, …, Un). This
SWF is averse to inequality and sees improvement in
social welfare as improvement in the well-being of the
worse off or the poorest of the poor in society. E.g.: LEAP
• The two types basically give some understanding of what
kind of social welfare would a competitive market
improve compared with a public sector.
• While the market may improve social welfare largely on
the basis of Utilitarian SWF, public sector activities may
improve social welfare on the basis of Rawlsian SWF.
Discuss this among yourselves! 19
 Social Welfare Function Types
• Applications:
• Market mechanism is based on the idea that once individual utilities
(well-being) increase then welfare of society as a whole is maximized.
But there are a lot of vertical equity problems embedded in the
Utilitarian SWF.
• For Rawlsian SWF, society is better off if the well-being of the worse
off individual is improved.
• The two SWF types also influence the political economic choice of
parties where we have liberal democracy (capitalism) and social
democracy (socialism).
• Which of the two appeals to you as a public finance student and why?
• Govt or public policy usually improve both types of SWF.
• For social welfare to be improved through the market mechanism, the
market must work efficiently (CS and PS should be maximized). What
does the concept of market efficiency entail?

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 Market Efficiency Basics
• Consumers, Producers and Efficiency of market
• I assume you have read Stiglitz Chapter 3 before this lecture.
• Do the equilibrium price and quantity maximize the total welfare of
buyers and sellers?
• Market equilibrium reflects the way markets allocate scarce resources.
• Whether the market allocation is desirable can be addressed by
welfare economics.
• Welfare economics is the study of how the allocation of resources affects
economic well-being.
• Buyers and sellers receive benefits from taking part in the market.
• The equilibrium in a market maximizes the total welfare of buyers and
sellers.
• Equilibrium in the market results in maximum benefits, and therefore
maximum total welfare for both the consumers and the producers of
the product.

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 Market Efficiency Basics
• Consumers, Producers and Efficiency of market
• Consumer surplus measures economic welfare from the
buyer’s side.
• Producer surplus measures economic welfare from the seller’s
side.
• Consumer surplus:
• Willingness to pay is the maximum amount that a buyer will
pay for a good. It measures how much the buyer values the
good or service.
• Consumer surplus is the buyer’s willingness to pay for a good
minus the amount the buyer actually pays for it.
• What does the consumer surplus measure?
• Consumer surplus, the amount that buyers are willing to pay
for a good minus the amount they actually pay for it, measures
the benefit that buyers receive from a good as the buyers
themselves perceive it.
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Figure 1: How the Price Affects Consumer Surplus

(a) Consumer Surplus at Price P

Price
A

Consumer
surplus
P1
B C

Demand

0 Q1 Quantity
Figure 2: How the Price Affects Consumer Surplus

(b) Consumer Surplus at Price P

Price
A

Initial
consumer
surplus
C Consumer surplus
P1
B to new consumers

F
P2
D E
Additional consumer Demand
surplus to initial
consumers
0 Q1 Q2 Quantity
Perfect Competitive market vs. Imperfect competitive
(Monopoly) market and Consumer Surplus (CS)
Fig. 4.1 in Stiglitz

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 Market Efficiency Basics
• Consumers, Producers and Efficiency of market
• Producer surplus:
• Producer surplus is the amount a seller is paid for
a good minus the seller’s cost.
• It measures the benefit to sellers participating in
a market.

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Figure 3: How the Price Affects Producer Surplus

(a) Producer Surplus at Price P

Price
Supply

B
P1
C
Producer
surplus

0 Q1 Quantity
Figure 4: How the Price Affects Producer Surplus

(b) Producer Surplus at Price P

Price
Additional producer Supply
surplus to initial
producers

D E
P2 F

B
P1
Initial C
Producer surplus
producer to new producers
surplus

0 Q1 Q2 Quantity
 Market Efficiency
• Consumer surplus and producer surplus may be used to address
the following question:
✓ Is the allocation of resources determined by free markets in any
way desirable?
• Consumer Surplus = Value to buyers – Amount paid by buyers
• Producer Surplus = Amount received by sellers – Cost to sellers
• Total surplus = Consumer surplus + Producer surplus
or
• Total surplus = Value to buyers – Cost to sellers
• Efficiency is the property of a resource allocation of maximizing
the total surplus received by all members of society.
• In addition to market efficiency, a social planner might also care
about equity – the fairness of the distribution of well-being
among the various buyers and sellers. 29
 Figure 5: Consumer and Producer Surplus in the Market
Equilibrium

Price A

D
Supply

Consumer
surplus

Equilibrium E
price
Producer
surplus

Demand
B

0 Equilibrium Quantity
quantity
 Market Efficiency
• Three Insights Concerning Market Outcomes
– Free markets allocate the supply of goods to the
buyers who value them most highly, as measured by
their willingness to pay.
– Free markets allocate the demand for goods to the
sellers who can produce them at least cost.
– Free markets produce the quantity of goods that
maximizes the sum of consumer and producer
surplus.

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Figure 6: The Efficiency of the Equilibrium Quantity

Price
Supply

Value Cost
to to
buyers sellers

Cost Value
to to
sellers buyers Demand

0 Equilibrium Quantity
quantity

Value to buyers is greater Value to buyers is less

than cost to sellers. than cost to sellers.
 Evaluating market equilibrium
• Because the equilibrium outcome is an efficient
allocation of resources, the social planner can leave
the market outcome as he/she finds it. This market
outcome applies to a perfectly competitive market.
• This policy of leaving the market well enough alone
goes by the French expression laissez faire.
• Market Power
– If a market system is not perfectly competitive, market
power may result.
• Market power is the ability to influence prices.
• Market power can cause markets to be inefficient because it
keeps price and quantity from the equilibrium of supply and
demand.
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 Evaluating market equilibrium
• Externalities
– created when a market outcome affects individuals
other than buyers and sellers in that market.
– cause welfare in a market to depend on more than
just the value to the buyers and cost to the sellers.
• When buyers and sellers do not take
externalities into account when deciding how
much to consume and produce, the equilibrium
in the market can be inefficient.

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 Quick summary
• Consumer surplus equals buyers’ willingness to pay for a good minus the amount they
actually pay for it.
• Consumer surplus measures the benefit buyers get from participating in a market.
• Consumer surplus can be computed by finding the area below the demand curve and
above the price.
• Producer surplus equals the amount sellers receive for their goods minus their costs of
production.
• Producer surplus measures the benefit sellers get from participating in a market.
• Producer surplus can be computed by finding the area below the price and above the
supply curve.
• An allocation of resources that maximizes the sum of consumer and producer surplus
is said to be efficient.
• Policymakers are often concerned with the efficiency, as well as the equity, of
economic outcomes.
• The equilibrium of demand and supply maximizes the sum of consumer and producer
surplus.
• This is as if the invisible hand of the marketplace leads buyers and sellers to allocate
resources efficiently.
• Markets do not allocate resources efficiently in the presence of market failures. 35
 Market efficiency
• Economics generally advocates a primary reliance on the
private sector rather than public sector for the production and
distribution of goods because it is believed that such economic
organization leads to efficient allocation of resources. This is to
say that the private market brings about economic efficiency
(market efficiency).
• Adam Smith explains this efficiency by arguing that individual’s
self interest will make them take economic decisions which
will inure to public interest rather than a small group of
individuals taking such decisions on behalf of the public. Thus
in competitive markets, an individual pursuing private gains
would promote the common good of society.
• Thus, individuals in the pursuit of his private interests (profits)
will end up also pursuing the public interest or social interest.
(Trickle down effect). You remember the Utilitarian SWF?
• Adam Smith: Public interest (SWF) is served when each
individual simply does what is in his own self-interest.
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 Market efficiency
• On the basis of self interest, Adam Smith explains if an individual
or a group of individuals want to satisfy their self-interest
(satisfaction), they will be willing to pay something for what will
make them satisfy their self-interest.
• Another individual (entrepreneur) also willing to satisfy his/her
self-interest (profits) will be willing to produce the item if what
people will pay for the item exceeds the cost of producing it. What
about if what they are willing to pay is lower than the cost of
producing it as in the case of public goods? Or if they are not
willing to pay anything but will enjoy the good?
• However, once the value placed on the item exceeds the cost of
producing it (there exists a profit), entrepreneurs will be willing to
produce it and will compete for the profits. They will even look for
innovative or new methods of producing it to reduce costs hence
there will be competition to drive out those that produce at a very
high cost (inefficient producers) to ensure efficiency.
• Once the item is produced, it will satisfy the self-interest of
satisfaction and also yield profits for entrepreneurs’ self interest.
• Hence social or public welfare is improved. This means no need for 37
any government or public sector economic functions.
 Market efficiency
• Deductions
• The market organization in production will work if
➢ Consumers are willing to pay something for an item.
➢ Consumers reveal the amount they are willing to pay in
line with the true value they place on the item.
➢ The cost (MC) of production is less than what they are
willing to pay.
• Questions:
• What if they are not willing to pay for the item?
• What if what they are willing to pay does not reveal
their true value for the item?
• What if what they are willing to pay is lower than the
cost of producing the item? 38
 Market efficiency: Composite Analysis
• Market efficiency is a criterion that is used to basically determine
economic decisions like what should be produced (consumer
sovereignty based on consumption or exchange efficiency), how it
should be produced (production efficiency), for whom and who
should make these decisions (product-mix efficiency).
• If the market mechanism decides all these efficiently, then there
will be Pareto efficiency or composite market efficiency.
• Pareto Optimality or efficiency: it is a property in resource
allocation that postulates that if the market is efficient then no
one can be made better off without someone being made worse
off. There shouldn’t be any trade off that will improve the welfare
of one individual without making someone worse off. Eg: If the
market is efficient, individual A can only be made better off if
individual B is some way made worse off.
• If the reverse happens, we say there is Pareto improvement or the
Pareto principle. Eg: if A is better off, B should be the same or also
be made better off some way, then there is a Pareto improvement.
• Read Summary notes on pg. 73-74 of Stiglitz’s textbook for more.
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 Market efficiency
• Pareto efficiency raises two fundamental theorems of welfare
1) If the economy is competitive, and satisfies certain other conditions, it is
Pareto efficient – (Every one will be well-off in line with factor endowment
and no one’s welfare can be improved without making somebody’s worse
off). So-called “first best”.
2) There are many Pareto efficient distributions, hence by redistributing
initial wealth or income (factor endowments) , the forces of competitive
market will freely play out to obtain Pareto efficient allocation of
resources. So-called “second best”. E.g. support the poor’s income and let
the market handle the rest by efficiently allocating resources.
• The implications of these theorems are that:
1. Competitive market will produce or generate Pareto optimal outcomes,
(but if government thinks the outcomes will not maximize social welfare,
there can be redistributions to achieve Pareto improvement, this will
however be Pareto inefficient).
2. Government can redistribute initial wealth (factor endowments or property
rights) and leave the rest to the competitive market to work out to
improve welfare efficiently.
3. Government should not interfere with the market outcomes (market has
some merits) but focus on redistribution of initial wealth or factor
endowments. 40
 Implications of the fundamental
theorems of Welfare
• This means that society can obtain a particular
efficient allocation by appropriately redistributing
factor endowments.
• This can be achieved through taxes/subsidies to
factor endowments (lump sum taxes), but these
taxes/subsidies should not affect choice (prices).
• In fact, this redistribution of factor endowments
could be viewed as the main role of government
in the perfectly competitive model.
• Kind of the Chicago School on PF.
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 Market efficiency in a single market
• In a single market, competition results in market efficiency when
the “invisible hands” of demand and supply interact.
• In deciding how much to demand, individuals equate the marginal
benefit (MB) they receive from consuming an extra unit with the
marginal cost (MC) of purchasing an extra unit. The MC here is just
equal to the price they have to pay (in a competitive market).
• In deciding how much of a good to produce or supply, competitive
firms (entrepreneurs) equate the MB they receive from producing
an extra unit (which just equal price) with the MC of producing an
extra unit.
• Market Efficiency requires that the MB associated with producing
one more unit of any good equals its MC. Thus, MB=MC.
• If MB>MC, society would gain from producing more of the good;
• If MB<MC, society would gain from reducing production of the
good eg air pollutants
• The conditions required for market efficiency are MB=MC, and
generally MB=P=MC for a competitive market efficiency.
• Example: MU=P=MC for consumers, MR=MC=P for producers etc. 42
 Market efficiency in a single market
• In analyzing economic (Pareto) efficiency, the economy must achieve three
aspects of efficiency to be Pareto efficient.
1. Exchange efficiency or efficiency in consumption: Whatever goods
produced have to go to the individuals who value them most. The value
placed on a good is equal to the MB. However, the relative value that one
individual (say A) places on the last unit of commodity (say X ) compared
to that placed on the last unit of another commodity (say Y) is the
marginal rate of substitution (MRSAx,y ). Therefore, efficiency in
consumption requires that MRSAx,y = MRSBx,y = … = MRSzx,y . Competitive
market in which individuals face the same prices always have exchange
efficiency. Thus, MRSAx,y = MRSBx,y = … = MRSzx,y . For competitive markets,
consumers face same price so MRSAx,y = MRSBx,y = … = MRSzx,y =Price.
(Read Stiglitz pg.74).
2. Production efficiency: Given society’s resources and technology, the
production of one good cannot be increased without decreasing the
production of another if it has to be Pareto efficient. This can be explained
looking at the rate of exchange of factors of production between firms,
generally referred to as marginal rate of technical substitution (MRTS). The
MRTSAL,K is the value (to firm A) of the last unit of labour (say L) relative to
the last unit of capital (say K).
For production efficiency, MRTSAL,K = MRTSBL,K = … = MRTSZL,K . For
competitive markets firms face the same factor prices so MRTSAL,K = 43
MRTSB = … = MRTSZ =Price.
 Market efficiency
• 3) Product-mix efficiency: Goods produced correspond to those
desired by individuals. Firms are willing to transform the
production of one good into another depending on market
conditions. The rate at which one good can be transformed into
another in production is referred to as marginal rate of product
transformation (MRPT). For Product-mix efficiency condition,
MRPTX,Y = MRSX,Y .For competitive markets, MRPTX,Y = MRSX,Y =Price

• For instance, if MRPTX,Y = 2Y/1X and MRSX,Y =1Y/1X then MRPTX,Y >
MRSX,Y meaning the economy can produce two units of Y by
sacrificing one unit of X, while the consumers are willing to
exchange one unit of Y for one unit of X. Obviously, the economy
(firms) produces too much of X relative to the preferences of the
consumers, and too little of Y relatively to the tastes of consumers.
Welfare can therefore be increased by increasing the production
of Y and decreasing the production of X.
• The firms are willing to transform 2Y to 1X (or 1Y to ½ X) but what
is actually produced is what the consumers are exchanging 1Y to
1X (or 2Y to 2X) meaning there is an over-production of X by ½ . 44
 Summary: Market efficiency
• Resource allocations that have the property that no one can be made better off
without someone else being made worse off are called Pareto efficient allocations.
If the market is efficient the above (Pareto efficiency) should also happen.
• Pareto efficiency requires exchange efficiency, production efficiency and product-
mix efficiency.
• The fundamental theorems provide conditions under which competitive economy
is Pareto efficient, and under which Pareto efficient allocation can be made through
markets provided that there is apt redistribution of initial factor endowments.
• Exchange efficiency implies 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 all individuals have the same MRS between any pair of commodities.
Competitive market in which individuals face the same prices always have
exchange efficiency.
• Production efficiency requires that, given the set of resources, the economy will
not be able to produce more of one commodity without reducing the output of
some other commodity. Production efficiency requires that all firms have the same
MRTS between any pair of inputs. Competitive market in which firms face or
receive the same prices always have production efficiency.
• Product mix efficiency requires that what is desired by individuals is what firms
produce to meet exact desires, consumer sovereignty!
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