Professorship in Faculty 07

Federal and Regional Financial Relations Prof. Dr. André W. Heinemann Business Studies & Economics

Public Sector Economics

Chapter 2
Equilibrium and Efficiency
2.1 A Simple Competitive Economy
The Model of Perfect Competition

 A functioning market coordinates individual decisions and actions of economic actors.

There is no need for central economic steering body  „invisible hand“ (A. Smith)

 A „functional“ market should meet 5 functions:

• Distribution of market income depends on performance.
• Production of goods and services matches consumer preferences.
• Production factors will be steered into the most productive alternative.
• Production can be adapted to changing conditions and parameters.
• Promoting the technological progress in products and production processes.

 In the ideal case, a functional market leads to market efficiency.

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2.1 A Simple Competitive Economy
The Model of Perfect Competition

 Main assumptions
• Atomistic market
 Many (small) suppliers, many (small) customers
 Large number of buyers and sellers
• Homogeneity of goods (homogeneous products)
• Transparency (perfect information), Mobility (no market barries to entry or exit), Divisibilities
of factors and products, well defined property rights, perfect mobility, rational actors
• No transaction costs

 Characteristics
• Uniform market price in equilibrium
• Market clearance in equilibrium
• Consumers and firms are price takers (who cannot control the prices, no participant with
market power to set prices)
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2.1 A Simple Competitive Economy
Private Households

Private households
 Offer production factor (Labor) and demand goods
 Objective: Individual utility maximization

 Marginal Willingness to Pay (𝑀𝑊𝑃):

How many monetary units a household is willing to pay maximally for one additional unit of good 𝑥?
 Monetary marginal utility

 Optimum for one individual: 𝑀𝑊𝑃 = 𝑝 (𝑝 = price of good 𝑥)

 Optimum for two individuals: 𝑀𝑊𝑃 𝐴 = 𝑀𝑊𝑃𝐵 = 𝑝

3
2.1 A Simple Competitive Economy
Firms

Firms
 Demand production factor (Labor) and supply goods
 Objective: Profit maximization

 Marginal costs (𝑀𝐶):

How many monetary units costs the production of an additional unit of good 𝑥?
 Marginal costs of production

 Profit maximum: 𝑝 = 𝑀𝐶 (𝑝 = price of good 𝑥)

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2.1 A Simple Competitive Economy
MWP and Competitive Economy

𝑝∗ 𝑆𝑥
𝐴
𝐸

𝐷𝑥𝐴
∗
𝑥𝐴 𝑥

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2.1 A Simple Competitive Economy
MWP and Competitive Economy

∗ 𝐸𝐵
𝑝 𝑆𝑥
𝐴
𝐸

𝐷𝑥𝐵
𝐷𝑥𝐴
∗ ∗
𝑥𝐴 𝑥𝐵 𝑥

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2.1 A Simple Competitive Economy
Horizontal Summation of Individual Demand Curves

∗ 𝐸𝐵 𝐸
𝑝 𝑆𝑥
𝐸 𝐴 𝐷𝑥𝐴+𝐵

𝐷𝑥𝐵
𝐷𝑥𝐴
∗ ∗
𝑥𝐴 𝑥𝐵 𝑥∗ 𝑥
(e.g. 5) (e.g. 7) (12)
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2.2 Competition Equilibrium and Pareto Efficiency
Pareto Efficiency

Vilfredo Pareto (18481923)

 Pareto improvement:
A reallocation that makes at least on individual better off without making anyone else
worse off.
• Strong Pareto improvment
• Weak Pareto improvement

 Pareto optimality:
An allocation at which the only way to make an individual better off is to make another
individual worse off.

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2.2 Competition Equilibrium and Pareto Efficiency
First Marginal Condition: Production Efficiency

2 Factors: 2 Goods:
Labor (𝐿) and Capital (𝐾) Good 1 (𝑋1 ) and Good 2 (𝑋2 )

Produktion function 𝑋𝑗 = 𝑋 𝐿𝑗 , 𝐾𝑗 with 𝑗 = 1, 2 (Sector 1 und Sector 2)

𝜕𝑋𝑗 𝜕𝑋𝑗
>0 ; >0
𝜕𝐿𝑗 𝜕𝐾𝑗
𝜕2 𝑋𝑗 𝜕2 𝑋𝑗
<0 ; <0
𝜕(𝐿𝑗 )2 𝜕(𝐾𝑗 )2

𝜕2 𝑋𝑗 𝜕2 𝑋𝑗
= >0
𝜕𝐿𝑗 𝜕𝐾𝑗 𝜕𝐾𝑗 𝜕𝐿𝑗

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2.2 Competition Equilibrium and Pareto Efficiency
First Marginal Condition: Production Efficiency

𝐾1
𝑋2
𝐿1
𝑋21
𝑋22

𝑋23
𝑇
𝑇´

𝑋13
𝑋12
𝑆
𝑋11

𝑋1 𝐿1
𝐾2

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2.2 Competition Equilibrium and Pareto Efficiency
Transformation Curve (or Production Possibilities Curve)

𝑋2

𝑀𝑅𝑇
𝑄
𝑉

𝑅 𝑋1

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2.2 Competition Equilibrium and Pareto Efficiency
Second Marginal Condition: Consumption Efficiency

2 Consumers: 2 Goods:
Consumer 𝐴 and Consumer 𝐵 Good 1 (𝑋1 ) and Good 2 (𝑋2 )

Utility function 𝑈 𝑖 = 𝑈 𝑖 (𝑥1𝑖 , 𝑥2𝑖 ) with 𝑖 = 𝐴, 𝐵

𝜕𝑈 𝑖
>0 ∀𝑗
𝜕𝑥𝑗𝑖
𝜕2 𝑈 𝑖
<0 ∀𝑗
𝜕(𝑥𝑗𝑖 )2

𝜕2 𝑈 𝑖 𝜕2𝑈 𝑖
= >0
𝜕𝑥1𝑖 𝜕𝑥21 𝜕𝑥2𝑖 𝜕𝑥1𝑖

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2.2 Competition Equilibrium and Pareto Efficiency
Second Marginal Condition: Consumption Efficiency

𝑥2𝐴 𝑆
𝑥1𝐵 𝑂𝐵
𝑥1𝐵
𝑈1𝐵
𝑈2𝐵

𝑈3𝐵 𝑆
𝑇 𝑥2𝐵
𝑇´

𝑈3𝐴
𝑈2𝐴
𝑆
𝐴𝑆
𝑥2 𝑈1𝐴

𝑂𝐴 𝑥1𝐴
𝑆
𝑥1𝐴
𝑥2𝐵

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2.2 Competition Equilibrium and Pareto Efficiency
Utility Possibilities Curve (or Frontier)

𝑈𝐵

𝛿 𝛾

𝑈𝐴

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2.3 Fundamental Theorems of Welfare Economics

First Fundamental Theorem of Welfare Economics:

A competition equilibrium is (under several conditions) Pareto efficient.

In effect, this result tells that a competitive economy „automatically“ allocates resources efficiently,
without any need for centralized direction.

Second Fundamental Theorem of Welfare Economics:

Society can obtain any Pareto efficient allocation of resources by making a suitable
assignment of initial endowments and then letting people freelxy trade with each others.

Roughly speaking, by redistributing income suitably and then getting out of the way and letting markets
work, the government can attain any point on the utility possibilities frontier.

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2.3 Fundamental Theorems of Welfare Economics
Second Fundamental Theorem of Welfare Economics

𝑥2𝐴
𝑂𝐵
𝑥1𝐵

𝛼
𝛾

𝛽 𝛿

𝑂𝐴 𝑥1 𝐴(𝛽) 𝑥1 𝐴(𝛿) 𝑥1𝐴

𝑥2𝐵

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2.4 Market Conditions and Market Failure
Fundamental Theorems of Welfare Economics and Market Failure

 Violation of Market Conditions = Market Failure

• Nonexistence of Markets
• Public Goods
• External Effects
• Asymmetric Information
• Market Power (Natural Monopoly in particular)

 Role of the Public Sector

• Reducing market failure.
• Individual examination of each case (Nirvana approach!)
• Efficieny-oriented justification of interventions of the public sector.

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2.4 Market Conditions and Market Failure
Fundamental Theorems of Welfare Economics and Market Failure

Public External Information

Indivisibilities
Goods Effects problems

 Existence of goods
without private prices.
 „free rider“ (or „forced
rider“)
 Problem for private
provision of public goods.
 One individual bears not
all costs caused by
economic actions.
 One individiual´s behavior
affects the welfare of
another individual in a
way that is outside the
market mechanism.
 Lack of knowledge  In some cases, production
factors or goods are not
 Uncertainty divisible.
 Decreasing Average Cost
 Extreme case:
Natural Monopoly

 Difference between
private costs (and
benifits) and social costs
(and benefits).

Elimination of
Interference of coordination function
coordination function

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2.5 Measures of Welfare
Fiscal Policy and Changes of Welfare

 Financial policy triggers changes in welfare.

 Are there advantages or disadvantages of fiscal policy (e.g. tax rate cut or increase of tax rate)
caused by changes in relative prices?

 What is the amount of change of welfare?

 The change of welfare is the change of benefits of all individuals who are consumers and producers.

 In addition: Who bears the costs of fiscal policy?

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2.5 Measures of Welfare
Fiscal Policy and Changes of Welfare

 Consumer Surplus
The amount by which consumer‘s willingness to pay for a commodity exceeds the sum
they actually have to pay.

 Producer Surplus
The amount that producers receive in payment in excess of what they would require to
supply a given quantity of a commodity.

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2.5 Measures of Welfare
Consumer and Producer Surplus

Consumer Surplus: Area 𝐸𝐽𝑝∗

𝑝
Producer Surplus: Area 𝐸𝐻𝑝∗
𝐽
𝑆𝑥

𝐸
𝑝∗

𝐷𝑥
𝐻

𝑥∗ 𝑥

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