Chapter 2

Efficient Markets and

Government

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Positive and Normative Economics
 Positive Economics explains “what is,”
without making judgments about the
appropriateness of “what is.”
 Normative Economics: designed to
formulate recommendations about
what “should be.”

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Normative Evaluation of Resource Use:
The Efficiency Criterion
 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 any one
person’s well-being without reducing
any other person’s well-being.

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 Figure 2.1 Efficient Output
A
Price, Benefit, and MSC
Cost (Dollars) 2.00 = P B
C
E
1.50 = P*

1.00 = P2 A D
MSB

Q1 = 10,000 Q2 = 20,000
Q* = 15,000 TSC
B TSB
Total Social Benefit

Z
and Cost

TSB – TSC

0 Q*
Loaves of Bread per Month 4
Conditions under which a Perfectly
Competitive Market System Exists
 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.

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If These Conditions are Met
P = MPB = MSB
and

P = MPC = MSC
so

P = MSB = MSC

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 Figure 2.2 Loss in Net Benefits Due to Monopolies
Price, Benefit, and

MSB = P B
MSC
Cost (Dollars)

E
Loss in Net Benefits
MSCM A

D = MSB
MR
0 QM Q*
Output per Month 7
 Figure 2.3 Taxes and Efficiency
New Supply = MPC + T > MSC
Supply = MSC = MPC
6 E'
Price (Cents per
Message Unit)

5 E

4 B

Demand = MSB

0 3 4
Billions of Message Units per Month 8
 Figure 2.4 Subsidies and Efficiency
Supply = MSC
Price (Dollars per Bushel)

5 A
E
4

3 C

Demand = MSB

0 Q* QS
Bushels of Wheat per Year
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 Market Failure: A Preview of the
Basis for Government Activity
Government intervention may be warranted if a
market exhibits:
 Monopoly power by one supplier
 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

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Figure 2.5 Utility Possibility Curve

Annual Well-Being of A UA

E1 Z
UA2
X E2
UA1

E3

0 UB1 UB2 UB
Annual Well-Being of B 11
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.

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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
compensation is paid.

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