Chapter 5: The Public Sector

Economic and technical efficiency Technical efficiency – no unemployed or

underemployed resources (i.e., operating on PPC).

Economic efficiency (also known as Pareto optimality) – it is not possible to benefit one or more individuals without harming someone else

Technical efficiency is a prerequisite for economic efficiency (but does not guarantee economic efficiency)

Markets and economic efficiency

voluntary trade in markets benefits each trading partner

under ideal conditions, markets attain a state of economic efficiency (Pareto optimality)

Market failure Markets may fail to achieve

economic efficiency as a result of: imperfect information externalities public goods the absence of property rights monopoly, or macroeconomic instability

Imperfect information One party may not benefit from a

market transaction if there is imperfect information about the item being sold

Possible corrective action: product labeling requirements (listing

ingredients or including warnings) requiring guarantees (such as “lemon laws”) requiring “truth in advertising” licensing workers in certain professions providing public information about products

Externalities Externalities are side effects of

production or consumption that affect individuals not directly involved in the activity or transaction

Positive externalities occur when one or more parties not involved in the transaction benefit from the activity

Negative externalities occur when third parties are harmed.

Positive externalities Those engaged in the transaction

do not take the external benefits into account in their decision making

This results in underproduction Possible remedies:

subsidy regulation

Negative externalities Negative externalities result in

social costs that are not borne by the parties involved in the transaction.

results in overproduction Possible solutions:

taxation regulation

Internalizing externalities The use of taxes or subsidies to

correct for an externality is sometimes referred to as “internalizing” the externality.

Public goods nonrival in consumption (one

person’s consumption does not affect the quantity or the quality of the good available to others)

free-rider problem results in underproduction

Possible solutions: government production or subsidization

Common property resources problem of the commons -

resources are commonly owned benefits are received by those who

use the resource costs are shared by all

overutilization government regulation

Monopolies higher prices and lower output antitrust law, regulation, or public

production

Macroeconomic instability economic inefficiency caused by

unemployment during recessions government policies designed to

stabilize the economy

Public choice theory

government policy is constructed by self-interested individuals

participants in policy formation are concerned about their own self interest, not the “public interest”

economic rent - a payment in excess of opportunity costs

rent-seeking behavior on the part of special-interest groups

Economic policy

Microeconomic policy - designed to correct for: imperfect information, externalities, public goods, the absence of property rights, and monopolies.

Macroeconomic policy - designed to enhance macroeconomic stability and encourage economic growth.