Chapter 2

Benchmark model of the economy: positive and normative approaches

Learning outcomes

• Identify the critical assumptions of the two-sector model

• Define what is meant by a Pareto-optimal allocation of resources

• Articulate the three conditions for a general equilibrium• Distinguish between allocative efficiency, X-efficiency,

and ‘dynamic’ efficiency (or economic growth)• Discuss the broad categories of market failure• Explain the allocative, distributive, and stabilisation

functions of government• Distinguish between direct and indirect forms of

government intervention.

The benchmark model assumptions

• Individual consumer or producer is:– Fully informed about the economy– Unaffected by the actions of other consumers or producers– Completely mobile– Always striving to maximise his/her own utility of profit

• Disturbances will cause instantaneous adjustments to return the system to a stable equilibrium.

Allocative efficiency

• Optimal mix of commodities• Interaction between:

– Consumption activities of consumers– Production activities of producers

• Simultaneous concurrence of 3 conditions:– Pareto optimality– Maximising utility subject to budget constraints– Producers and consumers achieve equilibrium

simultaneously.

Allocative efficiency refers to a situation in which the limited resources of a country are allocated in accordance with the wishes of its consumers.

Individual sector equilibria

Edworth-Bowley box diagram

Production possibility curve

Consumption and overall equilibria

Efficiency and economic growth

Technical efficiency or X-efficiency refers to a situation in which existing resources are utilised in the most

efficient manner.

X-inefficeincy and economic growth

Market failure

• Lack of information• Friction and lags in adjustments• Incomplete markets• Non-competitive markets• Macroeconomic instability• Distribution of income.

Allocative function

• Market failures distort the allocation of resources in the economy

• Incomplete markets– Characteristics of goods and services prevent efficient

supply– Existence of externalities.

Distributive function

• Fairness• Inequality in income distribution• Criteria for evaluation.

Stabilisation function

• Macro-economic objectives• 3 premises of stabilisation (Keynes):

– The market economy is inherently unstable– Macroeconomic instability is a form of market failure that is

highly costly to an economy– Governments are able to stabilise the economy by means of

appropriate macroeconomic policies.

• New Classical Macroeconomics• Neo-Keynsian theory.

Direct versus indirect government intervention

Direct government intervention refers to the actual participation of government in the economy.

Indirect government intervention to the regulatory function of government.

Direct versus indirect government interventionDirect intervention

• Actual participation in the economy

• Tax individuals and companies

• Borrow on financial markets• Execute budgeted spending• Examples:

– National defence– Electricity– Infrastructure– Provision of school text

books

Indirect intervention

• Regulatory function• Enacting law or proclaiming

legally binding rule• Indirect taxes and subsidies• Examples:

– Labour laws– Anti-tobacco laws

Thank you.