Public Finance (MPA405)

Dr. Khurrum S. Mughal

Lecture 2: Efficiency:Criterion and Government

Public Finance

Positive and Normative Economics

• Positive Economics explains “what is” without making judgments about the appropriateness of “what is.”

• Normative Economics: designed to formulate recommendations on what should be.

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 the well-being of any one person without reducing the well-being of any other person.

Welfare Economics

Efficiency Resource Use

Assumptions• 2 inputs (capital and labor)• 2 outputs (food and clothing)

Production Functions

F = F(LF,KF)

C = C(LC,KC)

Where • F = food production• C = clothing production

• Li = labor devoted to the production of good i

• Ki = capital devoted to the production of good i

Constraints

L = LF + LK

K = KF + LF

Productive Efficiency

• It is not possible to reallocate inputs to alternative uses in such a manner as to increase the output of any good without reducing the output of some alternative good.

Figure Productive Efficiency

F3

E* F6 F5 Z*

F3 F1

F4 Z1

C2 C3

C4 C5 C6

C1

D

0

K* F

K

L

K* C

KF

LF

LC

KC

L* F

L* C 0'

Efficiency Condition

MRTSFLK = MRTSC

LK

 • The Marginal Rate of Technical

substitution of Labor for Capital in each good are equal

Figure The Production-Possibility Curve

A

D

E 1

E 2

Food

per

Yea

r

Clothing per Year 0

T

F

C T'

Pareto Efficiency

Preferences on Consumption

UA = U(FA,CA)

UB = U(FB,CB)

 

Where

Ui = the utility of person i

Fi = food consumed by person i

Ci = clothing consumed by person i

Constraints

F = FA + FB

C = CA + CB

Food

per

Yea

r

Clothing per Year

T

T’

F

C

D

FA

CA

CB

FB

Figure Efficient Allocation of A Given Amount of Food and Clothing per Year For Two Consumers

UB1

UB2UB3

UB4

UB5UB6UB7

UA5

UA4

UA2UA1

UA6

FA*FB*

CB*

CA*

E*E**

UA3

UA7

0

Efficiency Criterion on Consumption and Production

MRSACF = MRSB

CF = MRTCF

Interpretation of Efficiency Criterion Suppose we say that the “price of a unit of clothing is $1.” Then clothing is the same as “money.” We can then say that MRSA

CF is A’s willingness to substitute clothing for

money, which is their marginal benefit of clothing, MBAC. The same is true for B. If these

are equal to the MRTCF then this represents the capability of turning money into clothing

as well. Thus it reflects the costs of production. Lastly if there are no other people who gain from either A or B consuming clothing or food then:

MSB = MBAC = MBB

C = MSCC

Efficiency and Economic Institutions

Given the conditions for a market rendering a Pareto Optimal outcome in perfect markets:

C = PKK + PLL

then production of a particular amount of a good is efficient if the slope of the production function for each good is equal to the slope of the isocost line.

Figure Cost Minimization and Productive Efficiency

Capi

tal

Labor

F = F1 per Year

0

K

L

E

Implications of Figure

• MRTSFLK = PL/PK

• MRTSCLK = PL/PK

• MRTSFLK = MRTSC

LK = PL/PK

Pure Market Economy and Pareto Efficiency

Step 1

So far we know that PF = MCF and PC = MCC from perfect competition

dividing one by the other we get

It can be shown that this ratio of MCs is equal to MRT

PC MCC

PF MCF

=

Pure Market Economy and Pareto Efficiency Step 2

• MCF is the amount of other resources

that must be given up to produce more Food. We will denote this fact by saying:

MCF = DC.

• It is the forgone clothing to produce more Food.

• The same applies the other way around

MCC = DF.

Pure Market Economy and Pareto Efficiency Step 3

Dividing these by each other we get:

MCC DFMCF DC

=

Pure Market Economy and Pareto Efficiency Step 4

= MRTCF

DF

DC

Since

AndMRTCF =

PC

PF

Then= MRTCF =

PC

PF

DF

DC

MCC

MCF

=

Figure 2A.5 Consumer Choice

E

UA3

UA2 UA1

Food

per

Yea

r

Clothing per Year 0

FA

A

B CA

Pure Market Economy and Pareto Efficiency Step 5

As just seen the slopes of the individual’s indifference curves are equal to the ratio of the prices. So

MRSCF =PC

PF

A

MRSCF =PC

PF

B

Pure Market Economy and Pareto Efficiency Final

MRSCF = MRSCF = MRTCF =PC

PF

A B

Market Imperfections

• Monopoly P > MC