Economics of the Public Sector

Lecture 2: Fundamentals of Welfare Economics

Alfa Farah

Department of Economics
Diponegoro University

The 2nd Semester of 2019/2010

Market Efficiency

I Most economies today are mixed economies, in which there is

both a private and a public sector
I At the core of the economy are profit-maximizing firms
interacting with households in competitive markets
I Since a competitive economy might not efficient, we need a
public sector
I To understand the role of public sectors, we need need to
understand when markets function well and when they do not
I Fundamentals of Welfare Economics:
1. Market Efficiency
2. Market Failures
3. Efficiency and Equity

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Market Efficiency

Focus Questions
I What do economists mean when they say the economy is
efficient?
I What conditions have to be satisfied if markets are to be
efficient?
I Why is there a general presumption that competitive markets
result in efficiency?

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Welfare Economics and Pareto Efficiency

I Welfare Economics is the branch of economics that focuses on

normative issues
I The most fundamental normative issue is the questions
regarding:
I What gets produced
I How it gets produced
I For whom it gets produced
I The process by which these decisions are made
I This implies that we have to make choices among various
alternatives
I The next question: How do we evaluate the alternatives?
What are the criteria?

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Welfare Economics and Pareto Efficiency

I A basic criterion is Pareto Efficiency

A given resource allocation is deemed Pareto efficient when it
is impossible for one economic agent’s utility to improve
without harming that of another economic agent → no one
can be made better off without someone being made worse
off.
I Pareto improvement
A Pareto improvement is a change in asset allocation that
makes some individuals better off while leaving all others no
worse off.
I Pareto Principle
The belief that Pareto improvement should be instituted

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Pareto Efficiency and Individualism

Pareto Efficiency is individualistic in 2 senses:

1. It’s concerned only with each individual’s welfare, not with the
relative well being of different individuals
It’s possible for a wealthy person to acquire even more wealth
without taking any away from their employees. This would be
a Pareto improvement and, therefore, work towards efficiency.
However, it has no regard for income distribution, no regard
for equity.
2. It’s each individual’s perception of their own welfare that
counts
Consistent with the principle of Consumer Sovereignty which
holds that individuals are the best judges of their own needs
and wants, of their own best interests.

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Fundamental Theorems of Welfare Economics
Relationship between competitive markets and Pareto efficient

First Theorem of Welfare Economics

Under certain conditions, every competitive economy is Pareto
efficient.

Second Theorem of Welfare Economics

Under certain conditions, every Pareto efficient allocation of
resources can be achieved through competitive market mechanism.

There are two crucial expressions in the statement of the theorems

1. Under certain conditions
2. Competitive markets
Failure of either one, or both, can result in inefficient outcomes,
and provide reasons for government intervention in the economy.

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Fundamental Theorems of Welfare Economics
Efficiency from the Perspective of Single Market

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Analyzing Economic Efficiency

Basic conditions for Pareto efficiency

1. Exchange efficiency: Marginal rate of substitution between
any two goods must be the same for all individuals
→ Given production choices, goods are consumed by those
2. Production efficiency: Marginal rate of technical substitution
between any two inputs must be the same for all firms
→ Given total resources, the production of a given good
cannot be increased without decreasing the production of
another good individuals that value them the most
3. Product mix efficiency: Marginal rate of transformation must
be egual marginal rate of substitution
→ The goods being produced correspond to those that are
desired by individuals

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Exchange efficiency
The Consumer Choice Problem

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Exchange efficiency
Edgeworth-Bowley Box

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Production Efficiency
Production Possibility Frontier

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Production Efficiency
Isoquant and Isocost Lines

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Production Efficiency

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Product Mix Efficiency
MRTS = MRS

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