2023 - Mdef - 612 - 2 B

What is Eciency in Economics
The Role of Public Sector: Eciency and Equity

Concerns
Dr. Edward Asiedu
University of Ghana Business School,Department of Finance
May 20, 2023
Email: edasiedu@ug.edu.gh
Dr. Edward Asiedu MDEF 612: Public Sector Finance

Outline
1 What is Eciency in Economics


What is Eciency in Economics What is Eciency in Economics
Outline
1 What is Eciency in Economics


Session Overview
What is eciency in economics?
What are the conditions for markets to be ecient?
Why is a competitive market considered ecient?
What are the key reasons why markets sometimes fail to

produce ecient outcomes?
What role can governments play to help markets achieve the

ecient outcome?
Why will governments intervene in a market even when it is

ecient?

Market Eciency (Pareto Eciency)
Economic eciency is based on Pareto optimality concept- a

concept named after Vifredo Pareto (1848-1923):
An allocation is said to be Pareto ecient or Pareto optimal if
it has the property that no one can be made better o without
someone being made worse o.
This is what economists normally mean when they talk about
eciency.

Market Eciency (Pareto Eciency)
Economic eciency is based on Pareto optimality concept- a

concept named after Vifredo Pareto (1848-1923):
An allocation is said to be Pareto ecient or Pareto optimal if
it has the property that no one can be made better o without
someone being made worse o.
This is what economists normally mean when they talk about
eciency.
Example : Consider the construction of the Circle Dubai, its

construction is likely to be a Pareto improvement. Likewise,
construction projects that further enlarge the Tema motor way.
Pareto improvement is when a change makes some individuals
better o without making anyone worse o.

Pareto Eciency
In the two construction examples, it is also possible that the

changes might make some individuals worse o.

Pareto Eciency

For instance in the case of the circle Dubai it may result in

relocation of some jobs around circle, which some sellers may
lose some customers, and in the process, be worse o.

Pareto Eciency

For instance in the case of the circle Dubai it may result in

relocation of some jobs around circle, which some sellers may
lose some customers, and in the process, be worse o.
It is also the case that Packages of changes together may

constitute a Pareto improvement, when each change alone
might not.

Pareto Eciency
An important property of Pareto eciency is:

It is individualistic
It is concerned only with each individual's welfare, not relative
well-being of dierent individuals. For instance a change that
made the rich much better o but left the poor unaected
would still be a Pareto improvement.

Pareto Eciency
An important property of Pareto eciency is:

It is individualistic
It is concerned only with each individual's welfare, not relative
well-being of dierent individuals. For instance a change that
made the rich much better o but left the poor unaected
would still be a Pareto improvement.
It is individual's perception of his own welfare that counts.

Fundamental Theorem of Welfare Economics
There are two theories of welfare economics which provide a
relationship between competitive markets and Pareto
eciency.
Welfare economics: welfare economics is a branch of
economics that focuses on optimal allocation of resources and
how the allocations aect social welfare.

eciency.
Competitive market: a competitive market is one in which a

large numbers of producers compete with each other to satisfy
the wants and needs of a large number of consumers. Each
producer and consumer has no market power.

eciency.
Competitive market: a competitive market is one in which a

large numbers of producers compete with each other to satisfy
the wants and needs of a large number of consumers. Each
producer and consumer has no market power.
Monopoly market: a market structure where a single

producer supplies a particular good or service to the market
and therefore has market power over that good or service.

The two welfare theorems are:

Every Competitive economy is Pareto ecient(1st welfare
theorem)

The two welfare theorems are:

Every Competitive economy is Pareto ecient(1st welfare
theorem)
Every Pareto ecient resource allocation can be attained via

competitive market mechanism, with the appropriate initial
redistribution(2nd welfare theorem).

Eciency From The Perspective of a Single Market
Optimal decision condition for consumers

In deciding how much to demand, individuals equate the
marginal benet (MB) they receive from consuming an extra
unit with the marginal cost (MC). MB=MC
In deciding how much to supply, rms equate the marginal
benet they receive with the marginal cost
MB=MC

Optimal decision condition for consumers

In deciding how much to demand, individuals equate the
marginal benet (MB) they receive from consuming an extra
unit with the marginal cost (MC). MB=MC
In deciding how much to supply, rms equate the marginal
benet they receive with the marginal cost
MB=MC
Market equilibrium occurs where supply equals demand in the

market.


Eciency requires that the MB associated with producing one

more unit of any good equal its MC.
If the MB>MC, society will gain by producing more of the
good.


good.
And if MB<MC, society will gain from reducing production of

the good.


good.
And if MB<MC, society will gain from reducing production of

the good.
At point E in gure 1., MB=MC-the condition required for

economic eciency.

Analyzing Economic Eciency
There are three aspects of Economic Eciency:

Exchange eciency
goods produced should go to those who value them
most(distribution of goods)


Exchange eciency
Production eciency
Given society's resources, production of one good cannot be
increased without a decrease in the other


Exchange eciency
Production eciency
Product Mix eciency
Goods produced must correspond to those desired by
individuals


Exchange eciency
Production eciency
Product Mix eciency
Goods produced must correspond to those desired by
individuals
All three are required for Pareto eciency

The Utility Possibility Curve
Utility : this is the benet that an individual gets from the

combinations of goods and services that the individual
consumes.


consumes.
More goods and services will generally increase an individual's

utility.


consumes.
More goods and services will generally increase an individual's

utility.
Utility possibility curve: this a curve that traces out the

maximum level of utility that may be achieved by two
consumers.
It is the maximum level of utility that an individual can
achieve, given the level of utility of the other individual


Figure 2 is a utility possibility curve for two individuals (Crusoe

and Friday)


and Friday)
Along the curve (frontier), it is not possible for Crusoe to

consume more unless Friday consumes less.


and Friday)

As a result, the utility possibility curve is downward-slopping

The higher Crusoe's utility, the lower the maximum level of
Friday's utility.


and Friday)


Friday's utility.
Thus we cannot increase Crusoe's utility without decreasing

the utility of Friday.


and Friday)


Friday's utility.
Thus we cannot increase Crusoe's utility without decreasing

the utility of Friday.
If the economy is Pareto ecient, it must be operating along

the curve(the utility possibility frontier).

The 1st welfare theorem says that a competitive economy

operates along the utility frontier.

The 1st welfare theorem says that a competitive economy

operates along the utility frontier.
The 2nd welfare theorem says that we can attain any point
along the utility possibility frontier using competitive markets,
provided we redistribute initial endowments appropriately.

Exchange Eciency
This concerns with the optimal distribution of goods.

Exchange eciency means that with a given set of available
goods, the goods are distributed such that no one can be
made better o without someone else being made worse o.

Exchange Eciency

Thus it requires that there is no scope for trade, or exchange

that would make both parties better o.

Exchange Eciency

Thus it requires that there is no scope for trade, or exchange

that would make both parties better o.
Exchange eciency requires all individuals have the same

marginal rate of substitution.
Marginal rate of substitution: the amount of a commodity
that an individual is willing to give up in exchange for a unit
of another commodity.

Exchange Eciency

Production Eciency
Production eciency concerns with optimal utilization of
resources in the production of goods and services.
It is achieved when it is not possible to produce more of one
good without reducing the production of other goods.

Production Eciency
production eciency requires that the marginal rate of

technical substitution be the same for all rms.
MRTSA =MRTSB = MRTSC =. . . . . . . . . =MRTSn , if there are
n number of rms.

Production Eciency

n number of rms.
Marginal rate of technical substitution is the amount of one

input required to compensate for a decrease in another input
by one unit.

Production Eciency

n number of rms.

by one unit.
A curve that depicts the dierent input combinations that

produces the same level of output is what we call an isoquant.

Production Eciency

n number of rms.

by one unit.
A curve that depicts the dierent input combinations that

produces the same level of output is what we call an isoquant.
The slope of an isoquant is the marginal rate of technical

substitution

Production Eciency

Production Eciency
Production along the frontier are feasible and ecient

Production Eciency
Points inside the frontier are attainable but inecient

Production Eciency
Points inside the frontier are attainable but inecient
Points outside the frontier are unattainable, given the

resources of the economy.

Product Mix Eciency
This concerns with the preferences of consumers and the
technical feasibility of those goods associated with consumers
preferences

Product Mix Eciency
preferences
Technical feasibility is what is presented by the production

possibility Frontier (PPF) or curve.

Product Mix Eciency
preferences

Given the PPF, we wish to get to the highest possible level of

utility represented by indierence curve.

Product Mix Eciency
preferences


Product mix eciency is achieved when the PPF or curve is

tangential to the indierence curve.

Product Mix Eciency
preferences


Product mix eciency is achieved when the PPF or curve is

tangential to the indierence curve.
Thus when marginal rate of transformation(MRT) is

equated to marginal rate of substitution(MRS).

Product Mix Eciency

Conditions for Pareto Eciency
Exchange eciency: MRS between any pair of goods must be

same for all individuals.


Production eciency: MRTS between any pair of inputs must

be the same for all rms



Product mix eciency: MRT=MRS.



Product mix eciency: MRT=MRS.
COMPETITIVE ECONOMIES SATISFY ALL THREE

Market Failure and The Role of Government
There six conditions under which markets are not Pareto

ecient (market failures)
Imperfect competition (monopoly, oligopoly and monopolistic
markets)


markets)
Public goods


markets)
Public goods
Externalities


markets)
Public goods
Externalities
Incomplete markets


markets)
Public goods
Externalities
Incomplete markets
Imperfect information


markets)
Public goods
Externalities
Incomplete markets
Imperfect information
Unemployment and other macroeconomic disturbances

Imperfect Competition
For market to achieve Pareto eciency, each rm should have
no market power to inuence prices.

There are however situations where some rms have such a

power to inuence market price e.g., industry for
supercomputers, cigarettes, aluminum etc.


Monopoly , Oligopoly and monopolistic competition are the

market situations that result in imperfect competition
Reasons for imperfect competition includes; declining average
cost curve, natural monopoly, high transportation cost,
imperfect information



In competitive market where optimal decision is where

MB=MR



In competitive market where optimal decision is where

MB=MR
Under imperfect competition, optimal decision is where

MR=MC MR is marginal revenue, returns from selling a unit
more of a good

Public Good
It is a good that either will not be supplied by the market or, if

supplied, will be supplied in insucient quantity. E.g., national
defense, street lights etc.

Public Good
It is a good that either will not be supplied by the market or, if

supplied, will be supplied in insucient quantity. E.g., national
defense, street lights etc.
Public good has two critical properties

Non-excludability
Non- Rivalrous

Externalities
Cases where the actions of one individual or one rm aect

other individuals or rms.

Externalities

Negative externalities: instances where an individual or rms

action impose a cost on others.

Externalities


e.g., a chemical plant that discharges its chemical waste into a
nearby stream imposes costs on downstream users of the water
from the stream.

Externalities


e.g., a chemical plant that discharges its chemical waste into a
nearby stream imposes costs on downstream users of the water
from the stream.
Positive externalities: instances where one individual's actions

confer a benet upon others.
An mango farm may confer a positive externality on a
neighboring beekeeper

Why Will Government Intervene in An Ecient Market
Competitive markets may give rise to a very unequal
distribution.

distribution.
Governments may have to intervene in situations where the
Pareto ecient outcome of the market is very unequal.
This is done via redistributive activities of government
The provision of merit goods

distribution.
Merit goods: these are goods that the government compels

individuals to consume, like seat belts and elementary
education.

distribution.

education.
The redistributive activities of governments can be done via

welfare activities such as health insurance ,support
programmes for the poor, transfers for retirees etc.

distribution.

education.
The redistributive activities of governments can be done via

welfare activities such as health insurance ,support
programmes for the poor, transfers for retirees etc.
The second is the concern that individuals may not act in their
own best interest
E.g. Continue to smoke even though it is bad for them,
fail to wear seat belts, though wearing seat belts increases the
chance of survival

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What is Eciency in Economics

The Role of Public Sector: Eciency and Equity

University of Ghana Business School,Department of Finance

May 20, 2023

Dr. Edward Asiedu MDEF 612: Public Sector Finance

1 What is Eciency in Economics

Dr. Edward Asiedu MDEF 612: Public Sector Finance

1 What is Eciency in Economics

Dr. Edward Asiedu MDEF 612: Public Sector Finance

What is eciency in economics?

What are the conditions for markets to be ecient?

Why is a competitive market considered ecient?

What are the key reasons why markets sometimes fail to

What role can governments play to help markets achieve the

Why will governments intervene in a market even when it is

Dr. Edward Asiedu MDEF 612: Public Sector Finance

Economic eciency is based on Pareto optimality concept- a

Dr. Edward Asiedu MDEF 612: Public Sector Finance

Economic eciency is based on Pareto optimality concept- a

Example : Consider the construction of the Circle Dubai, its

Dr. Edward Asiedu MDEF 612: Public Sector Finance

In the two construction examples, it is also possible that the

Dr. Edward Asiedu MDEF 612: Public Sector Finance

In the two construction examples, it is also possible that the

For instance in the case of the circle Dubai it may result in

Dr. Edward Asiedu MDEF 612: Public Sector Finance

In the two construction examples, it is also possible that the

For instance in the case of the circle Dubai it may result in

It is also the case that Packages of changes together may

Dr. Edward Asiedu MDEF 612: Public Sector Finance

An important property of Pareto eciency is:

Dr. Edward Asiedu MDEF 612: Public Sector Finance

An important property of Pareto eciency is:

Dr. Edward Asiedu MDEF 612: Public Sector Finance

Dr. Edward Asiedu MDEF 612: Public Sector Finance

Competitive market: a competitive market is one in which a

Dr. Edward Asiedu MDEF 612: Public Sector Finance

Competitive market: a competitive market is one in which a

Monopoly market: a market structure where a single

Dr. Edward Asiedu MDEF 612: Public Sector Finance

The two welfare theorems are:

Dr. Edward Asiedu MDEF 612: Public Sector Finance

The two welfare theorems are:

Every Pareto ecient resource allocation can be attained via

Dr. Edward Asiedu MDEF 612: Public Sector Finance

Optimal decision condition for consumers

Dr. Edward Asiedu MDEF 612: Public Sector Finance

Optimal decision condition for consumers

Market equilibrium occurs where supply equals demand in the

Dr. Edward Asiedu MDEF 612: Public Sector Finance

Dr. Edward Asiedu MDEF 612: Public Sector Finance

Eciency requires that the MB associated with producing one

Dr. Edward Asiedu MDEF 612: Public Sector Finance

Eciency requires that the MB associated with producing one

And if MB<MC, society will gain from reducing production of

Dr. Edward Asiedu MDEF 612: Public Sector Finance

Eciency requires that the MB associated with producing one

And if MB<MC, society will gain from reducing production of

At point E in gure 1., MB=MC-the condition required for

Dr. Edward Asiedu MDEF 612: Public Sector Finance

There are three aspects of Economic Eciency:

Dr. Edward Asiedu MDEF 612: Public Sector Finance

There are three aspects of Economic Eciency:

What is Eciency in Economics

The Role of Public Sector: Eciency and Equity

1 What is Eciency in Economics

1 What is Eciency in Economics

What is eciency in economics?

What are the conditions for markets to be ecient?

Why is a competitive market considered ecient?

Economic eciency is based on Pareto optimality concept- a

Economic eciency is based on Pareto optimality concept- a

Example : Consider the construction of the Circle Dubai, its

For instance in the case of the circle Dubai it may result in

For instance in the case of the circle Dubai it may result in

It is also the case that Packages of changes together may

An important property of Pareto eciency is:

An important property of Pareto eciency is:

Every Pareto ecient resource allocation can be attained via

Eciency requires that the MB associated with producing one

Eciency requires that the MB associated with producing one

Eciency requires that the MB associated with producing one

At point E in gure 1., MB=MC-the condition required for

There are three aspects of Economic Eciency:

There are three aspects of Economic Eciency:

There are three aspects of Economic Eciency:

There are three aspects of Economic Eciency:

Utility : this is the benet that an individual gets from the

Utility : this is the benet that an individual gets from the

Utility : this is the benet that an individual gets from the

If the economy is Pareto ecient, it must be operating along

Exchange eciency requires all individuals have the same

production eciency requires that the marginal rate of

production eciency requires that the marginal rate of

production eciency requires that the marginal rate of

A curve that depicts the dierent input combinations that

production eciency requires that the marginal rate of

A curve that depicts the dierent input combinations that

Production along the frontier are feasible and ecient

Production along the frontier are feasible and ecient

Points inside the frontier are attainable but inecient