Basic Economic Ideas and resource

allocation
A level
Economic Efficiency
 Where the scarce resources are used in the most
efficient way to produce maximum output
Productive efficiency
 When the firm produces at the lowest possible cost.

 An economy is productively efficient if it produces on the

boundary of the production possibility frontier.

 Competition may lead to firms being productively efficient

– Perfect competition is a necessary condition for
productive efficiency

 Condition: P = min AC
Allocative Efficiency
 Allocating the right amount of scarce resources to the
production of right products.

 Combination of products that will yield the greatest

possible level of satisfaction of consumer wants.

 A competitive market will lead to allocative efficiency

 Condition : P= MC
Pareto Optimality
 When a market is in equilibrium, with no external
influences and no external effects, it is said to be in a
state of Pareto optimality

 Pareto optimality exists when it is impossible to make

someone better off without making someone else worse
off.

 The concept can be explained by the PPC

Dynamic Efficiency
 Dynamic efficiency is a form of productive efficiency that
benefits a firm over time.

 Resources are allocated in such a way that the output

increases relative to the increase in resources.

 Dynamic efficiency is a long term phenomenon

Market Failure
 In the “real world” markets are not perfect as a result the
resources are not optimally allocated.
 Community surplus is not maximised when there is
market failure.
 Governments are expected to intervene to eliminate the
market failure and move towards the optimal allocation
of resources.
TYPES OF MARKET FAILURE

 Imperfect Competition
 Lack of Public Goods
 Under-supply of Merit Goods
 The existence of externalities
 TYPES
TYPES OF EXTERNALITY
OF EXTERNALITIES
1. Negative Externalities of production/external costs
2. Positive Externalities of production/external benefits
3. Negative Externalities of consumption
4. Positive Externalities of consumption
 Negative Externalities of
Production
 These occur when the production of a good or service
creates external costs that are damaging to third parties

 These relate mainly, but not exclusively to environmental

problems.
Negative Externalities of
Production
 Negative Externalities of
Production
MPC of the firm are below the MSC, as there is an extra
costs to society caused by the pollution that is created.
The firm will only be concerned with its private costs and
will produce at Q1. It is not producing at Q* where the
marginal social cost is equal to the marginal social benefit
and so it is a market failure. There is a misallocation of
society’s resources: too much paint is being produced at
too low a price.
 Negative Externalities of
Production
If the price of paint was increased money could be spent on
reducing the pollution from the factory and or cleaning up
the mess. There is a welfare loss to society of the extra
units from Q1 to Q* because the MSC is greater than the
MSB for those units. This is shown by the shaded triangle.
 Taxes on Pollution
The government could tax a firm in order to increase the
firm’s private costs and so shift the MPC curve upwards
towards the point of social efficiency.
 If the tax is equal to the external cost of the production,
then we say the government has internalised the
externality.
 If the tax is not equal to the external cost, then it will
reduce the deadweight burden, but not eliminate it.
Government Intervention: Tax
 Government Intervention: Tax

The government decides to impose a tax on a paint factory

emitting pollution. However, the tax is not equal to the
external cost. It reduces the deadweight burden, but does
not eliminate it.
There is a welfare loss, but it less than under the free
market with no government interference.
 Problems with Taxes

 First it is often difficult to measure the accurately the

pollution created and to put a value on it, which can be
regained by the tax.
 Second, it also difficult to identify which firms are
polluting and to what extent each firm is responsible for
the pollution.
 Third, it is often argued that taxes do not actually stop
the pollution from taking place.
 Legislation
 The government could legislate and could ban the
polluting firms or restrict their output in some way.
 It also pass laws relating to measureable environmental
standards in the firms production units.
 To meet the standards, the firm would have to spend
money, thus increasing their private costs.
Problems with Restricting Output

 A ban or restriction may lead to job losses and the non-

consumption of whatever was being produced, which may
have been a valuable product.
 Also the cost of setting and policing (enforcing) standards
may be greater than the cost of the pollution.
Tradeable Emission Permits

 The government could issues tradeable emission permits.

 These are a market-based solution to negative
externalities of production.
 Tradeable emission permits are issued by the government
and give firms the licence to create pollution up to a set
level.
 Once they are issued firms can buy, sell and trade permits
on the market.
Tradeable Emission Permits

 The government decides upon the level of pollution that

will permit each year and then splits the total level of
pollution up into a number of tradeable emission
permits, each allowing a certain level of pollution.
 The government then allocates these permits to
individual firms.
 Thus each firm now has a quota of emissions that it is
allowed to produce.
Tradeable Emission Permits

 The trading system means that it is the interests of firms

to pollute as little as possible.
 If a firms pollutes at a higher level that its permit allows, it
will need to buy permits from other firms and this will
raise its costs.
 If a firm pollutes less than they are allowed, then they can
sell their permit and make money.
 In the USA, the emission of chlorofluorocarbons (CFCSs)
is controlled by the use of tradable emission permits.
Tradeable Emission Permits – Problems

 It does not lead to the reduction of pollution, once the

allowable limit has been set.
 Firms simply pay the cost of polluting, some polluting
heavily and other not.
 The government faces a difficult decision when setting an
acceptable level of pollution and it also difficult to
measure firm’s pollution output.
Positive Externalities of Production/External
Benefits
 These occur when the production of a good or service
creates external benefits that are good/ advantageous for
third parties.
Positive Externalities of Production/External
Benefits
Government Action to Assist Firms
 On face value positive externalities, should not require
any government assistance.
 However, if firms have to provide extensive training to
their employees this increases their costs, and lowers
their profitability.
 Therefore the government may decide to assist these
firms in some form.
Training Subsidies

 The government could subsidise the firms that offer the

training.
 If this were to happen, then the MPC curve would be
shifted downwards by the subsidy, and if a full subsidy was
given, then MPC would be the same as the MSC and the
socially efficient point of “a” would be reached.
Training Subsidies – Problems

 First, it very difficult for government to estimate the level

of subsidy deserved by individual firms.
 Second the cost of the subsidies would probably imply an
opportunity cost and it is likely that the government
would cut back on spending in other areas, which may be
more worthy than this one.
Negative Externalities of Consumption
 The negative externalities of consumption produced
make the marginal social benefits in each case less than
the marginal private benefits.
 The private utility is diminished by the negative utility
suffered by third parties
 There are many products, that when consumed by
individuals adversely affect third parties.
 Examples include cigarettes and secondary smoking, cars
and air pollution, loud music and noise pollution.
Negative Externalities of Consumption
Negative Externalities of Consumption
As there is a free market, consumers will maximise their
private utility (benefit) and consume at a level where
MSC=MPB. They will ignore the negative externality they
are creating. This means they will over-consume cigarettes
by smoking Q1 cigarettes as a price of P1. The socially
efficient output is at Q* and so there is over consumption
of from Q* to Q1. Since the MSC is greater than the MSB
for these units, there is a welfare loss to society and a
market failure.
Government Action to Remedy
 It could ban cigarette smoking totally – make it illegal to
smoke.
Banning Smoking Totally – Problems

 Banning smoking would have a large effect upon the

tobacco industry in terms of shareholders and
employments.
 Governments also make a lot of revenue by taxing
cigarettes, which have price inelastic demand, because
they are habit forming.
 It must also be remembered that governments need votes
and smokers are not likely to vote for a government that
bans smoking.
 However, many governments have placed partial bans on
smoking in certain places.
Taxes on Cigarettes

 The government could impose indirect taxes on

cigarettes in order to reduce consumption.
Taxes on Cigarettes
TAXES ON CIGARETTES

 If the government imposes an indirect tax then this will shift

the MSC curve upwards to MSC + tax. This will reduce
consumption to the socially efficient level of output Q*, but
the price to consumers will be P2. The government will gain
significant revenue and this may be used to correct some of
negative externalities caused by smoking.
Problems with Taxes on Cigarettes

 The inelastic demand for cigarettes tends to mean that

taxes do not manage to reduce quantity demanded very
much, and so while government revenue is raised, quantity
demanded does not fall to the socially efficient level
(which some would argue was zero!)
Problems with Taxes on Cigarettes

 If taxes are raised too much, then experience suggests

that people start to look for other sources of supply.
 This can be seen in Europe, where smokers go to other
countries where cigarettes are cheaper. For example
Austrian smokers can go over the border to Slovakia.
 Often this process is illegal and so a black market may be
formed.
Education Programs Against Smoking

 The government could provide education about the

dangers of smoking and also fund negative advertising in
order to reduce demand for cigarettes and thus shifting
the MPB curve to the left.
Problems with Education programs

 There are doubts as to the effectiveness of anti smoking

programs.
 Many teenagers, seem prepared to accept the dangers of
smoking and are little affected by measures to put them
off.
Positive Externalities of Consumption
 There are certain goods or services which when
consumed (used) will provide external benefits to third
parties.
 When people “consume” health care, for example, they
create positive externality for society.
 If people are healthier, then they will not pass on illnesses
so that other people around them are less likely to
become ill. In addition a healthier workforce means that
the economy will be more productive, which may be a
benefit for the whole population.
 Thus the MSB of consuming health care is greater than
the MPB.
Positive Externalities of Consumption
Positive Externalities of Consumption
In a free market for health care (no subsidy), people will
consume at Q1 at a price of P1. However, the socially
efficient level of consumption would be Q* where MSB =
MSC. There is a potential welfare gain shown by the
shaded triangle, because of the units Q1 to Q*, MSB is
greater than MSC. If the consumption of health care
increases from Q1 to Q* then welfare in society will
increase.
Subsidies for Health Care

The government could subsidise the supply of health care.

Subsidies for Health Care
Subsidies for Health Care

A subsidy would shift the MSC curve downwards and in

this way, the socially efficient level of consumption at Q*
would be reached, with a price of P2. The government may
deem the importance of health care to be so great, that it
will subsidise it to the point where it is free to consumers.
Problems with Subsidising Health Care

 The main problem with such a solution is cost.

 While the provision is possible in many developed
countries, developing countries are not able to fund such
schemes and so do not fully benefit from the positive
externalities that are to be gained from the consumption
of health care.
Advertising to Consume Health Care Products

 The government could use positive advertising to

encourage people to consume more health care
products/services.
 This would shift the MPC curve to the right, towards the
MSC curve and would thus increase welfare.
Problems with Advertising

The problem here is that there may be a high cost in

funding advertising and although the effect may be beneficial
in the long run, the short run benefits may be minimal.
Government Legislation

 The government could pass laws insisting that citizens

have vaccinations against certain diseases or have regular
checks, but this will only be successful, if the governments
provides this free of charge.
 Also people often resent laws of this sort being imposed
by the government.
 They may see it as infringement on their civil liberties.
Cost benefit analysis
 A method for assessing the desirability of a project taking
into account the cost and benefits involved
 Identification
All relevant cost and benefit

Monetary values
Assigning monetary values on all relevant cost and befit

Forecasting
Future cost and benefit

Decision Making
Advantages of CBA
 Takes into account all relevant cost and benefit resulting
from the proposed investment project

 It is relatively easy for items where market price is

available.

 It takes into account the long term view – future cost

 Analysis is made based on the information obtained and

correct decision can be made
Disadvantages
 Very difficult to identify all the external cost and benefit

 Shadow prices are assigned where market price is not

available – the estimates may not be accurate / difficult to
ascertain

 Forecasting technique that is used to estimate values is

difficult and may not be accurate

 Political reasons are not taken into account