Chapter 5: The Public Sector

Economic and technical

efficiency
 Technical efficiency – no unemployed or
underemployed resources (i.e., operating on
PPC).
 Economic efficiency (also known as Pareto
optimality) – it is not possible to benefit one
or more individuals without harming someone
else
 Technical efficiency is a prerequisite for
economic efficiency (but does not guarantee
economic efficiency)
Markets and economic efficiency
 voluntary trade in markets benefits
each trading partner
 under ideal conditions, markets attain a
state of economic efficiency (Pareto
optimality)
Market failure
 Markets may fail to achieve economic
efficiency as a result of:
 imperfect information
 externalities
 public goods
 the absence of property rights
 monopoly, or
 macroeconomic instability
Imperfect information
 One party may not benefit from a market
transaction if there is imperfect information
about the item being sold
 Possible corrective action:
 product labeling requirements (listing ingredients
or including warnings)
 requiring guarantees (such as “lemon laws”)
 requiring “truth in advertising”
 licensing workers in certain professions
 providing public information about products
Externalities
 Externalities are side effects of production or
consumption that affect individuals not
directly involved in the activity or transaction
 Positive externalities occur when one or more
parties not involved in the transaction benefit
from the activity
 Negative externalities occur when third
parties are harmed.
Positive externalities
 Those engaged in the transaction do
not take the external benefits into
account in their decision making
 This results in underproduction
 Possible remedies:
 subsidy
 regulation
Negative externalities
 Negative externalities result in social
costs that are not borne by the parties
involved in the transaction.
 results in overproduction
 Possible solutions:
 taxation
 regulation
Internalizing externalities
 The use of taxes or subsidies to correct
for an externality is sometimes referred
to as “internalizing” the externality.
Public goods
 nonrival in consumption (one person’s
consumption does not affect the
quantity or the quality of the good
available to others)
 free-rider problem results in
underproduction
 Possible solutions: government
production or subsidization
Common property resources
 problem of the commons - resources
are commonly owned
 benefits are received by those who use the
resource
 costs are shared by all
 overutilization
 government regulation
Monopolies
 higher prices and lower output
 antitrust law, regulation, or public
production
Macroeconomic instability
 economic inefficiency caused by
unemployment during recessions
 government policies designed to
stabilize the economy
 Public choice theory
 government policy is constructed by self-
interested individuals
 participants in policy formation are concerned
about their own self interest, not the “public
interest”
 economic rent - a payment in excess of
opportunity costs
 rent-seeking behavior on the part of special-
interest groups
 Economic policy
 Microeconomic policy - designed to
correct for:
 imperfect information,
 externalities,
 public goods,
 the absence of property rights, and
 monopolies.
 Macroeconomic policy - designed to
enhance macroeconomic stability and
encourage economic growth.