Chapter 5: The Public Sector

1. Chapter 5: The Public Sector

2. 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)

3. Markets and economic efficiency • voluntary trade in markets benefits each trading partner • under ideal conditions, markets attain a state of economic efficiency (Pareto optimality)

4. 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

5. 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

6. 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.

7. 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

8. 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

9. Internalizing externalities • The use of taxes or subsidies to correct for an externality is sometimes referred to as “internalizing” the externality.

10. 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

11. 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

12. Monopolies • higher prices and lower output • antitrust law, regulation, or public production

13. Macroeconomic instability • economic inefficiency caused by unemployment during recessions • government policies designed to stabilize the economy

14. 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

15. 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.