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Public Finance ( MPA405 )

Public Finance ( MPA405 ). Dr. Khurrum S. Mughal. Lecture 2: Efficiency: Criterion and Government. Public Finance. Positive and Normative Economics. Positive Economics explains “what is” without making judgments about the appropriateness of “what is.”

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Public Finance ( MPA405 )

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  1. Public Finance (MPA405) Dr. Khurrum S. Mughal

  2. Lecture 2: Efficiency:Criterion and Government Public Finance

  3. Positive and Normative Economics • Positive Economics explains “what is” without making judgments about the appropriateness of “what is.” • Normative Economics: designed to formulate recommendations on what should be.

  4. Normative Evaluation of Resource Use: The Efficiency Criterion • Pareto Optimality • The efficiency criterion is satisfied when resources are used over any given period of time in such a way as to make it impossible to increase the well-being of any one person without reducing the well-being of any other person.

  5. Welfare Economics

  6. Efficiency Resource Use Assumptions • 2 inputs (capital and labor) • 2 outputs (food and clothing)

  7. Production Functions F = F(LF,KF) C = C(LC,KC) Where  • F = food production • C = clothing production • Li = labor devoted to the production of good i • Ki= capital devoted to the production of good i

  8. Constraints L = LF + LK K = KF+ LF

  9. Productive Efficiency • It is not possible to reallocate inputs to alternative uses in such a manner as to increase the output of any good without reducing the output of some alternative good.

  10. Figure Productive Efficiency L* LC 0' C K KC E* F6 Z* F5 C1 K* K* F C Z1 F4 C2 C3 F3 C4 D F3 C5 C6 KF F1 LF L 0 L* F

  11. Efficiency Condition MRTSFLK= MRTSCLK • The Marginal Rate of Technical substitution of Labor for Capital in each good are equal

  12. Figure The Production-Possibility Curve T E 1 E 2 A Food per Year D F C T' 0 Clothing per Year

  13. Pareto Efficiency Preferences on Consumption UA= U(FA,CA) UB = U(FB,CB) Where Ui = the utility of person i Fi= food consumed by person i Ci= clothing consumed by person i

  14. Constraints F = FA+ FB C = CA+ CB

  15. Figure Efficient Allocation of A Given Amount of Food and Clothing per Year For Two Consumers T CB CB* D F Food per Year UB1 UA7 FB UB3 UB2 UB4 E** UA6 E* FA* UB5 FB* UB6 UA5 UB7 UA3 UA4 FA UA2 UA1 CA* CA C 0 T’ Clothing per Year

  16. Efficiency Criterion on Consumption and Production MRSACF= MRSBCF= MRTCF

  17. Interpretation of Efficiency Criterion Suppose we say that the “price of a unit of clothing is $1.” Then clothing is the same as “money.” We can then say that MRSACF is A’s willingness to substitute clothing for money, which is their marginal benefit of clothing, MBAC. The same is true for B. If these are equal to the MRTCF then this represents the capability of turning money into clothing as well. Thus it reflects the costs of production. Lastly if there are no other people who gain from either A or B consuming clothing or food then: MSB = MBAC= MBBC= MSCC

  18. Efficiency and Economic Institutions Given the conditions for a market rendering a Pareto Optimal outcome in perfect markets: C = PKK + PLL then production of a particular amount of a good is efficient if the slope of the production function for each good is equal to the slope of the isocost line.

  19. Figure Cost Minimization and Productive Efficiency E K F = F1per Year L 0 Capital Labor

  20. Implications of Figure • MRTSFLK= PL/PK • MRTSCLK= PL/PK • MRTSFLK= MRTSCLK= PL/PK

  21. PCMCC PFMCF = Pure Market Economy and Pareto Efficiency Step 1 So far we know that PF= MCFand PC= MCCfrom perfect competition dividing one by the other we get It can be shown that this ratio of MCs is equal to MRT

  22. Pure Market Economy and Pareto Efficiency Step 2 • MCF is the amount of other resources that must be given up to produce more Food. We will denote this fact by saying: MCF= DC. • It is the forgone clothing to produce more Food. • The same applies the other way around MCC = DF.

  23. MCC DF = MCF DC Pure Market Economy and Pareto Efficiency Step 3 Dividing these by each other we get:

  24. DF DC PC MRTCF = PF MCC DF PC = = MRTCF = MCF DC PF Since Pure Market Economy and Pareto Efficiency Step 4 = MRTCF And Then

  25. Figure 2A.5 Consumer Choice A Food per Year FA CA B 0 Clothing per Year E UA3 UA2 UA1

  26. PC PC A B MRSCF = MRSCF = PF PF Pure Market Economy and Pareto Efficiency Step 5 As just seen the slopes of the individual’s indifference curves are equal to the ratio of the prices. So

  27. PC MRSCF = MRSCF = MRTCF = PF A B Pure Market Economy and Pareto Efficiency Final

  28. Market Imperfections • Monopoly P > MC

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