BBAF 406: Public Finance

Lecture 1:
Overview of Public Finance

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 Lecture 1 objectives
• Learning outcomes:
• Trace the foundations and justifications for government’s role in the economy/market.
• Explain how the main economic schools of thought conceptualize govt role vs market.
• Explain when not and when government can intervene in the market.
• Explain briefly how the govt intervenes and for what purpose.
• Explain briefly why govt intervention might not resolve a problem the market fails to
resolve.
• Explain govt objectives or functions when it intervenes.

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 Overview of Public Finance
• Public finance is a course that deals with economic analysis of government activities and
public policy. It discusses issues about role of government, economic justification for
government roles, and its associated matters like public expenditures and revenue issues
and the impact of public sector activities on the economy as a whole. Public finance also
studies public policy by exploring how the effectiveness of policy formulation and
application can be improved.
• Various economic arguments have been raised about whether there is need for government
activities in the economy given that the forces of demand and supply (the invisible hands)
are the key tools that determine how resources should be allocated.

• Historical perspectives on Public Finance:

• Classical economists conclude that government intervention is not necessary because
market will work efficiently in the allocation of resources. Therefore, government activities
will bring distortions into the market. Indeed, this can be true in government price controls
and government failure situations. They also state that Aggregate Supply (AS) creates its
own demand (Aggregate Demand) therefore no need for government activities. Besides,
they believe that every economy has the mechanism to self-correct or make re-
adjustments to be in optimum position hence the economy need not be induced by any
government activities to correct temporary distortions or deviations from optimum.

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 Overview of Public Finance
• Keynesian Economists' observation of the problems that
bedevilled the economy in the 1930s Great Depression recognized
the fact that supply was not able to create its own demand as a
result of high unemployment and recession. Therefore, they
proposed the Aggregate Expenditure framework which basically
explains that the Aggregate Demand is what determines Aggregate
Supply.
• Besides, Keynesians believe that the economy will take time to
correct itself or self-adjust to optimum. If the time it takes is long
time or eternity, then the economy would have collapse then.
They therefore make a strong case for government activities to
speed up, expedite or induce the self-adjustments to solve
economic problems.
• Keynesians made a strong case for the public sector or
government activities in the economy to achieve optimum. For
instance, if there is a recession then expansionary government
activities would be required to induce the economy to achieve
optimum. If there is an inflationary boom then contractionary
activities required to stabilize the economy. 4
 Overview of Public Finance
• Chicago School:
• This school of thought believes that a government intervention must
improve market efficiency, otherwise no need for it.
• For instance, government passing laws on the sanctity of
contracts/agreements and remedies for breach and institutions to
adjudicate breaches can improve market outcomes. Chicago school
will argue for govt role here.
• Thus, defining and enforcing property rights.
• But government intervention through taxes might not improve market
efficiency because of Deadweight loss: loss of consumer surplus and
producer surplus.
• Summary:
• Classicals: No need for govt intervention.
• Keynesians: Strong need for govt role various reasons & criticisms.
• Chicago School: Conditional; only if government activities improves
market efficiency or outcomes. 5
 Overview of Public Finance
• Public finance (PF) also examines the efficiency of the market (market
mechanism in efficient allocation of resources) and recognizes that
private markets can fail in efficiently allocating resources in certain
circumstances, hence govt role needed. Circumstance in which the
market can fail include the case of public goods, externalities, income
distribution inequality, information asymmetry, increasing returns
arguments, etc.

• PF also recognizes that even if a private market does not fail,

government activities might also be necessary to set regulatory
framework for the market to work (Chicago school justification!). This
framework involves defining and enforcing property rights to facilitate
rules of conduct in private markets. Market mechanism alone cannot
perform all economic functions. Public policy or government activity
is needed to guide, correct and supplement it in certain respects.
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 Overview of Public Finance
• It is worthy to note that though the market may fail, government
intervention or activities might not necessarily resolve market failure
because of issues of government failure as well.
• Some of the conditions which make the market fail can also make
government to fail. Besides, certain peculiar problems associated with
government activities can also make the government fail i.e rent seeking
behaviours, corruption, government monopolies, agency problems etc.
• Why are government activities or interventions common in developing
countries considering our overview of public finance so far? Discuss this
among yourselves!
• Trend of PF overview: Market efficient, Market inefficient or market
failure, govt role, govt failure, remedies for govt failure.
• PF concluding viewpoint: Whether the market fails or not, government
role needed, yet arguments for laissez faire are debated in PF.
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•
Question
Market mechanism alone cannot perform all economic functions. Public policy and/or
government activity is needed to guide, correct and supplement it in certain respects. Explain.
• Market mechanism involves the interaction between the forces of demand and supply in
allocation resources. For the market mechanism to perform its economic functions of allocating
resources efficiently, the market itself must be efficient. The efficiency of the market requires that
there is efficiency in consumption, in production and in product composition. These conditions
do break down in certain respects especially in the case of public goods, externalities,
information asymmetry, income distribution inequality, incomplete markets, etc.
• Therefore in principle, whenever such conditions break down (or the market fails), public policy or
government activity is required in those respects. Public policy is therefore required in such
circumstances to guide (in terms of defining and assigning property rights), correct (in terms of
regulation, taxes, subsidies etc as in the case of externalities) and supplement (in terms of
providing goods which the private market will not provide based on efficiency reasons eg. public
goods). If public policy or government activity is able to perform these, then the efficiency of the
market will be improved.
• Therefore public policy can improve the efficiency of the market in certain respects but not always
because of issues of government failure due to inability of consumers to reveal true preferences,
rent seeking activities, monopoly bureaucracy, agency problems etc.
• In conclusion, the statement means public policy or government activity can improve market
economic functions.
• NB: (A property right is a legal rule that describes what economic agents can do with an object or
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idea).
 Overview of Public Finance
• Tools of Public Finance:
• Positive analysis: What must be. E.g. If price increases, quantity demanded will fall for normal goods,
etc.
• The positive approach asks: what is it that the government does, what are its effects, and how does the
nature of the political process help explain what the government does and how it does it?

• Normative Analysis: Subjective view. E.g. Equity issues, questions of what should be produced, how it
should be produced, for whom and who should make these decisions, etc.
• The normative approach to the role of government asks: how can government address market failures
and other perceived inadequacies in the market’s resource allocation?

• Economic theory: Demand, supply, market equilibrium, etc.

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 Economic objectives/functions of government
• For government to intervene in situations of market failure,
government needs to set objectives and tailor its functions in line
with achieving the objectives.
• The economic objectives of government basically include:
✓ Macroeconomic stability (hence stabilization function)
✓ Equitable distribution of income (hence Distribution function)
✓ Economic growth (hence Allocation function)
• Government attempts to achieve these objectives by carrying out
Allocation Functions, Distribution or redistribution functions and
Stabilization functions.
• All these functions are executed through the budgetary process
where government expenditures, revenues and policies are
outlined. 10
 Economic objectives/functions of government
• Allocation function involves the provision of social goods or
the process by which total resource use is divided between
private and social goods, and by which a mix of social goods
is chosen.
• Distribution function: The adjustment of income and wealth
to ensure conformity with what society considers “fair” or
“just” state of distribution. This plays a key role in tax and
transfer policies.
• Stabilization or Macroeconomic stability Function: The use
of budget as a means of maintaining high employment, a
reasonable degree of price level stability and an appropriate
rate of economic growth, with allowances for effects of
trade and Balance of Payments (BOP).
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 Economic objectives/functions of government
• Allocation function:
• Due to the xtics of social or public goods, the market
system or mechanism (transactions between individual
consumers and producers or interaction between demand
and supply) may fail to bring about optimal provision of
these goods or may produce inefficient levels (of merit
goods) which will not benefit society.
• Government or public policy is required to facilitate
efficient provision and production.
• Allocation function involves provision of these public goods
to the “optimum”.
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 Economic objectives/functions of government
• Distribution function:
• Competitively, distribution of income requires that factor endowments (personal earning
abilities and ownership of accumulated and inherited wealth) should fetch prices in line
with their marginal product. But this manner of distribution of income may not be what
society considers “fair” because it can bring substantial degree of inequality; total
satisfaction or happiness of society might not be maximized; utility of income to various
individuals differs markedly.
• This therefore calls for public policy or government activity towards ensuring socially
acceptable income distribution.
• There is therefore need for redistribution by
➢ tax-transfer schemes: combining progressive taxation of high-income with a subsidy to
low-income households
➢ Progressive taxes to finance public services like public housing which benefit low-
income households
➢ a combination of taxes on goods purchased largely by high-income consumers with
subsidies to other goods which are used mainly by low-income consumers.
This may have efficiency losses but is it not worth it? Discuss.

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 Economic objectives/functions of government
• Stabilization function:
• Economic targets or goals like high employment, reasonable price level
stability, soundness of foreign accounts (BOP), and acceptable economic
growth rate do conflict one another as economic relationships indicate eg
Philip’s Curve; stagflation (sustained high unemployment coupled with high
inflation)
• There is need for a balance of one target with an acceptable or healthy
allowance for other targets.
• Given the private markets are driven purely by profits or quest for higher
returns; such markets might act to maximize one target to the detriment of
the other.
• Public policy is therefore required to set jointly achievable targets to better
the lots of all market actors.
• This is usually done through fiscal policy instruments and monetary policy
instruments on behalf of the government.
• Examples: maintaining stability in prices like inflation, depreciation, BOP, etc.
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 Practice Questions
1. Briefly explain why the self-correcting failure of the market underpins the Keynesian School of
thought on Public Finance.
2. Contrast the classical school of thought on PF with the Keynesians’.
3. How is the Chicago School on PF similar to the Keynesians’?
4. How is the Chicago School on PF similar to the Classicals’?
5. State three instances in which the market can fail.
6. Briefly explain how government interventions guide, correct and supplement the market mechanism
in certain respects.
7. Why are government intervention activities common in developing economies like Ghana?
8. Distinguish between positive and normative analyses in Public Finance.
9. State and briefly explain any three economic objectives of government intervention or public policy.

10.Briefly explain government failure and state three reasons why government failure in developing
economies.
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 Practice Questions
1. Briefly explain why the self-correcting failure of the market underpins the Keynesian School of thought on Public Finance.
Ans: The failure of the self-correcting mechanism establishes that government role can be necessary to speed up the self-correction of deviations in the market
or to correct the deviations themselves by govt activities.
2. Contrast the classical school of thought on PF with the Keynesians’.
Ans: The classicals do not see the need for government role in the economy because they believe the market will always be efficient and even if inefficient, the
market will self-correct in the long run. Keynesians believe government role will be necessary to prop up aggregate demand to motivate more production to
address recession.
3. How is the Chicago School on PF similar to the Keynesians’?
Ans: They both expect some government role except that the Chicago School’s is conditional on improving market outcomes, otherwise, no need for it.
4. How is the Chicago School on PF similar to the Classicals’? Ans: They both reject the need for government role of some sort.
5. State three instances in which the market can fail. Ans: Public goods, externalities, information asymmetry, increasing returns, imperfect competition, etc.
6. Briefly explain how government interventions guide, correct and supplement the market mechanism in certain respects.
Ans: guide (in terms of defining and assigning property rights), correct (in terms of regulation, taxes, subsidies etc as in the case of externalities) and
supplement (in terms of providing goods which the private market will not provide based on efficiency reasons eg. public goods).
7. Why are government intervention activities common in developing economies like Ghana?
Ans: Because many market failure circumstances apply to developing economies than developed economies. Or the market mechanism is much more efficient
in developed economies than developing economies.
8. Distinguish between positive and normative analyses in Public Finance.
Ans: Positive analysis explain what government does and their effects while normative analysis is about perspectives on what government should do. Once
government does the normative analysis and choices (e.g. fSHS), the next is the positive analysis which are the effects of what government has chosen to do
(e.g. enrolment increases).
9. State and briefly explain any three economic objectives of government intervention or public policy. Ans: Allocation, (re)distribution, stabilization.

10. Briefly explain government failure and state three reasons why government failure in developing economies. Ans: Government failure is a situation where
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government intervention is unable to resolve market inefficiency and this can be due to rent-seeking, bureaucracy, corruption, lack of preference revelation.
BBAF 406: Public Finance

Lecture 2:
Equity, Market Basics and Efficiency

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 Lecture 2 objectives
• Learning outcomes:
• By the end of this lecture, students will be able to:
• Explain equity and equity concepts like the benefit principle, ability-to-pay
principle, vertical and horizontal equity.
• Distinguish between Utilitarian and Rawlsian Social Welfare and apply to social
protection policies.
• Explain the welfare economics perspective and the Pareto efficiency theory of
market efficiency.
• Explain the two fundamental theorems of welfare economics and government
role based on these theorems.
• Explain Adam Smith’s fundamental thoughts on market efficiency.
• Explain the layman and economist’s statement of the three Pareto efficiency
conditions and link them to the basic questions of economics.
• Distinguish among the three perspectives on market efficiency: Welfare (CS,PS),
Pareto (CE, PE & PME) and single condition (MB=MC).
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 Concept of EQUITY
• Equity is a social construct that examines fairness in distributing resources among the
population. It looks not only at fairness in distributing income but also wealth, opportunities and
even public projects. Need for Cost-Benefit Analysis (CBA) as fair basis for public projects.
• Equity is the fairness of distribution of well-being (resources, wealth, income etc) among the
population.
• Equity does not in any way mean equality, rather, it is a call for fairness or justice in the
distribution of resources.
• Govt. should, therefore, design socially desirable policies to achieve fairness in the distribution of
resources
• Equity or fairness in government activities is achieved through taxation and provision of public
goods. Two Equity principles:
• As regards taxation, Benefit principle is crucial: thus, taxing in line with the benefits received
from a government activity.
• Benefit principle states that it is fair for people who benefit from a government activity to
contribute towards its sustenance. Example: User charges, social rent payment.
• Ability-to-pay principle: Fairness in determining the capacity of an individual to handle a
financial burden.
• Ability-to-pay-principle state that it is fair to impose much of the financial burden of
government activity on people have the capacity to bear such a burden. E.g. progressive taxation19
 2 Types of Equity
Welfare economists identified 2 types:
• Horizontal equity means when people in similar circumstances are
treated similarly in matters of remuneration and taxation. Eg : People
with similar abilities or income pay similar tax amounts. People doing
same work must receive same salary according to their ranks. Eg SSSS.
Horizontal equity can be alluded to by the phrase “Equals must be
treated equally”
• Vertical equity means different treatment of people in different
situations in order to reduce inequality in the society. Thus “Unequals
must be treated unequally”. This means tax system should be based
on ability-to-pay principle. Example is the income tax structure.
• Which of these equity types inure to the benefit of the poor in
society? Discuss!
• Although this has its own efficiency problems and may be inimical to
growth, the objective of attaining equity is very crucial. Thus, equity
should be seen as an end, while efficiency a means to an end.
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 Equity: Applications
• Discussion:
• Taxation: Progressive taxation; VAT, NHIS.
• Which kinds of equity are they meant to
achieve? Why?

• Remuneration: SSSS, Article 71 Remuneration,

Allowances, Social security.
• Which kinds of equity are they meant to
achieve? Why?
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 Social Interest and Market Efficiency
• Much like the competitive market, government or public
sector performs various economic functions in order to
achieve an ultimate goal of improving social or public
interest, collectively referred to as social welfare.
• While the market achieves this objective by assuming that
maximization of private welfare (self interests) will together
improve social welfare, public sector activities aim at achieving
this together or collectively.
• It is therefore necessary to understand the concept of social
welfare function in order to appreciate private market vs
public sector.

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 Social Welfare Function Analysis
• Social Welfare (SW) encompasses the well-being of the
society as a whole rather than the welfare of individuals.
But the society is made up of individuals hence we can
construct a social welfare function (SWF) as a function of
individual well-being.
• If well-being can be measured (say using utility) and
interpersonal comparisons of well-being is allowed, then
SWF=W= f(U1, U2, …, Un) where n is the population, U is
utility (benefit, satisfaction) then 3 properties can be drawn:
i. Pareto principle: If Ui rises then W=SW rises.
ii. Individualism: Social Welfare is only a function of
individual well-being, U1, U2, …
iii. Social welfare function can provide some basis for social
choice. (Choice of projects with CBA based on SW). 23
 Types of Social Welfare Function
• Utilitarian SWF: It says Social Welfare is the sum of individual well-being.
W=U1+U2+ … +Un. Thus, if the well-being of any member of the society (rich
or poor) improves, it means social welfare has improved. This type is however
pregnant with strong inequality and equity problems. Why?. SW can increase
but some members of society still worse off in society.
• Rawlsian SWF: Social Welfare is the welfare of the worst-off member of the
society. W= min(U1, U2, …, Un). This SWF is averse to inequality and sees
improvement in social welfare as improvement in the well-being of the worse
off or the poorest of the poor in society. E.g.: LEAP.
• The two types basically give some understanding of what kind of social
welfare would a competitive market mostly improve compared to a public
sector. Sometimes both.
• While the market may improve social welfare largely based on the Utilitarian
SWF, public sector activities mostly improve social welfare based on the
Rawlsian SWF. Discuss this among yourselves!

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 Social Welfare Function Types
• Applications:
• Market mechanism is based on the idea that once individual utilities (well-
being) increase then welfare of society as a whole is maximized. But there are
a lot of vertical equity problems embedded in the Utilitarian SWF. SW can
increase but some members of society still worse off in society.
• For Rawlsian SWF, society is better off if the well-being of the worse off
individual has improved.
• Which one applies to these public policies in Ghana? FSHS, NHIS, Free
Maternal care, LEAP, 1D1F, 1V1D, etc.
• The two SWF types also influence the political economic choice of parties
where we have liberal democracy (capitalism) – utilitarian SWF and social
democracy (socialism) – Rawlsian SWF.
• Which of the two appeals to you as a public finance student and why?
• Govt or public policy usually improve both types of SWF but mostly Rawlsian
SWF.
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 Welfare and market mechanism
• Next, we examine welfare from market perspectives (kind of Utilitarianism):
• Market mechanism (DD & SS) works such that Consumers are better off (Consumer Surplus, CS)
and producers are better off (Producer Surplus, PS) and hence both. Thus, welfare from market
mechanism, more of Utilitarianism.
• For social welfare to be improved through the market mechanism, the market must work
efficiently (CS and PS should be maximized). What does the concept of market efficiency entail?
• We look at the concept of market efficiency from two perspectives: Welfare economics
perspective (Maximizing total surplus = CS +PS); and Pareto Efficiency.
• Welfare economics perspective: Market efficiency work to accrue CS and PS (social welfare is
maximized based on utilitarian SWF).
• CS + PS and hence both so that SW= CS1 +CS2 +…+PS1 +PS2 +…, thus Utilitarian.
• Pareto Efficiency: Market efficiency requires that the market is efficient for consumers
(equivalence of CS), for producers (equivalence of PS), and both consumers and producers
together. Under what economic theory/conditions would these three dimensions of market
efficiency be achieved. Pareto efficiency conditions.
• Next, we look at welfare from the viewpoint of CS and PS, and Pareto efficiency conditions
associated.

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 Welfare economics perspective: Market Efficiency
• Consumers, Producers and Efficiency of market
• I assume students have read Stiglitz Chapter 3 before this lecture.
• Do the equilibrium price and quantity maximize the total welfare of
buyers and sellers?
• Market equilibrium reflects the way markets allocate scarce resources.
• Whether the market allocation is desirable can be addressed by
welfare economics.
• Welfare economics is the study of how the allocation of resources affects
economic well-being.
• Buyers and sellers receive benefits from participating in the market.
• The equilibrium in a market maximizes the total welfare of buyers (CS)
and sellers (PS).
• Equilibrium in the market results in maximum benefits, and therefore
maximum total welfare for both the consumers and the producers of
the product. Recall, the Utilitarian SWF concept?
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 Market Efficiency Basics
• Consumers, Producers and Efficiency of market
• Consumer surplus measures economic welfare of the market
mechanism from the buyer’s side.
• Producer surplus measures economic welfare of the market
mechanism from the seller’s side.
• Consumer surplus:
• Willingness to pay is the maximum amount that a buyer will pay for
a good. It measures how much the buyer values the good or service.
• Consumer surplus is the buyer’s willingness to pay for a good minus
the amount the buyer actually pays for it or equilibrium price.
• What does the consumer surplus measure?
• Consumer surplus, the amount that buyers are willing to pay for a
good minus the amount they actually pay for it, it measures the
benefit that buyers receive from a good as the buyers themselves
perceive it. 28
Figure 1: How the Price Affects Consumer Surplus

(a) Consumer Surplus at Price P

Price
A Supply

Consumer
surplus
P1
B C

Demand

0 Q1 Quantity
 Market Efficiency Basics
• Consumers, Producers and Efficiency of market
• Producer surplus:
• Producer surplus is the amount a seller is paid for
a good minus the seller’s cost.
• It measures the benefit to sellers participating in
a market.

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Figure 3: How the Price Affects Producer Surplus

(a) Producer Surplus at Price P

Price
Supply

B
P1
C
Producer
surplus

Demand
A

0 Q1 Quantity
 Market Efficiency
• Consumer surplus and producer surplus may be used to address the following
question:
✓ Is the allocation of resources determined by free markets in any way desirable?
• Consumer Surplus = Value to buyers – Amount paid by buyers
• Producer Surplus = Amount received by sellers – Cost to sellers
• Total surplus = Consumer surplus + Producer surplus
Or
Total surplus = Value to buyers – Amount paid by buyers + Amount received by sellers – Cost to sellers
• Total surplus = Value to buyers – Cost to sellers
• From the welfare economics perspective:
• Market Efficiency is the property of a resource allocation of maximizing the total
surplus received by all members of society (CS+PS).
• In addition to market efficiency, a social planner might also care about equity – the
fairness of the distribution of well-being among the various buyers and sellers. 32
 Figure 5: Consumer and Producer Surplus in the Market
Equilibrium

Price A

D
Supply

Consumer
surplus

Equilibrium E
price
Producer
surplus

Demand
B

0 Equilibrium Quantity
quantity
 Market Efficiency
• Three Insights Concerning Market Outcomes
– Free markets allocate the supply of goods to the buyers who value
them most highly, as measured by their willingness to pay. If a
buyer values the good most, he will be willing to pay highest price
for it because he would attach higher MU to it. If all buyers place
the same value on the product, then it can only be the highest price
(Consumption efficiency).
– Free markets allocate the demand for goods to the sellers who can
produce them at least cost. Producing at the least cost means a
seller can charge reduced prices so the free market would allocate
demand to such sellers.
– Free markets produce the quantity of goods that maximizes the sum
of consumer surplus and producer surplus. Hence both consumers
and producers are simultaneously benefitting.
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 Evaluating market equilibrium
• Because the equilibrium outcome is an efficient allocation of
resources, the government or the social planner can leave the
market outcome as he/she finds it. Thus, first-best theorem. This
market outcome applies to a perfectly competitive market. This is
also likened to Classical school of thought on PF.
• This policy of leaving the market well alone goes by the French
expression laissez faire. Hence the first-best theorem is sometimes
referred to as laissez faire. If the market mechanism is efficient,
laissez faire!
• But the competitive market can also inefficiently allocate resources
due to:
• Market Power (monopoly power)
– If a market system is not perfectly competitive, market power may result.
• Market power is the ability to influence prices.
• Market power can cause markets to be inefficient because it keeps price and quantity
off from the equilibrium of supply and demand.
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 Evaluating market equilibrium
• Externalities
– created when a market outcome affects individuals other than
buyers and sellers in that market.
– cause welfare in a market to depend on more than just the value
to the buyers and cost to the sellers but to third party
beneficiaries or sufferers.
• When buyers and sellers do not take externalities into
account in deciding how much to consume and produce,
the equilibrium in the market can be inefficient because of
misalignment between marginal benefits and marginal
costs. This is a market failure situation.
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 Quick summary
• Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay for it.
• Consumer surplus measures the benefit buyers get from participating in a market.
• Consumer surplus can be computed by finding the area below the demand curve and above the price.
• Producer surplus equals the amount sellers receive for their goods minus their costs of production.
• Producer surplus measures the benefit sellers get from participating in a market.
• Producer surplus can be computed by finding the area below the price and above the supply curve.
• An allocation of resources that maximizes the sum of consumer and producer surplus is said to be
efficient.
• Policymakers are often concerned with the efficiency, as well as the equity, of economic outcomes.
• The equilibrium of demand and supply maximizes the sum of consumer and producer surplus.
• This is as if the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently.
• Markets do not allocate resources efficiently in the presence of market failures.

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 Adam Smith’s thoughts on Market Efficiency
• Economics generally advocates a primary reliance on the private sector rather than
public sector for the production and distribution of goods because it is believed that
such economic organization leads to efficient allocation of resources (“First-best
theorem”: market will be efficient so no need for public sector). This is to say that the
private market brings about economic efficiency (market efficiency).

• Adam Smith explains this efficiency by arguing that individual’s self interest will make
them take economic decisions which will inure to public interest rather than a small
group of individuals taking such decisions on behalf of the public. Thus, in competitive
markets, an individual consumer pursuing private gains (satisfaction) would promote
the common good of society eventually. (Utilitarian SWF? Yes. W=U1+U2+ … +Un).

• Thus, an individual producer in the pursuit of their private interests (profits) will end
up also pursuing the public interest or social interest. (Trickle down effect!). You
remember the Utilitarian SWF?
• Adam Smith: Public interest (SWF) is served when each individual simply does what is
in his own self-interest (Utilitarian SWF).

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 Market efficiency & Adam Smith … contd
• Based on self interest, Adam Smith explains if an individual or a group of individuals want
to satisfy their self-interest (satisfaction), they will be willing to pay something for what
will make them satisfy their self-interest.
• Another individual (entrepreneur) also willing to satisfy his/her self-interest (profits) will
be willing to produce the item if what people will pay for the item exceeds the cost of
producing it. What about if what they are willing to pay is lower than the cost of producing
it as in the case of public goods? Or if they are not willing to pay anything but will enjoy
the good? Market failure!

• However, once the value placed on the item, at least, exceeds the cost of producing it
(there exists a profit), entrepreneurs will be willing to produce it and will compete for the
profits. They will even look for innovative or new methods of producing it to reduce costs
hence there will be competition to drive out those that produce at a very high cost
(inefficient producers) to ensure efficiency. Free entry and exit push!
• Once the item is produced, it will satisfy the self-interest of “satisfaction” and also yield
“profits” for the entrepreneur’s self interest. With individuals satisfied, society is satisfied
(Utilitarianism? Yes). Hence social or public welfare is improved.
• This means no need for any government or public sector economic functions. Market is
efficient in resource allocation! Laissez faire. First-best theorem as Adam Smith analyzed.

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 Market efficiency
• Deductions
• The market organization in production will work if
➢ Consumers are willing to pay something for an item.
➢ Consumers reveal the amount they are willing to pay in line with the
true value they place on the item.
➢ The cost (MC) of production is less than what they are willing to pay.
• Questions to be answered later:
• What if they are not willing to pay for the item?
• What if what they are willing to pay does not reveal their true value
for the item?
• What if what they are willing to pay is lower than the cost of
producing the item?
• Market failure is embedded in these answers, but Adam Smith is a
typical classicalist! 40
 Pareto Market efficiency: Composite mkt conditions
• Market efficiency is a criterion that is used to basically determine economic decisions like
what should be produced (consumer sovereignty based on consumption or exchange
efficiency), how it should be produced (production efficiency), for whom and who
should make these decisions (product-mix efficiency).
• If the market mechanism decides all these efficiently, then there will be Pareto efficiency
or composite market efficiency. The three conditions are therefore called Pareto
Efficiency conditions.
• Definition:
• Pareto Optimality or efficiency is a property in resource allocation that postulates that if
the market is efficient then no one can be made better off without someone being made
worse off. There shouldn’t be any trade off that will improve the welfare of one
individual without making someone worse off. Eg: If the market is efficient, individual A
can only be made better off if individual B is some way made worse off.
• If the reverse happens, we say there is Pareto improvement or the Pareto principle. Eg:
if A is better off, B should be the same or also be made better off some way, then there is
a Pareto improvement.
• Read Summary notes on pg. 73-74 of Stiglitz’s textbook for more.

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 3 Pareto efficiency conditions explained
• In analyzing economic (Pareto) efficiency, the economy must achieve three aspects of efficiency
to be Pareto efficient.
1. Exchange efficiency or efficiency in consumption or market must be efficient for consumers:
Whatever goods produced have to go to the individuals who value them most. The value
placed on a good is equal to the MB. However, the relative value that one individual (say A)
places on the last unit of commodity (say X ) compared to that placed on the last unit of
another commodity (say Y) is the marginal rate of substitution (MRSAx,y ). Therefore, efficiency
in consumption requires that MRSAx,y = MRSBx,y = … = MRSzx,y . Competitive market in which
individuals face the same prices always have exchange efficiency. Thus, MRSAx,y = MRSBx,y = …
= MRSzx,y . For competitive markets, consumers face same price so MRSAx,y = MRSBx,y = … =
MRSzx,y =Price. (Read Stiglitz pg.74).

2. Production efficiency or market must be efficient for producers: Given society’s resources
and technology, the production of one good cannot be increased without decreasing the
production of another if it has to be Pareto efficient. This can be explained looking at the rate
of exchange of factors of production between firms, generally referred to as marginal rate of
technical substitution (MRTS). The MRTSAL,K is the value (to firm A) of the last unit of labour
(say L) relative to the last unit of capital (say K).
For production efficiency, MRTSAL,K = MRTSBL,K = … = MRTSZL,K . For competitive markets firms
face the same factor prices so MRTSAL,K = MRTSBL,K = … = MRTSZL,K =Price.
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 3 Pareto efficiency conditions explained
• 3) Product-mix efficiency: or market must be simultaneously efficient for both
consumers and producers or product composition efficiency:
• Goods produced correspond to those desired by individuals. Firms are willing to
transform the production of one good into another depending on market
conditions. The rate at which one good can be transformed into another in
production is referred to as marginal rate of product transformation (MRPT). For
Product-mix efficiency condition, MRPTX,Y = MRSX,Y .For competitive markets,
MRPTX,Y = MRSX,Y =Price

• For instance, if MRPTX,Y = 2Y/1X and MRSX,Y =1Y/1X then MRPTX,Y > MRSX,Y meaning
the economy can produce two units of Y by sacrificing one unit of X, while the
consumers are willing to exchange one unit of Y for one unit of X. Obviously, the
economy (firms) produces too much of X relative to the preferences of the
consumers, and too little of Y relatively to the tastes of consumers. Welfare can
therefore be increased by increasing the production of Y and decreasing the
production of X.
• The firms are willing to transform 2Y to 1X (or 1Y to ½ X) but what is actually
produced is what the consumers are exchanging 1Y to 1X (or 2Y to 2X) meaning
there is an over-production of X by ½ . 43
 Market efficiency and Fundamental Welfare Theorems
• Pareto efficiency raises two fundamental theorems of welfare:
1) If the economy is competitive, and satisfies certain other conditions, it is Pareto efficient – (Everyone
will be well-off in line with factor endowment and no one’s welfare can be improved without making
somebody’s worse off). This the so-called “first best theorem”. Because the equilibrium outcome is an
efficient allocation of resources, the government or the social planner can leave the market outcome
as he/she finds it (Laissez faire). Kind of Classical school of thought on PF and Utilitarian welfare.
2) There can be many Pareto efficient distributions (i.e. possible pareto improvement points), hence by
redistributing initial wealth or income (factor endowments), the forces of competitive market will
freely play out to obtain Pareto efficient allocation of resources. This is so-called “second-best
theorem”. E.g. support the poor’s income thru LEAP and let the market handle the rest by efficiently
allocating resources. Kind of Chicago School of thought on PF and Rawlsian welfare. This will be
Pareto inefficient though. The “second-best theorem” often argues for government role.

• The implications of these theorems and government role in economy:

1. Competitive market will produce or generate Pareto optimal outcomes, (but if government thinks the
outcomes will not maximize social welfare, there can be redistributions (thru taxes, subsidies, etc) to
achieve Pareto improvement, this will however be Pareto inefficient).
2. Government can redistribute initial wealth (factor endowments or property rights) and leave the rest to
the competitive market to work out to improve welfare efficiently. This is Pareto inefficient, but
equity is attained.
3. Government should not interfere with the market outcomes (market has some merits) but focus on
redistribution of initial wealth or factor endowments.
4. If there are no potential pareto improvements, leave the market alone. Laissez faire! 44
 Implications of the fundamental theorems of Welfare
• This means that society can obtain a particular efficient
allocation by appropriately redistributing factor endowments.
• This can be achieved through taxes/subsidies to factor
endowments (lump sum taxes). But this often does.
• In fact, this redistribution of initial factor endowments could
be viewed as the main role of government in the perfectly
competitive model. This is a kind of the Chicago School on PF.
• Redistribution of factor endowments can be in the form of
assigning property rights as well. For instance, use of a parcel of
land as local market example.
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 Market efficiency single market condition: MB & MC
• In a single market, competition results in market efficiency when the “invisible hands” of demand and
supply interact as it is with the market mechanism yielding CS and PS.
• In deciding how much to demand, individuals equate the marginal benefit (MB) they receive from
consuming an extra unit with the marginal cost (MC) of purchasing an extra unit. The MC here is just equal
to the price they have to pay (in a competitive market) which reflects their marginal utility (MU).
• In deciding how much of a good to produce or supply, competitive firms (entrepreneurs) equate the MB
they receive from producing an extra unit (which is their marginal revenue – MR) to the MC of producing an
extra unit.
• Market Efficiency requires that the MB associated with producing one more unit of any good equals its MC.
Thus, MB=MC.
• If MB>MC, society would gain from producing more of the good. E.g. Education, Honesty.
• If MB<MC, society would gain from reducing production of the good. E.g. air pollutants
• The conditions required for market efficiency are MB=MC, and generally MB=P=MC for a competitive
market efficiency.
• MB = MC represents the situation where there’s no tendency to produce more or to produce less.
• Consumer’s MB is MU and Producers MB is MR.
• Example: MU=P=MC for consumers (consumption efficiency), MR=MC=P for producers (production
efficiency). The equilibrating variable P=MC would make for product-mix efficiency (efficiency for both
consumers and producers).
• The equilibrating variable (P=MC) implies that this single market condition (MB=MC) also tacitly agrees with
Pareto efficiency conditions just like the welfare economics perspectives.
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 Summary: Market efficiency
• Market efficiency is the ability of the market mechanism to allocate resources optimally.
• Market inefficiency would lead to no allocation, under-production or over-production.
• Pareto efficiency: Resource allocations that have the property that no one can be made better off without someone else
being made worse off are called Pareto efficient allocations.
• Market efficiency requires the market to be efficient for the consumer, efficient for the producer and efficient for both
simultaneously.
• Pareto efficiency perspective: Mkt is efficient if it has consumption efficiency, production efficiency and product-mix
efficiency.
• Welfare economics perspective: Mkt is efficient if it results in CS, PS and both.
• Single market perspective: Mkt is efficient if it results from MB=MC=P with P=MU.

• If the market is efficient, what happens?

• 1. Laissez faire (no govt role may be needed) as espoused by Classical economists, Adams Smith.
• 2. Govt role may be needed (To set regulatory framework, assign property rights, or redistribute factor endowments) as
espoused by Second-best theorem, Chicago PF School.
• Government is required to establish/define and enforce property rights and enforce contracts. Without this, markets by
themselves cannot function.
• 3. Govt role because competitive market outcomes may give rise to socially undesirable income distribution.

• If the market is inefficient, what happens?

• 1. Govt intervention/role is needed (in Public goods, externalities, Info. Asymmetry, etc) to address the specific
inefficiencies as espoused by the Keynesian Economists. Govt role to expedite resolution of output gaps.

• In our next lectures, we will discuss each market failure cause, the nature of the market inefficiency that results (no, under
or over-production), govt role to reduce or solve each market inefficiency.
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 Practice Questions
1. With one example each, briefly distinguish between vertical equity and horizontal equity.
2. Distinguish between Rawlsian social welfare and utilitarian social welfare concepts.
3. Briefly explain two problems of utilitarian social welfare function.
4. Distinguish between Rawlsian social welfare and utilitarian social welfare concepts on the basis of wealth
inequality.
5. Differentiate between consumer surplus and producer surplus.
6. Explain the effect of monopoly on consumer surplus.
7. Broadly explain how maximization of self-interest advances the arguments of no need for public policy
(following Adam Smith).
8. Briefly explain the efficiency condition in a single market situation.
9. What is Pareto efficiency of a market?
10. Briefly explain the three criteria for market efficiency (Pareto Efficiency).
11. What is the layman’s explanation to each criterion of Pareto efficiency?
12. Briefly explain how price can bring about Pareto efficiency.
13. Why do competitive markets satisfy Pareto efficiency?
14. Why are market in which participants face the same price Pareto efficient?
15. What is the role of government in “first best” and “second best” solutions in fundamental welfare
theorems?
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 TERM PAPER ASSIGNMENT 2024

Discuss any five situations of market failure in the Ghanaian

Economy and explain how government intervention has
addressed them.
To be submitted in the Week 7

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