Topic 11. Welfare economics:

Pareto optimality & the competitive economy

December 1st 2003

Lecture slides available from Nancy’s website:

Today’s lecture:

  • Pareto optimality
  • Competitive markets and social efficiency

Read:

Sloman chapter 11.

Note: our coverage of Pareto optimality in lectures will be slightly more advanced than that provided in Sloman & other first-year texts.

1. Introduction to welfare economics

  • Positive economics: descriptive
  • Normative economics: prescriptive

Welfare economics is the economic analysis of questions such as…

  • In what sense is a competitive market socially ‘optimal’?
  • Under what circumstances will markets ‘fail’?
  • What should the role of the Government be?
  • Answering such questions unavoidably requires value judgements.
  1. Social efficiency:
Pareto optimality
  • What is the weakest (least objectionable) value judgement we can use to judge different allocations of resources?

Pareto improvement:a change is ‘a good thing’ if at least one person can be made better off, and nobody is made worse off.

Once all such improvements have been made, the outcome will be Pareto optimal.

  1. Demonstrating Pareto optimality: Edgeworth box
  • 2 people
  • Fixed amount of 2 goods to allocated between them
  • Preferences/utility of each represented by their indifference curves maps.

Rotate Renu’s indifference curve map onto Ravi’s…

3a. How should the goods be allocated between the 2 people?

  • Can we say anything about whether any one allocation (e.g. point a) of goods is ‘better’ than another (e.g. point d)?


3b. Identifying Pareto improvements

On the diagram below…

* Shifts between which states would be a Pareto improvement?

* Which states are Pareto optimal? Why?

* What is the condition for Pareto optimality in consumption?

4. The optimality of a competitive economy.

A competitive economy delivers the following outcomes:

In Consumption:

Each consumer is utility maximising; chooses a quantity of each goods where their P = MU

Each consumer faces the same price.

In Production: P = MC

Each firm is profit maximising

P = MC for each

P the same for each perfectly competitive firm

Thus MU = MC

The opportunity cost of producing the last unit of each good in the economy exactly equals the addition to utility of producing it.

  • The ‘invisible hand’
  1. Measuring allocative efficiency: Total Surplus.

Consumer surplus:

  • Total value = ∑ MV of each unit consumed.

  • Consumer spending = P x Q

Producer surplus:

  • Total costs = ∑ MC of each unit sold.
  • Firm revenue = P x Q

5a. Total surplus

= consumer surplus + producer surplus.

6. Allocative efficiency (AE) & market equilibrium

  • In equilibrium P* and Q*, total surplus is maximised

  1. Conclusions
  • a competitive economy will generate an allocation of resources that is Pareto optimal

BUT

  • but may not be optimal in any other sense (e.g. may be considered unfair)

AND

  • There are a number of circumstances where markets fail to generate allocatively efficient outcomes (‘market failure’)

Next lecture (last one for the term!) market failures & their implications for allocative efficiency