Topic 11. Welfare economics:

Pareto optimality & the competitive economy

December 3rd 2004

Lecture slides available from Nancy’s website:

Today’s lecture:

  • Pareto optimality
  • Competitive markets and social efficiency

Read:

Sloman chapter 11, Section 11.1

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’?

(the ‘first fundamental theorem of welfare economics’)

  • 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.

One of the important theoretical proofs in welfare economics is that a competitive economy would be efficient (i.e. generate pareto optimal outcomes)

3. The optimality of a competitive economy.

In general, social efficiency occurs when MSB = MSC

In a perfectly competitive economy:

In Consumption:

Each consumer is utility maximising;

Each chooses a quantity of each goods where Px = MUx

Each consumer faces the same Px as any other consumer;

Each consumer faces the same Py as any other consumer

Alternatively: Px/Py = MUx/Muy

In Production:

Each firm is a price taker

Each firm is profit maximising

P = MC for each

Px = MCx and Py = MCy, therefore MCx/Mcy = Px/Py

A private market delivers the following outcome:

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.

Somewhat more advanced proof…

Px/Py = MUx/MUy

Px/Py = MCx/MCy

MUx/MUy = MCx/Mcy

  • 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

At Q* surplus =

At Q1 surplus =

At Q2 surplus =

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’)

The remaining two lectures will demonstrate the effect on AE of various sources of market failure.