1. 16.4 Competitive Market Efficiency
Pareto Efficient
No alternate allocation of inputs and goods makes one consumer better off without hurting another consumer
If another allocation improves AT LEAST ONE CONSUMER (without making anyone else worse off), the first allocation was Pareto Inefficient.

2. 16.4 Competitive Market Efficiency
Pareto Efficiency has three requirements:
Exchange Efficiency
Goods cannot be traded to make a consumer better off
2) Input Efficiency
Inputs cannot be rearranged to produce more goods

3. 16.4 Competitive Market Efficiency
3) Substitution Efficiency
Substituting one good for another will not make one consumer better off without harming another consumer

4. 1) Exchange Efficiency Model Assumptions
2 people
2 goods, each of fixed quantity
This allows us to construct an EDGEWORTH BOX – a graph showing all the possible allocations of goods in a two-good economy, given the total available supply of each good

5. 1) Edgeworth Box Example
Two people: Maka and Susan
Two goods: Food (f) & Video Games (V)
We put Maka on the origin, with the y-axis representing food and the x axis representing video games
If we connect a “flipped” graph of Susan’s goods, we get an EDGEWORTH BOX, where y is all the food available and x is all the video games:

6. 1) Maka’s Goods Graph Food Video Games Ou is Maka’s food, and Ox
is Maka’s Video Games u
Food O x
Maka
Video Games

7. 1) Edgeworth Box Food Video Games Susan y O’
O’w is Susan’s food, and O’y is Susan’s Video Games r
Total food in the market is Or(=O’s) and total Video Games is Os (=O’r) u
Food w
Each point in the Edgeworth Box represents one possible good allocation O x s
Maka
Video Games

8. 1) Edgeworth and utility
We can then add INDIFFERENCE curves to Maka’s graph (each curve indicating all combinations of goods with the same utility)
Curves farther from O have a greater utility
We can then superimpose Susan’s utility curves
Curves farther from O’ have a greater utility
Remember that:

9. 1) Maka’s Utility Curves
Maka’s utility is greatest at M3
Food M3 M2 M1 O
Maka
Video Games

10. 1) Edgeworth Box and Utility
Susan O’
Susan has the highest utility at S3 r S1 S2 A S3
At point A, Maka has utility of M3 and Susan has Utility of S2
Food M3 M2 M1 O s
Maka
Video Games

11. 1) Edgeworth Box and Utility
Susan O’
If consumption is at A, Maka has utility M1 while Susan has utility S3 r A B S3 C
By moving to point B and then point C, Maka’s utility increases while Susan’s remains constant
Food M3 M2 M1 O s
Maka
Video Games

12. 1) Exchange Efficiency Food Video Games Susan O’
Point C, where the indifference curves barely touch is EXCHANGE EFFICIENT, as one person can’t be made better off without harming the other. r S3 C
Food M3 M2 M1 O s
Maka
Video Games

13. 1) Pareto Improvement
When an allocation is NOT exchange efficient, it is wasteful (at least one person could be made better off)…
A PARETO IMPROVEMENT makes one person better off without making anyone else worth off (like the move from A to C)…
However, there may be more than one pareto improvement:

14. 1) Pareto Improvements Food Video Games Susan O’
If we start at point A:
-C is a pareto improvement that makes Maka better off
-D is a pareto improvement that makes Susan better off
-E is a pareto improvement that makes both better off r A S3 C S4
Food S5 E M3 M2 D M1 O s
Maka
Video Games

15. 1) The Contract Curve
Assuming all possible starting points, we can find all possible exchange efficient points and join them to create a CONTRACT CURVE
All along the contract curve, opposing indifferent curves are TANGENT to each other
Since each individual maximizes where his indifference curve is tangent to his budget line:

16. 1) The Contract Curve
Susan O’ r
Food O s
Maka
Video Games

17. 1) Example: House and Chase
Assume that House and Chase have the following utilities for books and coffee:
The Exchange Efficiency Condition therefore becomes:

18. 1) MATH – House and Chase
If there are 10 books, and 4 cups of coffee, then the contract curve is expressed as:
If House has 6 books, an exchange efficient allocation would be:

19. 1) MATH – House and Chase
Therefore, House would have 6 books and 2.4 cups of coffee, and Chase would have 4 (10-6) books and 1.6 (4-2.4) cups of coffee, for utilities of:

20. 2) Input Efficiency Model Assumptions
2 producers/firms
2 inputs (Labor and Capital), each of fixed quantity
This lead to a EDGEWORTH BOX FOR INPUTS– a graph showing all the possible allocations of fixed quantities of labor and capital between two producers

21. 2) Edgeworth Box For Inputs Example
Two firms: Apple and Google
Two inputs: Labor (L) and capital (K)
We put Apple the origin, with the y-axis representing capital and the x axis representing labor
If we connect a “flipped” graph of Google’s inputs, we get an EDGEWORTH BOX FOR INPUTS, where y is all the capital available and x is all the labor:

22. 2) Apple’s Input Graph Capital Labor
Ou is Apple’s capital, and Ox is Apple’s labor. u
Capital O x
Apple
Labor

23. 2) Edgeworth Box For Inputs
Google y O’
O’w is Google’s capital, and O’y is Google’s labor r
Total capital in the market is Or(=O’s) and total labor is Os (=O’r) u
Capital w
Each point in the Edgeworth Box represents one possible input allocation O x s
Apple
Labor

24. 2) Edgeworth and Production
We can then add ISOQUANT curves to APPLE’s graph (each curve indicating all combinations of inputs producing the same output)
Curves farther from O produce more
We can then superimpose Google’s Isoquants
Curves farther from O’ produce more
Remember that the slope of the Isoquant is MRTS and:

25. 2) Apple’s Isoquants Capital Labor Apple produces the most at A3 A3 A2

26. 2) Edgeworth Box for Inputs
Google O’
Google produces the most at G3 r G1 G2 A G3
At point A, Apple makes A3 Google produces G2
Capital A3 A2 A1 O s
Apple
Labor

27. 2) Edgeworth Box and Utility
Google O’
If production is at A, Apple produces A1 while Google produces G3 r A B G3 C
By moving to point B and then point C, Apple produces more while Google’s production remains constant
Capital A3 A2 A1 O s
Apple
Labor

28. 2) Input Efficiency Capital Labor Google O’
Point C, where the isoquant curves barely touch is INPUT EFFICIENT, as one firm can’t produce more without the other firm producing less. r G3 C
Capital A3 A2 A1 O s
Apple
Labor

29. 2) Pareto Improvement
When an input allocation is NOT input efficient, it is wasteful (at least one firm COULD produce more)…
A PARETO IMPROVEMENT allows one firm to produce more without reducing the output of the other firm(like the move from A to C)
However, there may be more than one pareto improvement:

30. 2) Pareto Improvements Capital Labor Google O’ If we start at point A:
-C is a pareto improvement where Apple produces more
-D is a pareto improvement where Google produces more
-E is a pareto improvement where both firms produce more r A G3 C G4
Capital G5 E A3 A2 D A1 O s
Apple
Labor

31. 2) Input Contract Curve
Similar to the goods market, a contract curve can be derived in the input market:
All along the contract curve, opposing isoquant curves are TANGENT to each other
Since each firm maximizes where their isoquant curve is tangent to their isocost line:

32. 2) Input Contract Curve
Google O’ r
Capital O s
Apple
Labor

33. 2) Example: Apple and Google
Assume that Apple and Google have the following production functions:
The Exchange Efficiency Condition therefore becomes:

34. The isoquant slope for Apple is:

35. The isoquant slope for Google is:

36. 2) MATH – Apple and Google
If there are 1000 workers, and 125 capital in Silicon valley, then the contract curve is expressed as:

37. 2) MATH – Apple and Google
Is the market input efficient if Apple has 200 workers and 50 capital?
No – Apple needs fewer capital (Google needs more capital) AND/OR
Google needs fewer workers (Apple needs more workers)

38. 3) Substitution Efficiency
Substitution Efficiency can be analyzed using the PRODUCTION POSSIBILITIES CURVE/FRONTIER
The PPC shows all combinations of 2 goods that can be produced using available inputs
The slope of the PPC shows how much of one good must be SUBSTITUTED to produce more of the other good, or MARGINAL RATE OF TRANSFORMATION (x for y) (MRTxy)

39. Production Possibilities Curve
Here the MRTSpr is equal to (7-5)/(2-1)=-2, or two robots must be given up for an extra pizza. 10 9 8
The marginal cost of the 3rd pizza, or MCp=2 robots 7 6
The marginal cost of the 6th and 7th robots, or MCr=1 pizza
Robots 5 4
Therefore, MRTxy=MCx/MCy 3 2
Therefore, MRTpr=2/1=2 1 1 2 3 4 5 6 7 8
Pizzas

40. 3) Substitution Efficiency and Production
If production is possible in an economy, the Pareto efficiency condition becomes:
Assume MRTpr=3 and MRSpr=2.
-Therefore Maka could get 3 more robots by transforming 1 pizza
-BUT Maka would exchange 2 robots for 1 pizzas to maintain utility
-Therefore 1 pizza is sacrificed for 3 robots, increasing Maka’s utility through the 3rd robot
-The Market isn’t Pareto Efficient

41. The First Fundamental Theorem Of Welfare EconomicsIF
All consumers and producers act as perfect competitors (no one has market power)
and
2) A market exists for each and every commodity
Then
Resource allocation is Pareto Efficient

42. First Fundamental Theorem of Welfare Economics Proof:
From microeconomic consumer theory, we know that:
Since prices are the same for all people:
Therefore perfect competition leads to exchange efficiency

43. First Fundamental Theorem of Welfare Economics Proof:
From microeconomic theory of the firm, we know that:
Since each firm in an industry faces the same wages and rents:
Perfect competition leads to input efficiency

44. First Fundamental Theorem of Welfare Economics Origins
From the PPF, we know that
Therefore a perfectly competitive market is Pareto Efficient:

45. Efficiency≠Fairness Government would exist to protect property rights
If Pareto Efficiency was the only concern, competitive markets automatically achieve it and there would be very little need for government:
Government would exist to protect property rights
Laws, Courts, and National Defense
But Pareto Efficiency doesn’t consider distribution. One person could get all society’s resources while everyone else starves. This isn’t typically socially optimal.

46. Fairness Food Video Games Susan O’ r
Points A and B are Pareto efficient, but either Susan or Maka get almost all society’s resources B C
Food A
Many would argue C is better for society, even though it is not Pareto efficient O s
Maka
Video Games

47. Fairness
For each utility level of one person, there is a maximum utility of the other
Graphing each utility against the other gives us the UTILITY POSSIBILITIES CURVE:

48. Utility Possibilities Curve
All points on the curve are
Pareto efficient, while all points below the curve are not.
Any point above the curve is unobtainable B
Maka’s Utility C A O
Maka
Susan’s Utility

49. Fairness Typical utility is a function of goods consumed: U=f(x,y)
Societal utility can be seen as a function of individual utilities:
W=f(U1,U2)
This is the SOCIAL WELFARE FUNCTION, and can produce SOCIAL INDIFFERENCE CURVES:

50. Typical Social Indifference Curves
An indifference curve farther from the origin represents a higher level of social welfare.
Maka’s Utility O
Maka
Susan’s Utility

51. Fairness
If we superimpose social indifference curves on top of the utilities possibilities curve, we can find the Pareto efficient point that maximizes social welfare
This leads us to the SECOND FUNDAMENTAL THEOREM OF WELFARE ECONOMICS

52. Maximizing Social Welfare
ii is preferred to i, even though ii is not Pareto efficient i ii
The highest possible social welfare, iii, is Pareto efficient
Maka’s Utility
iii O
Maka
Susan’s Utility

53. Second Fundamental Theorem of Welfare Economics
The SECOND FUNDAMENTAL THEOREM OF WELFARE ECONOMICS states that:
Society can attain any Pareto efficient allocation of resources by:
1) making a suitable assignments of original endowments, and then
2) letting people trade

54. Second Fundamental Theorem of Welfare Economics
Susan O’ r
By redistributing income, society can pick the starting point in the Edgeworth box, therefore obtaining a desired point on the Utility Possibility Frontier:
Starting
Point
Goal
Food O s
Maka
Video Games

55. Why Is Government so Big?
Government has to ensure property laws are protected. (1st Theorem)
Government has to redistribute income to achieve equity. (2nd Theorem)
Often the assumptions of the First Welfare Theorem do not hold (Econ 350)

56. Why Trade and Not Tax?
Taxes and penalties punish income-enhancing behavior, encouraging people to work less.
Subsidies and incentives give an incentive to stay in a negative state to keep receiving subsidies and incentives.
Lump sum transfers have the least distortion,
AND TRADE ALWAYS BENEFITS BOTH PARTIES…

57. 16.5 Gains From Free Trade
Trade ALWAYS makes society better off by increasing the productivity of scarce resources
The basis for the gains from specialization and trade is Comparative Advantage

58. Theory of Comparative Advantage:
Production Possibilities :
Carl and Mike: retired neighbours: hobbies are making wine and beer
PPF’s for 1 month’s production:
Carl’s Production
Possibilities
Mike’s Production
A B C
Wine (btls)
Beer (btls.) ,

59. Carl’s Proposition
“Lets each of us do what we do best and trade. This will give each of us more than we now have without either of us working any harder.”
Notice that voluntary trade does not take place unless both parties benefit.

60. Mike’s Production Possibilities/ Opportunity Costs
Bottles of beer
In a month Mike can produce either 80 bottles of wine or 80 bottles of beer
Opp cost of 80 wine is 80 beer Opp cost of 1 wine is 1 beer
Opp cost of 80 beer is 80 wine Opp cost of 1 beer is 1 wine • A B
Consumption choice before trade 80 • C 40 •
Bottles of wine 40 80

61. Carl’s Production Possibilities/ Opportunity Costs
Opp cost 100 wine is 1000 beer Opp Cost 1 wine is 10 beer
Opp cost of 1000 beer is 100 wine Opp Cost 1 beer is 1/10 wine
Bottles of beer • A
100 B
Consumption choice before trade •
700 C • 30
100
Bottles of wine

62. Opportunity Cost Table
Theory of Comparative Advantage:
When producer A has a lower opportunity cost of producing good A compared to another producer, then producer A is said to have a comparative advantage in the production of good A.
Opportunity Cost Table
Opportunity cost of 1 beer
Opportunity cost of 1 wine
Carl
1/10 wine
10 beer
Mike
1 wine
1 beer

63. Comparative Advantage: Specialization
Carl has a “comparative advantage” (lowest opportunity cost producer) in the production of beer and therefore specializes in beer production.
Mike has a “comparative advantage” in the production of wine and therefore specializes in wine production
As long as opportunity costs differ, there is comparative advantage

64. Comparative Advantage: Specialization
Theory of Comparative Advantage
if specialization takes place according to comparative advantage (the lowest opportunity cost producer) and then trade takes place…. both parties can benefit: that is, move outside their current PPF’s.

65. Carl & Mike Before Specialization & Trade
Carl Produces & Consumes
Mike Produces & Consumes
Total Consumption + =
Wine (btls.)
Beer (btls.) 30
700 40 70
740
Carl & Mike After Specialization, but Before Trade
Mike Produces & Can Consume + =
Wine (btls.)
Beer (btls.)
1,000 80
Carl Produces & Can Consume
Total Production & Consumption
Total Gains
+10
+260

66. (terms of trade: 5 beer for 1 wine)
Trade: The Benefits of Specialization
Carl proposes, after specialization, that he trade Mike 175 beer for 35 wine.
(terms of trade: 5 beer for 1 wine)
Carl gets wine for a reduced sacrifice
35 wine for 175 beer instead of 350 beer, the opportunity cost before trade
Mike gets beer for a reduced sacrifice
175 beer for 35 wine instead of 175 wine, the opportunity cost before trade

67. Terms of Trade: 1 Wine for 5 Beer
Since voluntary trade requires that both parties benefit from the trade.
Before trade:
Carl: 1 wine “trades” for 10 beer
Mike: 1 wine trades for 1 beer
Carl is better off as he now only has to give up 5 beer for a wine
After trade 1 wine “trades” for 5 beer
Mike is better off as he now only has to give up 1/5 wine for a beer
The Terms of Trade are between the personal ones that exist before trade, thus producing gains for both parties participating in the trade

68. Trade Between Carl & Mike
175 Bottles of Beer To
Trades away
1 Wine trades for 5 Beer or
1 Beer trades for 1/5 Wine
Mike (specializes in wine)
Carl (specializes in beer)
35 Bottles of Wine
Trades away To
Before trade Mike gave up 1 wine to get 1 beer, after trade1/5 wine
Before trade Carl gave up 10 beer to get a wine, after trade 5 beer

69. Carl & Mike After Specialization & Trade
Trades
For (+)
Away (-)
Consumes
After
Trade
Produced & Consumed
Before Trade
Gains
from
Trade
Produces
Wine (btls.) Beer (btls.)
1,000
+35
-175 35
825 30
700 +5
+125
Mike
Trades
For (+)
Away (-)
Consumes
After
Trade
Produced & Consumed
Before Trade
Gains
from
Trade
Produces
Wine (btls.)
Beer (btls.) 80
-35
+175 45
175 40 +5
+135

70. Mike’s Production Possibilities After Trade
Bottles of beer
Mike produces 80 wine and then trades 35 wine for 175 beer,
leaving him with 45 wine and 175 beer, point D • D
Consumption after trade
175 • A B 80 • C 40 •
Bottles of wine 40 45 80

71. Carl’s Production Possibilities/ Opportunity Costs, After Trade
Bottles of beer
Carl produces 1000 beer and trades 175 beer
to Mike for 35 wine, leaving him with 825 beer
and 35 beer, point D • A
100 D •
Consumption after trade
825 B •
700 C • 30 35
100
Bottles of wine

72. Absolute Advantage
When a producer with of set of inputs can produce more output than another with the same inputs, the first producer has an absolute advantage in production of the output.
Carl has an absolute advantage in the production of both wine and beer.

73. Gains from Specialization and Trade
Specialization produces gains for both traders, even when one trader enjoys an absolute advantage in both endeavors.
Unless two people/firms/countries have IDENTICAL opportunity costs, Trade is always beneficial

74. Why No Free Trade?
Misunderstanding: people misunderstand the facts or hold to political or ideological dogma, or confuse voluntary jobs with enforced slavery
Short-run effects: in the SHORT-RUN, there may be some unpopular adjustments:
Richer, developed countries may lose jobs to developing countries with a comparative advantage
Poorer, developing countries may have short-run environmental damage until the higher incomes lead to environmental protection

75. Chapter 16 Conclusions
General equilibrium requires simultaneous equilibrium in multiple markets
One change can cause a cascade of changes through markets until a new equilibrium is reached
An equilibrium is Pareto Efficient if no other allocation of inputs can make one person better off without making another worse off.

76. Chapter 16 Conclusions
4) Pareto Efficiency requires exchange efficiency (goods can’t be traded), input efficiency (more can’t be produced) and substitution efficiency (substituting production won’t improve outcome)
5) The First Fundamental Theorem of Welfare Economics states that if all perfectly competitive markets exist, allocations are Pareto Efficient

77. Chapter 16 Conclusions
6) The Second Fundamental Theorem of Welfare Economics states that governments can redistribute wealth to reach any pareto efficient outcome
7) Free Trade is always beneficial to all parties
8) Economic truths, when properly applied and explained, can cut through ideologies and make people cry