PARETO OPTIMALITY

AND PERFECT
COMPETITION
 WHAT IS EFFICIENCY
• The figure shows attainable utility levels for the two members of the
economy, Anna and Brewster. For every allocation inside the feasible set
ABO, it is possible to find a pareto preferred allocation( pareto
improvement). Basically, for any interior allocation, any allocation to the
upper right( that is, in the direction that improves both Anna’s and
Brewster’s utility) is a pareto improvement . Note that for X, all
allocations in the shaded region are pareto preferred to X( that is,
pareto improvements over X). This is because all allocations in that
region give both Anna Brewster just as much utility as at X, and for at
least one of them, more utility.
• All allocations leading to utility on the curved line AB are as good as
possible, in a pareto sense. This leads to the notion of pareto frontier.
• If Z is on the pareto frontier, it is not possible to find another allocation
that is preferred to Z. This is our notion of efficiency. It is also referred
to as pareto optimality.
• An allocation is efficient, or pareto optimal, if it lies on the pareto
frontier. An allocation is inefficient if it is not on the pareto frontier.
• But what about the different allocations like R, Y, S that lie on the pareto frontier, since, we cannot
compare them.
• For example, suppose the society is at X, and economists might promote a move to S. However,
some might view Anna as undeserving, and might prefer Y or R or even Z. If she is already a
millionaire earning billions of euros, then a move to S seems counterproductive.
• The bottom line is that efficiency may not be the only goal in dividing the social pie.
EFFICIENCY AND COMPETITIVE
MARKETS
• Typically, there are two types of inefficiencies that exists in an economy: inefficiencies in exchange
and inefficiencies in production.
• Inefficiency in exchange means that resources could be moved around among individuals without
making anyone worse-off. For instance take the example of waste disposal. Suppose a law is
passed prohibiting the disposal of waste across regional boundaries. This means that wastes must
be disposed of locally, possibly in an area of high population density. There might a rural region
that would be willing to take the wastes for an appropriate fee( and at lower disposal costs),
making everyone better off . Efficiency would be promoted by removing such a restriction on waste
shipments.
• The other type of inefficiency occurs in production. For instance, suppose environmental
regulation calls for the use of scrubber on the smoke generated by factory. The same reductions in
pollution could be achieved by changing its production process. But the regulations do not allow
changes in production processes to reduce emissions, only the scrubber. In this example, resources
are wasted in production with no apparent gain. Everyone could be better by using a method of
pollution that costs less.
• Two of the most important results in economics are:- A) Competitive markets are efficient (i.e., on
the pareto frontier. B) Pareto optimum can be achieved with a competitive market by appropriately
transferring income among individuals. We will show that pareto optimality and competitive
equilibrium are the same.
 EFFICIENCY IN EXCHANGE
• The figure shows the indifference curves for garbage disposal services
and wine, reflecting Anna’s preferences.
• Marginal rate of substitution between garbage disposal service and
wine( say, at point X*) is the slope of the tangency to the indifference
curve at that point. MRS of wine for garbage disposal services
indicates how much wine consumption would need to increase to
offset a one unit drop in garbage disposal consumption to keep utility
constant.
• At a point above X*, the MRS of wine for garbage disposal increases as
garbage disposal increases and wine consumption decreases.

Suppose Anna and Brewster are endowed with certain quantities of coupons for garbage disposal services and
wine. We are interested in how these people might trade. Assume Anna has coupons for a ton of garbage
disposal (no wine) and Brewster has a bottle of wine( no garbage disposal wine). Both would prefer a little of each
good.
• The Edgeworth box is a useful graphic way of representing
exchange of two commodities between two individuals.
The given Edgeworth box for Anna and Brewster is
constructed by superimposing indifference curve of Anna
on Brewster.
• The total amount of wine to trade is the length of the
horizontal axis; the total amount of garbage disposal
services to trade is the height of the vertical axis.
• Any point in the figure represents a division of the two
goods between the two people. Point A represents the
initial endowment: Anna with all the garbage disposal
services and Brewster with all the wine.

• Any division of the two goods that lies between the lines AB and AC will result in increased utility for both the
individuals and thus will be a pareto improvement.
• It turns out that any point in the ABC region at which the indifference curves of Anna and Brewster are tangent
to one another lies on the pareto frontier, also called the contract curve.
• Consider a point such as A where the tangency does not apply, then clearly there are allocations that are pareto
preferred to A
• Now consider those allocations on the dotted line XY corresponding to allocations where one of
Brewster’s indifference curves is tangent to one of Anna’s.
• Along the contract curve(XY), one person can improve utility only by decreasing the other’s utility.
• So we know, whatever be the initial endowment of the two individuals, we know the result will be
somewhere along the contract curve.
• In our case the initial endowment is at point A, the result of bargaining must lie on the segment
of the contract curve.
• Tangency between two indifference curves gives us a necessary condition for pareto optimum.
The tangency is same as the slope of the indifference curve. The slope of the indifference curve is
the marginal rate of substitution. As a result at a pareto optimum, the marginal rate of
substitution between any two goods should be the same for all the individuals.
• Thus we have shown in the simple model that free exchange leads to a pareto optimal division of
the goods. In other words, efficiency is achieved.
EFFICIENCY IN PRODUCTION
• In exchange we were concerned with moving goods and bads around among individuals to
improve everyone’s welfare. We now turn to the question of combining resources to produce
goods and bads. We are concerned with efficiency in production.
• Suppose we have a firm which has land which can be used for producing wine or disposing of
garbage. We also have fixed labour. We can put all labour in the production of wine, or we can
put all labour in the production of wastage disposal services, or we can use labour to produce
both wine and wastage disposal services.
• The question is how to split labour between these two activities. Alternatively, how much garbage
disposal and wine is to be produced? Contrast this with previous example, in which there was a
fixed amount of wine and wastage disposal services, and the question was how to divide it
between Anna and Brewster.
• The PPF shows the trade-off between garbage disposal services and wine. The points along the
line AB are the efficient combinations of wine and wastage disposal services.
• The point D inside the production possibility frontier is inefficient as
there could be pareto improvement from that point. So the first
condition for efficiency is that the economy operates on the pareto
frontier.
• The inputs into production in our example (labour) are fixed resulting
in costs C. But the producer does have a choice about how much wine
and wastage disposal to produce.
Profits for the producer are given by:
• This is obviously a straight line with intercept
• Profits are highest when the intercept is as high as possible, which means the line is shifted s far to the
right as possible, while still having a point on the productions set.
• The slope of the PPF is called the marginal rate of transformation(MRT) between the two goods. The
MRT for point E is shown in the figure. The MRT shows the rate at which output of one good has to be
sacrificed to increase the output of the other good. For instance, if at E, 2kg more of garbage can be
disposed of by reducing wine output by 1kg , then MRT of wine for waste disposal would be 2 ( 2kg
garbage disposal/ bottle wines). With a market, the marginal rate of transformation between two
goods is equal to the price ratio of those two goods.
• One condition that is not obvious from the above figure, is that if there are multiple producers of wine
and garbage disposal services, for efficiency to hold, the MRT between wine and garbage disposal must
be the same for all producers. Suppose there are two producers( A and B). If producer A has a larger
MRT between garbage and wine than producer B and if we reduce wine production from A by one unit
and increase wine production from B by one unit, then wine production remains constant and overall
garbage disposal increases( because it increases for A more than it declines for B). This is obviously
pareto improvement. Consequently, for efficiency to hold, the MRT between any two outputs be the
same for all producers in the economy.
• All that remains is to put production and exchange together. The basic necessary condition for
efficiency is that the marginal rate of transformation( In production) between any two commodities be
the same as the marginal rate of substitution(In consumption) between these two commodities for any
individual consuming both commodities. Furthermore, the MRT must be the same for all the firms
producing the two goods.
• All problem solved just leave the market free. But then why pollution is a problem in a market
economy. The reason is that the generation of pollution violates one of the assumptions of a
competitive economy. What are those assumptions? There are four assumptions that must hold
before we declare a market competitive. These are given below:
1. Complete property rights. If I am making a decision about consumption or production of a good
or bad, then I must be able to capture all of the benefits and bar all of the costs associated with
consumption or production. For example, If I own a bottle of wine, I am sole beneficiary. If I sell
the bottle of wine, I transfer all the benefits to the person who purchases it, in exchange of a
payment. If I own a firm polluting environment, then I do not bear all of the costs of that
pollution , the population living near the firm bears most of the costs.
2. Atomistic participants. Producers and consumers are small relative to the market and thus
cannot influence prices.
3. Complete information. Consumers and producers have full knowledge of current and future
prices.
4. No transaction costs. There should be no hurdles to pareto improving trades. If there is a fee for
trading, then even though there are gains from trade, the transaction costs may prevent those
from being realised.