ECSUDepartment of Development Economics

NREE (MDE 5151)

Chapter 1:

Efficiency, Property rights,

externality and the environment

Efficiency

• production efficiency: cannot produce more output atcurrent cost given current knowledge

• consumption efficiency: goods cannot be reallocated acrosspeople so that at least someone is better off and no one isharmed

• Pareto principle

• An allocation of resources is Pareto Efficient when there isno alteration of it that could make someone better offwithout making someone else worse off.

• Vilfredo Pareto (1848-1923)

– Economist and Sociologist

Pareto principle

allows us to rank different allocations of goods and services where no interpersonal comparisons need to be made.

The Concept of Pareto Efficiency.

Any allocation where we cannot make one personbetter off without harming another person is Paretoefficient.

• Definition 1: An allocation of goods, either input oroutput goods, is said to be Pareto Efficient if wecannot find a reallocation of those goods such thatwe can produce more of something (utility oroutput) without producing less of something else.

• Definition 2: A reallocation of goods that allowsmore of something to be produced without thesacrifice of something else is said to be ParetoImproving.

• It follows immediately from the definitions above that aPareto Efficient allocation is one where all Paretoimprovements have been exhausted.

• Pareto efficiency may be thought of as a minimumrequirement for a ”good” allocation of societies resources,one where all the opportunities to get something for

nothing have been exploited.

• Pareto efficiency does not involve value judgements aboutwhat goods are produced or who receives them.

Pareto Efficiency in a Two Person, Two Firm, TwoGood, Two Input, Economy.

• We shall now define Pareto Efficiency for an economyconsisting of two consumers who consume two goods thatare produced using two factors of production.

Efficiency in consumption

Efficiency in production

Efficiency in production and consumption

17

Assumptions of Perfect Competition

• There are a large number of people buying any one good

– each person takes all prices as given and seeks to maximize utility given his budget constraint

• There are a large number of firms producing each good

– each firm takes all prices as given and attempts to maximize profits

• Welfare economics theory points to a set of circumstances such thata system of free markets would sustain an efficient allocation ofresources. The ‘institutional arrangements’, as we shall call them,include the following:

1.Markets exist for all goods and services produced and consumed.

2.All markets are perfectly competitive.

3. All transactors have perfect information.

4. Private property rights are fully assigned in all resources and commodities.

5. No externalities exist.

6. All goods and services are private goods. That is, there are no public goods.

7. All utility and production functions are ‘well behaved’

perfect competitionand Pareto efficiency

• With perfect competition firms and workers do not affectprices and wages and all of them face the same prices.

• Prices and wages are flexible and free to adjust accordingto market conditions until demand equals supply and thereis full employment of resources. This is the equilibriumcondition.

• If all market are perfectly competitive, the Pareto EfficiencyCondition is satisfied, i.e. there is an optimal allocation ofresources (characterized by efficiency in production andefficiency in exchange): it is not possible to improve thewelfare of one agent without reducing that of anotheragent.

• Pareto efficiency requires:

• Production efficiency: production is maximized given theresources and technology available. This means that giventhe resources available, the production of one good cannotbe increased without reducing the production of another.

• Exchange efficiency: social welfare is maximized, given theavailable resources. This means that whatever the goodsproduced, they go to the individuals who value them most(are willing to pay more for them).

• Product mix efficiency (or total efficiency): the goods andservices produced correspond to those desired byindividuals.

21

General Equilibrium

• Assume that there are only two goods, x and y

• All individuals are assumed to have identical preferences

– represented by an indifference map

• The production possibility curve can be used to show how outputs and inputs are related

22

Edgeworth Box Diagram• Construction of the production possibility

curve for x and y starts with the assumption that the amounts of k and l are fixed

• An Edgeworth box shows every possible way the existing k and l might be used to produce x and y

– any point in the box represents a fully employed allocation of the available resources to x and y

23

Edgeworth Box Diagram

Ox

Oy

Total Labor

Tota

l Cap

ital

A

Cap

ital

fo

r x

Cap

ital

fo

r y

Labor for yLabor for x Capitalin yproduction

Capitalin xproduction

Labor in y production

Labor in x production

24

Edgeworth Box Diagram

• Many of the allocations in the Edgeworth box are technically inefficient

– it is possible to produce more x and more y by shifting capital and labor around

• We will assume that competitive markets will not exhibit inefficient input choices

• We want to find the efficient allocations

– they illustrate the actual production outcomes

25

Edgeworth Box Diagram

• We will use isoquant maps for the two goods

– the isoquant map for good x uses Ox as the origin

– the isoquant map for good y uses Oy as the origin

• The efficient allocations will occur where the isoquants are tangent to one another

26

Edgeworth Box Diagram

Ox

Oy

Total Labor

Tota

l Cap

ital

x2

x1

y1

y2

A

Point A is inefficient because, by moving along y1, we can increasex from x1 to x2 while holding y constant

27

Edgeworth Box Diagram

Ox

Oy

Total Labor

Tota

l Cap

ital

x2

x1

y1

y2

A

We could also increase y from y1 to y2 while holding x constantby moving along x1

28

Edgeworth Box Diagram

Ox

Oy

Total Labor

Tota

l Cap

ital

At each efficient point, the RTS (of k for l) is equal in bothx and y production

x2

x1

x4

x3

y1

y2

y3

y4

p4

p3

p2

p1

The Edgeworth Box• An allocation is a feasible allocation if the total amount of

each good that is consumed is equal to the total amountavailable.

2222

1111

BABA

BABA

XX

XX

• Net demand=gross demand-initial endowment

• In the context of general equilibrium net demands are sometimes called excess demands.

111

AAA Xe

The Algebra of Equilibrium

Walras’ Law

40

Departing from the Competitive Assumptions

• The ability of competitive markets to achieve efficiency may be impaired because of

– imperfect competition

– externalities

– public goods

– imperfect information

41

Imperfect Competition• Imperfect competition includes all situations

in which economic agents exert some market power in determining market prices

– these agents will take these effects into account in their decisions

• Market prices no longer carry the informationalcontent required to achieve Pareto efficiency

42

Externalities• An externality occurs when there are

interactions among firms and individuals that are not adequately reflected in market prices

• With externalities, market prices no longer reflect all of a good’s costs of production

– there is a divergence between private and socialmarginal cost

43

Public Goods

• Public goods have two properties that make them unsuitable for production in markets

– they are nonrival

• additional people can consume the benefits of these goods at zero cost

– they are nonexclusive

• extra individuals cannot be precluded from consuming the good

44

Imperfect Information

• If economic actors are uncertain about prices or if markets cannot reach equilibrium, there is no reason to expect that the efficiency property of competitive pricing will be retained

• Adverse selection and moral hazard

• Signaling

45

Distribution

• Although the First Theorem of Welfare Economics ensures that competitive markets will achieve efficient allocations, there are no guarantees that these allocations will exhibit desirable distributions of welfare among individuals

46

Distribution

• Assume that there are only two people in society (Smith and Jones)

• The quantities of two goods (x and y) to be distributed among these two people are fixed in supply

• We can use an Edgeworth box diagram to show all possible allocations of these goods between Smith and Jones

47

DistributionOJ

OS

Total Y

Total X

UJ4

UJ3

UJ2

UJ1

US4

US3

US2

US1

48

Distribution

• Any point within the Edgeworth box in which the MRS for Smith is unequal to that for Jones offers an opportunity for Pareto improvements

– both can move to higher levels of utility through trade

49

DistributionOJ

OS

UJ4

UJ3

UJ2

UJ1

US4

US3

US2

US1

A

Any trade in this area is an improvement over A

50

Contract Curve

• In an exchange economy, all efficient allocations lie along a contract curve

– points off the curve are necessarily inefficient

• individuals can be made better off by moving to the curve

• Along the contract curve, individuals’ preferences are rivals

– one may be made better off only by making the other worse off

51

Contract CurveOJ

OS

UJ4

UJ3

UJ2

UJ1

US4

US3

US2

US1

A

Contract curve

52

Exchange with Initial Endowments

• Suppose that the two individuals possess different quantities of the two goods at the start

– it is possible that the two individuals could both benefit from trade if the initial allocations were inefficient

53

Exchange with Initial Endowments

• Neither person would engage in a trade that would leave him worse off

• Only a portion of the contract curve shows allocations that may result from voluntary exchange

54

Exchange with Initial EndowmentsOJ

OS

UJA

USA

A

Suppose that A represents the initial endowments

55

Exchange with Initial EndowmentsOJ

OS

UJA

USA

A

Neither individual would be willing to accept a lower level of utility than A gives

56

Exchange with Initial EndowmentsOJ

OS

UJA

USA

A

Only allocations between M1 and M2 will be acceptable to both

M1

M2

57

The Distributional Dilemma

• If the initial endowments are skewed in favor of some economic actors, the Pareto efficient allocations promised by the competitive price system will also tend to favor those actors

– voluntary transactions cannot overcome large differences in initial endowments

– some sort of transfers will be needed to attain more equal results

58

The Distributional Dilemma

• These thoughts lead to the “Second Theorem of Welfare Economics”

– any desired distribution of welfare among individuals in an economy can be achieved in an efficient manner through competitive pricing if initial endowments are adjusted appropriately

Important Points to Note• Competitive markets can establish equilibrium prices by

making marginal adjustments in prices in response toinformation about the demand and supply for individualgoods

– Walras’ law ties markets together so that such a solution is assured (in most cases)

• Competitive markets need not yield equitable distributionsof resources, especially when initial endowments are veryskewed

– in theory any desired distribution can be attained throughcompetitive markets accompanied by lump-sum transfers

• there are many practical problems in implementing such transfers

Welfare Economics• Welfare economics studies the rationale for public intervention in

terms of efficiency and equity.

• According to this theory perfect competition in all marketsautomatically allocates resources efficiently and fully employs all theavailable resources (first best).

• At the basis of this result is the classical approach which states thatthe invisible hand of the market is the best way to maximise socialwelfare through the maximization of individual interests.

• Only when the market does not work (due to market failures), thegovernment intervention is justified to support a more efficient andequitable use of resources.

• In order to avoid the risk of introducing distortions (due togovernment failures), government intervention is justified only when:

It is limited to clearly identified market failures

It is directly targeted at market failures

FundamentalTheorems of Welfare Economics

First theorem of welfare economicsAny competitive equilibrium is Pareto efficient• Every competitive economy is Pareto efficient because the

perfectly competitive market mechanism allocates scarceresources efficiently.

• This can be proved. For more details, read Mas-Collel et.al(1995).Microeconomic Theory.

Second theorem of welfare economicsany Pareto-efficient equilibrium can be obtained by

competition, given an appropriate endowment

• Pareto Efficiency is associated with economic efficiency, but notnecessarily with equity or fairness. A Pareto Optimum may notbe socially desirable (for example an economy based on slaverymay reach a Pareto optimum, but it is undesirable).

• However: Society may achieve any Pareto efficient resourceallocation by an appropriate initial redistribution of resourcesand free trade (2nd theorem of Welfare Economics).

• Under certain assumptions, the goals of equity and efficiencycan be separated:

• Society may achieve a whole series of Pareto efficientallocations of resources from which to choose, according tosocial preferences in relation to equity and efficiency issues.

• The socially preferred distribution of wealth/consumptionmay be reached by redistributing initial endowments vialump sum taxes/subsidies (which do not change the agents’behavior).

• This is the only thing the government needs to do: toensure efficiency, policy makers should not interfere withthe competitive market mechanism.

Reasons for market failure

• Factors that will interfere with competitive markets’ abilities to achieve efficiency include

– market power

– externalities

– existence of public goods

– imperfect information (adverse selection and moral hazard)