Masoud Anjomshoa 1 Ethics, Social Choice, Economic Efficiency and Environment ECO313 Note#3
A Pareto efficient or Pareto Optimal allocation of resources is an allocation in which no one can be made better off without making someone else worse off. Pure Exchange Economy: Suppose there is no production in an economy. - There are only 2 people in this simple economy, say, Adam and Eve. - There are only 2 goods in this isolated economy, Apples (for food), and Figs (or fig leaves for clothing). - Total supply of Apples and Figs in the economy is fixed. 1- Pure Exchange Economy: Masoud Anjomshoa 2
Masoud Anjomshoa 3 Pure Exchange Economy: An Edgeworth box shows all possible allocations of Apples and Figs available in the economy to Adam and Eve. Adam Eve Apple Adam O Fig Adam Apple Eve Fig Eve
- All allocations may not be efficient, like point O. Masoud Anjomshoa 4 Pure Exchange Economy: Adam Eve A A O P F A A E F E W T - But using Pareto improvements, we can achieve Pareto efficient allocations like W, P, or T.
Contract Curve: The locus of all possible Pareto efficient allocations. Masoud Anjomshoa 5 Adam Eve A A F A A E F E At all points along Contract Curve, the Adam and Eve’s indifference curves are tangent to each other. Contract Curve Contract Curve:
Pareto Efficient distribution of goods (consumption) happens when (along contract curve) indifference curves are tangent, so: Pareto Efficiency in Consumption: Masoud Anjomshoa 6 Pure Exchange Economy: Adam Eve AF AF MRS MRS
Masoud Anjomshoa 7 While allocation P is more equitable, allocation T is Efficiency vs. Equity: Adam Eve A A F A F E favorable to Eve. Contract Curve P W T All three allocations are equally Pareto efficient. more favorable to Adam and allocation W is more A E
Many may prefer K the maximum amount of one person’s utility given each level of utility attained by the other person. Masoud Anjomshoa 8 Utility Possibility Frontier (UPF): A graph showing Utility Possibility Frontier: Adam Eve Contract Curve P W T K U Adam T U Eve W K P L - All points along UPC are attainable and Pareto optimal. - All points above UPC are NOT attainable. (Like L).
- There are only 2 goods in this isolated economy, Apples (A), and Figs (F). 2- Economy with Production: A = A(L , K) F = F(L , K) - In order to produce Apples (A) and Figs (F), only two factors are needed: Labor (L) and Capital (K) - Production functions have Constant Returns to Scale property: We assume that: 9 Masoud Anjomshoa
10 An Edgeworth box shows all possible combination of K and L allocated to produce Apples (A) and Figs (F). Edgeworth Box: A F L A E O K A L F K F B C - All allocations may not be efficient (like E). - Allocations B, C, and O are Pareto Efficient . Masoud Anjomshoa
11 - All efficient allocations happen when isoquants are tangent. Edgeworth Box: A F L A O K A K F B C D Contract Curve Fig LK Apple LK MR