332_GameTheory

332_GameTheory - Welfare Theorems, Space, Time, and Mkt...

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1 Economic Geography Lecture 4 -- Advanced Micro Slide 1 Welfare Theorems, Space, Time, and Mkt Failures Pareto Optimality Assumptions Required for Markets to be Efficient and Equitable 1 st Welfare Theorem – Efficiency 2 nd Welfare Theorem – Equity Types of Market Failures Thin Markets Incomplete information about market prices and characteristics of goods Externalities Public Goods, Missing or Incomplete Markets Tragedy of the Commons Intergenerational (In)Equity The Folk Theorem, Time, and Space Cooperative Games and the Bargaining Problem Nash Solution for a Bargaining Problem Relationship to Economic Geography Problems sustaining cooperation, being nice to people and environment land reform – how to (re)allocate resources as fairly as possible Economic Geography Lecture 4 -- Advanced Micro Slide 2 Gains from Trade and Pareto Optimality Voluntary exchanges in thick or thin markets allow traders to gain by exchanging something they value less for something they value more. A market is Pareto Optimal (PO) when it has exhausted all gains from trade. I.e., the trades result in an allocation that is on the Pareto Optimal frontier; no more mutually beneficial trades are possible. We refer to this as an efficient outcome because it is not wasting any potential gains from trade. But it is not necessarily a fair outcome; they may wind up at one extreme or another of the PO frontier. Trader 2 Trader 1 0 = No trade gains from trade Pareto Optimal frontier
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2 Economic Geography Lecture 4 -- Advanced Micro Slide 3 First Welfare Theorem – Efficiency 1 st Welfare Theorem (cf notes by David Autor, MIT): “A free market, in equilibrium, is Pareto efficient.” Intuitively, the market has exhausted all potential gains from trade. Efficiency says that the market will translate the actions of large numbers of self-interested traders into equilibrium prices that result in a Pareto efficient equilibrium. This does NOT imply that the efficient outcomes will necessarily be fair. I.e., it does not say anything about how the pie of potential gains from trade will be divided. Merely that the pie will be as large as possible. Economic Geography Lecture 4 -- Advanced Micro Slide 4 Second Welfare Theorem – Equity (Fairness) 2 nd Welfare Theorem (cf notes by David Autor, MIT): “Providing that preferences are convex, any Pareto efficient allocation can be a market equilibrium.” Intuitively, given appropriate initial endowments, any point on the Pareto Optimal frontier can be an equilibrium in a competitive market. So there is not necessarily any tradeoff between equity and efficiency. It is possible for competitive markets to make the pie as large as possible, and for carefully arranged initial endowments of wealth and resources to support any PO outcome and thus any division of the pie. However
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332_GameTheory - Welfare Theorems, Space, Time, and Mkt...

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