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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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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 selfinterested 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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 Spring '08
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