Unformatted text preview: reto Optimal allocation. That is, there is no need to rely on other methods (such as dictatorship) to make allocations of resources in the economy. The market process itself is Pareto efficient. So to answer the key question above: 202 Yes, it is possible to get a set of prices which makes a given Pareto optimal allocation a general equilibrium solution. However, this answer only works under the additional assumption of convex preferences (i.e. all indifference curves are convex). Thus, the Second Fundamental Theorem of Welfare Economics can be stated as follows: Under perfect competition and the additional assumption of convex preferences Pareto optimality can be realized by general equilibrium solution. [Pareto Optimality] Perfect Competition Convex Preferences => [General Equilibrium] Now, what if we don't have the additional assumption of convex preferences? It is possible that the Second Fundamental Theorem of Welfare Economics will break down!!!! For example, in the diagram below we have consumer A with non-convex preferences where point 1 represents a Pareto optimal allocation (since the two indifference curves are tangent to one another at point 1) but not a general equilibrium solution (since the two consumer equilibrium points do not match up...consumer B is on their highest indifference curve at point 1 but consumer A is on a higher indifference curve at point 2).
Price Ratio OB 1
Pareto Optimal solution 2 ICA2 ICA1 O
B ICB XA 203 WELFARE MEASURES We will look at two commonly used measures in applied welfare economics: Compensating Variations (CV) and Equivalent Variations. We need these welfare measures to coordinate our theoretical results with "the Real World". We already know that the two Fundamental Theorems (taken together) establish a one-to-one correspondence between economic efficiency and optimality for a market economy under perfect competition. The "Real World" is, however, not perfect and hence, we would not really expect Pareto optimality to prevail in "reality". This generates the need for analytical measures that can tell us just how far (or how close) we are from the ideal theoretical w...
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This note was uploaded on 05/25/2010 for the course ECON 301 taught by Professor Sning during the Spring '10 term at University of Warsaw.
- Spring '10