Question

Are the following statements true, false, or uncertain? Explain your answer

(c) If there are no firms, only individuals trading with one another (an exchange economy), and everyone has the same marginal rate of substitution, then the allocation of resources is Pareto efficient. (d) Consider two social welfare functions, SWFA - U 2U2 and SWF min (Ui, U2)

Answer 1

c)

TRUE

In an exchange economy, pareto efficient allocations are the set of bundles, such that no individual can be better off without making anyone else worse off. Thus, for generating pareto efficient allocations, we must have tangency condition to be satisfied i.e.

Slope of indifference curve of 1st consumer = slope of indifference curve of 2nd consumer =..... = slope of indifference curve of nth consumer

=> MRS₁ = MRS₂ = ....... =MRS_n

Hence the allocation of resources is pareto efficient.

d)

TRUE

In SWF_A = U₁ + 2U₂

Maximizing this social welfare function means maximizing the total income of both the persons in the society, without regard to how incomes are distributed in society. This means that the function does not distinguish between an income transfer from rich to poor and vice versa.

On the contrary in SWF_B = min (U₁, U₂),

measures the social welfare on the basis of the poorest individual member of society.

Thus maximizing SWF_B  would mean maximizing the income of the poorest person in society, hence this involves redistribution of the income.