Question

1. i) What do we mean by Pareto efficiency? ii) What is a market failure? iii) Have you ever encounter a situation where the allocation was not efficient? iv) Efficiency is not the same than equity. Explain the difference v) (Difficult) Why efficiency is a commonly used as an objective for public policy (more than equity). (Hint: think about which type of policies will be easier to pass in the congress?) vi) One hundred people are distributed in two beaches. In Beach A, there are 98 people (A = 98), while in Beach B only 2 (B = 2). Is this allocation efficient? Is equalitarian? (assume that people are more happy if the beach is less crowded). vii) Answer to the same questions with (A= 100, B = 0) and with (A = 50, B = 50). viii) Find an allocation that is NOT Pareto efficient an NOT equalitarian (Hint: you might need more than one beach).

Answer 1

i) Pareto optimum is a state of economy where resources cannot be reallocated to make one individual better off without making at least one individual worse off. An economy is said to be in a Pareto optimum state when no economic changes can make one individual better off without making at least one other individual worse off. This means that the resources are allocated in the most efficient manner.

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ii) Market failure is the economic situation defined by an inefficient distribution of goods in the free market (not pareto optimum). In market failure, the individual incentives for rational behavior do not lead to rational outcomes for the group. This means that each individual makes the correct decision for him or herself, but those prove to be the wrong decisions for the group.

Causes of market faliure :

Concentration of market power (monopoly)

Externality

Public goods

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Under-provision of public goods is an exampe of inefficient allocation of resources

Public goods have two distinct propety: nonexcludability and nonrivalrous consumption. “

Merit goods are those goods and services that the government feels that people will under-consume, and which ought to be subsidised or provided free at the point of use so that consumption does not depend primarily on the ability to pay for the good or service, such as education.

Merit goods and services create positive externalities when consumed and can have a significant effect on social welfare. Market failure occurs when merit goods and services are under-consumed under free market conditions.

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Efficiency and equity are not the same:

Efficiency is concerned with the optimal production and allocation of resources given existing factors of production. For example, producing at the lowest cost.

Equity is concerned with how resources are distributed throughout society.