Question

Please answer the following questions clearly and concisely (1-3 sentences). Use examples and/or give further explanation as necessary.

1. Under what conditions are markets allocatively efficient and Pareto efficient? What do effienst lvly eicent and P allocatively efficient and Pareto efficient mean?

Answer 1

Case of Allocative Efficiency

Allocative Efficiency takes place when there is an optimal distribution of goods and services, taking into account consumer’s preferences.

It occurs at an output level where the price equals the Marginal Cost (MC) of production because the price that consumers are willing to pay is equivalent to the marginal utility that they get. Therefore the optimal distribution is achieved when the marginal utility of the good equals the marginal cost.

Example using diagram Price Q2, Allocatively S MC inefficient MU > MC 15 Q1, Allocatively efficient MU MC 6 40 70

Figure 1

In figure 1, At an output level of 40, the marginal cost of the good is £6, but at this output, consumers would be willing to pay a price of £15. Here, the price (which reflects the good’s marginal utility) is greater than marginal cost which results into under-consumption. If output increased and price fell, society would benefit from enjoying more of the good.

Price S MC 17 Allocatively efficient MU MC Allocatively inefficient MC > MU 7 D MU 110

Figure 2

In figure 2, at an output level of 110, the marginal cost is £17, but the people are willing to pay a price of £7. At this output, the marginal cost (£17) is much greater than the marginal benefit (£7) so there is over-consumption. Society is over-producing this good.

Therefore, allocative efficiency will occur at a price of £11 where the marginal cost (MC) = marginal utility.

Case of Pareto Efficiency

Pareto efficiency takes place when it is impossible to make one party better off without making someone worse off.

It will occur on a production possibility frontier. When an economy is operating on a simple production possibility frontier, say, at point A, B or C (in figure 3) then it is not possible to increase output of goods without reducing output of services. Hence, points A, B and C are said to be Pareto efficient.

Goods Pareto efficiency Pareto inefficient. 21 27 Services

Figure 3

However, at Point D, it is possible to increase either goods or services without leading to a decline in the output of the other. Thus, point D would be Pareto inefficient, and this is generally considered to be bad for the economy.