Question

What 3 conditions are necessary in an economy to ensure that a competitive equilibrium is also pareto optimal?

Answer 1

The three conditions required to ensure that a competitive equilibrium is pareto optimal are:

1. There is exchange efficiency: There should not be an exchange possible between consumers such that one consumer is no worse off and other is strictly better off than before, for any bundle of goods. If there is a case in competitive equilibrium that the goods between consumers can be reallocated in such a way that one consumer is strictly better off and others are no worse off than before, then exchange efficiency has not be reached. Thus in exchange efficiency, such a case is not allowed.

2. There is production efficiency: Production efficiency is a case when it is not possible to reallocate the factors of production in such a way that output of one good has strictly increased and the output of other goods have not been decreased. In other words, there should be no such case where the total supply of one good can be increased without hurting the supply of other goods, by reallocating the factors of production.

Production efficiency is violated when factors of production such as land or labor is used for a less productive sector. For example: there are two factors; land and labor. Two goods produced are agriculture and textiles. Suppose there is more labor in agriculture and their productivity is very low. If some workers are shifted from agriculture to high productive sector such as textiles, then it is possible that agriculture output doesn't decrease but textile production increases. If there is no such case for any amount of reallocation, then production efficiency has been achieved.

3. Output efficiency must be reached: Output efficiency is a situation where there is no reallocation of goods produced such that welfare of consumer increases and the welfare of other consumers is no worse than before. That is there is o alternative combination of goods produced in equilibrium such that even one consumer's welfare has strictly increased and other consumers's welfare has remained the same.

If all these three conditions are met, then competitive equilibrium is also pareto optimal.