Question

4) In our example of the negative externalities from pollution, we concluded that the loss of social surplus from the extemality (deadweight loss) was significantly less than the dollar value of the damages caused by pollution. Briefly explain the economics behind this conclusion. On a related note, why does this lead economists to say that optimal amount of pollution might not be zero? 2) Give a brief definition of Pareto Efficiency, and describe how a perfectly competiive market structure will generate: a) Pareto Efficiency in Consumption/Exchange (Equal MRS across consumers) b) Pareto Efficiency in Production (Equal MRTS across firms) c) Pareto Efficiency in Output Mix (MRS MRT across all goods) You need to explain howan individual consumerlproducer would optimize in these circumstances, and why that indvidual behavior generates Pareto efficiency. For example, for b) you should discuss how MRTS is involved in a firm's profit maximizing decision

Answer 1

The economist Vilfredo Pareto proposed that an efficient economic allocation of resources occurs when one economic agent is made better off without making another agent worse off. Such changes in allocation are known as "Pareto improvements." The condition where the reallocation does not allow for Pareto improvements is called Pareto efficient. In a perfectly competitive market the following three conditions of Pareto efficiency have to be satisfied:

1. A Pareto-optimal state of production achieved through allocation of the factors of production among the products by producers keeping in mind profit maximizing behavior.
2. A Pareto-optimal state of exchange in consumption through utility maximizing distribution of the goods by the individuals
3. A Pareto-optimal product-mix making the marginal rate of product transformation (MRPT) between the goods equal to the marginal rate of substitution (MRS) between the goods for each individual

Perfect competitive allocation is said to be Pareto optimal as it does not leads to deadweight loss and there is no further scope for Pareto improvement. This happens through following process:

1. Each consumer would purchase the quantities of the goods where the Marginal rate of substitution (MRS) between the two goods equals the ratio of their prices. i.e.

                               MRS^A_x,y = MRS^B_x,y = P_x/P_y

This equation is Pareto-optimal condition for exchange (or consumption) in a perfectly competitive market.

2. Each producer will allocate the factors of production where the Marginal rate of technical substitution (MRTS) between the factors equals the ratio of the prices of the factors.

                                        MRTS^x_L,_K = MRTS^y_L,_K = w/r

            This is the Pareto-optimal marginal condition for production for the competitive market.

3. The producers would decide upon a product-mix for which marginal rate of product transformation

MRPT_x,_y = P_x/P_y

4. the Pareto-optimality condition for product-mix would be satisfied when there would be simultaneous equalization in both the product and consumer markets:     

                   MRPT_x,_y = P_x/P_y = MC_x/MC_y (As profit maximizing condition under perfect competition is P_x=MC_x and P_y= MC_y )