While thinking about the case of a pure exchange economy, it is argued that we do not take in to consideration the production process while assuming that individuals are endowed with a stock of consumption goods. When bearing in mind the case of a pure exchange economy, we, let’s say, suppose that there are two consumers, Alfa and Beta, and two goods, x and y. Using the Edgeworth Box, we can show the trade among these consumers and the final distribution that they consume. In other way, an Edgeworth Box represents the allocation of two goods with fixed supplies among two consumers.
Edgeworth Box
x x(A) 2 Consumers (A, B)
2 Goods (x, y)
y
At Point A:
y(A) y(B) MRS(x,y) of A is lower
than MRS(x,y) of B
The shaded area
represents Pareto
efficiency. Anywhere
there they are both
better off
y At Point B:
x(B) x MRS(x,y) of A is equal
to MRS(x,y) of B
Both consumers have an initial endowment of the goods x and y. While going northeast, consumer A is better off, and while going southwest, consumer B is the one who is better off. A Pareto allocation should maximize the utility of consumer B, given the utility of consumer A. If not, the utility of consumer B can always be increased without making consumer A worse off. In other words, this is a Pareto improvement. It takes place while moving from a point, for example A, on the above diagram which demonstrates the initial endowment, to a point inside the first two indifference curves, (IC (A) and IC (B)). The slope of the first two indifference curves is defined as the rate of which a consumer wants to exchange the good x for the good y. In other words, this is the Marginal Rate of Substitution (MRS). The two indifference curves (IC’ (A) and IC’ (B)) show that the utility of both consumers is higher than before due to the fact that for example consumer A can now give up the same number of the good y and get more of good x. The allocation C is not Pareto efficient because it is possible for both consumers to make themselves better off by transferring commodities between them. (Gravelle and Rees, 1992)
Furthermore, in order to examine the conditions in which the equilibrium resource allocation in a market economy is efficient, we should conclude with the First Theorem of Welfare Economics. In Morgan, Katz and Rosen, (2005), it is mentioned that the First Theorem relies on the fact that any market equilibrium is Pareto efficient. In Gravelle and Rees, (1992), this is true only if there exist markets for all goods which enter into production and utility functions. In other words, markets are complete. There are markets, sellers and buyers for all goods. Secondly, it is assumed that markets are competitive as consumers and producers have the idea that they have no effect on prices. From this we can conclude that they are price-takers; they take prices as given since they do not have power over price. A third assumption is that there is perfect knowledge and transaction costs are negligible. Then, it is supposed that there are no public goods. Finally, it is assumed that there are no externalities; the behaviour of consumer A does not influence consumer B’s behaviour. If these assumptions are not all together satisfied, then government failure exists which needs government intervention.
Now moving to the Second Welfare Theorem, it is important to say that in Morgan, Katz and Rosen, (2005), it is believed that any Pareto efficient allocation can not always be a market equilibrium, but only for some set of prices and initial endowments when preferences and production sets are convex. This is therefore the main difference between the First and Second Theorems of Welfare Economics. When preferences and production sets are convex, we deal with decreasing returns to scale. Another difference is that the First Theorem argues that the free-market will be efficient whereas the Second Theorem tells us that the free-market can be equitable only by reallocating endowments. As an outcome of this, appropriate prices give efficiency while appropriate endowments give equity.
However, all these conditions mentioned above so that the market equilibrium to be Pareto efficient may not be satisfied and subsequently the economy can not be efficient and optimal. First of all, consumers might not be price takers. There is also the case of a monopoly in the market where the price is not set at marginal cost. Then, both theorems do not take into account facts. In other words, we do not know anything about preferences and prices. The economy is not in equilibrium due to the fact that in many markets there is excess supply or demand. The economy is dynamic, meaning that many factors affecting consumption and prices are changing (tastes, technology, weather, income). In addition, markets may not be complete since it is not likely to be satisfied in a real world economy.
Moreover, some markets may not exist. For example, public goods, such as street lighting; if such a good was privately provided, its production level was going to be sub-optimal. Then, in the case of the presence of externalities the economy can not be efficient. An externality can be present if, for example, consumer A’s behaviour influences the behaviour of consumer B. Furthermore, preferences and production sets may be not-convex. This is true if there are increasing returns to scale.
To conclude, taking the above facts into consideration, it can be said that the concepts of Pareto efficiency, market equilibrium, and the First and Second Welfare Theorems “provide considerable insight into relative desirability of different allocations of resources.” (Boadway and Bruce, 2001) Finally, looking on Welfare Economics makes it easier to make a distinction upon the cases where there is a necessity of government intervention and where there are private markets.
BIBLIOGRAPHY
Begg D., Fisher S., Dornbush R., 2005, Economics, 8th edition, McGraw-Hill
Bohm P., 1973, Social efficiency: A concise introduction to Welfare Economics, 1st edition, Halsted Press
Gravelle H., Rees R., 1992, Microeconomics, 2nd edition, Longman
Morgan, Katz, Rosen, 2005, Microeconomics, McGraw Hill
Robin W. Boadway, Bruce N., 1991, Welfare Economics, Blackwell
Sloman J., 2003, Economics, 5th edition, Prentice Hall.
Varian H. R., 2006, Intermediate Microeconomics: A Modern Approach, 7th edition, Norton
Jane Hosking, Why do markets fail to provide public goods and under provide merit goods?, Journal of Economic Review, Vol.12, No.2, November 2004.
Accessed on 2 December 2007
Accessed on 2 December 2007
