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CHAPTER 1: APPENDIX

THE WELFARE ECONOMICS

Welfare Economics
Concerned with how well an economy

operates in terms of efficiency and

equity/social justice
Efficiency - allocation of resources
Equity - distribution of income

Pareto Efficiency
An allocation of

commodities and inputs

is Pareto Efficient if the
only way to make one
individual better off is to
make another worse off

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3 Conditions for Efficiency

Production Efficiency

maximum output

Consumption Efficiency
maximum utility
Allocation Efficiency
optimum mix of commodities

Production Efficiency
An allocation of inputs is production efficient if

the only way to increase the output of one

commodity is to decrease the output of
another commodity

Production Efficient Allocations

0' Wine

Capital

Production efficient
allocations

B4
B3

B2

B1
W1
j

W2
W3
W4

0
Bread

Labour
6

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Production Efficiency Condition

The MRTS between capital and labour must

be equal for all commodities

Marginal rate of technical substitution

MRTS KBread
MRTS KW,ine
,L
L

Wine

Production Possibilities Curve

j'

MCb

h'

MCv

k'

Bread
8

Marginal Rate of Transformation

The MRT is the rate at which the economy

can transform one output into another by

shifting its resources

the (negative of the) slope of the production

possibilities curve

MRTV , B

MC B
MCV
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Consumption Efficiency
An allocation of commodities is consumption

efficient if the only way to make one person

better off is to make another person worse
off.
The MRS between each pair of goods must
be equal for all consumers (marginal rate of
substitution).
Cain
Abel
V ,B
V ,B

MRS

MRS

10

Consumption Efficient Allocations

Abel

0'
Contract curve

C4
C3

Wine

C2

C1
A1
j

A2
A3
A4

0
Cain

Bread
11

Allocation Efficiency
A mix of commodities is allocation efficient if

the MRT between any two goods is equal to

consumers common MRS between the two
commodities

, Abel
MRTV , B MRS VCain
,B

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Wine

Pareto Efficiency
MRS VC,,BA MRTV , B

Abel

A Pareto
efficient
allocation

m
n
Cain

Bread
13

Abels utility

Utility Possibilities Frontier

n'
m'

Cains utility
14

Utility Possibilities Frontier

A graph that shows the maximum amount of

utility on individual can obtain, given

anothers level of utility
The locus of all Pareto efficient points

15

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First Fundamental Theorem

If all producers and consumers act as price-

takers and there is a market for every

commodity, the equilibrium allocation of
resources is Pareto efficient.
That is, the economy operates at some point
on the utility possibilities frontier

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Proof of 1st Welfare Theorem

Production Efficiency

MRTS KBread

,L

w
MRTS KW,ine
L
r

Consumption Efficiency

MRS VCain
,B

PB
MRS VAbel
,B
PV

Allocation Efficiency

MRS VC,,BA

PB MC B

MRTV , B
PV MCV
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Second Fundamental Theorem

Any particular Pareto optimum can be

achieved through competitive markets by

simply prescribing an appropriate initial
distribution of factor ownership and a price
vector.

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Market Failure
Market Power

Monopoly, oligopoly, monopolistic competition

Price > MC

Nonexistence of Markets
Asymmetric information
Externalities

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