Week # 2 Class # 2
Quick Review
Economic Efficiency = Pareto Frontier
Exchange Efficiency vs. Production Efficiency
Markets and Efficiency in a two consumer model
Adding Bads to the Model
This is a Long-Lecture. Ask questions and get
involved (or we might all fall asleep!)
Last Class
Finished Up Social Choice Mechanisms
Arrow’s Impossibility Theorem – A Bummer
What Next?
1. Identify Efficient Allocations
2. Choose One that reflects equity concerns
Economic Efficiency
Key Point: Regardless of choice mechanism it is desirable
to be at an “efficient” allocation.
Exchange Efficiency: Can goods be moved around between
consumers to yield a Pareto improvement?
Production Efficiency: Can resources used in production be re-
arranged to yield a Pareto Improvement?
Choose the the cheapest way to achieve a given level of
pollution.
Identify the right balance between pollution and
consumption.
Economic Efficiency
ParetoFrontier = Set of
allocations for which
there are no Pareto
Preferred allocations
Economic Efficiency:
Efficient if on the Pareto
Frontier
Exchange Efficiency
One Person Problem
Two Goods: Wine and Cheese
CD = Budget Constraint
X* = Optimal Allocation
Marginal Rate of Substitution (MRS) is
the slope of the indifference curve.
MRS = The Rate at Which Cheese can
be exchanged with Wine at constant
utility.
At A, more cheese required per unit of
wine.
At X* MRS = Pw/Pc – WHY?
2 Consumers: Edgeworth Box
All possible allocations in box
Both preferences represented
A: Initial Allocation
Lens: Potential Pareto
Improvements over A
EG: Contract Curve same
MRS
Contract Curve = tangencies =
efficient allocations, Why?
Consumers will trade to contract
curve. Why?
Key Point: Trade Efficiency
Markets and Efficiency
(adding prices to Edgeworth Box)
Now Assume prices and both can buy and sell
wine and cheese.
Budget Constraint for one consumer:
PCC0 + PWW0 = PCC+PWW
Defines a line through the initial endowment:
C = [C0 + (PW / PC) W0 ] - (PW / PC) W
Analogous to single consumer budget constraint
Adding Prices to Edgeworth Box
AD = One Possible Budget
Line
Because Anna and Brewster
are the entire market, they
share the same budget line.
Multiple Budget Lines
Through A (different
relative prices: PW / PC)
Adding Prices to Edgeworth Box
Market Equilibrium:
1. Budget line must pass
through initial endowment
(affordability)
2. At X*, both indifference
curves must be tangent to
budget line Contract
Curve (individual
optimization, MRS =
PW / PC
Thoughts on Market Equilibrium
1. Equilibrium will typically exist
2. At equilibrium prices, both parties will choose x*
3. Many potential Pareto improvements are possible
4. A set of potential efficient outcomes are possible with
barter (GE on contract curve).
5. Market will typically yield a unique outcome for each
initial allocation
6. Different initial allocation Different Equilibrium
7. Key Point: market yields efficiency
Adding Bads to notion of Exchange Efficiency
Environmental Economics often deals with bads,
not goods.
Basic framework still works
Prices for bads are negative
Example: Garbage (we are paid to accept)
Bads – Single Person Model
For Discussion:
Explain Shape of
Indifference Curves –
also, which way
happiness?
Explain Budget
Constraint: CD
Bads – Edgeworth Box
Vertical Axis =
Amount of Garbage
to be disposed of.
X* equals efficient
allocation
Bottom Line: Exchange yields efficiency with one good and one
bad just as with two goods.