Economics 3C03: Weekly Review 2
Welfare economics is the branch of economic theory concerned with the social
desirability of different economic outcomes. In this overview of welfare economics, we will
review the concept of Pareto efficiency and examine the First and Second Welfare Theorems in a
simple economy.
We begin with a brief discussion of Pareto efficiency, as it is fundamental to our
understanding of the First and Second Welfare Theorems. Pareto efficiency is achieved when no
individual in the economy can be made better-off without making another individual worse-off.
To illustrate this concept we will imagine there are only two people in our economy; Adam and
Eve, with just two goods; coconuts and bananas. In this case, a Pareto efficient allocation would
mean that changing the distribution of coconuts or bananas to improve the welfare of one
consumer would degrade the welfare of the other. We will expand on these notions soon.
The First Welfare Theorem states that given:
1. Perfectly competitive markets.
2. A market for every commodity.
free trade between individuals in the economy will result in a Pareto efficient equilibrium.
Ignoring the technical conditions, we will demonstrate this intuitively by expanding on our
simple economy. Suppose in our economy, Adam grows bananas and Eve grows coconuts and
each of them need some bananas and some coconuts to survive. Beyond simply surviving,
having more bananas and more coconuts makes them better-off because they enjoy eating (Don’t
we all?). Adam and Eve will choose to trade with each other to maximize their enjoyment. They
will trade bananas for coconuts until they decide that they can no longer reach an agreement.
Adam and Eve are smart enough to not make themselves worse-off, so the trade does not
continue beyond this point. This is a Pareto efficient allocation because trading more will make
one of them worse-off, so it is impossible to move to a new allocation without violating our
condition for Pareto efficiency. This is a simple example of the First Welfare Theorem in action.
The Second Welfare Theorem states that any Pareto efficient allocation can be achieved
by transferring resources between individuals in the economy. In the case of our simple
economy, transferring coconuts or bananas away from their producer and giving them to the
other. Suppose Adam grows so many bananas that the value of his bananas is far greater than the
value of Eve’s coconuts. When Adam and Eve trade, Eve barely gets enough to survive while
Adam enjoys lots of food. Society could choose to transfer some bananas to Eve before trade
occurs, so that she can achieve a more fair allocation of food at the end of trade. The implication
of the Second Welfare Theorem is that any Pareto efficient allocation can be achieved by
distributing the right amount of goods in the beginning, then allowing trade. This would allow
our simple economy to be more equitable between Adam and Eve. This is difficult to achieve in
practice, as the notion of fairness in an economy is widely debated. Nevertheless, the Second
Welfare Theorem implies that is it possible to create more fair outcomes by redistributing
resources then allowing free trade.
Now, we have studied Pareto efficiency and the implications of the First and Second
Welfare Theorems in the context of a simple economy. Although we illustrated these principles
with a simple economy, the notions generalize to more complex economies with millions of
people and many goods. These principles are widely used in the study of welfare economics in
Canada and abroad.
Econ 3c03 assignment 2 week 2
Welfare economics is a branch of economics which deals with how to improve
social welfare in the public sector using micro economic analysis.
One of the main concepts discussed in welfare economics is Pareto
optimality/efficiency. A P.O allocation is when an allocation of resources is such
that there is no way to increase the well being of one individual without decreasing
that of another individual.
To illustrate this concept, an Edgeworth box is used which is in the shape of a
rectangle/square and consists of two goods and two individuals. A pareto optimal
allocation is when the indifference curves of both individuals are tangent to each
other. There are multiple points in the box which represent pareto optimality.
Connecting these points together gives us a curve, which is known as a contract
curve. This represents all of the possible P.O points in an Edgeworth box. In
algebraic terms, this relationship between the two indifference curves can be
written as MRS of individual one= MRS of individual two. MRS is the marginal
rate of substitution (the rate at which an individual gives up good 1 for good 2
while maintaining the same level of utility).
The pareto optimal allocation can also be illustrated on a production possibility
frontier. A production possibility frontier (PPF) is a graph which represents the
production of good one on x axis and good 2 on the y axis. The slope of the ppf is
known as the marginal rate of transformation (MRT) which is calculated as the
marginal cost of good 1/the marginal cost of good 2. A point on the curve is Pareto
optimal when the MRT= MRS of individual 1= MRS of individual 2.
In the real world, it is next to impossible to achieve pareto optimality. There are
two main reasons for it. Firstly, the existence of monopoly and imperfect
competition means that resources are not efficiently utilised, and a dead weight
loss is created. Therefore, the marginal rate of substitutions will not be equal to the
marginal rate of transformation.
Another reason for the non-existence of pareto optimal condition is due to
externalities. Externality is the affect of production or consumption of a good on
the third party. (society, larger community) An example of externality can be
cigarettes, where people who do not smoke get affected by the air pollution caused
by it. Externalities lead to imposition of taxes and restriction of quantities of good,
which prevents pareto optimality.
The state of not reaching Pareto efficiency is known as market failure. It is
important for the governments and policy makers of countries to try and reduce the
negative impact of monopolies on the overall economy of a country to reach closer
to the pareto optimal condition.
Econ 3c03 assignment 2 week 2
Welfare economics is a branch of economics which deals with how to improve
social welfare in the public sector using micro economic analysis.
One of the main concepts discussed in welfare economics is Pareto
optimality/efficiency. A P.O allocation is when an allocation of resources is such
that there is no way to increase the well being of one individual without decreasing
that of another individual.
To illustrate this concept, an Edgeworth box is used which is in the shape of a
rectangle/square and consists of two goods and two individuals. A pareto optimal
allocation is when the indifference curves of both individuals are tangent to each
other. There are multiple points in the box which represent pareto optimality.
Connecting these points together gives us a curve, which is known as a contract
curve. This represents all of the possible P.O points in an Edgeworth box. In
algebraic terms, this relationship between the two indifference curves can be
written as MRS of individual one= MRS of individual two. MRS is the marginal
rate of substitution (the rate at which an individual gives up good 1 for good 2
while maintaining the same level of utility).
The pareto optimal allocation can also be illustrated on a production possibility
frontier. A production possibility frontier (PPF) is a graph which represents the
production of good one on x axis and good 2 on the y axis. The slope of the ppf is
known as the marginal rate of transformation (MRT) which is calculated as the
marginal cost of good 1/the marginal cost of good 2. A point on the curve is Pareto
optimal when the MRT= MRS of individual 1= MRS of individual 2.
In the real world, it is next to impossible to achieve pareto optimality. There are
two main reasons for it. Firstly, the existence of monopoly and imperfect
competition means that resources are not efficiently utilised, and a dead weight
loss is created. Therefore, the marginal rate of substitutions will not be equal to the
marginal rate of transformation.
Another reason for the non-existence of pareto optimal condition is due to
externalities. Externality is the affect of production or consumption of a good on
the third party. (society, larger community) An example of externality can be
cigarettes, where people who do not smoke get affected by the air pollution caused
by it. Externalities lead to imposition of taxes and restriction of quantities of good,
which prevents pareto optimality.
The state of not reaching Pareto efficiency is known as market failure. It is
important for the governments and policy makers of countries to try and reduce the
negative impact of monopolies on the overall economy of a country to reach closer
to the pareto optimal condition.
Economics 3C03: Weekly Review 2
Welfare economics is the branch of economic theory concerned with the social
desirability of different economic outcomes. In this overview of welfare economics, we will
review the concept of Pareto efficiency and examine the First and Second Welfare Theorems in a
simple economy.
We begin with a brief discussion of Pareto efficiency, as it is fundamental to our
understanding of the First and Second Welfare Theorems. Pareto efficiency is achieved when no
individual in the economy can be made better-off without making another individual worse-off.
To illustrate this concept we will imagine there are only two people in our economy; Adam and
Eve, with just two goods; coconuts and bananas. In this case, a Pareto efficient allocation would
mean that changing the distribution of coconuts or bananas to improve the welfare of one
consumer would degrade the welfare of the other. We will expand on these notions soon.
The First Welfare Theorem states that given:
1. Perfectly competitive markets.
2. A market for every commodity.
free trade between individuals in the economy will result in a Pareto efficient equilibrium.
Ignoring the technical conditions, we will demonstrate this intuitively by expanding on our
simple economy. Suppose in our economy, Adam grows bananas and Eve grows coconuts and
each of them need some bananas and some coconuts to survive. Beyond simply surviving,
having more bananas and more coconuts makes them better-off because they enjoy eating (Don’t
we all?). Adam and Eve will choose to trade with each other to maximize their enjoyment. They
will trade bananas for coconuts until they decide that they can no longer reach an agreement.
Adam and Eve are smart enough to not make themselves worse-off, so the trade does not
continue beyond this point. This is a Pareto efficient allocation because trading more will make
one of them worse-off, so it is impossible to move to a new allocation without violating our
condition for Pareto efficiency. This is a simple example of the First Welfare Theorem in action.
The Second Welfare Theorem states that any Pareto efficient allocation can be achieved
by transferring resources between individuals in the economy. In the case of our simple
economy, transferring coconuts or bananas away from their producer and giving them to the
other. Suppose Adam grows so many bananas that the value of his bananas is far greater than the
value of Eve’s coconuts. When Adam and Eve trade, Eve barely gets enough to survive while
Adam enjoys lots of food. Society could choose to transfer some bananas to Eve before trade
occurs, so that she can achieve a more fair allocation of food at the end of trade. The implication
of the Second Welfare Theorem is that any Pareto efficient allocation can be achieved by
distributing the right amount of goods in the beginning, then allowing trade. This would allow
our simple economy to be more equitable between Adam and Eve. This is difficult to achieve in
practice, as the notion of fairness in an economy is widely debated. Nevertheless, the Second
Welfare Theorem implies that is it possible to create more fair outcomes by redistributing
resources then allowing free trade.
Now, we have studied Pareto efficiency and the implications of the First and Second
Welfare Theorems in the context of a simple economy. Although we illustrated these principles
with a simple economy, the notions generalize to more complex economies with millions of
people and many goods. These principles are widely used in the study of welfare economics in
Canada and abroad.
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