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Economic Efficiency

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An allocation of resources is said to be efficient if it is not possible to make one or more persons better off without making at least one other person worse off (applying the Pareto criterion).

Efficiency in allocation requires that three efficiency conditions are fulfilled:- efficiency in consumption,

- efficiency in production, and

- product-mix efficiency.

BY

Axa

Axb

A0

AX

IB1

I = indifference curve

possible allocation of fixed amounts of X and Y between consumers A and B

IB0

IA

a

BYa

AYa

b

BYb

AYb

BX

B0

BXa

BXb

AY

in b the marginal rates of utility substitution are equal; MRUSA = MRUSB

BY

A0

AX

A

C

A

A

A

B

B

A

B

A

B

B

C

B

BX

B0

AY

C = contract line that links efficient consumption good (X,Y) allocations between A and B consumers

KY

Lxa

Lxb

X0

LX

IY1

IY0

I = isoquant

the possible allocation of fixed amounts of inputs (L and K) to produce X and Y consumption goods

IX

a

KYa

KXa

b

KYb

KXb

LY

Y0

LYa

LYb

KX

in b the marginal rates of technical substitution are equal; MRTSX = MRTSY

Y

if MRUSA = MRUSB, the slopes of individuals' indifference curves are the same => one I.

MRUS = MRT

YM

a

Ya

b

Yb

I

Yc

c

Production Possibility Curve/Transformation Curveusing all the available resources

XM

0

Xa

Xb

Xc

X

in b the marginal rates of transformation are equal: MRTL = MRTK = MRUSA = MRUSB

WELFARE MAXIMISATION

Product Possibility/ Production Space

Utility Possibility /Space

X0Y0 and X1 and Y1 are Product Mixes

UU’ is the Grand Utility Frontier

Each point represents MRPT = MRS for each product Mix)

WELFARE MAXIMISATION

Assumptions -

Grand Utility Frontier acts like the Budget constraint and W1-W4 are the desired levels of

Welfare. Tangential point is the Point of Maximum Satisfaction . Point of Welfare Maximization

is Pareto Optimal State

Pareto optimality is necessary but not a sufficient condition for Welfare maximization.

Pt L is on a higher Welfare than Pt N .