Question

With the Pigou's assumption, graphically illustrate the Pareto Efficient Allocation. *A production possibilities curve should be included in the graph

Answer 1

Understanding Pareto Efficiency

To clearly understand the concept of Pareto Efficiency, it is important to introduce the concept of Pareto Improvement.

Pareto Improvement: A resource allocation is Pareto improved if there exists another allocation in which one person is better off, and no person is worse off.

Pareto Efficiency: A resource allocation is Pareto efficient if no Pareto improvement is possible.

Therefore, Pareto Efficiency indicates that resources can no longer be allocated in a way that makes one party better off without harming other parties. In Pareto Efficiency, resources are allocated in the most efficient way possible.

Pareto Efficiency and the Production Possibility Frontier

The concept of Pareto efficiency can be applied to the production-possibility frontier. Consider the following diagram of an economy with outputs of Good A on the x-axis and Good B on the y-axis:

Good B U A Good A

Consider points A, B, C, D above – which are Pareto efficient?

Recall that resource allocation is Pareto efficient if no Pareto improvement is possible.

• Points A and B are Pareto inefficient because there is a possibility of increasing the output of both goods A and B. It would be a Pareto improvement as the total output in the economy increases.
• Points C and D are Pareto efficient because there is no Pareto improvement possible. Increasing the output of one good would decrease the output of the other good.

Therefore, every point on the PPF frontier is Pareto efficient.

Simple Example of Pareto Efficiency

Consider the following background information for an allocation problem:

• Two types of goods: Apples and oranges
• Two individuals: Colin and John

Consider the preferences for each individual:

• Colin does not have a preference for apples or oranges
• John has a preference for apples over oranges

Consider the following allocation:

• Apples are all allocated to Colin
• Oranges are all allocated to John

• Is each allocation above Pareto efficient?

  To determine whether an allocation is a Pareto efficiency, it is important to determine if a Pareto improvement is possible. As in, is there a way to make an individual better off without making someone else worse off? Since each individual prefers as much of the chocolate bar as possible, there is not an allocation that makes an individual better off without making someone else worse off. Therefore, all three allocations are Pareto efficient.

  The example illustrates an important aspect of Pareto efficiency. That is, Pareto efficiency does not equate to fairness or equality. Allocations in the first and third allocation illustrate that even though the opposing individual does not have any chocolate bar, it is Pareto efficient because allocating a portion of the chocolate bar to the individual who does not have any would make the person who is losing that portion of the chocolate bar worse off.

  THANK YOU