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PROGRAMME MEC
LECTURER DR MUMBENGEGWI
ASSIGNMENT 6
1
We derive a set of conditions which a Pareto efficient allocation must satisfy
by con-sidering a simple economy in which there are two consumers, two
goods, two inputs and two rms. Individual h has the utility function
u h(xh1, xh2, zh) where xhi is hs consumption of commodity i and zh is hs
supply of an input. An input can be numbered according to which
individual supplies it. The individuals initial endowments of resources a r e
N and R. With non-satiation, the marginal utility of commodity i for
individual h is always positive: u i h >0(i = A, B; h = A, B) and the marginal
utility to h of supplying more of input h is always negative: u z h < 0.
Firm i produce the total output xi of commodity i according to the
production function
2
xi > xhi where i= 1, 2 [2] h=1
2
zh > zih where h = 1, 2 [3] i=1
Our assumptions that consumers are not satiated and that marginal
products are positive means that these material balance requirements
will bind as equalities in a Pareto efficient allocation.
Feasible allocations must also satisfy the constraint that the supply
of input cannot exceed individual hs initial endowment of N and R .
U A ( X A , YA , N A , R A ) U B ( X BYB , N B , RB )
max s.t
L U A ( X A , YA , N A , RA ) U B ( X BYB , N B , RB ) U 1 ( X X A X B ) 2 (Y YA YB )
B
1 ( N N A N B ) 2 ( R RA RB ) 1 ( g ( N A , RA ) X ) 2 ( f Y ( N B , RB )
X
2
[5]
The rst-order conditions are
L
U XAA 1 0
X A
[6]
L
U YAA 2 0
YA
[7]
L
U XBB 1 0
X B
[8]
L
U YBB 2 0
YB
[9]
Efficient Consumption
U XA A 1 U X B
B
U YAA 2 U XB B
[10]
Therefore:
MRS XA ,Y MRS XB ,Y
A B
MRTS XY
5 MRTS XY
that the and = 3, so that individual A is willing to
give up ve units of com-modify Y to acquire one unit of commodity X
whereas individual B is only willing to give up three units of commodity Y
in exchange for one unit of commodity X. Then transferring four units of
3
commodity Y from individual A to individual B and 1 unit of commodity X
from individual B to individual A will make both individuals better off.
Hence the initial situation cannot have been Pareto efcient and equality of
MRS is a necessary condition for a Pareto efcient allocation of goods
among consumers.
L
U NA 1 0
N
[11]
L
U RB 2 0
R
[12]
L
1 g NXA 1 0
N A
[13]
L
1 g RXA 2 0
R A
[14]
L
2 f NYB 1 0
N B
[15]
4
L
2 g YRB 2 0
RB
[16]
1 g NX A Y
1 2 f N B
1 g RXA 2 2 f RYB
[16]
MPNXA MPNYB
MPRXA MPRYB
[17]
Only allocations where the isoquants are tangential are efficient and since the slope
MRTS NX,R MRTS NY , R
of an isoquant is the firms MRTS this yields as a necessary
condition for efficient use of a given supply of inputs. (We h a v e follow the same
procedure used to derive [13]). The ratio of the marginal products f R/f N is the
marginal rate of technical substitution MRTS of input R for input N in the
production of good X or Y. Equality of marginal rates of technical substitution
across rms is necessary for efciency.
d) The last set of conditions are those necessary for the mix of outputs X,
and Y produced by the rms to be efcient. With Efficient in Output Mix
we want the mix of outputs produced to be efficient with input supply
MRT MRS
held constant. .
1 1 0
Making use of the fact that from [12] we can rearrange [11] to
get
L
1 1 0
X
[18]
5
L
2 2 0
Y
[19]
1 1
From
1 g NX A 1
1
g NXA
1
(i)
2
g RXA
1
.. (ii)
1
f NYB
2
(iii)
2
f RYB
2
. (iv)
Dividing the condition on good 2 by the condition on good 1 gives the efcient output mix
condition
f NXB 1 1 1 1
MRT XY Y
MRS XY
A
MRS XY
B
g Na 2 1 2 2
[20]
6
that a 0 is on the locus C 0 of points of tangency of their indifference curves.
is not equal to the slope of the production possibility curve at A0, thus
box with the same O1 origin but with O 2 shifted to A1. We give individual B
the same consumption bundle as he had in the original Edgeworth box.
Figure 1
Y
7
2) Demontration that a competitive equilibrium is a pareto optimal
the origin at 0 B. Line AB is the budget line for both individuals A and B. The
assumption of non-satiation means that it cannot be efcient to have total
consumption of any good less than the output of the good. Hence we
restrict attention to consumption bundles for the individuals which add up
to the total output of the two goods.
Figure 2
8
Pareto superior to A0 since it puts both individuals on indifference
curves further from their respective origins.
No allocation in the box where the indifference curves cross can be Pareto
A3 or A4 are efcient.
The locus CC of points of tangency between the indifference curves is
the set of all Pareto efcient allocations of the given total outputs
measured by the sides of the box. In a simple pure exchange economy
with consumers having a xed endowment of consumption goods,
the efcient consumption conditions are all that is required for Pareto
optimal. Since A 1 is on the contract curve CC the competitive
equilibrium is a Pareto optimal .