ASSIGNMENT No.

2
Course : Advanced Microeconomics Code : 805
Semester: Spring, 2020 Level : M.Sc. Economics
Q.No.1-Illustrate graphically the general profit maximizing rules for a monopolist.

Consider a monopoly firm, comfortably surrounded by barriers to entry so that it need not fear
competition from other producers. How will this monopoly choose its profit-maximizing quantity
of output, and what price will it charge? Profits for the monopolist, like any firm, will be equal to
total revenues minus total costs. The pattern of costs for the monopoly can be analyzed within
the same framework as the costs of a perfectly competitive firm—that is, by using total cost, fixed
cost, variable cost, marginal cost, average cost, and average variable cost. However, because a
monopoly faces no competition, its situation and its decision process will differ from that of a
perfectly competitive firm. A perfectly competitive firm acts as a price taker. The demand curve it
perceives appears in Figure 1(a). The horizontal demand curve means that, from the viewpoint of
the perfectly competitive firm, it could sell either a relatively low quantity like Ql or a relatively
high quantity like Qh at the market price P.

While a monopolist can charge any price for its product, that price is nonetheless
constrained by demand for the firm’s product. No monopolist, even one that is thoroughly
protected by high barriers to entry, can require consumers to purchase its product. Because
the monopolist is the only firm in the market, its demand curve is the same as the market
demand curve, which is, unlike that for a perfectly competitive firm, downward-sloping.

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Figure 1 illustrates this situation. The monopolist can either choose a point like R with a low price (Pl)
and high quantity (Qh), or a point like S with a high price (Ph) and a low quantity (Ql), or some
intermediate point. Setting the price too high will result in a low quantity sold, and will not bring in
much revenue. Conversely, setting the price too low may result in a high quantity sold, but because of
the low price, it will not bring in much revenue either. The challenge for the monopolist is to strike a
profit-maximizing balance between the price it charges and the quantity that it sells.

In order to determine profits for a monopolist, we need to first identify total revenues and total costs.
An example for the hypothetical HealthPill firm is shown in Figure 2.

Total costs for a monopolist follow the same rules as for perfectly competitive firms. In other
words, total costs increase with output at an increasing rate. Total revenue, by contrast, is
different from perfect competition. Since a monopolist faces a downward sloping demand curve,
the only way it can sell more output is by reducing its price. Selling more output raises revenue,
but lowering price reduces it. Thus, the shape of total revenue isn’t clear. Let’s explore this using
the data in Table 1, which shows points along the demand curve (quantity demanded and price),
and then calculates total revenue by multiplying price times quantity. (In this example, we give
the output as 1, 2, 3, 4, and so on, for the sake of simplicity. If you prefer a dash of greater
realism, you can imagine that the pharmaceutical company measures these output levels and the
corresponding prices per 1,000 or 10,000 pills.) As Figure 2 illustrates, total revenue for a
monopolist has the shape of a hill, first rising, next flattening out, and then falling.

Quantity Price Total Revenue Total Cost

Q P TR TC

1 1,200 1,200 500

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Quantity Price Total Revenue Total Cost

Q P TR TC

2 1,100 2,200 750

3 1,000 3,000 1,000

4 900 3,600 1,250

5 800 4,000 1,650

6 700 4,200 2,500

7 600 4,200 4,000

8 500 4,000 6,400

Table 1. Total Costs and Total Revenues of HealthPill

In this example, total revenue is highest at a quantity of 6 or 7. However, the monopolist is

not seeking to maximize revenue, but instead to earn the highest possible profit. In the
HealthPill example in Figure 2, the highest profit will occur at the quantity where total revenue
is the farthest above total cost. This looks to be somewhere in the middle of the graph, but
where exactly? It is easier to see the profit maximizing level of output by using the marginal
approach, to which we turn next.

Marginal Revenue and Marginal Cost for a Monopolist

In the real world, a monopolist often does not have enough information to analyze its entire total
revenues or total costs curves; after all, the firm does not know exactly what would happen if it were
to alter production dramatically. But a monopolist often has fairly reliable information about how
changing output by small or moderate amounts will affect its marginal revenues and marginal costs,
because it has had experience with such changes over time and because modest changes are easier
to extrapolate from current experience. A monopolist can use information on marginal revenue and
marginal cost to seek out the profit-maximizing combination of quantity and price.

Table 2 expands Table 1 using the figures on total costs and total revenues from the
HealthPill example to calculate marginal revenue and marginal cost. Recall that marginal
revenue is the additional revenue the firm receives from selling one more (or a few more)
units of output. Similarly, marginal cost is the additional cost the firm incurs from producing
and selling one more (or a few more) units of output. This monopoly faces a typical U-shaped
average cost curve and upward-sloping marginal cost curve, as shown in Figure 3.

Quantity Total Revenue Marginal Revenue Total Cost Marginal Cost

Q TR MR TC MC

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Quantity Total Revenue Marginal Revenue Total Cost Marginal Cost

Q TR MR TC MC

1 1,200 1,200 500 500

2 2,200 1,000 775 275

3 3,000 800 1,000 225

4 3,600 600 1,250 250

5 4,000 400 1,650 400

6 4,200 200 2,500 850

7 4,200 0 4,000 1,500

8 4,000 –200 6,400 2,400

Table 2. Costs and Revenues of HealthPill

Notice that marginal revenue is zero at a quantity of 7, and turns negative at quantities higher
than 7. It may seem counterintuitive that marginal revenue could ever be zero or negative:
after all, doesn’t an increase in quantity sold always mean more revenue? For a perfect
competitor, each additional unit sold brought a positive marginal revenue, because marginal
revenue was equal to the given market price. However, a monopolist can sell a larger quantity
and see a decline in total revenue, since in order to sell more output, the monopolist must cut
the price. As the quantity sold becomes higher, at some point the drop in price is
proportionally more than the increase in greater quantity of sales, causing a situation where
more sales bring in less revenue. In other words, marginal revenue is negative.

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A monopolist can determine its profit-maximizing price and quantity by analyzing the marginal
revenue and marginal costs of producing an extra unit. If the marginal revenue exceeds the
marginal cost, then the firm can increase profit by producing one more unit of output.

For example, at an output of 4 in Figure 3, marginal revenue is 600 and marginal cost is 250, so
producing this unit will clearly add to overall profits. At an output of 5, marginal revenue is 400 and
marginal cost is 400, so producing this unit still means overall profits are unchanged. However,
expanding output from 5 to 6 would involve a marginal revenue of 200 and a marginal cost of 850, so
that sixth unit would actually reduce profits. Thus, the monopoly can tell from the marginal revenue
and marginal cost that of the choices in the table, the profit-maximizing level of output is 5.

The monopoly could seek out the profit-maximizing level of output by increasing quantity by
a small amount, calculating marginal revenue and marginal cost, and then either increasing
output as long as marginal revenue exceeds marginal cost or reducing output if marginal
cost exceeds marginal revenue. This process works without any need to calculate total
revenue and total cost. Thus, a profit-maximizing monopoly should follow the rule of
producing up to the quantity where marginal revenue is equal to marginal cost—that is, MR =
MC. This quantity is easy to identify graphically, where MR and MC intersect.

Choosing the Price

Once the monopolist identifies the profit maximizing quantity of output, the next step is to
determine the corresponding price. This is straightforward if you remember that a firm’s demand
curve shows the maximum price a firm can charge to sell any quantity of output. Graphically,
start from the profit maximizing quantity in Figure 3, which is 5 units of output. Draw a vertical
line up to the demand curve. Then read the price off the demand curve (i.e. $800).

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The marginal revenue curve for a monopolist always lies beneath the market demand curve. To
understand why, think about increasing the quantity along the demand curve by one unit, so that
you take one step down the demand curve to a slightly higher quantity but a slightly lower price.
A demand curve is not sequential: it is not that first we sell Q 1 at a higher price, and then we sell
Q2 at a lower price. Rather, a demand curve is conditional: if we charge the higher price, we
would sell Q1. If, instead, we charge a lower price (on all the units that we sell), we would sell Q 2.
So when we think about increasing the quantity sold by one unit, marginal revenue is
affected in two ways. First, we sell one additional unit at the new market price. Second, all the
previous units, which could have been sold at the higher price, now sell for less. Because of
the lower price on all units sold, the marginal revenue of selling a unit is less than the price of
that unit—and the marginal revenue curve is below the demand curve.
Tip: For a straight-line demand curve, the marginal revenue curve equals price at the lowest level
of output. (Graphically, MR and demand have the same vertical axis.) As output increases,
marginal revenue decreases twice as fast as demand, so that the horizontal intercept of MR is
halfway to the horizontal intercept of demand. You can see this in the Figure 4.

Q.No.2-What is meant by contract curve for exchange and how it is derived?

ANS:

Difference between Contract Curve for Exchange and Utility Possibility Curve
In welfare economics, a utility–possibility frontier (or utility possibilities curve), is a widely-
used concept analogous to the better-known production–possibility frontier. The graph
shows the maximum amount of one person's utility given each level of utility attained by all
others in society. Points on the curve are, by definition, Pareto efficient, while points off the
curve are not. However, based on the extent of society’s preferences for an equal distribution
of real income, a point off the curve may be preferred. All points on or below the utility–
possibility frontier are attainable by society; all points above it are not attainable. The utility–
possibility frontier is derived from the contract curve.

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The utility–possibility frontier (UPF) is the upper frontier of the utility possibilities set, which is the set
of utility levels of agents possible for a given amount of output, and thus the utility levels possible in
a given consumer Edgeworth box. The UPF is the contract curve of the Edgeworth box.
In a competitive economy, any allocation over the utility–possibility frontier is a Pareto optimum,
as the UPF is a representation of the Pareto contract curve in a different dimension (utilities
versus goods). The set of points, which for a given level of utility of person 1, utility of person 2 is
maximized (subject to resource availability). Because all points along the UPC represent different
real income distributions, all being Pareto efficient, it is difficult to determine which utility
combination is preferable to society. Usually, the social welfare function, which incorporates the
deservedness of the two individuals and states how society’s well-being relates to that of the two
individuals, is required to maximize social welfare. To do so, a point on the UPC would be chosen
that also fell on the highest indifference curve for society. It is assumed that the value of social
welfare changes as the individual utility of any society members changes, thus shifting the UPC
to the right for utility increases or to the left for utility decreases.
In microeconomics, the contract curve is the set of points representing final allocations of two goods
between two people that could occur as a result of voluntary trading between those people given their
initial allocations of the goods. All the points on this locus are Pareto efficient allocations, meaning
that from any one of these points there is no reallocation that could make one of the people more
satisfied with his or her allocation without making the other person less satisfied. The contract curve
is the subset of the Pareto efficient points that could be reached by trading from the people's initial
holdings of the two goods. It is drawn in the Edgeworth box diagram shown here, in which each
person's allocation is measured vertically for one good and horizontally for the other good from that
person's origin (point of zero allocation of both goods); one person's origin is the lower left corner of
the Edgeworth box, and the other person's origin is the upper right corner of the box. The people's
initial endowments are represented by a point in the diagram; the two people will trade goods with
each other until no further mutually voluntary trades are possible. The set of points that it is
conceptually possible for them to stop at are the points on the contract curve.
Any Walrasian equilibrium lies on the contract curve. As with all points that are Pareto
efficient, each point on the contract curve is a point of tangency between an indifference
curve of one person and an indifference curve of the other person. Thus, on the contract
curve the marginal rate of substitution is the same for both people.
The Utility Possibility Frontier and the Con-tract Curve
With the aid of Anne and Bruce we can introduce some further notions that are important building
blocks in the theory of public decisions. The Utility Possibility Set and the Utility Possibility Frontier
Suppose that Anne and Bruce have utility functions UA(C; T) and UB(C; T), representing their
preferences over games of cribbage and temperature. We can graph the possible distributions of
utility between them. On the horizontal axis of Figure 1.2, we measure Anne's utility and on the
vertical axis we measure Bruce's utility. Each possible combination of temperature and number of
games of cribbage determines a possible distribution of utility between Anne and Bruce.
The utility possibility set is denned to be the set of all possible distributions of utility between
Anne and Bruce.
It is interesting to interpret the meaning of the entire boundary of the utility possibility set.

In general, the utility possibility set need not be a convex set. In fact it could be of almost any shape. But,
by construction, the utility possibility frontier is the part of the boundary of the utility possibility set that
slopes downward and to the right. One question that may have occurred to you is the following. We

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know that if someone's preferences can be represented by one utility function, then these
same preferences can also be represented by any monotonic transformation of that function.
Sometimes this idea is expressed by saying that representation of preferences by utility functions is
unique only up to monotonic transformations. But the shape of the utility possibility frontier will in
general depend on which monotonic transformation you use. This is true. You have to specify the
utility representation that you intend to use and then draw the utility possibility frontier.
Q.No.3-What is the relationship between partial and general equilibrium analysis?
In economics, partial equilibrium is a condition of economic equilibrium which takes into
consideration only a part of the market (with all other parts remaining constant) to attain equilibrium.
As defined by Leroy lopes, "A partial equilibrium is one which is based on only a restricted range
of data, a standard example is price of a single product, the prices of all other products being
held fixed during the analysis." The supply and demand model is a partial equilibrium model
where the clearance on the market of some specific goods is obtained independently from prices
and quantities in other markets. In other words, the prices of all substitute goods and
complement goods, as well as income levels of consumers, are taken as given. This makes
analysis much simpler than in a general equilibrium model, which includes an entire economy.
Here, the dynamic process is that prices adjust until supply equals demand. It is a powerfully simple
technique that allows one to study equilibrium, efficiency and comparative statics. The stringency of
the simplifying assumptions inherent in this approach makes the model considerably more tractable,
but may produce results which, while seemingly precise, do not effectively model real-world
economic phenomena.Partial equilibrium analysis examines the effects of policy action in creating
equilibrium only in that particular sector or market which is directly affected, ignoring its effect in any
other market or industry assuming that they being small will have little impact if any; hence, this
analysis is considered to be useful in constricted markets. Léon Walras first formalized the idea of a
one-period economic equilibrium of the general economic system, but it was French economist
Antoine Augustin Cournot and English political economist Alfred Marshall who developed tractable
models to analyze an economic system.

1. Commodity price is given and constant for the consumers.

2. Consumers' taste and preferences, habits, incomes are also considered to be constant.
3. Prices of prolific resources of a commodity and that of other related goods (substitute
or complementary) are known as well as constant.
4. Industry is easily availed with factors of production at a known and constant price
compliant with the methods of production in use.
5. Prices of the products that the factor of production helps in producing and the price
and quantity of other factors are known and constant.
6. There is perfect mobility of factors of production between occupation and places.
The above-mentioned points relate to a perfectly competitive market but can be further
[2]
extended to monopolistic competition, oligopoly, monopoly and monopsony markets.
Applications of partial equilibrium discusses, when does an individual, a firm, an industry,
factors of production attain their equilibrium points-

1. A consumer is in a state of equilibrium when they achieve maximum aggregate

satisfaction on the expenditure that they make depending on the set of conditions
relating to his tastes and preferences, income, price and supply of the commodity etc.

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 2. Producers’ equilibrium occurs when they maximize their net profit subject to a given
set of economic situations.
3. A firm's equilibrium point is when it has no inclination in changing its production.
o In the short run: Marginal Revenue = Marginal
Cost. Algebraically MR=MC
1.
o In long run: Long run Marginal Cost = Marginal Revenue = Average Revenue = Long
run Average Cost
[3]
Algebraically LMC=MR=AR=LAC at its minimum are the conditions of equilibrium. It means
that a firm is earning only a "normal profit" and has no intension to leave the industry.

1. Equilibrium for an industry happens when there is normal profit made by an industry It is such
a situation when no new firm wants to enter into it and the existing firm does not want to exit.
Only one price prevails in the market for a single product where the quantity of goods
purchased by a buyer = total quantity produced by different firms. All the firms produces till
that level where Marginal Cost=Marginal Revenue, and sells the product at market price
[
ruling at that point of time.
1. Factors of production, i.e., land, labor, capital, and entrepreneurs are in equilibrium
when they are paid the maximum possible so as maximize the income. Here the Price =
Marginal Revenue Product.
At this price it does not have any enticement to look for employment anywhere else.
The quantity of factors which its owners want to sell should be equal to the quantity which
the entrepreneurs are ready to hire.

1. It is restricted to one particular portion of the economy.

2. It lacks the ability to study the interrelations of all the parts of the economy.
3. This analysis will fail if the improbable assumptions, which disconnect the study of
specific market from the rest of the economy, are not taken into consideration.
4. It has been unsuccessful in explaining the outcome of economic disturbance in the
market that leads to demand and supply changes, moving from one market to another
and thus instigating second- and third-order waves of change in the whole economy.

Consumer surplus
The amount that a consumer is ready to pay for a particular good minus the amount that the
[5]
consumer actually pays. The amount that the consumer is willing to pay has to be greater.
In the graph given here, P1 is the price that a consumer is ready to pay for a particular product. But
the producer may reduce the price to P2 expecting that either more people would buy at the reduced
rate, or the person who was ready to pay P1 will purchase more of the same. The producer may further
[5]
reduce the price to P3, again expecting more buyers or the same buyers purchasing more. The price
keeps on falling until P’, where the demand and the supply curves intersect: their intersection is the
equilibrium point. Hence the consumer surplus for first consumer can be calculated as P 1 - P’,
decreasing for the second consumer to P2 - P’, and so on. Thus the total

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consumer surplus in the market can be obtained by summing up the three rectangles. The
triangle with the purple outline to the left indicates that area
Producer surplus
Amount that a producer finally receives by selling a particular product minus the amount the producer
is ready to accept for that good. The amount that the producer receives should be greater. If only one
unit of the commodity was demanded at the price P 1, this becomes the price which the producer
expects to receive. But if two units are demanded, the minimum price at which the producer would be
ready to increase the supply shifts to P 2. This continues and the final price that ultimately prevails in
the market is P’, the price which is obtained by the intersection of the demand and supply curve in the
market. The producer's surplus here would be initial price minus the final price. And total producer
surplus in the market will be summation of the three rectangles.

Difference between partial and general equilibrium

hidePartial Equilibrium General Equilibrium

• Developed by Alfred Marshall. • Léon Walras was first to develop it.

• More than one variable or economy as a whole is

• Related to single variable
taken into consideration

• Based on two assumptions: • It is based on the assumption that various

sectors are mutually interdependent.
1. Ceteris Paribus There is an effect on other sectors due to change in
2. Other sectors are not affected due to one.
change in one sector.
• Prices of goods are determined simultaneously
• and mutually.
Other things remaining constant, price of a
good is determined Hence all product and factor markets are
simultaneously in equilibrium.
Q.No.4-Contrast the general equilibrium in exchanges with general equilibrium in production.

General equilibrium analysis addresses precisely how these “vast numbers of individual and
seemingly separate decisions” referred to by Arrow aggregate in a way that coordinates productive
effort, balances supply and demand, and leads to an efficient allocation of goods and services in the
economy. The answer economists have provided, beginning with Adam Smith and continuing through
to Jevons and ∗Various sections of these notes draw heavily on lecture notes written by Felix Kubler;
some of the other sections draw on Mas-Colell, Whinston and Green. 1 Walras is that it is the price
system plays the crucial coordinating and equilibrating role: the fact the everyone in the economy
faces the same prices is what generates the common information needed to coordinate

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disparate individual decisions. You doubtless are familiar with the standard treatment of
equilibrium in a single market. Price plays the role of equilibrating demand and supply so that
all buyers who want to buy at the going price can, and do, and similarly all sellers who want
to sell at the going price also can and do, with no excess or shortages on either side. The
extension from this partial equilibrium in a single market to general equilibrium reflects the
idea that it may not be legitimate to speak of equilibrium with respect to a single commodity
when supply and demand in that market depend on the prices of other goods. On this view, a
coherent theory of the price system and the coordination of economic activity has to
consider the simultaneous general equilibrium of all markets in the economy.
This of course raises the questions of (i) whether such a general equilibrium exists; and (ii) what are
its properties. A recurring theme in general equilibrium analysis, and economic theory more
generally, has been the idea that the competitive price mechanism leads to outcomes that are efficient
in a way that outcomes under other systems such as planned economies are not. The relevant notion
of efficiency was formalized and tied to competitive equilibrium by Vilfredo Pareto (1909) and Abram
Bergson (1938). This line of inquiry culminates in the Welfare Theorems of Arrow
(1951) and Debreu (1951). These theorems state that there is in essence an equivalence between
Pareto efficient outcomes and competitive price equilibria. Our goal in the next few lectures is to
do some small justice to the main ideas of general equilibrium. We’ll start with the basic concepts
and definitions, the welfare theorems, and the efficiency properties of equilibrium. We’ll then
provide a proof that a general equilibrium exists under certain conditions. From there, we’ll
investigate a few important ideas about general equilibrium: whether equilibrium is unique, how
prices might adjust to their equilibrium levels and whether these levels are stable, and the extent
to which equilibria can be characterized and changes in exogenous preferences or endowments
will have predictable consequences. Finally we’ll discuss how one can incorporate production
into the model and then time 2 and uncertainty, leading to a brief discussion of financial markets
General Equilibrium Theory is a macroeconomic theory that explains how supply and demand in
an economy with many markets interact dynamically and eventually culminate in an equilibrium
of prices. The theory assumes that there is a gap between actual prices and equilibrium prices.

The goal of the theory is to identify the precise set of circumstances under which the
equilibrium price is likely to achieve stability.

Léon Walras and General Equilibrium Theory

The theory is most closely associated with Léon Walras, who wrote "Elements of Pure
Economics" in 1874. While the idea had been vaguely hinted at by earlier economists, he was
1
the first one to articulate the idea thoroughly. Walras started his explanation of General
Equilibrium Theory by describing the simplest economy imaginable. In this economy, there
were only two goods that could be exchanged, referred to as x and y. Everyone in the
economy was presumed to be a buyer of one of these products and a seller of the other.
Under this model, supply and demand would be interdependent, because the consumption of
2
each of the goods would be dependent on the wages derived from selling each of the goods.
The price of each of the goods would be decided by a bidding process, which Walras referred to as
"tâtonnement" (or "groping" in English). He described this in terms of an individual seller calling out
the price of a good in the market and consumers responding by either buying or declining to pay.
Through a trial and error process, the seller would adjust the price to suit demand—thus, establishing
the equilibrium price. Walras believed that there would be no exchange of goods until the equilibrium
2
price was reached, an assumption that has been criticized by others.
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Multi-Market Settings
When describing equilibrium on a grander scale, Walras applied this principle to multi-market
settings, which are much more intricate. He introduced a third good to his model, referred to
as z. From this, three price ratios could be determined, one of which would be redundant as it
3
would not give any information that could not be identified from the others. This redundant
good could be identified as the standard by which all other price ratios could be expressed.
The standard would provide a guide to currency rates.

The Bottom Line

Theoretically, Walras's theory had transformational effects. Economics, formerly a literary
and philosophical discipline, was now viewed as a determinist science. His insistence that
economics could be reduced to disciplined mathematical analysis persists today.

In more recent terms, it can also be said that Walras' equilibrium theory has long-lasting
effects. It blurs the lines between microeconomics and macroeconomics, as the economics
that relates to individual households and companies cannot be viewed as existing separately
from the macroeconomy.

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Q.No.5-Explain I detail the concept of Pareto optimality.

PARETO-OPTIMALITY DEFINED

A pareto-optimal allocation of goods or services occurs when no one in the society can be
made better off without making at least one person worse off. As a result, there are no more
gains in trade to be made. In a two-person, two-good society, a pareto-optimal allocation can
be demonstrated graphically as the point where two indifference curves are tangent. At this
point, the following mathematical conditions are true:

(1) Marginal Rate of Substitution (MRS) = dQy/dQx = MUx/MUy=Px/Py

1 2
(2) MRS = MRS

In other words, goods x and y have been distributed among individuals in society so that the
added utility for each dollar spent on a good is the same for all goods and for all individuals,
The MRS is simply the slope of a line drawn tangent to the indifference curves.

PERFECT COMPETITION DEFINED

A perfectly competitive market is one which has the following characteristics:

1. Perfect Information: All individuals have immediate access to accurate information

about prices and quality of goods and services. Moreover, they know the implications
of current actions on future welfare.

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 2. Price Taking: The behavior of buyers and sellers in a market does not influence the
price of goods or services in that market each buyer or seller represents a very small
share of the market.
3. Free Entry and Exit: Business can easily move into or out of a market. This is generally
characterized by large numbers of producers or "potential" producers.
4. No Externalities: Individual choices do not affect the welfare of others, Decisions and their
consequences are private. Therefore, the marginal social cost of a good and the marginal
social benefit of a good are reflected in the price of the good (i.e. MSB x=PX=MSCx).
5. No Public Goods: Goods may not be both non-rival and non-excludable, It must be
possible to withhold the good from those who haven't paid for it (i.e. the good is
exclusive in consumption); or it must be true that the consumption of the good by one
person reduces the availability of the good for other persons (i.e. the good is rival in
consumption). When a good is non-rival, it has a zero marginal cost of production. An
additional person may enjoy the good with no added costs to production.

Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering

and social sciences. The term is named after Vilfredo Pareto (1848–1923), an Italian economist
who used the concept in his studies of economic efficiency and income distribution.
In a Pareto efficient economic system no allocation of given goods can be made without making
at least one individual worse off. Given an initial allocation of goods among a set of individuals, a
change to a different allocation that makes at least one individual better off without making any
other individual worse off is called a Pareto improvement. An allocation is defined as "Pareto
efficient" or "Pareto optimal" when no further Pareto improvements can be made.
Pareto efficiency is a minimal notion of efficiency and does not necessarily result in a
socially desirable distribution of resources: it makes no statement about equality, or the
overall well-being of a society.

Looking at the Production-possibility frontier shows how productive efficiency is a precondition for
Pareto efficiency. Point A is not efficient in production because you can produce more of either one or
both goods (Butter and Guns) without producing less of the other. Thus, moving from A to D enables
you to make one person better off without making anyone else worse off (Pareto improvement).
Moving to point B from point A, however, is not Pareto efficient, as less butter is produced. Likewise,
moving to point C from point A is not Pareto efficient, as fewer guns are produced. A point on the
frontier curve with the same x or y coordinate will be Pareto efficient.
An economic system that is not Pareto efficient implies that a certain change in allocation of goods
(for example) may result in some individuals being made "better off" with no individual being made

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worse off, and therefore can be made more Pareto efficient through a Pareto improvement.
Here 'better off' is often interpreted as "put in a preferred position." It is commonly accepted
that outcomes that are not Pareto efficient are to be avoided, and therefore Pareto efficiency
is an important criterion for evaluating economic systems and public policies.
If economic allocation in any system is not Pareto efficient, there is potential for a Pareto
improvement—an increase in Pareto efficiency: through reallocation, improvements to at least one
participant's well-being can be made better without reducing any other participant's well-being.
In the real world ensuring that nobody is disadvantaged by a change aimed at improving
economic efficiency may require compensation of one or more parties. For instance, if a change
in economic policy dictates that a legally protected monopoly ceases to exist and that market
subsequently becomes competitive and more efficient, the monopolist will be made worse off.
However, the loss to the monopolist will be more than offset by the gain in efficiency. This means
the monopolist can be compensated for its loss while still leaving an efficiency gain to be realized
by others in the economy. Thus, the requirement of nobody being made worse off for a gain to
others is met. In real-world practice compensations have substantial frictional costs. They can
also lead to incentive distortions over time since most real-world policy changes occur with
players who are not atomistic, rather who have considerable market power (or political power)
over time and may use it in a game theoretic manner. Compensation attempts may therefore lead
to substantial practical problems of misrepresentation and moral hazard and considerable
inefficiency as players behave opportunistically and with guile.
In real-world practice, the compensation principle often appealed to is hypothetical. That is, for
the alleged Pareto improvement (say from public regulation of the monopolist or removal of
tariffs) some losers are not (fully) compensated. The change thus results in distribution effects in
addition to any Pareto improvement that might have taken place. The theory of hypothetical
compensation is part of Kaldor–Hicks efficiency, also called Potential Pareto Criterion. Hicks-
Kaldor compensation is what turns the utilitarian rule for the maximization of a function of all
individual utilities postulated by Samuelson as a solution to the optimal public goods problem,
into a rule that mimics Pareto efficiency. This is how Pareto-efficiency finds itself at the heart of
modern Public Choice theory where under certain conditions Black's median voter opts for a
Hick-Kaldor compensated Pareto efficient level of public goods.
Under certain idealized conditions, it can be shown that a system of free markets will lead to a
Pareto efficient outcome. This is called the first welfare theorem. It was first demonstrated
mathematically by economists Kenneth Arrow and Gerard Debreu. However, the result does not
rigorously establish welfare results for real economies because of the restrictive assumptions
necessary for the proof (markets exist for all possible goods, all markets are in full equilibrium,
markets are perfectly competitive, transaction costs are negligible, there must be no externalities,
and market participants must have perfect information). Moreover, it has since been
demonstrated mathematically that, in the absence of perfect information or complete markets,
outcomes will generically be Pareto inefficient (the Greenwald–Stieglitz theorem).

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