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Book No. – 3 (Economics)
Book Name – Principles of Microeconomics (HL Ahuja)
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1. THE CONCEPT OF PARETO EFFICIENCY
2. THE ECONOMIC EFFICIENCY OF PERFECT COMPETITION
2.1. Allocative Efficiency or Product-Mix Efficiency
2.2. Distributive Efficiency: Optimum Distribution of Goods among People or Households
3. SUCCESSES AND FAILURES OF PERFECT COMPETITION
3.1. Failures of the Perfectly Competitive Economy
3.2. Prof. Amartya Sen’s Critique of Economic Efficiency based on Pareto Optimality
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Economic Efficiency of Perfect Competition
Chapter – 25
THE CONCEPT OF PARETO EFFICIENCY
- Perfect competition ensures economic efficiency and maximum social welfare in the market economy.
- This is based on the Pareto efficiency or Pareto optimality criterion put forward by Vilfredo Pareto.
- Pareto efficiency avoids cardinal measurement of utility and interpersonal comparison of utilities between individuals.
- According to Pareto’s criterion, a change is efficient if it makes some people better off without making others worse off.
- Pareto efficiency occurs when no further change in resource allocation can improve the welfare of any individual without reducing the welfare of someone else.
- Changes in individual welfare should be judged by the individuals themselves based on their own estimations, not by others.
- For example, if two individuals exchange goods voluntarily, both are better off, fulfilling Pareto’s criterion.
- Interpersonal comparison of utility is avoided by Pareto, meaning changes where some individuals gain and others lose are not evaluated.
- In real-world changes, it is rare for no one to be worse off, making the Pareto criterion less applicable to such situations.
- Nicholas Kaldor and J.R. Hicks introduced a compensation criterion to evaluate changes that make some individuals better off and others worse off.
- According to the Kaldor-Hicks criterion, social welfare or economic efficiency increases if the gainers from a change can compensate the losers and still remain better off.
- However, this compensation is potential and not actual, leaving the question of whether such a change actually increases social welfare unresolved.
- The main focus is whether a perfectly competitive economy achieves Pareto optimality or economic efficiency based on the Pareto criterion.
THE ECONOMIC EFFICIENCY OF PERFECT COMPETITION
Economic efficiency refers to the production of goods and resources that people want at the lowest possible cost of production.
The three basic questions arising from resource scarcity are:
- What goods will be produced?
- How will these goods be produced?
- Who will get the goods produced (distribution of national product)?
A perfectly competitive economy ensures:
- Allocative efficiency: Efficient allocation of resources among goods.
- Productive efficiency: Resources are used at the minimum cost possible.
- Distributive efficiency: Distribution of final goods maximizes social welfare.
Productive Efficiency:
- Occurs when resources cannot be reallocated to produce more of one good without reducing the output of another.
- The two aspects of productive efficiency are:
- Efficient allocation of resources within a firm: Achieved when a firm produces output at the minimum possible cost using the least cost technique.
- Efficient allocation of resources among firms: Achieved when all firms producing a product have the same marginal cost.
Perfect competition ensures:
- Firms produce at minimum cost as price is constant for each firm.
- All firms equate price with their marginal cost, ensuring marginal cost is the same for all firms producing the same product.
In competitive markets, all firms face the same factor prices and will employ factors until the marginal revenue product (MRP) of each factor equals its price.
- Marginal Revenue Product (MRP) = Price of the Factor.
If firms in a competitive market pay the same factor prices and have equal marginal revenue products for each factor, then allocation of resources among firms is efficient.
Productive efficiency requires the economy to operate on the production possibility curve (PP).
- Points on the curve, such as A, B, or E, represent efficient production.
- If the economy operates inside the curve (e.g., at point K), it is inefficient and can produce more goods without reducing the production of others.
An economy will move along the production possibility curve depending on preferences and the willingness and ability to pay for goods. This aspect is related to allocative efficiency.