Exercise 2 Jan Abrell Centre for Energy Policy and Economics (CEPE) D-MTEC, ETH Zurich Exercise 2 13.03.2018 1
Outline Exercise 1 Exercise 2 Exercise 3 Exercise 2 13.03.2018 2
Exercise 1 Exercise 2 13.03.2018 3
(a) Define and explain Pareto-Efficiency An allocation is Pareto-efficient (or simply efficient) if it is not possible to make one individual better off without making an other individual worse off An allocation is Pareto-inefficient (there exists an Pareto improvement) if we can make one individual better off without making another worse of No distributional statement Exercise 2 13.03.2018 4
(b) Derive the condition for Pareto-efficiency in consumption Use the definition of Pareto-efficiency to distribute the total amount of commodities ( ) Definition implies maximizing utility of one agent holding utility of the other constant (here: B s utility constant at Exercise 2 13.03.2018 5
(c, d) Use a figure to explain the efficiency condition Marginal rate of utility substitution equalized across consumers Exercise 2 13.03.2018 6
Outline Exercise 1 Exercise 2 Exercise 3 Exercise 2 13.03.2018 7
Exercise 2 Exercise 2 13.03.2018 8
(a) Explain what is meant by capital using some examples Capital is not just money: Production sites Machineries Cars and trucks Knowledge Exercise 2 13.03.2018 9
(b) Explain Pareto-efficiency in production An allocation is Pareto-efficient (or simply efficient) if it is not possible to make one individual better off without making an other individual worse off Pareto-efficiency in production A factor allocation is Pareto-efficient is it is not possible to produce more of one commodity without producing less of an other commodity Exercise 2 13.03.2018 10
(c) Derive the condition for Pareto-efficiency in production Maximize output of one firm holding output of the other constant under given factor supply Exercise 2 13.03.2018 11
(d, e) Use a figure to explain the efficiency condition Marginal rate of technical substitution equalized across firms Exercise 2 13.03.2018 12
Outline Exercise 1 Exercise 2 Exercise 3 Exercise 2 13.03.2018 13
Exercise 3 Exercise 2 13.03.2018 14
(a) Using your figures, explain why a market economy ensures production and consumption efficiency. Exercise 2 13.03.2018 15
(a) Using your figures, explain why a market economy ensures production and consumption efficiency. Exercise 2 13.03.2018 16
(b) State the first welfare theorem and its main assumptions. Every competitive equilibrium is an Pareto-efficient allocation Assumptions Private commodities No externalities Property rights assigned Markets for all commodities Perfect information Perfect competition Market Failures 06.03.2018 17
(c) For each assumption, provide an example when it fails Public goods (e.g. air quality) Non-rival in consumption Non-excludability Externalities (e.g. pollution) Individuals utility depends on other individuals consumption Markets for all commodities (e.g. air quality) Perfect information (e.g. used car sales) Perfect competition (e.g. crude oil market, PC operating systems) Market Failures 06.03.2018 18
(d) What is the difference between an Pareto-efficient and an optimal allocation? An allocation is pareto-efficient (or simply efficient) if it is not possible to make one individual better off without making another worse off. Efficiency makes no distributional statement Use welfare function to determine optimal allocation in terms of distribution Welfare Economics 06.03.2018 19
(e) State the second welfare theorem and explain its relation to optimal allocations. Second Theorem Every Pareto-efficient allocation can be obtained with an competitive equilibrium (using lump-sum transfers) Optimal allocation Choose one out of many Pareto-efficient allocations Second welfare theorem Allows to reach chosen, optimal allocation redistributing either initial endowment or using lump-sum transfers of wealth Exercise 2 13.03.2018 20
Questions? Exercise 2 13.03.2018 21