Question

Make a curve that illustrates the maximum point for a country's welfare. And explain it

Answer 1

The microeconomic analysis leads to the condition of Pareto efficiency as an ideal in welfare economics. When the economy is in a state of Pareto efficiency, social welfare is maximized in the sense that no resources can be reallocated to make one individual better off without making at least one individual worse off. One goal of economic policy could be to try to move the economy toward a Pareto efficient state. A resource allocation is Pareto efficient if no Pareto improvement is possible.

The concept of Pareto efficiency can be explained with the help of Edgeworth Box Diagram. Assume the existence of an economy with two agents, Adam and Eve, who consume two goods Apple and Fig Leaves of which there are fixed supplies. Further, endowment of the goods between Adam and Eve are represented by their Indifference Curves that are convex toward the people's respective origins. IC's and Marginal Rate of Substitutions must be same for both Adam and Eve. If their initial allocation is not at a point of tangency between an indifference curve of Adam and one of Eve, then that initial allocation must be at a point where an indifference curve of Adam crosses one of Eve which is at point X. These two indifference curves form a lens shape, with the initial allocation at one of the two corners of the lens. Adam and Eve will choose to make mutually beneficial trades — i.e, they will trade to a point that is on a better (farther from the origin) indifference curve for both. Such a point will be in the interior of the lens, and the rate at which one good will be traded for the other will be between the marginal rate of substitution of Adam and that of Eve. Since the trades will always provide each person with more of one good and less of the other, trading results in movement upward and to the left, or downward and to the right, in the diagram. The two people will continue to trade so long as each one's marginal rate of substitution (the absolute value of the slope of the person's indifference curve at that point) differs from that of the other person at the current allocation (in which case there will be a mutually acceptable trading ratio of one good for the other, between the different marginal rates of substitution). At a point where Adam's marginal rate of substitution equals Jane's marginal rate of substitution, no more mutually beneficial exchange is possible. This point is called a Pareto efficient equilibrium. In the Edgeworth box, it is a point at which Adam's indifference curve is tangent to Eve's indifference curve, and it is inside the lens formed by their initial allocations.

MRS for Adam = MRS for Eve

The maximum point of welfare for a country is there, where both the Indifference curves are tangent to each other i.e at point Y.