Question

Describe the following concepts:
a) Explain the concept of Pareto activity (graphs and equations) with the help and discuss the importance of the concept in economics.
b) Lerner index (explain its description and formula).
c) Normal profit (define and discuss its importance in economics)

Answer 1

Ans:(a) Pareto effeiciency is a condition where no individual can be better off without making at least one individual or preference criterion worse off. A situation is called pareto efficient if no change could lead to improved satisfaction to all the agents. The pareto frontier is the set of pareto efficient allocations as shown in the graph, known as Pareto Set also.

In the below picture points A and B on the PPF are Pareto efficient points, whereas point C is pareto inefficient .Pareto optimal allocation is a condition where alternative improvement in at least one individual preference is possible. Consider an economy with n agents and k goods.Then an allocation {x₁, x₂ ,..... , x_n} where x_i belongs to R^k is pareto optimal ifthere is no other feasible allocation so that utility for each agent is u_i (x'_{i) >} u_i (x_i) for all i= {1,2,.....n} (b) Lerner Index is ameasure of the market power of a firm. It measures the monopoly power,; it is index of percent markup of price over marginal cost.. The Lerner Index is a positive number (L.>0) increasing in the amount of market power. The index will be determined by the amount of market power than the firm has.

Lerner Index Formula = (P-MC)/ P = -1/E^d where E^d = Price elasticity of demand

It provides the relationship between the percent mark up and the price elasticity of demand.

By rearranging the above equation we get

P= MC/(1+1/E^d) . This relates the price to marginal cost. Suppose the monopoly has the price elasticity equal to -2. P= 2MC. To summarise:

• If E^d is large,the firm has less market power and a small markup.
• If E^d small, the firm has more market power, and a large markup.

(c) Normal profit is a profit that takes into account both the explicit and implicit cost. Normal profits occurs when the difference between a company's revenue and both the combined explicit and implicit costs are equal to zero. It is a condition that exists when a company's economic profit is zero.

Economic profit = Revenues - Explicit Costs - Implicit Costs

Normal profit occurs when the economic profit is zero or revenues equal explicit and implicit costs. Implicit costs also known as opportunity costs.

Normal profit allows the business owners to compare the profitability of their work with that of other business ventures.It tells us whether a sector is rising or declining.