Question

Although a competitive equilibrium is always Pareto efficient, a Pareto efficient outcome is not necessarily a competitive equilibrium.1 Explain. (It is sufficient to give an example of a Pareto efficient outcome that is not a competitive equilibrium and explain why it is not.)

(A competitive equilibrium requires that consumer utility-maximize, firms profit-maximize, and Supply equals Demand (markets clear) under the assumptions that firms and consumers are price-takers, firms are owned by consumers, all goods are private goods, and there is perfect information.)

Answer 1

Competitive Equilibrium in microeconomics is defined as an economic condition where the supply of goods and services satisfies the demand for goods and services thereby making both producers and consumers satisfied. The price for the good or service is well accepted by both producers and consumers as providing them maximized profit and maximized utility respectively. Moreover, in a Competitive equilibrium, there is large number of suppliers who compete for the best price and the consumer is generally the price taker. The consumers are perfectly aware about the market and have all the necessary information to choose the right product.

                               Whereas, Pareto Efficiency is an absolute condition of satisfaction or utility, where, every individual, be it the consumers or producers, are all in their optimal state of satisfaction, i.e. they have attained the maximum utility, and there is no other condition or situation available which could further increase their utility without negatively affecting the utility of another individual. In other words, Pareto efficiency is an economic condition where the satisfaction or utility of one individual cannot be made better off without making another individual’s utility worse off.

                         It is accepted that a competitive equilibrium is always Pareto efficient, because whenever market achieves competitive equilibrium, it directly satisfies all conditions of Pareto efficiency, i.e. the market is in perfect state where all factors in a market are satisfied and in perfect equilibrium. For example, if a market is in competitive equilibrium, then we cannot further increase the profit of the producers without reducing the utility of the consumers and cannot further increase the utility of the consumers without reducing the profit of the producers. If the competitive equilibrium condition in a market is tempered with to achieve more profit or utility, then the market no longer remain in Competitive equilibrium.

                       But Every Pareto efficient condition is not necessarily a competitive equilibrium. Let us explain this scenario with the help of an example:

                       Let us suppose that in a market, there are a total of 100 apples. Consumer A and Consumer B are the only two individuals in the market. Now, it is possible that in an extreme condition of Pareto efficiency, Consumer A has all the 100 apples and he is satisfied with exactly 100 apples, and Consumer B does not have any apple and he is also perfectly satisfied with having exactly no apples. This extreme condition is also satisfying Pareto efficiency, as both the individuals are perfectly satisfied or are attaining maximized utility with this given condition. But this condition does not satisfy the requirements of competitive equilibrium, as in a competitive equilibrium their utility or satisfaction received by both the individuals must be equal or there must not be unequally of profit or satisfaction. Hence, we can conclude that every competitive equilibrium is Pareto efficient, but all Pareto efficient conditions is not necessarily a competitive equilibrium.