Question

Competitive markets generate a Pareto efficient outcome. Illustrate and explain, using the two fundamental theorems of welfare economics.

Answer 1

A situation/ allocation / outcome is Pareto efficient when no one party can be rendered better off without the other being made worse off. The outcome of a competitive market is Pareto efficient . The demand & supply diagram for a perfectly competitive market reveals a downward-sloping demand curve & an upward- sloping supply curve. Market-clearing / equilibrium price level is established by the intersection of market supply & market demand. At this price level consumer surplus is denoted by the right-angled triangle over the equilibrium level of price & under the market demand curve & producer surplus by the right-angled triangle under the equilibrium level of price & over the market supply curve. At this price level the total surplus / welfare gains are maximised & neither the firms nor the customers can be made better off i.e. experience a rise in surplus without the other experiencing a surplus loss. Consumer surplus is the discrepancy between what the customers are willing to pay & what they really pay. Producer surplus is the discrepancy between what the firms are willing to accept & what they really accept in return for their output. The market outcome of perfect competition is thus Pareto efficient. In a monopoly ,on the other hand ,the profit-maximising monopolist fixes a price level where MC=MR, limiting output & raising the level of price over & above the market-clearing level. This lessens consumer surplus & augments producer surplus. However, at the prevailing market price there are customers who are ready to pay more than MC for additional units. The monopolist can thus augment its profit by manufacturing more units & this would augment consumer surplus also. Both the monopolist & the customers can be made better off. This implies that the outcome in a monopoly is Pareto inefficient as either the producer or the customers or, actually, both sides can be made better off without the other being rendered worse off.