Efficiency in Exchange

As we know, competitive market is efficient because it maximizes consumer and producer surplus. Exchange economy : Market in which two or more consumers trade two goods among themselves. Efficient allocation (Pareto Efficient) : Allocation of goods in which no one can be made better off unless someone else is made worse off.

Chapter 16 (16.2)
Efficiency in Exchange

P O Tuitional EBA Microeconomics

The advantage of trade

Individual V New Initial Allocation Trade Final Allocation 7F,1C -1F,+1C 6F, 2C 3F, 5C +1F,-1C 4F,4C

The actual terms of trade depend on the bargaining process. Among the possible outcomes are trade of 1F by V for anywhere between and 3 units of clothing from New. Economic efficiency: The two consumers MRSs must be equal. MRSV = MRSNew

New has a lot of clothing and little food, her MRS of food for clothing is 3:1, she will give up 3 C for 1 F. Vs MRS of food for clothing is . V values clothing more highly than New does, whereas New values foods more highly than V does.

The edgeworth Box Diagram

10F 6C

Find point A that represents the initial allocation. 0New After trade point at B. We can see the effect of trade between V and New. Point B represents the market basket of both New and V after the mutually beneficial trade.

0V

6C 10F

Efficient Allocations
A trade from A to B thus made both better off. But is B an efficient allocation? The answer depends on MRSs, which depends in turn on the shape of their indifference curves. As we will see, B is not an efficient point because indifference curve of them intersect. See book, page 586-587. 0V

The Contract Curve

0New

 The contract curve : Curve showing all efficient allocations of goods between two consumers, or of two inputs between two production function. These allocation are efficient because there is no way to reallocate goods to make someone better off without making someone else worse off.

Consumer Equilibrium in a Competitive Market

In Competitive market, Jame and Karen are price taker. An equilibrium is a set of prices at which the quantity demanded equals the quantity supplied in every market. Not all price are consistent with an equilibrium, if the price of food is 1 and the price of clothing is 3, food must be exchange for clothing on a 3-to-1 basis. The market is therefore in disequilibrium This disequilibrium should be only temporary.

The Economic Efficiency of Competitive Markets

Efficiency: must occur at the tangency of two indifference curve. Because the indifference curves are tangent, all marginal rates of substitution between consumers are equal. Because each indifference curve is tangent to the price line, each persons MRS of clothing for food is equal to the ratio of the prices of the two goods. MRS1=PC/PF=MRS2

Comprehensive Problem
Ki has 3 liters of soft drinks and 9 sandwiches. V has 8 liters of soft drinks and 4 sandwiches. With these endowments, Kis MRS of soft drinks for sandwiches is 4 and Vs MRS is equal to 2. Draw an edgeworth box diagram to show whether this allocation of resources is efficient.

Comprehensive Problem
Fill in the missing information in the following tables. For each table, use information provide to identify a possible trade. Them identify the final allocation and a possible value for the MRS at the efficient solution. (a) Normans MRS of food for clothing is 1 and Ginas MRS of food for clothing is 4: Individual Initial Allocation Trade Final Norman 6F,2C Gina 1F,8C

(b) Michaels MRS of food for clothing is 0.5 and Kellys MRS of food for clothing is 3. Individual Initial Allocation Trade Final Michael 6F,2C Kelly 1F,8C

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