Pareto Optimal

(Efficiency in Exchange)

Econ 102 SS AY 2019-2020

Economic efficiency
• Economic Efficiency > Pareto optimal
• An allocation is Pareto optimal when it is impossible to make
someone else better off without making someone else worse off.

• Efficiency in product mix: What to produce?

• Efficiency in production: How to produce?
• Efficiency in exchange: For whom to produce?
Efficiency in Exchange
• To prove that this is the efficiency in exchange condition, we show
𝐴 𝐵
that any time that 𝑀𝑅𝑆𝑋𝑌 ≠ 𝑀𝑅𝑆𝑋𝑌 we can still improve the current
condition through reallocation of goods between A and B
• Pareto Optimality
• An allocation is already PO if we can no longer make one individual better off
without making the other individual worse off
• Pareto Improvement
• An increase in the societal welfare as a result if reallocation of resources (no
change in 𝑋ത and 𝑌ത
Efficiency in Exchange
Given:
• Consumers: A and B
• Goods: X and Y
Constraint:
• X and Y are fixed at any given point in time:
𝑋 = 𝑋ത Y = 𝑌ത
𝑋𝐴 + 𝑋𝐵 = 𝑋ത 𝑌𝐴 + 𝑌𝐵 = 𝑌ത
• Efficiency in exchange condition:
𝑴𝑹𝑺𝑨𝑿𝒀 = 𝑴𝑹𝑺𝑩 𝑿𝒀
Efficiency in Exchange
• Suppose Keynes and Crusoe were living in an isolated island.
• Collectively, they have 50 cords of firewood and 80 bars of candy and
no way of producing more of either good.
Keynes’ endowment: WoodK = 30 and CandyK = 20
Crusoe’s endowment: WoodC = 20 and CancyC =60
Efficiency in Exchange
Keynes’ endowment Crusoe’s endowment

Panel C is called an
Edgeworth box, which
Keynes’ wood

illustrates trade between two

Crusoe’s wood
people with fixed
Keynes’ candy
endowments of two goods
Crusoe’s candy

Crusoe’s candy
• Keynes prefers bundles in

Crusoe’s wood
A and B to e
• Crusoe prefers bundles in
B and C to e
Keynes’ candy

Keynes’ candy
 Efficiency in exchange
Crusoe’s candy
The contract curve contains all the
Pareto-efficient allocations

Crusoe’s wood
At any point on the contract curve,
no further trade is possible. We
can’t reallocate goods to make one
of them better off without harming
the other.
• At a Pareto-efficient
Keynes’ candy

equilibrium, the marginal rates

if substitution between people
Keynes’ candy
are equal because their
indifference curves are tangent.

Keynes
Crusoe