NAME MUSVOVI GEORGE

REG NUMBER R151648D

PROGRAMME MEC

COURSE MICROECONOMICS (MEC 521)

LECTURER DR MUMBENGEGWI

ASSIGNMENT 6

1. Given a 2 person, 2 input, 2 output, 2 firm model of a simple economy

with production, in which persons A and B are endowed with resources N
and R which they utilize to produce two outputs X and Y, formulate this
as a constrained optimization problem and derive the following Pareto
Optimality Conditions for this economy:

a) Exchange Efficiency condition: or (efficiency in

consumption)
b) Input Supply Efficiency condition (efficiency in input
supply)
c) Production Efficiency Condition: (efficiency in input use)
d) Product mix (efficiency in output
composition)

2. Demonstrate that a competitive general equilibrium is Pareto optimal.

1) Preliminary Assumptions under pareto efciency conditions

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 We derive a set of conditions which a Pareto efficient allocation must satisfy
by con-sidering a simple economy in which there are two consumers, two
goods, two inputs and two rms. Individual h has the utility function
u h(xh1, xh2, zh) where xhi is hs consumption of commodity i and zh is hs
supply of an input. An input can be numbered according to which
individual supplies it. The individuals initial endowments of resources a r e
N and R. With non-satiation, the marginal utility of commodity i for
individual h is always positive: u i h >0(i = A, B; h = A, B) and the marginal
utility to h of supplying more of input h is always negative: u z h < 0.
Firm i produce the total output xi of commodity i according to the
production function

xi =f i(R, N) i =1, 2..(1)

It is impossible for the total consumption of good i by individuals to

exceed the output of rm i and for the total use of input h by the rms
to exceed the supply by individual h:

2
xi > xhi where i= 1, 2 [2] h=1
2
zh > zih where h = 1, 2 [3] i=1

Our assumptions that consumers are not satiated and that marginal
products are positive means that these material balance requirements
will bind as equalities in a Pareto efficient allocation.
Feasible allocations must also satisfy the constraint that the supply
of input cannot exceed individual hs initial endowment of N and R .

A Pareto efficient allocation is the solution to the problem

U A ( X A , YA , N A , R A ) U B ( X BYB , N B , RB )
max s.t

and equation [1], [2] and[3]

The Lagrangean for the Pareto efciency problem is

L U A ( X A , YA , N A , RA ) U B ( X BYB , N B , RB ) U 1 ( X X A X B ) 2 (Y YA YB )
B

1 ( N N A N B ) 2 ( R RA RB ) 1 ( g ( N A , RA ) X ) 2 ( f Y ( N B , RB )
X

2
 [5]
The rst-order conditions are
L
U XAA 1 0
X A
[6]

L
U YAA 2 0
YA
[7]

L
U XBB 1 0
X B
[8]

L
U YBB 2 0
YB
[9]

Efficient Consumption

U XA A 1 U X B
B

U YAA 2 U XB B
[10]

Therefore:

MRS XA ,Y MRS XB ,Y

MRS measures the rate at which individual is willing to substitute

commodity x for commodity y it is the marginal valuation of commodity
X in terms of commodity Y. Consumption cannot be efcient if the
individuals have different marginal valuations of the goods. Thus suppose

A B
MRTS XY
5 MRTS XY
that the and = 3, so that individual A is willing to
give up ve units of com-modify Y to acquire one unit of commodity X
whereas individual B is only willing to give up three units of commodity Y
in exchange for one unit of commodity X. Then transferring four units of

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 commodity Y from individual A to individual B and 1 unit of commodity X
from individual B to individual A will make both individuals better off.
Hence the initial situation cannot have been Pareto efcient and equality of
MRS is a necessary condition for a Pareto efcient allocation of goods
among consumers.

b) Efficient input supply

L
U NA 1 0
N
[11]

L
U RB 2 0
R
[12]

The left-hand side of [14] is individuals marginal rate of substitution between

his input supply and consumption of commodity X and Y. It is the rate at which
individual must be compensated by being given more of commodity if he
increases his supply by one unit .The right-hand side is the marginal product of
in the production of commodity x or y. Pareto efciency requires that the
additional output produced by an extra unit is just equal to the marginal cost, in
terms of good R and N..
c) Efficiency in input use

L
1 g NXA 1 0
N A
[13]

L
1 g RXA 2 0
R A
[14]

L
2 f NYB 1 0
N B
[15]

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 L
2 g YRB 2 0
RB
[16]

1 g NX A Y
1 2 f N B

1 g RXA 2 2 f RYB
[16]

MPNXA MPNYB

MPRXA MPRYB
[17]

MRTS NX, R MRTS NY , R

Only allocations where the isoquants are tangential are efficient and since the slope
MRTS NX,R MRTS NY , R
of an isoquant is the firms MRTS this yields as a necessary
condition for efficient use of a given supply of inputs. (We h a v e follow the same
procedure used to derive [13]). The ratio of the marginal products f R/f N is the
marginal rate of technical substitution MRTS of input R for input N in the
production of good X or Y. Equality of marginal rates of technical substitution
across rms is necessary for efciency.

d) The last set of conditions are those necessary for the mix of outputs X,
and Y produced by the rms to be efcient. With Efficient in Output Mix
we want the mix of outputs produced to be efficient with input supply
MRT MRS
held constant. .
1 1 0
Making use of the fact that from [12] we can rearrange [11] to
get
L
1 1 0
X
[18]

5
L
2 2 0
Y
[19]

1 1
From

1 g NX A 1

1
g NXA
1
(i)

2
g RXA
1
.. (ii)

1
f NYB
2
(iii)

2
f RYB
2
. (iv)

Dividing the condition on good 2 by the condition on good 1 gives the efcient output mix
condition
f NXB 1 1 1 1
MRT XY Y
MRS XY
A
MRS XY
B

g Na 2 1 2 2
[20]

MRT is the marginal rate of transformation between the two goods.

Figure 2 illustrates the necessity of the efcient in output condition. With a

given supply of inputs the production possibility set for the economy is the
set of all out-put combinations on or inside the production possibility curve
PP. The production possibility set is generated from the production
Edgeworth box whose sides measure the given input supplies. Assume that

the allocation a 0 of the total output between consumers is also efcient, so

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that a 0 is on the locus C 0 of points of tangency of their indifference curves.

Suppose, however, that the common slope of their indifference curves at a 0

is not equal to the slope of the production possibility curve at A0, thus

violating condition [19]. Since the indifference curves at a0 have a steeper

slope than PP at A0, consider shifting inputs from rm 2 to rm 1, moving

down PP to A1. This movement gives rise to a new con-sumption Edgeworth

box with the same O1 origin but with O 2 shifted to A1. We give individual B
the same consumption bundle as he had in the original Edgeworth box.

Figure 1
Y

Thus the consumption allocation is now at a1 where the distance from

a1 to A1 is 2the same as the distance from a 0 to A0 so that individual

2 has the same consumption bundle. Individual Bs utility is
unaffected by the change in the output mix. Individual As

consumption is still measured from O. He is better off at a1 than at

a 0 since a1 lies above his indifference curve through a 0. Hence the

change in the allocation from (A0, a 0 ) to (A1, a1) is a Pareto

improvement and the initial allocation was not Pareto efcient.

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2) Demontration that a competitive equilibrium is a pareto optimal

An Edge worth box is used to demonstrate the existence of competitive

equilibrium which is pareto optimal. The horizontal side of the box measures
a xed total output of good X and the vertical side measures a xed total
output of good Y. Individual As consumption of good X is measured

horizontally from the origin at 0A and her consumption of good Y

vertically from 0A. Similarly, individual Bs consumption is measured from

the origin at 0 B. Line AB is the budget line for both individuals A and B. The
assumption of non-satiation means that it cannot be efcient to have total
consumption of any good less than the output of the good. Hence we
restrict attention to consumption bundles for the individuals which add up
to the total output of the two goods.

Figure 2

The edge-worth box reveal that a single point denes a consumption

bundle of both individuals. Since we are holding the individuals
labour supplies constant we can draw their indifference curves for the
two commodities in the box. The individuals have strictly quasi-
concave utility functions so that their indifference curves are convex

to their respective origins. The allocation A0 is not Pareto optimal

since it is possible to transfer commodities between the individuals

so as to make them both better off. For example the allocation A1 is

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Pareto superior to A0 since it puts both individuals on indifference
curves further from their respective origins.
No allocation in the box where the indifference curves cross can be Pareto

optimal. Allocations where the indifference curves are tangent as at A1,

A3 or A4 are efcient.
The locus CC of points of tangency between the indifference curves is
the set of all Pareto efcient allocations of the given total outputs
measured by the sides of the box. In a simple pure exchange economy
with consumers having a xed endowment of consumption goods,
the efcient consumption conditions are all that is required for Pareto
optimal. Since A 1 is on the contract curve CC the competitive
equilibrium is a Pareto optimal .