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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
Welfare Economics
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Pure Exchange Economy
• Economy with
– 2 people (Adam & Eve)
– 2 commodities (Apples & Figs)
– Fixed supply of commodities (e.g., on a desert island)
• An Edgeworth Box depicts the distribution of goods
between the two people.
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Figure 3.1
Pure Exchange Economy
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Pure Exchange Economy
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Pure Exchange Economy
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Figure 3.2
Pure Exchange Economy
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Figure 3.3
Pure Exchange Economy
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Pure Exchange Economy
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Figure 3.4
Pure Exchange Economy
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Figure 3.5
Pure Exchange Economy
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Figure 3.7
Pure Exchange Economy
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Pure Exchange Economy
MRS Adam
af MRS Eve
af
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Production Economy
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Figure 3.8
Production Economy
MCa
MRSaf MRSaf
Adam Eve
MC f
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First Fundamental Theorem of
Welfare Economics
• Assume that
– All producers and consumers act as perfect competitors (e.g.,
no market power)
– A market exists for each and every commodity
• Under these assumptions, the first fundamental theorem
of welfare economics states that a Pareto efficient
allocation will emerge.
• Implication: Competitive economy automatically allocates
resources efficiently, without central planning.
• Conclusion: Free enterprise systems are amazingly
productive.
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Second Fundamental Theorem of
Welfare Economics
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Figure 3.10
Second Fundamental Theorem of
Welfare Economics
W F (U Adam , U Eve )
• Could then maximize society’s preferences, or demonstrate that
some Pareto-inefficient bundles are preferred to some Pareto-
efficient ones.
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Figure 3.12
Second Fundamental Theorem of
Welfare Economics
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Market Failure
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Evaluating Policy
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Recap of Tools of
Normative Analysis
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