Pareto and social optimality

Pareto Optimality / New Welfare Economics:

The New Welfare Economics represents a break with the utilitarian tradition in Economics. The
new welfare economists claim to arrive at optimum conditions of production and exchange
without adding the utilities of different persons or comparing the satisfactions of different
individuals. The new welfare economics is claimed to be objective and scientific and not
ethical. It is said that welfare economics furnishes an analysis of the causes governing the
measure of welfare or an increase or decrease thereof. Italian born Vilferdo Pareto is said to be
the pioneer of new welfare economics, although there have been introduced some subsequent
refinements since then.

The Italian Economist Vilferdo Pareto has laid down the conditions for maximising social
welfare or for achieving a social optimum. A Paretian optimum refers to a situation in which
it is impossible to make any one better off without making some one worse off. For judging such
a situation, Pareto has enunciated a very simple and straightforward criterion thus: "Any change
which harms no one and which makes some people better off (in their own estimation) must be
considered to be an improvement."

In the following diagram, an example of a community is taken, in which there are only two
persons X and Y:
The utility of X is represented along horizontal axis and that of Y along the vertical axis. The
Pareto criterion states that if we start off from a situation which is represented by a point like A,
then a policy change by the Government is an improvement if it results in a move to any point
like B or C which lies to the right of A or above. At B, X is better off than at A with Y as well
off as before, whereas the move to C benefits Y without harming X and the move to D, benefits
both the persons.

Conditions of Paretian Optimum:

The conditions of Paretian optimum are given below:

(a) Optimum Allocation of Products: Allocation of products to be optimal must be such as to

make it impossible for any pair of individuals to exchange any quantity of any pair of consumer
goods resulting in increase in one's satisfaction without decreasing that of another. That is, if any
alternative allocation can increase some one's satisfaction without decreasing another's, it is not
optimal. To put in terms of indifference curve technique, the marginal rate of substitution
(MRS) between any two good must be same for any pair of owners of the same two goods. We
know that MRS is the rate at which units one good can be exchanged for the units of another
without lowering the level of satisfaction.

This can be explained with the help of an Edgeworth Box diagram. The Edgeworth diagram for
consumption shows the indifference curve preference maps of the two individuals and their
derived levels of satisfaction from the various combinations of goods. The indifference curve
preference maps of both A and B have been combined and shown with the help of an Edgeworth
Box in the following figure:
The indifference curve preference map of A starts from origin O, whereas the indifference curve
preference map of B starts from origin O'. I1 to I8 represents the indifference curves of
individuals A and B. I1, I2, I3 and I4 represent the indifference curves of individual A, and I 5, I6,
I7 and I8 represent the indifference curves of individual B. The slope of an indifference curve, as
we know, at any point is the marginal rate of substitution between commodities X and Y
(MRSxy). The point would be optimal where the MRSxy of both individuals are same. If the
MRSxy is not the same, then with the help of exchange, it is possible to increase the level of
satisfaction of one without diminishing that of the other. Now if we joint the points L, M, N, P
where the different sets of indifference curves of individuals A and B are tangent to each other,
we get a curve known as 'Contract Curve', i.e., cc'. The points L, M, N and P lie on the contract
curve cc'. At each of these points, the MRS xy for A and B is the same. Therefore, each point
along a contract curve cc' represents a point of Pareto-optimality. In other words, any
redistribution of the goods X and Y between A and B will yield a lower level of satisfaction.

(b) Optimum Degree of Specialisation: It refers to the condition that the marginal rate of
transformation (MRT) between any two goods must be the same for any pair of firms producing
both of them. The MRT between two goods is the amount of one good which would have to be
sacrificed to produce one unit of another good. This only means the ratio of marginal
opportunity cost of the two goods. Obviously, if MRT is not the same for any pair of producers,
it would be possible to increase the combined output of the two goods or increase the output of
one without decreasing that of another. This will mean that the present degree of specialisation
is not the optimum.
(c) Optimum Factor Utilisation: This represents optimum relationship between the factor and
the product. The utilisation of a factor will be optimal if the marginal rate of transformation
(MRT) between any factor and any product is the same for any two firms using the factor and
producing the product. If MRT is not the same, it will be a departure from the optimum.

(d) Optimum Allocation of Factors: All factors of production must be so allocated among the
various uses that the marginal production in each use is that same. If it is not the same, it will
pay to shift some units of a factor from one use to another. In terms of new economics, the
marginal rate of technical substitution (MRTS) between any pair of factors must be the same for
any two firms using both to produce the same product. Only then, the allocation will be
optimal. If it is not, it will be possible to increase the total product by shifting a factor from one
firm to another.

(e) Optimum Direction of Production: Another condition for maximising welfare is that the
marginal rate of substitution between any pair of products for any person consuming both must
be the same as the marginal rate of transformation for the community between them. In terms of
utility analysis, it means:

(i) That the ratios of marginal utilities of the two goods must be the same for all consumers, i.e.,

MU of A = MU of B and so on.
Price of A Price of B

This will represent maximum satisfaction of the consum

(ii) The ratio of their marginal costs must be the same for all producers producing them, i.e.,

MC of A = MC of B and so on.
Price of A Price of

(iii) These ratios must be equal.

This condition relates to the maximum efficiency of the economic system. The goods must be
produced in such combinations that they not only conform to consumers' preferences but are also
produced at the minimum average cost. If it is technically possible to substitute one good for
another and make one better off without making another worse off, the production is not optimal.

Let us take a community producing two goods.

The quantity of each good it produces will depend on its factor endowments and on its existing
technical knowledge. By factor endowments we mean the amounts of factors of production the
community possesses. Let us assume that the community can produce either 100 bushels of
wheat or 100 yards of cloth when all its factors are fully and most efficiently employed in the
production of either wheat or cloth respectively. The various combinations of wheat and cloth
that it can produce are shown by the 'production possibility curve' or the 'transformation curve'. If
the community chooses to produce wheat only, it can produce 100 bushels. If it would also like
to produce cloth, it must forgo the production of some of its wheat. The amount of wheat, which
the community foregoes in order to have an extra unit of cloth, is known as the 'opportunity cost'
of wheat in terms of cloth.

In the following diagram, the community's production possibility curve drawn on the assumption
of increasing opportunity cost. The meaning of increasing opportunity cost is that the amount of
extra wheat the community produces by decreasing production of cloth with given factors is
steadily increasing.

Let us superimpose the indifference curve preference map, i.e., I1 and

I2 of an individual A on AB production possibility curve. Now the Pareto-
Optimal point would be where the slope of production possibility curve AB and
of the indifference curve (A) is the same or tangent. In this diagram, point P is
the optimal point, as the slope of the indifference curve I2 and PB on curve AB
is the same. The point Q is not the point of optimum.

(f) Optimum Allocation of a Factor-Unit's Time: The owner of a factor unit

has the option of using the factor to render him a direct service or hiring it out
to others for aiding in production. Hence, the problem for the owner of a
factor is to allocate the time of factor rendering direct services or working for a
money reward in an optimal manner.

(g) Inter-Temporal Allocation of Assets: Every individual firm has to bring

about an optimal allocation of factor inputs and product output over time. A
firm may produce a given output stream with various time patterns of factor
inputs and conversely, it may have various time patterns of outputs with a
given input stream of factor services. It refers to the allocation of products or
factors that may relate to different moments of time. In this case, the
allocation will bring maximum welfare when the marginal rate of substitution
between any pair of moments is the same for every pair of individuals or firms.

The above-discussed conditions are also known as 'First-Order

Conditions'. From the above first-order conditions, the Pareto-Optimality can
be attained. But the fulfilment of these first-order conditions may not be
enough to lead to welfare optimality. To achieve an optimum welfare position,
it is very necessary that the 'Second-Order Conditions'along with the first
order conditions should also be satisfied to achieve the maximum
welfare. These second order conditions are no other than the stability
conditions for equilibrium position. The fulfilment of second order conditions
means that all the indifference curves and the production possibility curves
should have the right curvature in the neighbourhood of any position where
marginal conditions are satisfied. In the neighbourhood of maximum welfare,
all indifference curves must be convex to the origin and all transformation
curves must be concave to it.

In the following figure, AB is the production possibility curve of the community,

I1 and I2 are the indifference curves of an individual. The point b is a point of
optimum welfare as the indifference curve I2, is a tangent to the production
possibility curve AB. At point a, the indifference curve I1 is also a tangent to
the production possibility curve AB but it is not a point of optimum welfare, as
by moving from a to b, the community reaches on a higher indifference curve
I2.
Relation between Pareto Optima and Perfect Competition:

(a) Equality of Marginal Rate of Substitution: Under conditions of perfect

competition, the consumer in order to maximise satisfaction makes the
marginal rate of substitution between any two goods equal to the ratio of their
prices. At equilibrium, the MRS between two goods is equal to the ratio of
their prices for any consumer. Therefore, the first condition of optimum
allocation of goods of Pareto-optimality is satisfied under perfect competition.

(b) Equality of Marginal Rate of Transformation b/w Two Factors: Under

conditions of perfect competition, in order to have minimum cost combination
of the factors to produce a given output tries to equate the marginal rate of
transformation (MRT) between two factors to the ratio of their prices. At
equilibrium, this condition of equating MRT between two factors to the ratio of
their prices is satisfied. Hence, the condition about the optimum allocation of
factors is also satisfied.

(c) Equality of Marginal Rate of Transformation b/w Two

Commodities: The producer under perfect competition, in order to maximise
the profits, tries to equate the marginal rate of transformation (MRT) between
two commodities to the ratio of their prices. At equilibrium, this condition of
equating MRT between two commodities to the ratio of their prices is
satisfied. Hence, the condition about the optimum utilisation of a factor is
satisfied.

(d) Equality of Marginal Product of Each Factor: The producer in order to

maximise his profits tries to equate the marginal product of each factor to its
price and, at equilibrium, this condition is satisfied. Therefore, the condition of
optimum factor-product relationship is satisfied.
(e) Equality of MRS to MRT b/w Two Commodities: Under perfect
competition, at equilibrium, the marginal rate of substitution (MRS) between
the two commodities is equal to the marginal rate of transformation (MRT)
between the two commodities and both are equal to the ratio of their
prices. Therefore, the condition about the optimum direction of production is
also satisfied.

(f) Equality of MRS & MRT: Under perfect competition, a factor will be
utilised to the point where the marginal rate of substitution (MRS) between
employment of the factor and its leisure equals the rate of payment made to
it. Similarly, with a view to maximising his profit, a producer equates the MRT
between the factor and its product. Since the price of the product is the same
for all the producers and rate of payment is the same for all the factor units,
the condition of optimum allocation of a factor unit's time is also satisfied.

(g) Equality of Marginal Productivity of Asset: An owner of an asset makes

the MRS between present income and future income equal to his rate of time
preference. In the same way, a borrower of the asset equates the cost of
borrowing with the MRS between the present asset and future asset. Since
under perfect competition, the rate of payment for all similar assets is the
same, as also the cost to the borrowers, it is equal to the marginal productivity
of the asset. In this way, the condition of inter-temporal optimum allocation of
assets is also fulfilled under perfect competition.

From the above it is clear that under perfect competition all the marginal
conditions of Paretian-optimum are satisfied.

Obstacles to Welfare Maximisation:

If maximum welfare is to be attained, optimum allocation of factors of

production is essential. This allocation must be in keeping with the
consumer's preferences. For this purpose, there must prevail perfect
competition. But, in the real world, there is no perfect competition, instead
there is imperfect competition. This constitutes a big obstacle in the way of
the attainment of maximum welfare. We shall see how different forms of
imperfect competition stand in the way of welfare maximisation:

(a) Monopoly: By pursuing restrictive price and output policies, the

monopolists exploit the consumers' weakness by charging exorbitant prices
and by restricting output. They reduce the national income. In all these ways,
they reduce social welfare, especially because they cause misallocation of
productive resources.
Under monopoly, the monopolist faces a downward sloping demand curve
(instead of horizontal straight line as under perfect competition). Hence, the
marginal revenue is less than average revenue / price. In order to maximise
profit, the producer will equate marginal cost and marginal revenue. His
marginal cost is less than the price or price is kept higher than the marginal
costs. Thus, the monopolist does not operate at the optimum output
level. This means higher prices for the consumers and lower remuneration for
the factors of production. By creating a divergence between factor price and
the value of its marginal product, a monopoly distorts factor allocation. Too
little resources are used in monopolised industries, which is not in conformity
with consumer's preferences.

(b) Monopsony: It is a buyer's monopoly. Firstly, take the case of

monopsony in factor market, where a firm is compelled to pay higher prices
for factors in use. Hence, the marginal cost of the factor will exceed its price
per unit. For profit maximisation, the factor will tend to be used up to a point
where its marginal cost is equal to its marginal revenue product. But as said
above, marginal cost exceeds price. Hence, the price paid to the factor is less
than marginal product. Thus, the factor is not being paid its worth, which
shows a faulty allocation of factors which in turn militates against welfare
maximisation.

Take the case of monopsony in product market. In this case, the marginal
cost of the product will be higher than the price paid by the monopsonist. The
quantity purchased will be smaller and the price paid lower than under
competition. This represents misallocation of resources in the economy.

(c) Monopolistic Competition: In this case, there are too many firms in the
industry operating at less than optimum scales of output having excess
capacity which is socially wasteful. Product differentiation compels
waste. Hence there is a reduction in social welfare.

(d) Oligopoly: In pure oligopoly (without product differentiation), there is a

misallocation of resources and hence a reduction of social welfare. In this
case, a dominant firm determines the price and output policy. In order to
maximise profit, the firm equates marginal cost with the marginal
revenue. But the price will exceed marginal cost and distort resource
allocation.

Market Structure and Social Welfare:

In the Paretian sense, if a policy change makes at least one individual better
off without making any one worse off it is said to maximise social welfare. Let
us see how this social optimum can be attained under different market
structures:

(a) Social Welfare under Perfect Competition: To achieve maximum social

welfare under perfect competition, the allocation of resources needs to be
efficient. For allocation of resources to be efficient, it is necessary that the
MRS between any two commodities for a consumer is equal to the MRT
between these two commodities is equal from producer's point of view. This
would lead to:

 The equality of the ratio of marginal utilities and the ratio of commodity
prices for the consumers, which would result in maximum satisfaction;
and
 The equality of the ratio of marginal costs and the ratio of commodity
prices for the producers, which would result in maximum profit.

This situation is possible only in perfectly competitive market.

The conditions of perfect competition also bring about the equality between
the private marginal product and social marginal product. The basic condition
for maximum welfare is that social marginal utility be equal to social marginal
cost:

Maximum Social Welfare = Social Marginal Utility = Social

Marginal Cost

The equality between private marginal utility and social marginal utility will
depend upon the distribution of money income in the community. The
distribution must be such as would equalise its marginal utilities for all the
consumers. The marginal cost of producing any alternative commodity would
be the same as for the one that is being produced. This will lead to equality
between private marginal cost with private marginal utility and hence the
social marginal utility and social marginal cost. This is how conditions of
perfect competition result in the attainment of maximum social welfare.

(b) Monopoly: The conditions of efficient allocation of resources do not exist

in a condition of monopoly, therefore, the maximum social welfare cannot be
attained under monopoly. The monopoly equilibrium is based on the equality
of marginal revenue and marginal cost. Under conditions of monopoly, price
is greater than marginal revenue of output and also the marginal cost. The
inequality of price and marginal cost represents the violation of basic condition
of efficient allocation of resources and hence maximisation of social
welfare. Following things are happened under monopoly:

 Under monopoly, the entrepreneur neither achieves optimum levels of

production nor does he like to achieve it.
 A productive factor is not paid according to its marginal productivity
because, simply under monopoly, the price exceeds the marginal cost
of a commodity.
 Since productive factors do not get paid according to their marginal
productivity under monopoly, they are not attracted to this form of
business enterprise / industry to the fullest extent; whereas in the
interest of maximum social welfare, it is necessary that the factors must
be employed where their marginal productivities are at their highest
points.

It is thus clear that monopoly form of business is not consistent with the
maximum social welfare. Whatever the form of monopoly, whether in the
commodity market or in the factor market (monopsony), it works as a
hindrance to the achievement of maximum social benefits.

(c) Monopolistic Competition: Under monopolistic competition, efficient

allocation of resources is not as possible as compared to perfect
competition. Under monopolistic competition, in the short run, the demand
curve is not tangential to the average cost curve at its lowest or optimum
point. On the other hand, the demand curve is tangential to the average cost
curve at a point higher than the optimum scale point. It is shown in the
following diagram:
Since the levels of output are not optimum, the allocation of productive
resources under monopolistic competition cannot be termed as efficient as in
the case of perfect competition. If social welfare is to be maximised there
must be fullest use of installed capacity. However, in the long run, the total
efficiency achieved can be summed up to the level of maximum social
welfare. Because in the long run, the long run average revenue curve or the
demand curve is tangent to the long run average cost curve at its lowest point
or the optimum point. Which is because of greater divisibility of the factors of
production in the long run. In the long run, the indivisible factors of production
can be used more economically because, in the long run, they are, in fact, to
extent, divisible. In the long run, the cost curves depend on 'returns to
scale'. In the long run, the amount of capital can be altered and the
management can be arranged differently. If all the factors of production can
be used in varying proportions, it means that the scale of operations of the
firm can be changed. Consider the following diagram:

The concept of Pareto-optimality thus assumes that anyone would prefer an option that is
cheaper, more efficient, or more reliable or that otherwise comparatively improves one’s
condition.

The concept of Pareto-optimality is often not very discriminating. A state of affairs x is Pareto-
optimal provided that for any alternative state of affairs y, one can find at least one person who
strictly prefers x to y. If one takes a wide view of preferences and includes preferences informed
by moral principles or other sentiments, such as envy, then many states of affairs satisfy that
condition.
The set of states of affairs and the set of people whose preferences are relevant for determining
Pareto-optimality depend on the context. For example, in the first and second fundamental
theorems of welfare economics, the set of people includes every member of the economy, and
the set of possible states includes every technologically feasible allocation of commodities.
Alternatively, the equilibrium created by the model known as the prisoner’s dilemma (the Nash
equilibrium) is said to be Pareto-suboptimal because each individual prefers an outcome different
from the outcome resulting from the equilibrium strategies.

The set of states of affairs and the set of people whose preferences are relevant for determining
Pareto-optimality depend on the context. For example, in the first and second fundamental
theorems of welfare economics, the set of people includes every member of the economy, and
the set of possible states includes every technologically feasible allocation of commodities.
Alternatively, the equilibrium created by the model known as the prisoner’s dilemma (the Nash
equilibrium) is said to be Pareto-suboptimal because each individual prefers an outcome different
from the outcome resulting from the equilibrium strategies.