ECON A311

Intermediate Microeconomics

Unit 4
General equilibrium and
Pareto efficiency

241
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Contents

Introduction 1

General equilibrium 3
The Edgeworth box 6
The existence of general equilibrium 7

Pareto efficiency 10
Allocation efficiency 10
Allocation efficiency and competitive price system 13
Production efficiency 14

Production possibility frontier (PPF) 17

Interpreting the slope of the PPF 18
Production efficiency and competitive price system 19

Summary 22

Answers to self-test questions 23

 Unit 4 1

Introduction
This unit is about efficiency. You learned the definition of perfect
competition in the last unit. Perhaps you have already challenged the
validity of the assumption behind perfect competition, and argued that
perfect competition is only an ideal setting which is uncommon in the
real world.

Mainstream economists often argue, however, that the importance of

perfect competition is not based on the validity of these assumptions
(although we do find a few industries which agree quite well with the
assumptions). Perfect competition is important because it gives a
benchmark for studying the welfare implications under different market
structures such as monopoly and oligopoly. In this unit, I will show you
that under perfect competition, resources are efficiently allocated to
consumption and production.

This is, of course, a statement with very strong policy implications. If the
objective of a government is to promote efficiency, that government
should therefore design and execute policies encouraging competition.
Obviously there are cases in which government intervention is necessary,
and these cases will be the subject matter of the next two units. In this
unit, however, we’ll assume that government does not play any role in
the economy.

Obviously, if we want to assert that perfect competition is a most

desirable market structure in terms of efficiency, we have to be sure what
we mean by ‘efficiency’. We touched on this issue in the last unit.
Remember that in the long-run, a firm will generate an output level
where the long-run average total cost is lowest. You may have guessed
that this is related to production efficiency. It is. But the issue of
efficiency is more general than this.

We shall develop the concept generally referred to as Pareto efficiency as

the basis for our discussion in this unit. Moreover, we bypass all the
high-powered mathematics required for the rigorous treatment of general
equilibrium and efficiency and adopt a simpler approach. We assume that
there are only two goods and two consumers, and represent the scenario
of general equilibrium by the Edgeworth Box — a combination of the
indifference maps of the two consumers. Based on a basic concept (the
Pareto efficiency) and a basic tool (the Edgeworth Box), I shall show you
that resources are utilized in the most efficient manner if all sectors in an
economy are perfectly competitive.

To summarize, this unit:

• differentiates between partial equilibrium and general equilibrium;

• describes the general equilibrium of a two-goods world by using an

Edgeworth box;

• explains the definition of Pareto efficiency;

2 ECON A311 Intermediate Microeconomics

• constructs an Edgeworth box diagram to describe efficiency in

exchange and efficiency in production;

• explains the production possibility frontier in terms of Pareto

efficiency; and

• links the concept of competitive equilibrium to Pareto efficiency.

You will see that this is not a lengthy unit, and the readings are not
demanding in terms of quantity. However, the concepts discussed in this
unit are by no means easily comprehended, especially for those of you
who may not be used to abstract thinking. You may need to go back and
forth between this study unit and the reading materials several times in
order to get the connections between all the concepts discussed in this
unit, although I will do my best to make them clear for you!
 Unit 4 3

General equilibrium
In the last unit we studied a firm’s behaviour under perfect competition.
You should remember that the analysis was based on the assumption that
individual markets are isolated. Studying the equilibrium price and
quantity of a single market, assuming that it is isolated from other
markets, is referred to as partial equilibrium analysis.

I think you should have no problem accepting the proposition that all
markets are interrelated. General equilibrium analysis is the study of the
impact of changes in the equilibrium price and quantity of one market to
the equilibrium price and quantity of another market.

As an illustration of gereral equilibrium analysis let’s recall our

discussion of factor demand in Unit 3. The demand for inputs is
sometimes called derived demand. However, it should be clear to you by
now that output supply and input demand are simultaneously determined.
If the product market and the factor market are perfectly competitive,
both the product and factor prices are determined by the markets,
independent of the production decisions of individual firms. Faced with
market prices, a firm chooses the appropriate level of output and of input
to maximize profit. Moreover, the output and input must be constrained
by the production function. Provided that the producer is price-taker in
both the output and input markets, i.e. output price P and input price w
are given, the level of output and input must satisfy the following
conditions:

MC = P for the product market,

VMPL = w for the labour market, and

Q = f(L) the production function (assume labour as the only input).

The argument is summarized in the following figures.

Figure 4.1 The supply of output and the demand for input are jointly
determined
4 ECON A311 Intermediate Microeconomics

Since the firm is a price-taker, the firm sets the quantity demanded for
labour at L* where the marginal product of labour equals wage rate
(panel B) and output level at Q* where marginal cost equals the product
market price (panel C). Moreover, L* and Q* must be consistent with
technological constraint represented by the production function (panel A).

Note that although the demand for inputs is derived demand, and we
analyse the demand without referring to the output market, the supply of
output and the demand for input are in fact determined simultaneously
under perfect competition. The following example demonstrates this
point.

Suppose the short-run production function, with labour as the only input,
is represented as

Q = 3L0.5,

and the corresponding average product function and marginal product

function are given, respectively, as

APL = Q/L = 3/L0.5,

MPL = ∆Q/∆L = 1.5/L0.5.

We can compute the average and marginal cost function as

w w wL0.5 wQ
MC = = 0.5
= = .
MPL 1.5 / L 1.5 4.5

The marginal value product function is obtained by multiplying MPL by

P:

VMPL = P × MPL = P × 1.5/L0.5.

Finally, the output supply function derived from the profit maximization
condition, MC = P, is:

wQ
=P.
4.5

If the factor price w = 20, the supply function is

20Q = 4.5P.

Similarly, the input demand function is given by MVPL = w , i.e.

P × 1.5/L0.5 = w.

If the output price P = 100, the labour demand function is given by

150 .
L=
w

From the above computation, you can see that the output supply function
contains the information concerning the factor market in a subtle way.
 Unit 4 5

Similarly, the labour demand function contains the information related to

the output market.

Clearly, we can solve the output supply equation and input demand
equation simultaneously, and obtain the solution

Q = 100 × 4.5/20

L = 56.25.

You should be able to see that this example simply reiterates the
proposition that the output and input decisions are based on the price
information of both the product and the factor market; the decisions
regarding the two markets are interrelated and have to be made
simultaneously. In other words, given that both the output and input
markets are competitive and hence all the prices are given, and that the
technology (production function) is known, the output and input levels
are determined uniquely and simultaneously.

Now go through the following reading, which discusses, with examples,

how the disturbance in equilibrium in one market affects the equilibrium
of another market. The argument should be easy to follow.

Reading
PR (2018) 16.1 ‘General equilibrium analysis’, pp. 609–16.

You should note the profound implication of what you’ve read — the
equilibrium prices and quantities of all markets are simultaneously
determined. Of course, you would imagine that determining the
equilibrium prices and quantities of all the markets is a much more
complicated problem. The more relevant question to ask is: is it possible,
at least theoretically, that the hundreds of thousands of different markets
can be settled at an equilibrium? That is, does a state of general
equilibrium really exist? This is a formidable question to answer. You
need to be equipped with very high-powered mathematical tools such as
topology in order to rigorously address this area.

Fortunately for us, the economic intuition of general equilibrium is not

difficult to understand. I will lay out the framework of general
equilibrium analysis with the help of a simplified model of an exchange
economy of two individuals and two goods under perfect competition.
6 ECON A311 Intermediate Microeconomics

The Edgeworth box

To make the analysis simple, let’s start with a two-good, two-individual
economy. Let’s assume it is a pure exchange economy without
production. The scenario can be depicted by using the Edgeworth box.
The Edgeworth box is a pictorial description of how resources are
allocated to individuals, and is a very useful tool for analysing pure
exchange.

Figure 4.2 The Edgeworth box

In the figure given above, two resources (food and clothes) are initially
owned by two individuals (A and B), represented by the point M. The
point M denotes that the endowment of A is FA0 units of food and CA0
units of clothes, and B’s endowment is FB0 units of food and CB0 units of
clothes. The horizontal and vertical dimensions of the box represent,
respectively, the total amount of food (FT) and clothes (CT) available in
the economy, which are simply the sums of the endowments of the
individuals.

FA0 + FB0 = FT

C A0 + CB0 = CT

The light curves bowing towards OA are indifference curves representing

A’s utility. The heavy curves bowing towards OB represent B’s
indifference curves. Note that the Edgeworth box constructed in this way
is composed of two indifference maps, with the origin of B’s indifference
map located in the upper right hand corner.
 Unit 4 7

The existence of general equilibrium

Now suppose that the individuals trade their endowments under a set of
given prices of clothes and food, say, PC and PF. The prices can be
represented compactly by the price ratio PF/PC, which is the slope of the
line PP in the Edgeworth box represented in Figure 4.3 on the following
page. First, note that the line must pass through the point M, which, as
you recall, represents the initial endowment. Under this given set of
prices, the money incomes of A and B are, respectively:

IA = PCCA0 + PFFA0 , and

IB = PCCB0 + PFFB0.

The associated budget constraint, applying both to A and B, is

represented by the line PP, as shown in the following figure.

Figure 4.3 Allocation without equilibrium

Suppose that individuals are free to trade. Individual A would prefer to

consume more food and less clothes to raise her utility level. Similarly,
individual B would prefer to consume more clothes and less food.
Suppose that after trading, individual A consumes the market basket
represented by S and individual B consumes the market basket
represented by R. The prices under which the trade take place are
represented by the line PP.

It is clear that both A and B could improve their welfare under this
allocation scheme. However, this is not an equilibrium allocation because
markets are not cleared. There is an excess supply of clothes and an
excess demand for food:

FA1 + FB1 > FA0 + FB0

CA1 + CB1 < CA0 + CB0.

Since the markets are not in equilibrium, the prices in each of the markets
respond until equilibrium is attained. That is, the adjustments take place
simultaneously in all markets so that the final equilibrium consists of an
equilibrium in each of the markets.
8 ECON A311 Intermediate Microeconomics

In our Edgeworth box analysis, individual A is willing to lower the

asking price of clothes in order to sell more clothes to B, and to pay a
higher price for food to compete for more food. By doing so, individual A
achieves a higher level of utility. The reverse is true for individual B.
Thus, the slope of PP changes and the utility levels of both A and B
increase. The adjustment process will continue until an equilibrium is
reached, where each individual chooses the most preferred market basket,
and their choices exhaust the available resource in each market. This
result is shown graphically in Figure 4.4.

Figure 4.4 Equilibrium allocation

In the figure, the price line (which is also the budget constraint), passes
through the initial endowment M and the final allocation E. Note that the
line is tangent to UA and UB at point E, signifying that the utility of A and
B is maximized. Note also that E is such an allocation that total supply
equals total demand for both the food and clothes markets:

FAE + FBE = FA0 + FB0

CAE + CBE = CA0 + CB0.

We have come to an important conclusion. If individuals are free to

compete for resources, the prices and quantities of all markets adjust
until all markets are cleared. I hope you appreciate the ‘beauty’ of this
argument!

However, this discussion is by no means rigorous proof of the existence

of general equilibrium under perfect competition. Proving the existence
of general equilibrium is a formidable task, although it was achieved by
mathematical economists Kenneth Arrow and Gerald Debru in the 1950s,
with the help of some very high-powered mathematics. Nevertheless, we
now know that if market participants are free to compete for resources,
all markets will be cleared simultaneously. Moreover, the market clearing
is supported by equilibrium prices (represented by the price line in the
Edgeworth box diagram).
 Unit 4 9

We will stop our discussion on the existence of general equilibrium here.

In the next section we switch to an equally important topic — economic
efficiency. Before you go on to that topic, however, you should make
sure you’ve understood the essence of the concepts presented here by
completing Self-test 4.1.

Self-test 4.1

1 Construct indifference curves for A and B, passing the initial

endowment M in the Edgeworth box shown in Figure 4.2. Do you
think either A or B is happy with this initial endowment?

2 A final equilibrium is represented by the point E in Figure 4.3. Can

you find another point at which both A and B are happier?

3 Recall that the slope of an indifference curve can be interpreted as

the marginal rate of substitution. How do you relate the prices of
food and clothes to the marginal rate of substitution at E?
10 ECON A311 Intermediate Microeconomics

Pareto efficiency
A good place to start when trying to understand Pareto efficiency is to
recall the welfare implications of the government tax policy we discussed
in the previous unit. We showed that there is welfare loss. That is, the
government tax policy lowers economic efficiency. Is the result merely a
coincidence? Or does the result reflect the profound implication that
government intervention generally has a negative impact on the optimal
allocation of economic resources?

In order to answer this question, we have to make sure we are clear about
the meanings of economic efficiency and optimal allocation of resources.
The following reading is an intuitive discussion of economic efficiency.

Reading
PR (2018) 16.2 ‘Efficiency in exchange (The advantages of trade)’,
pp. 616–17.

Allocation efficiency
Until the turn of the twentieth century, even economists themselves had
no consensus on what exactly they meant by economic efficiency. It was
the Italian economist Vilfredo Pareto who gave an operational definition.
An allocation of resources is said to be Pareto efficient if there is no
alternative allocation that makes everybody better off. At first glance it
seems that this definition, focusing only on the allocation of resources, is
too narrow to cover other economic activities. You will see later in this
unit, however, that the definition is in fact very powerful and that it has
profound theoretical and practical implications. Let us refer to the
Edgeworth box again, which is our next figure.

Figure 4.5 M and N are not Pareto efficient

 Unit 4 11

The point M in the figure represents an initial endowment, i.e. individual

A is endowed with FA0 units of food and CA0 units of clothes, while
individual B is endowed with FB0 units of food and CB0 units of clothes.
Is this initial endowment a Pareto efficient allocation? To answer this
question, let us rephrase the definition of Pareto efficiency. If we can find
another allocation so that at least one individual is better off without
making the other worse off, then the initial allocation is not Pareto
efficient. It is clear that N represents such an allocation. At N, individual
A consumes less of the clothes (-∆C) for more food (+∆F) resulting in a
higher utility level UA1. Individual B, by trading a quantity of food (-∆F)
for more clothes (+∆C), also enjoys higher utility (UB1). Since both
individuals are better off, N is Pareto superior to M. The initial
endowment, M, is not a Pareto efficient allocation.

It should be clear to you that there are other allocation schemes which are
Pareto superior to M. In fact, all the points bound by the curves UA0 and
UB0 are Pareto superior to M. You may want to convince yourself by
constructing indifference curves passing through one of these points. The
next question is — can we find a Pareto efficient allocation if M is not
one? Consider the following Edgeworth box.

Figure 4.6 E is Pareto efficient

The allocation is represented by point E where individual A consumes

less clothes (-∆CE) for more food (+∆FE) to reach the utility level UAE
and individual B consumes more clothes (+∆CE) for less food (-∆FE) to
reach the utility level UBE. Being at point E, can we further improve the
welfare of at least one individual without hurting the other? The answer is
no. To check the validity of the assertion, you can simply pick any point in
the Edgeworth box and make a comparison to E. What do you find?

There is one very important observation about point E. E is the point of

tangency — the slope of the indifference curves UAE and UBE must be the
same at E. Now, recall from Unit 1 the economic interpretation of
indifference curves (the slope of an indifference curve represents the
marginal rate of substitution). Thus, the marginal rate of substitution
between food and clothes for individuals A and B must be equal at E. We
are now ready to state the condition for Pareto efficiency.
12 ECON A311 Intermediate Microeconomics

To achieve Pareto efficiency, the marginal rate of substitution (MRS)

must be equalized across individuals, or
A B
MRSCF = MRSCF .

This is referred to as the condition for Pareto efficiency in exchange. In

this condition, the superscripts denote the individuals and the subscripts
denote the goods for exchange. Pareto efficient allocation is not unique,
as demonstrated in the following Edgeworth box.

Figure 4.7 Contract curve

The allocation schemes represented by x, y and z are Pareto efficient. In

fact, all the points along the dotted line, known as the contract curve, are
Pareto efficient. The following reading is a more detailed discussion of
the Pareto efficiency of exchange. When you have finished the reading,
complete Self-test 4.2.

Reading
PR (2018) ‘The Edgeworth box diagram’, pp. 617–18; ‘Efficient
allocations’, pp. 618–20; ‘The contract curve’, pp. 620–21.

Self-test 4.2

1 What is a Pareto efficient allocation?

2 What is the contract curve in a pure exchange economy?

3 In a public offering of two new stamps (A and B), Pierre obtains 20

pieces of stamp A and five pieces of stamp B, while Sean obtains 25
pieces of stamp A and ten pieces of stamp B. For Pierre the MRS of
 Unit 4 13

stamp A for stamp B is 1/3 and for Sean it is two. Illustrate by using
an Edgeworth box how both would be made better-off through trade.

We discussed the concept of Pareto efficiency in the previous section.

You can now see that this is a definition of efficiency which is
operational, i.e. we can apply the definition to make a statement.
However, ask yourself, is it the best outcome if an economy settles in a
state of Pareto efficiency? Keep this question in your mind as you read
the following sections. I shall give you an answer — but not the answer
—later!

Allocation efficiency and competitive price

system
You see that all the allocation schemes along the contract curve are
Pareto efficient. Which allocation scheme should be chosen? Recall our
discussion on general equilibrium. We concluded that if individuals are
free to trade, i.e. under a competitive price system, the economy will
eventually settle at an equilibrium. At this equilibrium, of course, all
markets are cleared. In our example, the food market and the clothes
market are cleared. This scenario is illustrated in the following
Edgeworth box.

Figure 4.8 A competitive price system supports allocation efficiency

The equilibrium is represented by the point E. You can see E is the

tangency point where the marginal rates of substitution between food and
clothes are equal across the two individuals. Moreover, the marginal
rates are equal to the price ratio of food and clothes represented by the
price line P’P’. This tangency condition, the condition for Pareto
efficiency in exchange in a competitive equilibrium, is shown
algebraically as follows:

A B PF
MRSCF = MRSCF =− .
PC
14 ECON A311 Intermediate Microeconomics

If we allow the market to take care of the allocation through the price
mechanism, the economy will settle at a state where all markets are
cleared under the prices PF and PC. The resulting allocation is efficient in
the Pareto sense — you cannot find another allocation which improves
the welfare of one individual without hurting the other. Can you see how
this is simply an elaborated version of Adam Smith’s ‘invisible hand’?
Now, please go through the following reading.

Reading
PR (2018) ‘Consumer equilibrium in a competitive market’,
pp. 621–23; ‘The economic efficiency of competitive markets’,
pp. 623–24.

Production efficiency
So far our discussion assumes a pure economy without production. We
will, however, discuss production efficiency in this section. You will see
that the notion of Pareto efficiency is also applicable, and that the
framework of analysis is identical to the allocation efficiency. Again, for
simplicity, we consider an economy of two producers producing only two
outputs, clothes (C) and food (F). The technology in production is
described by the following production functions:

C = c(K,L),
F = f(K,L).

Suppose the inputs for the production of clothes are KC of capital and LC
of labour, and the inputs for the production of food are KF of capital and
LF of labour. If a total of KT of capital and LT of labour are available for
the production, we must have:

K C + K F = KT
LC + LF = LT

represented by the sides of the Edgeworth box in the following figure.

 Unit 4 15

Figure 4.9 The production scheme Z is Pareto efficient

In this Edgeworth box, the isoquants associated to the production of food

are the curves bowing to the origin OF, while those bowing to OC are the
isoquants related to the production of clothes. Point W represents a
possible point for the allocation of resources for production. At this point,
the economy produces QF0 units of food and QC0 units of clothes. Is this
an efficient production scheme? Clearly not. The economy can generate
more by moving to any point bound by the isoquants QF0 and QC0. You
should notice that the argument is exactly the same as the discussion of
the Pareto efficiency in consumption — the allocation scheme
represented by W is not Pareto efficient in production.

Now, you can see that the notion of being Pareto efficient is not only
useful for analysing the resource allocation for production, it is also
useful for the analysis of the efficiency in production. In our Edgeworth
box for production analysis, Z represents a Pareto efficient allocation.
The economy cannot produce more of one good without producing less
of the other good by deviating from Z.

Since Z is a tangency point of the isoquant QCZ and QFZ the slopes of the
isoquants at Z must be equal. Recall from Unit 2 that the slope of an
isoquant can be interpreted as the marginal rate of technical substitution
(MRTS) between inputs, i.e. capital and labour. Thus, the condition for
production efficiency is that the marginal rate of technical substitution
between inputs across different industries must be equal, or
F C
MRTS KL = MRTS KL .

Note that this is consistent with the cost minimization condition, which
states that for the industry i, the marginal rate of transformation between
capital and labour is equal to the ratio of the input prices:

i wi
MRTS KL =− .
ri
16 ECON A311 Intermediate Microeconomics

If the input markets are perfectly competitive, all industries are facing the
w w
same set of input prices, i.e. i = . In our two-industry example of
ri r
producing only food and clothes, the marginal rate of technical
substitution is equal across the food and clothes industries:

F C w.
MRTS KL = MRTS KL =−
r

This is referred to as the condition for Pareto efficiency in production.

This condition is shown graphically in the next diagram. You can see that
all the allocation schemes represented by the points along the contract
curve (the dotted line) for production are Pareto efficient.

Figure 4.10 Pareto efficient production schemes

You should complete your study of this topic by working through the
following reading in your textbook.

Reading
PR (2018) 16.4 ‘Efficiency in production’, p. 627; ‘Input
efficiency’, pp. 627–28.

In the next section, we’ll examine another way to look at Pareto

efficiency. You’ll have another self-test at the end of that topic.
 Unit 4 17

Production possibility frontier

(PPF)
We can represent the Pareto efficient production schemes in an
alternative way. Recall the production possibility frontier in your
introductory economics course. You will see that it is closely related to
the Pareto efficiency in production.

Consider the production scheme represented by point e in the Edgeworth

box on page 13. You can read from the isoquants that QCe units of clothes
and QFe units of food are produced under this production scheme. This
production scheme is denoted by the point E on the production
possibility frontier (PPF) in the following figure.

Figure 4.11 Production possibility frontier

Similarly, the point d and f in the Edgeworth box on page 13 are

associated, respectively, with the D and F on the production possibility
frontier represented in Figure 4.11. Clearly, each point on the PPF
represents a possible outcome of production in the economy, and each of
these outcomes is Pareto efficient in the sense that the economy cannot
increase the production of one good without sacrificing the production of
another good. For example, moving from point D to E on the PPF, the
production of food is increased by ∆QF units while the production of
clothes is decreased by ∆QC units. You should also recall from your
introductory course that PPF is a technology constraint on how much can
be produced. It displays the combinations of the most efficient outputs
under the constraint of the given state of technology, and any output
combinations represented by the points under the PPF are the result of
production inefficiency.
18 ECON A311 Intermediate Microeconomics

Interpreting the slope of the PPF

How do we interpret the slope of the PPF? Consider a small reduction in
the production of clothes ∆C for a small increase in the production of
food ∆F. The ratio ∆C/∆F is called the marginal rate of transformation
between food and clothes, and can be represented by the slope of the PPF.

Since the production schemes along the PPF are Pareto efficient, the
resource required (i.e. the marginal cost) for the production of ∆F (more
of the food) must come from the resource released from producing ∆C
(less of the clothes). Thus, the ratio ∆C/∆F, or, the marginal rate of
transformation (MRTCF) must equal the ratio of the marginal costs
MCF/MCC:

MCF
MRTCF = − .
MCC

The following figure shows you a numerical illustration of this result.

For the sake of simple exposition, we assume that labour is the only input.

Figure 4.12 Interpreting the slope of production possibility frontier

Suppose the marginal cost of clothes and food are four and two,
respectively. In moving from E to F along the production possibility
frontier, one less unit of clothes is produced (∆C = -1). Since the
marginal cost of producing clothes is four, four units of labour are
released. They should be allocated to produce food if resources are not to
be idle. If the marginal cost of producing food is two, then two units of
food are produced from the four units of labour released from the clothes
production (∆F = 2). Thus, the slope of the PPF from E to F is ∆C/∆F =
-1/2, which is the same as -MCF/MCC (= 2/4 = 1/2).

It’s time for another textbook reading, which you should have no trouble
following!
 Unit 4 19

Reading
PR (2018) ‘The production possibilities frontier’, pp. 628–29.

Production efficiency and competitive price

system
A perfectly competitive price system is an economic model in which
individuals are utility-maximizers, firms are profit-maximizers, and each
of the participants are price-takers.

In our simple model of only two goods, the price can be represented
compactly as the price ratio. The price ratio can be depicted graphically
as the slope of the parallel lines in the following figure.

Figure 4.13 Competitive price system and production efficiency

The lines in the above figure, two dotted and one solid, have slopes equal
P
to − F . Note that all firms are facing the same set of prices for goods
PC
and inputs under perfect competition. Clearly, any production schemes
represented by the points on cc are unfeasible, and the production
schemes represented by the points inside the PPF are inefficient. The
only production scheme which is Pareto efficient and consistent with the
given competitive market price is the point E. That is, the economy
produces CT units of clothes and FT units of food. Moreover, from the
condition for profit maximization

MCC PC
= ,
MCF PF

the marginal rate of transformation must equal the price ratio:

PC
MRTCF = − .
PF
20 ECON A311 Intermediate Microeconomics

Now, we can complete our story by considering the consumption of food

and clothes again. Recall the condition for utility maximization states
that the marginal rate of substitution is equal to the price ratio:

PF
MRSCF = − .
PC

So, under perfect competition, the marginal rate of transformation and

the marginal rate of substitution must be equal, and are determined by
market prices:

PF A B
MRTCF = − = MRSCF = MRSCF .
PC

This scenario is represented in the following figure.

Figure 4.14 A competitive equilibrium

To maximize profit, the economy produces at E’, generating CT units of

clothes and FT units of food. The marginal rate of transformation at E’ is
the slope of p’p’, the price ratio of food and clothes. Note that E’
represents the total goods available for consumption. We can construct
an Edgeworth box OFTE’CT with the contract curve represented by the
dotted curve. To maximize utility, the consumers choose to consume at E,
where the marginal rate of substitution is the same as the price ratio of
food and clothes, satisfying the utility maximization condition. Clearly,
the slope of pp equals the slope of p’p’. The important point to note is
that the profit maximizing production scheme presented by E’, the utility
maximizing consumption scheme represented by E, and prices
represented by pp (or p’p’) are determined simultaneously. Some
economists label this scenario as competitive equilibrium. Thus, if we
have a perfectly competitive economy (i.e. there are hundreds of
thousands of households and firms competing for the limited resources)
the markets, with price as signals for buying and selling, will guide the
market participants to the efficient allocation of resources with all the
markets cleared.

You should complete your work in this unit with the following reading
and self-test.
 Unit 4 21

Reading
PR (2018) ‘Output efficiency’, pp. 629–30; ‘Efficiency in output
markets’, pp. 631–32.

Self-test 4.3

1 Which production scheme along the contract curve is most efficient?

2 Locate the three production schemes in the following Edgeworth box

in the production possibility frontier.

3 What is the marginal rate of transformation? If the marginal rate of

transformation MRTXY between X and Y is 3 and the marginal cost of
producing Y is 5, what is the marginal cost of X?

4 The PPF shows you the possible production schemes. Which

schemes should be chosen?

5 Explain how the economy adjusts when MRSCF and MRTCF are not
equal.
22 ECON A311 Intermediate Microeconomics

Summary
This unit discussed theoretical issues related to general equilibrium and
efficiency. As I mentioned in the introduction to this unit, the reading
was not demanding in terms of quantity, but you might have found
understanding the concepts to be quite challenging.

First, we defined general equilibrium as a scenario in which the

quantities supplied and quantities demanded are cleared in all markets
equal with prices and outputs determined uniquely. You also explored
the concept of Pareto efficiency and derived the conditions for Pareto
efficiency in consumption and production. You were then shown, again
with the help of the Edgeworth box, that the general equilibrium outcome
from perfect competition is Pareto efficient.

You should have noted that Pareto efficiency was the starting point of the
discussion, and that the Edgeworth Box is a very useful tool in our two-
good, two-individual model. You should note that the condition of Pareto
efficiency in exchange is the result of freedom in exchange among
individuals — this condition is consistent with the individuals’ utility
maximizing. Similarly, the condition of Pareto efficiency in production is
the result of perfect competition among the firms, and the condition is
consistent with the firms’ cost minimizing. Finally, we considered the
general equilibrium of the entire economy, i.e. we considered the
economy’s production and consumption simultaneously. This approach
generates the conditions for Pareto efficiency in product mix.

You may think that the discussion in this unit was too theoretical and is
really just a lot of intellectual games for academics in ivory towers. It’s
not! The theories we’ve discussed have profound policy implications.
Many governments, including that of Hong Kong, encourage competition
and endorse economic policies which rely primarily on markets. This is
because they all recognize that competition generates the most efficient
outcome in resource allocation for consumption and production. Any
deviation from perfect competition will reduce efficiency.

Can we conclude that we should leave all economic activity to the

invisible hand? That is, can we say that the market is omnipotent? In the
next two units, we will address the issues of imperfect competition and
the cases where government intervention is necessary, even from the
viewpoint of economists endorsing competition.
 Unit 4 23

Answers to self-test questions

Self-test 4.1
1

The light curve passing through M represents A’s indifference curve

and the heavy curve represents B’s indifference curve. It is clear that
A can increase her utility by consuming less clothes and more food
and thus move her utility curve further to the northeast (a higher
utility level). Similarly, B can consume more clothes and less food to
move her utility curve to the southwest (a higher utility level). In fact,
either A or B would be happier if they could achieve any allocation
represented by a point bounded by the two curves.

2 No. You can find another point at which A is happier but B is less
happy, or a point where B is happier but A is less happy, but you
cannot not find another point at which both A and B are happier.

3 At E, the slope of A’s indifference curve, the slope of B’s

indifference curve, and the slope of the price line pp are all equal at
point E. Hence in this allocation scheme, the individual A’s marginal
rate of substitution between food and clothes equals individual B’s
marginal rate of substitution, and they in turn equal the price ratio of
food and clothes.

Self-test 4.2
1 When an allocation is Pareto efficient, it is impossible to improve the
welfare of one party without lowering the welfare of the other.

2 In a pure exchange economy, the market participants can settle at an

allocation scheme which is Pareto efficient. A contract curve is the
set of Pareto efficient allocation schemes.
24 ECON A311 Intermediate Microeconomics

From the figure, you can see that both individuals can be better-off
through trade. However, unless we have specific information
concerning the utility functions, the quantities of trading are
unknown. Nevertheless, we know that the final allocation should be
represented by a point bounded by the two indifference curves.
Moreover, the equilibrium MRS should lie between 1/3 and 2.

Self-test 4.3
1 We do not have enough information to answer this question. In fact,
the question is wrongly posed. Recall the self-test question on
allocation efficiency. We cannot compare the Pareto efficiency of
two allocation schemes on a contract curve. Similarly, we cannot
compare the Pareto efficiency of the production schemes along the
contract curve.

2 Each point on the PPF represents the output mix from a point on the
contract curve. The points on the contract curve are given, and
indicate the output mix of (50, 10), (30, 50) and (10, 80), where the
first number in the parenthesis stands for food and the second number
clothes. The resulting PPF is shown as follows:

3 Marginal rate of transformation, represented by the slope of PPF,

indicates the trade-off between producing one good for another good.
MRT is also related to the marginal cost of production as
MRTXY = MCY/MCX. If MRTXY = 3, MCY = 5, then MCX = 5/3 = 1.67.
 Unit 4 25

4 Under a competitive price system, resources are allocated to the

production where the marginal rate of transformation equals the price
ratio. This is depicted as the tangency point E in the following figure.

5 You can find the answer on pages 691–692 of BPP. Figure 18-12 on
page 692 of the text highlights the argument. When MRSCF and
MRTCF are not equal, it must be that one good is overproduced and
the other is underproduced. The economy can adjust to other
production schemes to improve the Pareto efficiency in consumption.

Consider the condition of Pareto efficiency in consumption,

MRSYX = -PX/PY, and the condition of Pareto efficiency in production,
MRTYX = -P’X/P’Y. In the following diagram, under the production
scheme M, MRSYX > MRTYX. That is, we must have -PX/PY > -P’X/P’Y,
or PX/PY < P’X/P’Y. The consumers are willing to pay a higher PX for
more X and lower PY to consume less Y. Hence producers produce
more X and less Y, changing the production scheme from M to N.
This is the production scheme where MRSYX = MRTYX.