Overall Efficiency

UNIT 2 OVERALL EFFICIENCY AND WELFARE and Welfare

Economics
ECONOMICS
Structure
2.0 Objectives
2.1 Introduction
2.2 General Equilibrium of Production and Exchange
2.2.1 General Equilibrium in Production and Exchange and Perfect Competition
2.2.2 Pareto Optimality Criterion
2.3 Welfare Economics: The Concept
2.3.1 Value Judgements
2.3.2 Social Welfare Function
2.3.2.1 Bergson-Samuelson Social Welfare Function
2.3.2.2 Classical Utilitarian or Benthamite Welfare Function
2.3.2.3 Weighted Sum of Utilities Welfare Function
2.3.2.4 Minimax or Rawlsian Social Welfare Function
2.3.3 Maximisation of Social Welfare
2.3.3.1 Isowelfare Curves
2.3.3.2 Utility Possibility Curve (UPC)
2.3.3.3 Grand Utility Possibility Curve (GUPC)
2.3.3.4 How does Society Maximise Social Welfare?
2.4 Let Us Sum Up
2.5 Some Useful References
2.6 Answers or Hints to check Your Progress Exercises

2.0 OBJECTIVES
After going through the unit, you will be able to explain:

x general equilibrium of production and exchange;

x perfect competition and general equilibrium in production and

exchange;

x the Pareto optimality criterion;

x the concept of welfare economics and value judgements;

x social welfare functions, viz. Bergson-Samuelson, Classical Utilitarian or

Benthamite, Weighted sum of utilities, Minimax or Rawlsian; and

x maximisation of social welfare using the tools like Isowelfare curve and
grand utility possibility frontier.

25
General Equilibrium
2.1 INTRODUCTION
A General equilibrium in production and in exchange together builds up the
overall efficiency in the economy. It results in an overall Pareto efficient
outcome in the economy where producers maximise their profit earnings
and simultaneously consumers maximise their satisfaction levels. In this unit
we will study the concept of simultaneous equilibrium in all the markets i.e.,
factor as well as commodity markets. For this we will make use of the
concept of general equilibrium in exchange with no production we came
across in Unit 8 of Intermediate Microeconomic-I course and the condition
of general equilibrium in production we discussed in Unit 1 of the present
course of Intermediate Microeconomics-II course.
Efficiency in production and exchange does not always guarantee maximum
social welfare because efficiency is independent of equity. To address this
shortcoming of the concept of Pareto efficiency, we will study the concept
of welfare economics that explicitly make use of value judgements. Thus, we
will learn about how to account for the social welfare and how it can be
maximised. In this regard we will study different welfare functions and the
associated welfare indifference curves and combine it with the grand utility
possibility frontier to arrive at the constrained bliss or the maximum social
welfare point.

2.2 GENERAL EQUILIBRIUM OF PRODUCTION AND

EXCHANGE
In the first unit we derived the production possibility curve (PPC) or
transformation curve using the concept of general equilibrium in
ƉƌŽĚƵĐƚŝŽŶ͘ůůƉŽŝŶƚƐĂůŽŶŐƚŚĞƚƌĂŶƐĨŽƌŵĂƚŝŽŶĐƵƌǀĞ;ƌĞĨĞƌƉŽŝŶƚƐ഻͕&഻ĂŶĚ
'഻ŝŶ&ŝŐ͘Ϯ͘ϭͿĐŽƌƌĞƐƉŽŶĚƚŽƚŚĞƉŽŝŶƚƐŽŶƚŚĞĐŽŶƚƌĂĐƚĐƵƌǀĞ;ƉŽŝŶƚƐ͕&ĂŶĚ
G, respectively) where the isoquants of two goods (X1, X2, X3 for good X and
Y1, Y2 and Y3 for good Y) are tangent to each other. Each point corresponds
to a different output mix. In Fig. 2.1, for instance, point E correspond to the
output mix given by (X1, Y3), point F correspond to (X2, Y2) and point G to (X3,
Y1).
Now we come to the question— where on PPC the economy should
operate? In other words, what combination of good X and Y should be
produced? An efficient output-mix results when there is general equilibrium
of production and exchange, that is, when subjective wants (or preferences)
of consumers are balanced with the objective conditions of production.

Recall from Unit 8 of Intermediate Microeconomics-I of Semester 3 and

refer Fig.2.2, given the initial endowment bundle (point W) and preferences
of consumers A and B, general equilibrium of exchange with no production
occurs at a point (here, point E) where marginal rate of substitution (MRS)
between two goods (X and Y) is equal among the two consumers.
26
 OB Overall Efficiency

Good Y
and Welfare
Y1 Economics

Y2 G
Y3
F
E X3

X2
X1
OA Good X

഻
Y3

Y2 &഻

Y1 '഻
Good Y

PPC

X1 X2 X3 Good X

Fig. 2.1: General Equilibrium in Production and PPC

This is the point of tangency between their respective indifference curves

(ICA and ICB) and the budget line (PQ) passing through the initial endowment
‫כ‬ ‫כ‬
௉ ௉
point. At point E, MRSAXY = MRSBXY= ൬௉ೣ ൰ , where ൬௉ೣ ൰ represent
೤ ೤

equilibrium price ratio of the two goods.

P XB OB
Good Y

ICB
E
YA YB

W
ICA

OA XA Q Good X

Fig. 2.2: General Equilibrium of Exchange with no Production

27
General Equilibrium The general equilibrium of production and exchange will be represented by
the output mix on the transformation curve— where producers maximise
their profit earnings and simultaneously consumers maximise their utilities.
The equilibrium occurs at a point where MRSXY equals MRTXY.
More specifically, general equilibrium in exchange and production occur at a
point where the rate at which consumers are willing to exchange one good
for another (MRSXY) equals the rate at which (on the production side) one
good can be transformed into another (MRTXY). We locate such an
ĞƋƵŝůŝďƌŝƵŵ ĐŽŶĚŝƚŝŽŶ ŝŶ &ŝŐ͘ Ϯ͘ϯ͘ >Ğƚ ƵƐ ƐĞůĞĐƚ ĂŶLJ ƉŽŝŶƚ ;ŚĞƌĞ ഻Ϳ ŽŶ ƚŚĞ
transformation curve TC so that the total outputs of commodities X and Y
are OX1 and OY1, respectively. These output levels determine the volume of
the two commodities available to consumers A and B, and thus form the
dimensions of an Edgeworth box diagram for exchange. Drop perpendiculars
ĨƌŽŵ ഻ ŽŶ ƚŚĞ ƚǁŽ ĂdžŝƐ͘ EŽǁ ŝŵĂŐŝŶĞ ʽ ĂƐ ƚŚĞ ŽƌŝŐŝŶ ŽĨ ĐŽŶƐƵŵĞƌ ͕
ƐŝŵŝůĂƌůLJ͕ƉŽŝŶƚ഻ďĞĐŽŵĞƐƚŚĞŽƌŝŐŝŶŽĨĐŽŶƐƵŵĞƌ͘

/ŶĚŝĨĨĞƌĞŶĐĞĐƵƌǀĞƐŽĨĂŶĚʦĂƌĞĚƌĂǁŶŝŶƚŚĞĞdžĐŚĂŶŐĞďŽdž͘ƵƌǀĞƐ1, A2
and A3 ƌĞƉƌĞƐĞŶƚ ͛ƐŝŶĚŝĨĨĞƌĞŶĐĞ ĐƵƌǀĞƐ͕ ĂŶĚ ʦ1 ʦ2 and B3 ĂƌĞ ʦ͛Ɛ /Ɛ͘ dŚĞ
ůŽĐƵƐŽĨƚĂŶŐĞŶĐŝĞƐŽĨƚŚĞŝŶĚŝĨĨĞƌĞŶĐĞĐƵƌǀĞƐŽĨĂŶĚʦĂƌĞ͕&ĂŶĚ'͘LJ
ũŽŝŶŝŶŐ ƚŚĞƐĞ ƉŽŝŶƚƐ͕ ǁĞ ŐĞƚ Ă ĐŽŶƐƵŵƉƚŝŽŶ ĐŽŶƚƌĂĐƚ ĐƵƌǀĞ K&'഻͘ dŚŝƐ
curve is the locus of the various Pareto-optimal allocation of two
commodities between the two consumers where MRSA = MRSB. Among
these various efficient allocation points, point E represents a condition of
general equilibrium in exchange which is consistent with the condition of
ŐĞŶĞƌĂů ĞƋƵŝůŝďƌŝƵŵ ŝŶ ƉƌŽĚƵĐƚŝŽŶ͘ WŽŝŶƚ  ĂŶĚ ഻ ƚŽŐĞƚŚĞƌ ĞŶƐƵƌĞ ƚŚĞ
condition of general equilibrium of production and exchange as slope of the
tangents to both these points are equal.

T
Good Y

XB ഻
Y1
B1 G
P
B2 A3
E S
YA YB
B3
F A2

A1 Q
C
O XA X1 Good X

Fig. 2.3: General Equilibrium of Production and Exchange

28
General equilibrium of production and exchange requires Overall Efficiency
and Welfare
Economics
MRSAXY= MRSBXY= MRTXY
as given by the slopes of tangents PQ and RS, respectively. Here, general
ĞƋƵŝůŝďƌŝƵŵ ŽĨƉƌŽĚƵĐƚŝŽŶ ŽĐĐƵƌƐ Ăƚ ƉŽŝŶƚ ഻ ǁŚĞƌĞ ƉƌŽĚƵĐĞƌƐ ƉƌŽĚƵĐĞ Ky1
units of good X and OY1 units of good Y as an output mix; and General
equilibrium of exchange occurs at point E where A2 (the indifference curve
representing consumer A) is tangent to B2 (the indifference curve
representing consumer B) with the individual A consuming OXA units of good
X and OYAƵŶŝƚƐŽĨŐŽŽĚzĂŶĚĐŽŶƐĞƋƵĞŶƚůLJ͕ƚŚĞŝŶĚŝǀŝĚƵĂůĐŽŶƐƵŵŝŶŐ഻yB
ƵŶŝƚƐŽĨŐŽŽĚyĂŶĚ഻zB units of good Y.
If MRSXY тDZdXY then the rate at which consumers are willing to exchange
two goods will be different from the rate at which one good is transformed
into another in the production process. For instance, if MRTXY is 4Y /1X and
MRSXY is 2Y/1X then this is a state of disequilibrium. Here, in the production
process 4 units of good Y needs to be given up for producing an additional
unit of good X, whereas consumers are ready to sacrifice only 2 units of
good Y for an additional unit of good X. This implies consumers place higher
valuation on good Y, and as a result consumers can be made better off by
moving along the PPC to a point where more of good Y and less of good X is
produced. As production of good Y increases, MRTXY falls, and consumers
consume more of good Y and less of good X, MRSXY tend to rise or in other
words, their valuation of good Y begins to fall until the two rates MRTXY and
MRSXY become equal. In perfect competition the market forces bring up
such equalisation which ensures maximum satisfaction for the consumers
and profit maximisation for the producers. Therefore, any disequilibrium
between marginal rate of substitution and marginal rate of transformation
will lead to change in the output mix and thus the final equilibrium
substitution or transformation rate between the goods.

To summarise, the general equilibrium condition for overall efficiency is:

஺ ஻
‫ܴܵܯ‬௑௒ ൌ ‫ܴܵܯ‬௑௒ ൌ ‫ܴܶܯ‬௑௒
2.2.1 General Equilibrium of Production and Exchange and
Perfect Competition
If the market structure is characterised by perfect competition then we can
obtain a unique general equilibrium of production and exchange. However
the equilibrium definitely depends on the initial allocation of factors
between the production of two goods and the initial endowment of two
goods among two individuals. The equilibrium changes with the change in
these initial two conditions. The condition for general equilibrium of
production and exchange is given by:
஺ ஻
‫ܴܵܯ‬௑௒ ൌ ‫ܴܵܯ‬௑௒ ൌ ‫ܴܶܯ‬௑௒

29
General Equilibrium Now, the slope of the transformation curve ‫ܴܶܯ‬௑௒ ǡ ™Š‹ Š measures the
rate of transformation of one good into another, is equal to the ratio of their
respective marginal costs:
ெ஼೉
‫ܴܶܯ‬௑௒ ൌ (1)
ெ஼ೊ

Under the conditions of perfect competition in the market, price of a

commodity is equal to the marginal cost of production of that commodity,
that is, we have:

‫ܥܯ‬௑ ൌ ܲ௑ ƒ†‫ܥܯ‬௒ ൌ ܲ௒ (2)

Therefore, from (1) and (2), we get

‫ܥܯ‬௑ ܲ௑
‫ܴܶܯ‬௑௒ ൌ ൌ
‫ܥܯ‬௒ ܲ௒
In Fig. 2.3, slope of the tangent (RS) drawn to the transformation curve at
௉೉
point E’ is the ratio of price of good X to price of good Y, i.e. . The point of
௉ೊ
general equilibrium of production is shown as point E’ in the diagram where
OX1 amount of good X and OY1amount of good Y will be produced. So given
the perfect competition in goods market, there is a unique general
equilibrium in production at a point where the marginal rate of
transformation is equal to ratio of the prices of goods.

This output mix obtained as the general equilibrium of production is then

distributed among the consumers. Consumers maximise their satisfaction
subject to their respective budget constraint. The condition for utility
maximisation under perfect competition is:

஺
ܲ௑
‫ܴܵܯ‬௑௒ ൌ
ܲ௒

஻
ܲ௑
‫ܴܵܯ‬௑௒ ൌ
ܲ௒
From above we know that general equilibrium in exchange is achieved at a
point where the indifference curves are tangent to each other and under
perfect competition the MRS equals the price ratio. So the perfect-
competitive equilibrium condition under general equilibrium in exchange is:

஺ ஻
ܲ௑
‫ܴܵܯ‬௑௒ ൌ ‫ܴܵܯ‬௑௒ ൌ
ܲ௒
Since under perfect competition, both consumers and producers are price-
takers, the general equilibrium condition for the optimum output mix under
perfect competition will be given by:

஺ ஻
ܲ௑
‫ܴܶܯ‬௑௒ ൌ ‫ܴܵܯ‬௑௒ ൌ ‫ܴܵܯ‬௑௒ ൌ
ܲ௒

30
 Overall Efficiency
2.2.2 Pareto Optimality Criterion and Welfare
Economics
Pareto efficiency implies a condition where no one can be made better off
without making someone else worse off. When we consider overall
efficiency in context of general equilibrium in production and exchange, it
implies a state where all possibilities of gain from trade and all possibilities
of efficient allocation of resources are fully exhausted. This means a
condition where marginal rate of substitution between two goods is equal
to the marginal rate of transformation so that consumer satisfaction is
maximised and goods in the economy are produced as per the consumer
preferences. That is, Pareto efficiency requires satisfaction of the following
three marginal conditions:

a) Efficiency in Exchange— requiring efficient distribution of commodities

among consumers.
b) Efficiency in Production— requiring efficient allocation of factors among
firms.
c) Efficiency in Output mix— requiring efficient allocation of factors
among commodities.
Check Your Progress 1
஺ ஻
1) Show that the condition for overall efficiency is ‫ܴܵܯ‬௑௒ ൌ ‫ܴܵܯ‬௑௒ ൌ
‫ܴܶܯ‬௑௒ .
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
2) Define general equilibrium in product mix in an economy with perfect
competition in product and factor market. Clearly state all the
conditions for existence of such an equilibrium.
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
3) True or False: Pareto efficiency requires that each individual’s Marginal
rate of substitution be equal to Marginal rate of transformation.
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
31
General Equilibrium
2.3 WELFARE ECONOMICS: THE CONCEPT
Till now we have confined ourselves to Positive economics, that is, we have
answered the question “How it is?” We discussed the concept of efficiency
in production and exchange using the Pareto optimality criterion. The idea
of Pareto optimality rests on the given distribution of income or the
underlying allocation of resources. Any redistribution of income will result in
a new optimum, a new product mix and allocation of factors among
production of commodities. An allocation in which a person is holding
everything in the economy and the other gets nothing is also a Pareto
efficient allocation (as any sort of reallocation to benefit some other
individual will surely hurt the individual possessing everything), but surely it
is not the desired allocation from the welfare point of view. That is, Pareto
optimality criterion does not guarantee maximum social welfare. Hence to
check on the maximum social welfare, one has to think beyond the Pareto
optimality concept. Moreover, this criterion does not embrace those
changes in the economic state which make some persons better off and
others worse off.
To address such shortcomings, the concept of value judgement needs to be
introduced in respect to income distribution and initial factor employment
in production of different commodities. This is because, Pareto efficiency
works independent of how the income is initially distributed. In place of
Positive economics that deals with “how it is”, we will study about
Normative economics which deals with “what ought to be”. From normative
point of view we attach a value judgement to different economic
allocations. Under this we talk about how we judge and establish norms to
judge different allocations on the basis of not just economic efficiency (as in
the case with Pareto efficiency) but also the social welfare. Thus, in welfare
economics attempt is made to establish criteria or norms with which to
judge or evaluate alternative economic states and policies from the
viewpoint of welfare of the society.

2.3.1 Value Judgements

Value judgement means belief of people about what is good or bad. Value
judgement plays a crucial role in evaluating different economic policies on
welfare grounds. These judgements are developed in a society on the basis
of values prevailing in the community which is under study. Measuring social
welfare is not an easy task as it involves interpersonal utility comparisons
and value judgements. The study of welfare economics is concerned with
policy-making to promote social welfare. Value judgements and ethical
norms cannot be ignored in such welfare analysis where the goal is to
maximise welfare or happiness of the economy.

In welfare economics we claim an allocation to be efficient or optimal if it

results in maximum social welfare. Various economists have developed
32
different concepts for measuring social welfare. One such concept of Overall Efficiency
and Welfare
measuring social welfare is the paternalist one. Under this, social welfare is Economics
said to be affected only by the change in the welfare of the dictator or the
paternalist. The individual preferences of all other consumers are ignored
and the dictator’s idea of welfare dominates. This did not gain much
acceptance among economists. The other one is the Paretian concept which
states that welfare increases if someone is made better off and none worse
off and welfare decreases if someone is made worse off and none better off.
However in practical situations we usually find that with any economic
change some are made better off and some are made worse off. Therefore
even the Paretian concept has limited applicability to real economic
problems. Another criterion on evaluating change in social welfare is the
Compensating principle developed by Kaldor and Hicks. They claimed that
their criterion does not involve value judgement and interpersonal
comparisons and can still evaluate the situation where few are made better
off and others worse off. They claimed that with any economic change the
overall welfare is said to increase if those who gain can compensate those
who are worse off and are still in a better position as compared to the initial
economic allocation. The fourth one is the concept that involves
interpersonal comparison of individual preferences and utility. This involves
value judgement. This is the theory of social welfare functions and it
overcomes the limitation of judging the situations where few people are
made better off and some other worse off.
In this section we will concentrate on the concept of maximization of social
welfare employing the tools like social welfare function (which reflects social
preferences by aggregating individual preferences)and grand utility
possibility frontier(derived from the Pareto optimality criterion).

2.3.2 Social Welfare Function

A social welfare function is a mathematical representation of the combined
welfare of all economic agents in a society. It is simply a rule for aggregating
individual welfare levels to obtain welfare of the society as a whole. The
aggregation process itself depends upon an explicit value judgement about
social value of individuals’ welfare levels, in other words, the aggregating
process involves some value judgement regarding how much does an
individual’s welfare contribute to social welfare.
2.3.2.1 Bergson-Samuelson Social Welfare Function
As per the Bergson-Samuelson social-welfare function, collective well-being
depends on the utilities of the individuals that constitute that society. The
individual utility functions (Ui) are ordinal and are a function of whatever it
may be that provides individuals with utility or satisfaction. A social welfare
function (SWF) of a society of n individuals will be given by

SWF = W(ܷଵ ǡ ǥ Ǥ Ǥ ܷ௡ ሻǤ
33
General Equilibrium Recall from Unit 1 of Intermediate Microeconomics 1 course, a utility
function represents and preserves a complete, transitive, reflexive, and
continuous preference relation of an individual. Or in other words, it can be
said that an individual i prefers allocation X to Y if ܷ௜ ሺܺሻ>ܷ௜ ሺܻሻ. Here it is
assumed that aggregated utility function are monotonically increasing in
each individual utility to ensure that if all individuals prefer X to Y then a
society of n individuals also prefers X to Y. In other words, a social welfare
function is an increasing function of each individual’s utility.

Let us consider some examples of the functional form of the social welfare
functions.
2.3.2.2 Classical Utilitarian or Benthamite Welfare Function
Thus, social welfare is the sum of utilities obtained by all the n members of
the society. The function is given by
௡

ܹሺ‫ݑ‬ଵ ǡ ǥ ǥ Ǥ ǡ ‫ݑ‬௡ ሻ ൌ ‫ݑ‬ଵ ൅ ‫ݑ‬ଶ ൅Ǥ Ǥ Ǥ ൅‫ݑ‬௡ ൌ ෍ ‫ݑ‬௜

௜ୀଵ

where W represents the social welfare and ui with i = 1…n represent utilities
of the individual n members of the society. The goal of a society is to
maximise social welfare, that is, the aggregate of utilities of the individuals
comprising the society. The assumption of the law of diminishing marginal
utility of money income requires that maximum social welfare is achieved
when income is so distributed that marginal utility of income is equal for all
individuals in the society. The further assumption that individuals have the
same utility functions ensures that maximisation of social welfare is
achieved only with equal distribution of income.

2.3.2.3 Weighted sum of Utilities Welfare Function

When Utilities of each individual in the society are given equal weight, we
get a Classical Utilitarian or Benthamite welfare function that we just
discussed. A more generalised form of this function involves giving different
weight (ai,) to different individuals in a way to reflect the importance of
members of the society. The functional form then becomes:

ܹሺ‫ݑ‬ଵ ǡ ǥ ǥ Ǥ ǡ ‫ݑ‬௡ ሻ ൌ σ௡௜ୀଵ ܽ௜ ‫ݑ‬௜ ; where ai> 0

2.3.2.4 Minimax or Rawlsian social welfare function

A welfare function that cares of the welfare or utility level attained by the
worst off individual in the society is given by the following form:

ܹሺ‫ݑ‬ଵ ǡ ǥ ǥ Ǥ ǡ ‫ݑ‬௡ ሻ ൌ ݉݅݊ሼ‫ݑ‬ଵ ǡ ǥ ǥ Ǥ ǡ ‫ݑ‬௡ ሽ

In this case, maximisation of social welfare will involve maximisation of the
welfare of the least well-off individual in the society. In other words, the
function describes an equity seeking behaviour in the distribution of utility
by choosing allocations that maximises the minimum utility level in the
34
society. Thus it implies that improvements in the utilities of the richest do Overall Efficiency
and Welfare
not improve the social welfare. Economics

2.3.3 Maximisation of Social Welfare

The problem of welfare maximisation involves the objective of maximising
the welfare of the society as a whole using the SWF subject to the constraint
that any allocation must be Pareto efficient. If not, then there exist some
allocation that gives strictly greater utility to someone, with all others
getting the same utility, as in this given allocation. But since by construction
welfare function is increasing in utility it must then give higher social welfare
with this new allocation which contradicts that we originally had a welfare
maximum.
2.3.3.1 Isowelfare Curves
An Isowelfare curve (similar to an individual indifference curve) is a locus of
all the allocations of individual utilities in the utility space with identical
levels of social welfare. For a society of two individuals, social welfare
function can be represented with the help of isowelfare curves as is shown
in Fig. 2.4.
Utility of individual B (UB)

W4
W3
W2
W1
O Utility of individual A (UA)
Fig. 2.4: Isowelfare Curves

Individual A and B are represented on the horizontal and vertical axis,

respectively. W1 W2 W3 and W4 are the three isowelfare curves representing
successively higher levels of social welfare. An isowelfare curve is a locus of
various combinations of utilities received by individuals A and B which
results in equal level of social welfare. The form of the social welfare
function (SWF) reflecting different value judgements determine the shape of
the isowelfare curves. For instance, Fig. 2.5 A represent isowelfare curves of
a Utilitarian social welfare function, whereas Fig. 2.5 B represent isowelfare
curves of a Rawlsian social welfare function of a society.

35
 Utility of individual B (UB)
General Equilibrium

Utility of individual B (UB)

W3
W2
W1
W1 W2 W3
O Utility of individual A (UA) O Utility of individual A (UA)

Fig.e 2.5A: Isowelfare Corves Fig. 2.5B: Isowelfare Curves

2.3.3.2 Utility Possibility Curve (UPC)

For every Pareto efficient output-mix that lie on the production possibility
curve (PPC), there exist an exchange locus— which is nothing but the
contract curve in an Edgeworth box defining a set of Pareto optimal
ĂůůŽĐĂƚŝŽŶƐŽĨƚŚĞŽƵƚƉƵƚͲŵŝdžĂŵŽŶŐƚŚĞĐŽŶƐƵŵĞƌƐŽĨƚŚĞŐŽŽĚƐ;K഻ŝŶ&ŝŐ͘
2.6 A). On plotting this exchange locus on the utility space, where we
measure utility of individual A on horizontal axis and utility of individual B on
vertical axis, we get a Utility Possibility Curve (UPC) for the output-mix (OX1,
OY1) (Refer Fig. 2.6 B).
Good Y

Utility of individual B

XB ഻ E1
Y1
P B1 G
A3 E2
B2
E
YA YB S
B3
F A2 E3

A1 Q
O Utility of individual A
O XA X1 Good X
Fig. 2.6(A):'ĞŶĞƌĂůƋƵŝůŝďƌŝƵŵŽĨWƌŽĚƵĐƚŝŽŶ Fig. 2.6(B): hƚŝůŝƚLJWŽƐƐŝďŝůŝƚLJƵƌǀĞ;hWͿ
ĂŶĚdžĐŚĂŶŐĞ

Here, an attempt is made to map the exchange contract curve from the
output space of the PPC to a utility space. For instance, we plot efficient
allocations F, E and G on the contract curve in Fig. 2.6 A to the utility space
in Fig. 2.6 B as points E1, E2 and E3, respectively. Utility level attained by
consumers A and B at the tangency point F of their respective indifference
curves A1 and B3 is represented by point E1 in the utility space. Similarly,
36
points E2 and E3 represent utility levels at the tangency points E and G, Overall Efficiency
and Welfare
respectively. The negative (downward) slope of the UPC implies— given the Economics
factors and the output-mix, it is not possible to increase the utility of one
individual unless the utility of the other individual is reduced.
For any given output-mix, there exist a large number of Pareto optimal
allocations of that output-mix between the consumers (as is represented by
ƚŚĞ ĞdžĐŚĂŶŐĞ ĐŽŶƚƌĂĐƚ ĐƵƌǀĞ K&'഻ ŝŶ &ŝŐ͘ Ϯ͘ϲ Ϳ͘ ŵŽŶŐ ƚŚĞƐĞ ĞĨĨŝĐŝĞŶƚ
allocations, there exist only one allocation which is compatible with the
given output-mix as is represented by point E on the exchange contract
curve (where MRS = MRT) and the corresponding point E1 on the utility
ƐƉĂĐĞ͘ dŚĂƚ ŝƐ͕ ƉŽŝŶƚ  ĂŶĚ ഻ ƌĞƉƌĞƐĞŶƚ WĂƌĞƚŽ ĞĨĨŝĐŝĞŶƚ ŽƵƚĐŽŵĞ ĨŽƌ
economy as a whole, and corresponding point E1 on utility possibility curve
gives the utility combination received by the two individuals when economy
reaches an overall Pareto optimal resource allocation pattern given the
resources, technology, tastes and preferences.

2.3.3.3 Grand Utility Possibility Curve (GUPC)

For any given output-mix on PPC, a utility possibility curve indicates
different combinations of utility levels of the two consumers. Among those
various utility combinations, only one as we saw is compatible with the
overall Pareto efficient outcome for economy. While deriving UPC, we
ĐŽŶƐŝĚĞƌĞĚ ഻ ĂƐ ƚŚĞ ŝŶŝƚŝĂů ŽƵƚƉƵƚͲŵŝdž͘  ƉƌŽĚƵĐƚŝŽŶ ƉŽƐƐŝďŝůŝƚLJ ĐƵƌǀĞ ŝƐ
nothing but the mapping of Pareto optimal factor allocation for the
production of two commodities from the Edgeworth box in to an output
space. Hence, there could be varying output-mix possibilities to begin with.

Corresponding to each output-mix, by fitting an Edgeworth box,

corresponding exchange contract curve is determined, which in turn fix a
particular UPC in the utility space. Thus, there will be as many exchange
contract curves and the corresponding UPCs as there are points on the PPC;
and on each UPC, there will be one point which will represent the Pareto
efficient outcome for the economy as a whole. Grand Utility Possibility
Curve (GUPC) is nothing but the locus of all such points, representing the
utility combinations attained by the two individuals when economy reaches
an overall Pareto optimal resource allocation pattern for a given factor
endowment, state of technology and preference order of the individuals. In
other words, every point on the grand utility possibility curve represents the
position of Pareto optimality or economic efficiency with regard to the
allocation of the products among the consumers, allocation of factors
among different products and the direction of production.

37
 Utility of individual B
General Equilibrium

Good Y
e1഻

p G1
e2഻
q

r G2
e1 e2

e3഻
G3
e3 GUPC
O p഻ q഻ r഻
O
Good X Utility of individual A

Fig. 2.7:Grand Utility Possibility Curve (GUPC)

In Fig. 2.7 on the left we have a production possibility curve with three
possible output-mix given by points e1഻͕ Ğ2഻ ĂŶĚ Ğ3഻͘ KĞ1഻͕ KĞ2഻ĂŶĚ KĞ3഻
represent the corresponding exchange locus which are plotted in the utility
ƐƉĂĐĞ ŽŶ ƚŚĞ ƌŝŐŚƚ ĂƐ ƌĞƐƉĞĐƚŝǀĞ ƵƚŝůŝƚLJ ƉŽƐƐŝďŝůŝƚLJ ĐƵƌǀĞƐ ƉƉ഻͕ ƋƋ഻ ĂŶĚ ƌƌ഻͘
Overall Pareto optimal points e1, e2 and e3 on the exchange contract curves
are plotted in the utility space as points G1, G2 and G3, respectively. Points
like G1, G2 and G3 show the utility combinations attained by two individuals
when Pareto efficient outcome for economy as a whole (that is when MRS =
MRT) is reached starting from output-mix e1഻͕ Ğ2഻ ĂŶĚ Ğ3഻͕ ƌĞƐƉĞĐƚŝǀĞůLJ͘ Ŷ
envelope curve of all such points which represent utility combinations
corresponding to the Pareto optimal outcome for economy as a whole is
what is known as the Grand Utility Possibility Curve (GUPC). It is called so, as
it envelopes a family of utility possibility curves corresponding to each point
on the PPC with each UPC represented by only a single point on GUPC
where MRS = MRT. This is also known as utility possibility set. It consists of
all Pareto efficient allocations which means at the boundary of the curve
there does not exist any other feasible allocation that can give higher utility
to both the individuals together. The grand utility possibility frontier satisfies
all Pareto efficiency criteria i.e. efficiency in production, product
composition and distribution. It gives the maximum utility that an individual
can attain given the welfare of other individual when economy has attained
Paretian outcome.

2.3.3.4 How Does Society Maximise Social Welfare?

As discussed above, every point on the grand utility possibility curve is
Pareto optimum. Also, isowelfare curves depict social welfare function
obtained on the basis of some value judgement regarding distribution of
38 welfare. Thus welfare analysis combining grand utility possibility frontier
with the concept of social welfare function results in a solution of maximum Overall Efficiency
and Welfare
social welfare. Economics

In Fig. 2.8, W1, W2 ,W3 and W4 represent four isowelfare curves and UU'
depict the grand utility possibility frontier. Social welfare will be maximised
where the grand utility possibility curve is tangent to an isowelfare curve,
that is, at point W*with individual A deriving a utility of ܷ஺‫ כ‬and individual B
deriving a utility of ܷ஻‫ כ‬. This is known as the point of “constrained bliss”
because a movement away from point W* along the GUPC will reduce total
social welfare. For instance, consider point P or Q on the GUPC. They
represent a lower level of welfare because they are on the lower isowelfare
curve W2. Moreover, all points above the W* such as point R on the W4
curve are beyond the reach of the society given the factor endowment and
technology. Thus point W* represent maximum social welfare where the
general equilibrium conditions of production and exchange are
simultaneously satisfied.

U
Utility of individual B (UB)

P
R

UB* W*

Q W4
W3
W2
W1
O UA* U'
Utility of individual A (UA)
Fig. 2.8: Social Welfare Maximisation

Check Your Progress 2

1) What is a Social Welfare function? Elaborate on different types of social
welfare functions.
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
2) What is meant by value judgements? Explain their role in welfare
economics.
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
39
General Equilibrium 3) Prove that allocation under welfare maximisation is also a Pareto
efficient allocation.
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
4) With the help of a diagram, derive a grand utility possibility curve and
mark the point of “constrained bliss”
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
5) Rawlsian welfare function states that the societal welfare depends on
the utility of worse off agent. Construct the welfare function that counts
the society welfare in terms of the welfare of the best off agent.
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
6) Explain how a society attains maximum social welfare.
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….

2.4 LET US SUM UP

The unit began with the derivation of the concept of overall efficiency, in
other words, the condition of general equilibrium in production and
exchange. This occurs at a point where marginal rate of substitution of
consumers equates marginal rate of transformation under production.
General equilibrium in production and exchange results in a Pareto optimal
outcome for the economy as a whole, where both, the producers as well as
the consumers optimise. Also, association of the overall equilibrium
condition with the perfect competition was analysed. A Pareto efficient
40
outcome does not guarantee maximum social welfare; this further led to Overall Efficiency
and Welfare
some discussion on the aspect of the welfare economics. Value judgment is Economics
imperative and plays an important role in welfare economics, which
basically aims at developing economic policies to increase social welfare. We
discussed some examples of social welfare functions, viz. Bergson-
Samuelson, Classical Utilitarian or Benthamite, Weighted sum of utilities,
Minimax or Rawlsian. Towards the end we discussed the equilibrium
condition of welfare maximisation which occurs at the point of tangency
between the grand utility possibility curve and the isowelfare curve.

2.5 SOME USEFUL REFERENCES

x Hal R. Varian (2006), 7th edition Intermediate Microeconomics, Chapter
(31-33), East – West Press.
x C.Synder and W.Nicholson (2010), Indian edition Fundamental of
Microeconomics, Chapter13 , Cengage Learning India.
x A.Koutsoyiannis (1985) ,2nd edition Modern Microeconomics, Chapters
21-23, English language book socity/Macmillian (ELBS).

2.6 ANSWERS OR HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) See Sub-section 2.2.2.
2) See Section 2.2.
3) True.
Check Your Progress 2
1) Social welfare function is an aggregation of individual preferences.
Briefly write about Bergson and Samulseon, Benthamite and Rawlsian
social welfare function.
2) Refer Sub-section 2.3.1
3) Refer Section 2.2 and 2.3 and write.
4) Welfare maximisation allocation must be Pareto efficient. If not then
there exist some allocation that gives strictly greater utility to someone
and all other get the same utility as in this given allocation. But since by
construction welfare function is increasing in utility it must then give
higher social welfare than the given allocation which contradicts that
we originally had a welfare maximum.
5) ܹሺ‫ݑ‬ଵ ǡ ǥ ǥ Ǥ ǡ ‫ݑ‬௡ ሻ ൌ ƒšሼ‫ݑ‬ଵ ǡ ǥ ǥ Ǥ ǡ ‫ݑ‬௡ ሽ
6) Refer Section 2.3 and answer

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