Question

1. Recall the Edgeworth Box discussed in class.

1. What does it mean for an allocation to be on the contract curve in terms of efficiency and equity?

2. Write and explain an equation that indicates that a group of many people will trade to a Pareto Efficient allocation of goods if markets are perfectly competitive.

Answer 1

a> To be on the contract curve, it implies that the outcome is efficient but it does not gurantee equity.

Efficiency means both can not be better off by moving to another outcome. So, to make one party better off, another one must be worse off. Thus, points on contract curve are efficient but they are not equal. For example, one party having everything and another party having nothing is efficient but not equal.

b> Suppose there are two people A and B and two goods x and y and the utility for both of them are x^2+y^2.

Now, A has initial allocation of (4,6) and B has inital allocation of (6,4). This outcome is not pareto efficient.

The utility of A is 4^2+6^2=52= Utility of B

Now, suppose they exchange 4 unit of x for 4 unit of y, they get (10,0) and (0,10) final outcome.

Thus, they have utility of 10^2=100 each

This is pareto efficient, as you can not make both better off from this outcome.