Internal Assessment

Arrow’s Impossibility Theorem, formulated by economist Kenneth Arrow, states that no

voting system can simultaneously fulfill a set of fair and rational criteria while consistently
producing a coherent collective decision, without leading to a dictatorship. Specifically,
Arrow asserts that any system adhering to the following conditions will inevitably result in
one voter’s preferences dominating the outcome:
• Individual preferences must be complete (able to rank all options), reflexive (an option
is at least as good as itself), and transitive (if X > Y and Y > Z, then X > Z), and the
collective decision must also exhibit these properties.
• If every voter prefers option X to option Y, the group’s ranking must reflect this by
placing X above Y.
• The group’s ranking of two options must be determined solely by voters’ preferences
between those two options, unaffected by preferences for other alternatives.
Arrow’s theorem concludes that any system meeting these axioms will result in a dictatorial
outcome, where a single voter dictates the group’s decision.
For example, imagine 150 voters deciding among three community initiatives—X, Y, Z—
with preferences split evenly:
• 50 rank X > Y > Z.
• 50 rank Y > Z > X.
• 50 rank Z > X > Y.
In pairwise comparisons, 100 voters prefer X over Y, 100 prefer Y over Z, and 100 prefer Z
over X, forming a cycle. This inconsistency highlights the difficulty of aggregating
individual preferences into a stable group choice, as no initiative emerges as the clear winner.

Conditions of the Theorem

Arrow’s theorem hinges on five key axioms that a voting system must satisfy to be
considered fair and rational. These conditions ensure the system can handle diverse
preferences and produce consistent, equitable outcomes:
1. Non-Dictatorship: The collective decision must not be determined solely by one
individual’s preferences, ignoring the inputs of others. This condition ensures that the
system remains democratic by requiring the group outcome to reflect the preferences
of all voters, not just a single “dictator” whose choices override everyone else’s.
2. Unrestricted Domain: The voting system must allow for all possible preference
orderings that voters might have, without restrictions on how they rank the
alternatives. For example, a voter should be free to prefer option A over B over C, or C
over A over B, and the system must still generate a valid outcome, ensuring inclusivity
and flexibility across diverse opinions.
 3. Independence of Irrelevant Alternatives (IIA): The group’s preference between two
alternatives, say A and B, should depend only on how voters rank A versus B, and not
be influenced by their preferences for other alternatives, like C. If voters’ rankings of
A and B remain unchanged, adding or removing C from consideration should not alter
the group’s ranking of A versus B, ensuring decision-making consistency.
4. Pareto Efficiency: If every voter prefers one alternative over another—for instance,
all prefer option A to option B—the group’s collective ranking must reflect this by
placing A above B. This condition ensures that the system respects unanimous
agreement, aligning the group outcome with clear consensus to uphold basic
rationality.
5. Social Ordering: The collective preference must be a complete and transitive
ordering, meaning it can compare any pair of alternatives (e.g., A is preferred to B or
vice versa) and maintain logical consistency. Transitivity requires that if the group
prefers A to B and B to C, it must also prefer A to C, avoiding cycles or contradictions
in the group’s decision-making process.

Importance of this Theorem

Arrow’s Impossibility Theorem has far-reaching implications across economics, political
science, and social choice theory. It highlights the fundamental challenge of designing voting
systems or decision-making mechanisms that fairly aggregate individual preferences into a
collective choice without sacrificing rationality or fairness. For instance, in democratic
elections, the theorem suggests that no system can perfectly reflect voter preferences while
avoiding paradoxes, influencing the design of electoral systems like majority rule or ranked-
choice voting. In economics, it informs welfare economics by showing the difficulty of
creating policies that equitably maximize social welfare when preferences vary widely. The
theorem underscores the trade-offs inherent in group decision-making, prompting
policymakers and theorists to explore alternative mechanisms, such as relaxing certain
conditions, to achieve more practical outcomes.

Implications of Violating the Conditions

Violating one or more of Arrow’s conditions can lead to a voting system that avoids the
impossibility result, producing consistent and non-dictatorial outcomes, but each violation
comes with trade-offs that affect fairness, rationality, or practicality:
1. Violating Non-Dictatorship: Allowing a dictator—where one voter’s preferences
always determine the group outcome—ensures a consistent and transitive social
ordering, as there are no conflicting preferences to reconcile. However, this eliminates
fairness entirely, as all other voters’ preferences are ignored, resulting in an
undemocratic system that contradicts the goal of collective decision-making. For
example, in a small committee, if one member’s ranking always prevails, decisions are
consistent but exclude broader input.
2. Violating Unrestricted Domain: Restricting voter preferences, such as requiring
“single-peaked” preferences (where voters have a clear favorite and preferences
 decline as options deviate from it), can lead to consistent outcomes, as seen in the
Median Voter Theorem under majority rule. This allows a system to select a stable
winner, like choosing a tax rate where voters prefer rates closer to their ideal.
However, this limits voter freedom, excluding complex or polarized preferences,
which may alienate groups with diverse or non-linear views, reducing the system’s
inclusivity.
3. Violating Independence of Irrelevant Alternatives (IIA): Ignoring this condition
allows systems like ranked-choice voting, where the introduction of a third alternative
can change the outcome between two others, even if their relative rankings remain
unchanged. While this can produce outcomes that better reflect overall preferences in
some cases—such as electing a compromise candidate—it introduces the risk of
strategic voting, where voters manipulate rankings to influence results, potentially
undermining trust in the system. For instance, in an election, adding a minor candidate
might shift the winner, even if voters’ preferences between the main candidates are
unchanged.
4. Violating Pareto Efficiency: If the system does not respect unanimous preferences—
where all voters prefer A to B but the group ranks B above A—it fails to align with
clear consensus, making the system appear irrational and unfair. This could lead to
outcomes that defy logical expectations, such as a policy being rejected despite
universal support, eroding the system’s legitimacy and causing voter dissatisfaction.
5. Violating Social Ordering:
• Non-Transitivity: If the collective preference is not transitive, it can lead to
cycles, known as the Condorcet Paradox (e.g., A > B, B > C, C > A). This
prevents a clear winner, as in a city council vote where Project A beats B, B
beats C, and C beats A, leading to indecision or arbitrary choices that fail to
reflect a stable group preference.
• Incomplete Rankings: If the system cannot rank certain pairs of alternatives, it
may become paralyzed, unable to decide between options when preferences
conflict. For example, in a budget allocation scenario, if the system cannot
compare two proposals, decision-making stalls, delaying critical outcomes.
Conclusion
Arrow’s Impossibility Theorem reveals a fundamental limitation in collective decision-
making: no voting system can perfectly balance fairness, rationality, and inclusivity without
resorting to a dictatorship. By violating conditions like unrestricted domain or IIA, systems
can achieve consistent outcomes, but at the cost of restricting voter freedom or introducing
vulnerabilities like strategic voting. These trade-offs highlight the ongoing challenge of
designing equitable decision-making processes in diverse societies, encouraging the
exploration of alternative frameworks that prioritize practicality over theoretical ideals.
 Continuous Assessment
The Monopolist’s Motive Behind Price Discrimination
A monopolist employs price discrimination to enhance its profits by leveraging differences in
consumers’ willingness to pay. The strategy involves charging varied prices for the same
product based on consumer characteristics, market segments, or purchase quantities, rather
than a uniform price. The core principle is that consumers exhibit varying demand
elasticities, enabling the monopolist to implement price discrimination by charging higher
prices to those with inelastic demand and lower prices to those with elastic demand.
The key motives include:
• Capturing Consumer Surplus: Consumer surplus is the difference between what
consumers are willing to pay and what they actually pay. By tailoring prices to
different segments of the market, a monopolist can extract more of this surplus,
converting it into revenue. For example, a monopolist might charge higher prices to
consumers with inelastic demand (less sensitive to price changes) and lower prices
to those with elastic demand (more sensitive to price changes).
• Increasing Market Coverage: Price discrimination allows a monopolist to sell to
consumers who would otherwise be priced out of the market under a single-price
strategy. For instance, offering discounts to students or low-income groups can
expand the customer base, increasing total output and revenue.
• Maximizing Profits Across Heterogeneous Consumers: Consumers have varying
preferences, incomes, and valuations for a product. Price discrimination enables the
monopolist to segment the market and charge prices that align with each group’s
willingness to pay, thereby optimizing profits. This is particularly effective in
markets where consumer valuations differ significantly.
• Reducing Deadweight Loss: Under a single-price monopoly, some consumers
who value the product above its marginal cost but below the monopoly price are
excluded, creating deadweight loss. Price discrimination, especially perfect (first-
degree) price discrimination, can reduce this loss by allowing the monopolist to sell
to more consumers at prices closer to their willingness to pay.

Impact on Consumers
The impact of price discrimination on consumers varies depending on its form and
implementation, making it not inherently detrimental. The effects can be analyzed across its
three degrees:
• First-Degree (Perfect) Price Discrimination: The monopolist charges each consumer
their maximum willingness to pay, as seen with personalized pricing in luxury car
sales. Consumers still purchase if the price matches their valuation, but they retain no
surplus, with all benefits accruing to the monopolist. This achieves Pareto efficiency
by maximizing output, yet consumers gain no net benefit, and over time, this could
discourage repeat purchases if they feel fully exploited. Additionally, the lack of
surplus may push some consumers to seek alternatives, potentially reducing long-term
market loyalty.
 • Second-Degree Price Discrimination: Prices vary with quantity, such as tiered
pricing for internet data plans. Heavy users might benefit from lower per-unit costs,
while light users pay more per unit. The outcome is mixed—some consumers gain
access or savings, while others face higher effective prices, and this variability can
lead to confusion or dissatisfaction among those unaware of optimal purchasing
strategies. Moreover, the complexity of pricing tiers might deter some consumers from
maximizing their benefits, further complicating the welfare impact.
• Third-Degree Price Discrimination: Different groups face different prices, like a
cinema charging less for matinee shows versus evening screenings. Elastic-demand
groups (e.g., retirees) benefit from lower prices, while inelastic-demand groups (e.g.,
last-minute bookers) pay more. Total consumer welfare depends on the balance of
gains and losses, with output potentially increasing, benefiting society overall, though
this can sometimes foster resentment among higher-paying groups who perceive
unfairness. Furthermore, the success of this strategy may depend on the monopolist’s
ability to accurately segment markets, as misjudgments could lead to unintended
losses for certain consumer segments.
In positive scenarios, consumers gain access to goods they couldn’t afford otherwise, such as
discounted medications for rural patients. However, those with inelastic demand may face
exploitation, though the net effect often hinges on increased market coverage rather than
universal harm.

Pareto Relation Between Single-Price Monopolist and Two-Part Tariff Outcomes

To assess the Pareto relationship, we compare the welfare outcomes for the monopolist and
consumers under a single-price monopoly versus a two-part tariff, determining if one can
improve without harming the other.

Single-Price Monopoly
In a single-price monopoly, the monopolist maximizes profit by setting output where
marginal revenue (MR) equals marginal cost (MC), then charging a price (P*) on the demand
curve corresponding to that output. For example, a single-price electricity provider might
determine MR = MC at an output of Q* = 200 units, setting P* = $15, which is above the
marginal cost of $10. This leads to:
• Consumer Surplus: Only consumers willing to pay $15 or more purchase, so surplus
is the area above P* and below the demand curve, benefiting fewer consumers due to
the high price.
• Producer Surplus: The monopolist earns a profit of (P* - MC) × Q*, or ($15 - $10) ×
200 = $1,000, capturing revenue from the markup over marginal cost.
• Deadweight Loss: Consumers who value electricity between $10 (MC) and $15 are
excluded, reducing output below the socially efficient level (e.g., 250 units where P =
MC), resulting in a deadweight loss of potential welfare (e.g., from the 50 units not
produced).
Two-Part Tariff
Under a two-part tariff, the monopolist employs a pricing strategy consisting of a fixed fee
(entry or access fee) charged to all consumers, combined with a per-unit price for each unit
consumed. The optimal design typically sets the per-unit price equal to marginal cost (MC)
to encourage efficient consumption, while the fixed fee is set to extract the maximum
consumer surplus that consumers are willing to pay without deterring participation. For
instance, if MC = $10 and the demand curve indicates consumers value the first unit at up to
$25, the monopolist might set the per-unit price at $10, allowing consumption up to the
efficient quantity of 250 units, and set a fixed fee of $15 per consumer, capturing the surplus
of the marginal consumer (e.g., one valuing the product at $25 minus the $10 per-unit cost).
• Consumer Surplus: Reduced to zero for participating consumers, as the fixed fee
extracts all surplus above the per-unit cost, though they benefit from accessing the
efficient quantity at a cost-reflective price.
• Producer Surplus: Significantly increases, as the monopolist collects the fixed fee
from all consumers plus revenue from units sold at MC, potentially exceeding single-
price monopoly profits (e.g., $15 fixed fee per consumer + $10 × 250 units).
• Deadweight Loss: Eliminated, as the output aligns with the socially optimal level
where price equals marginal cost, maximizing total welfare.
Pareto Analysis
• Monopolist: Strictly better off with a two-part tariff, as the fixed fee allows the
monopolist to capture the entire consumer surplus in addition to covering production
costs, leading to higher profits compared to the single-price monopoly.
• Consumers: Not necessarily worse off—those able to pay the fixed fee gain access to
the efficient quantity at a per-unit price equal to MC, which was unavailable under the
single-price monopoly’s restricted output. However, their net surplus is zero after
paying the fixed fee, leaving them at a break-even point rather than a net gain.
• Social Welfare: Improves due to the elimination of deadweight loss, as the efficient
quantity is produced and consumed, aligning total surplus with the optimal level.
• Pareto Efficiency: The two-part tariff achieves efficiency by matching output to the
point where demand intersects MC, unlike the single-price monopoly’s suboptimal
output. However, it is not Pareto superior because some consumers (e.g., those with
high willingness to pay) lose surplus to the fixed fee, and hypothetical compensation
from the monopolist’s extra profits would be needed to make all parties better off,
which is typically impractical.
Conclusion
The two-part tariff outperforms the single-price monopoly in total welfare by eliminating
deadweight loss and maximizing output, benefiting the monopolist significantly. Consumers
are not worse off in terms of access but lose surplus, preventing a strict Pareto improvement.
The single-price monopoly’s inefficiency underscores the two-part tariff’s potential, though
equitable surplus distribution remains a challenge.