Pareto Optimality: Conditions and Composition

1. Introduction to Pareto Optimality: The welfare of a

society depends, in the broadest sense, upon the
satisfaction levels of all its consumers. But almost every
change in the economic state of the society will have
favourable effects on some members and unfavorable
effects on others.
Evaluation of such a social change is impossible unless
the economist is ready to go into interpersonal
comparison of utility under some value judgement,
which he may not be willing to do. Rather, he will be
willing to evaluate such changes where at least one
person has been better off and no one worse off.
The Italian economist Vilfredo Pareto (1848-1923) said
that if a change in the economic state makes at least one
individual better off without making anyone worse off,
then the change is for the betterment of social welfare,
i.e., the change is desirable. In that case, we say that the
initial state was Pareto-non-optimal.
On the other hand, if a change makes no one better off
and at least one worse off, implying that the change will
make the society worse off, then, from the point of view
of welfare, the initial economic state is Pareto-optimal.
Therefore, the Pareto optimality criterion can be
stated in this way:
A situation in which it is impossible to make any one
better off without making someone worse off, is said to be
Pareto optimal or Pareto-efficient.
Obviously, the concept of Pareto optimality avoids
interpersonal comparison of utility. Since most
government policies involve changes in the economic
state, which benefit some people and bring discomforts to
others, it is obvious that the concept of Pareto optimality
is of limited applicability in the real world situations.
Pareto Optimality Conditions: For the attainment of
Pareto-efficient situation in an economy, three marginal
conditions must be satisfied.
These are:
(i) Marginal condition for efficiency in the allocation of
factors among firms (efficiency in production);
(ii) Marginal condition for efficiency of distribution of
commodities among consumers (efficiency in
consumption); and
(iii) Marginal condition for efficiency in the allocation
of factors among commodities (efficiency in product-
mix or composition of output).
Assumption:
In order to derive these three marginal conditions for the
attainment of Pareto optimality, we shall assume, for the
sake of simplicity, that there are only two consumers (I
and II), two factors of production (X1 and X2). and two
commodities (Q1 and Q2), i.e., our model here would be
a 2 x 2 x 2 model.
2. Efficiency in Production: If we assume that the
consumer goods are of “more is better” type and that
external effects are absent in consumption, then an
increment in the quantity produced of at least any one
consumer good without a decrement in the quantity of
any other, can lead to an improvement in utility level of
at least one consumer without utility decrements for
others.
Therefore, Pareto optimality in production requires that
the output level of each consumer good be at a
maximum, given the output levels of all other consumer
goods.
We may derive the marginal condition for Pareto-
efficiency in production with the help of Fig. 21.1
which is called an Edge-worth box diagram. The
dimensions of the rectangle in Fig. 21.1 represent the
total available quantities, and x02, of the inputs X1 and
X2 that would all be used to produce the consumer
goods Q1 and Q2.
Any point in the box represents a particular allocation of
the inputs over the production of the two goods.

For example, if the allocation of the inputs is given by the

point B, the quantities of X1 and X2 used in the production
of good Q1 are measured by the coordinates of B with
reference to the origin O, and the quantities of X1 and
X2 used in the production of good Q2 are measured by the
coordinates of point B with reference to the origin O’.
The isoquant (IQ) maps for goods Q, and Q2 are given in
Fig. 21.1 with reference to the points of origin O and O’,
respectively.
Now, the marginal condition for Pareto efficiency in
production would be obtained if we maximise the output
of good Q1 subject to a given output level of good Q2.
Such maximisation would occur at a point of tangency
between the IQs for the two goods.
For example, maximisation of output of Q1 subject to the
quantity of Q2 as given by IQ3, would occur at the point
of tangency S between the IQs for the goods. Similarly,
maximisation of output of Q2 subject to the quantity of Qi
as given by IQ3, would occur at the point of tangency R
between the IQs for the two goods.
However, at the point of tangency between the IQs for the
two goods, we have numerical slope of IQ for good Q1 =
numerical slope of IQ for good Q2
MRTSX1, X2 or, in the production of Q1 = MRTSX1,X2 in the
production of Q2 (21.1)
Thus, the marginal condition for Pareto efficiency in
production is given by (21.1) which states that the
marginal rate of technical substitution (MRTS) between
the two inputs should be the same in the production of the
two goods.
It is obvious from above that the Pareto efficiency point in
production must necessarily be a point of tangency
between the IQs for the two goods. If we join all the
points of tangency between the IQs for the two goods, by
a curve, we would obtain what is called the Edge-worth
contract curve for production which we would denote by
CCP. The CCP would run from the point O to the point O’
in Fig. 21.1.
We have obtained then that all the points on the CCP are
Pareto-efficient points in production. That is, if we are at
some point on the CCP, then we are no longer able to
effect by a change in the allocation of the inputs, an
increase in the output of one of the goods without
reducing the quantity of the other.
On the other hand, any point like B in Fig. 21.1, which
does not lie on the CCP and which does not satisfy
condition (21.1), is Pareto-non-optimal. At the point B,
we are on IQ2 for good Q1 and on IQ’2 for good Q2.
However, after a reallocation of the resources, if the
economy reaches at some point on the CCP between R
and S, then the quantities of both the goods would be
larger, and if the economy reaches just at the point R or S,
then the quantity of one of the goods would be larger and
that of the other good would remain the same.
This shows that any point B that does not lie on the CCP,
is Pareto-non-optimal, and, by a reallocation of the
resources, if the economy is brought on to some point on
the segment RS of the CCP, then at least one of the goods
would be produced in a larger quantity, that of the other
remaining the same.
We have seen that all the points on the CCP are Pareto-
optimal. However, we cannot compare any two points,
e.g., R and S, on the CCP because if the economy moves
from S to R, the output of Q1 would increase and that of
Q2 would decrease resulting in advantage for some people
and disadvantage for some others, and since interpersonal
comparison of utility is ruled out, we cannot compare the
points R and S.
Mathematical Derivation of the Conditions:
We may also derive mathematically the marginal
condition for Pareto efficiency in production.
Let us suppose that the production functions for the
goods Q1 and Q2 are:
q1 = q1 (x11, x12)
and q2 = q2 (x21, x22) (2.12)
where q1 and q2 are the quantities produced of goods
Q1 and Q2, x11 and x12 are the quantities of inputs X1 and
X2 used in the production of Q1, and x21 and x22 are the
quantities of these inputs used in the production of good
Q2.
Since the total available quantities of the two inputs
are x01 and x02, we may write:
As per the requirements of Pareto optimality, the
efficiency conditions may be derived if we maximise
q1 as given by (21.2) subject to:

where q02 is any given quantity of good Q2.

The relevant Lagrange function for this constrained
maximisation problem is:
The first order or the necessary conditions for
maximum q1 subject to q2 = q02 are:

Pareto efficiency condition (21.1) or (21.7) gives us that

the available quantities of the two inputs, X1 and X2,
should be allocated over the production of the two goods,
Q1 and Q2, in such a way that the MRTS between the
inputs may be the same in the production of the two
goods.
We may now see with the help of a simple example why
condition (21.7) is necessary for Pareto efficiency in
production. Let us suppose that in the production of Q1,
MRTSX1,x2 = 2 and, in the production of Q2, MRTSX1,x2 =
1
i.e., the MRTS is not the same in the production of the
two goods.
It follows from above that we can substitute 1 unit of
X1 for 2 units of X2 in the production of Q1, and keep the
output of Q1 constant. Similarly, we can substitute 1 unit
of X1 for 1 unit of X2 in the production of Q2, and keep
the output of Q2 constant. So, all we have to do is to take
1 unit of X1 out of the production of Q2 and use it in the
production of Q1.
This releases 2 units of X2 from the production of Q1, 1
unit of which may be transferred to the production of
Q2 to keep its output at the initial level. If we do all this,
the output of Q1 and Q2 would remain unchanged, and yet
we are left with an extra unit of X2. We can use this unit
in the production of Q1 (or Q2) and get more of Q1 (or of
Q2). Thus, one output is increased without reducing the
other output.
The above example shows that if the MRTSX1, X2 in the
production of the two goods are not equal, if MRTS in the
production of Q2 is lower, say, than that in the production
of Q1; then we have to take away the marginal unit of
input X1 from the production of Q2 and transfer it to the
production of Q1 where the MRTSX1,X2 is higher, and take
away from the field the input X2, in exchange.
As we continue the process, the MRTS in the production
of Q2 would rise as the quantity of X1 falls, and the MRTS
in the production of Q1 would fall as the quantity of
X1 increases, and, as we have seen, the allocation
becomes better in the Pareto sense.
Therefore, if we are to reach the Pareto-efficient situation,
we have to continue the process till the MRTS becomes
equal in the production of the two goods. For when the
MRTS in the production of both the goods becomes the
same, no further reallocation will be able to increase the
production of at least one of the goods without reducing
the production of the other good.
To understand this, let us suppose that the MRTS between
the two inputs are equal in the production of the two
goods, and it is equal to 4. In that case, if we take away 1
unit of X, from the production of Q2, and transfer it to the
production of Q1, the latter would release 4 units of X2 in
exchange, so that the output level of Q1 might remain
constant.
These 4 units of X2 should be transferred to the
production of Q2 because there the MRTS is 4, and when
4 units of X2 are given to be used in the production of
Q2 in exchange for 1 unit of X1, the output of Q2 would
remain unchanged at the initial level.
Therefore, by means of a reallocation of the resources, we
have not been able to increase the production of at least
one of the goods. On the contrary, a reallocation of the
inputs would keep the outputs of the two goods
unchanged at their initial quantities.
3. Pareto Optimality in Production and Perfect
Competition: Pareto optimality in production is
guaranteed under perfect competition. For, under
perfect competition, the prices r1 and r2 of the two
inputs, X1 and X2, are given to the firms that produce
the goods Q1 and Q2, and each profit-maximising firm
equates the MRTSX1,x2 to the ratio of the prices of the
inputs.
That is, for the producer of Q1 we get:
From (21.8), we obtain:
MRTSx1, x2 in the production of Q1 = MRTSx1,x2 in the
production of Q2 (21.9)
Since condition (21.9) is the same as condition (21.7),
Pareto efficiency in production is a certainty under perfect
competition.
We may now obtain a graphical solution of equation
(21.7) or (21.9) for the allocation of inputs X1 and X2 over
the production of goods Q1 and Q2 and for the quantities
produced of Q1 and Q2. The satisfaction of the marginal
condition (21.7) or (21.9) is guaranteed under perfect
competition.
Let us suppose that in the competitive markets the prices
of the inputs are given to be r1 and r2. Let us now draw a
straight line ST of slope – r1/r2 through the point O’ in
Fig. 21.1, and pick up the point e on the contract curve for
production (CCP) where the common slope of the
isoquants has been equal to the slope of the line ST. That
is, at the point e, we have numerical slopes of the IQs of
two individuals = the numerical slope of the line ST =
r1/r2

That is, at the point e in Fig. 21.1, the marginal condition

for efficiency of production has been satisfied. At this
point quantities of the two inputs, x011 and x021 would be
used in the production of Q1 and these quantities, when
substituted in the production function for Q1, would give
us the output quantity of Similarly, quantities of the two
inputs, x021 and x022, would be used in the production of
Q2 and the output here would be q02.
4. Efficiency in Consumption or Exchange: A
distribution of the given quantities of the two
commodities Q 1 and Q2 among two consumers I and II
is said to be Pareto-efficient if it is impossible, by a
redistribution of these goods, to increase the utility of
one individual without 0 reducing the utility of the other.
The marginal condition for efficiency in consumption or
exchange can be derived with the help of the Edgeworth
box diagram given in Fig. 21.2. The dimensions of the
rectangle in Fig. 21.2 represent the total available quan-
tities, q01 and q02, of the two goods in a pure- exchange
economy.
Any point in the box represents a particular distribution
of the commodities between the two consumers. For ex-
ample, if the distribution of commodities is given by
point A, the quantities of Q 1 and Q2 consumed by
consumer I are measured by the coordinates of A with
respect to the origin O and the quantities of the two
goods consumed by II are measured by the coordinates
of A w.r.t. the origin O’.
The indifference map of consumer I has been given
w.r.t. the origin O and that of II has been given w.r.t. the
origin O’.
Now, the marginal condition for Pareto efficiency in
consumption or exchange would be obtained if we
maximise the utility level of consumer I or II subject to
the given utility level of consumer II or I. Such
maximisation would occur at a point of tangency
between the indifference curves (ICs) of the two
consumers. For example, maximisation of utility of
consumer I subject to the utility level of II as given by
IC1 of consumer II, would occur at the point of
tangency, E, between the ICs of two consumers.
Similarly, maximisation of utility of consumer II subject
to the utility level of I as given by IC 3 of consumer I
would occur at the point of tangency, F, between the ICs
of the two consumers. It may be added, therefore, that
the exchange equilibrium is not unique.
Now, at the point of tangency between the ICs of the
two consumers, we have numerical slope of IC of
consumer I = numerical slope of IC of consumer II
=> MRSQ1,Q2 of consumer I = MRS Q1,Q2 of consumer
II (21.11)
Thus, the marginal condition for Pareto efficiency in
consumption is given by (21.11). It is obvious from
above that any point of tangency between the ICs of two
consumers is a Pareto efficiency point. If we join all
such points of tangency by a curve in Fig. 21.2, we
obtain what is known as the Edgeworth contract curve
for consumption or Exchange (CCC or CCE), which
would run from the point O to the point O’.
Therefore, all the points on the contract curve at which
(21.11) is satisfied, are Pareto-efficient points in
consumption. For, if we are at some point on the
contract curve, in Fig. (21.2), we are not able to effect,
by a change in the distribution of the goods, an
improvement in the utility of one consumer without
reducing the utility of the other.
Therefore, let us note again that the point of Pareto
efficiency in exchange is not unique. On the other hand,
any point like A, which does not lie on the contract
curve and which does not satisfy (21.11), is Pareto-non-
optimal. At the point, A, consumer I is on his IC 2 and
consumer II is on his IC 2.
However, after a redistribution of the commodities, if
the consumers are brought at some point on the contract
curve between E and F, then both the consumers would
benefit for both of them would reach now higher ICs,
and if they are brought just at the point E or F, then one
of them will benefit, while the utility level of the other
will remain the same.
This shows that any point A, which does not lie on the
CCE, is Pareto-non-optimal and by a redistribution of
the commodities, if we bring the consumers on to the EF
segment of the CCE, then at least one of them would
benefit, the utility level of the other remaining the same.
We have seen that all points on the contract curve are
Pareto-efficient. However, we cannot compare the
points on the contract curve because that will involve
interpersonal comparison of utility, which is not
possible without an explicit value judgement.
Mathematical Derivation of the Conditions:
We may also derive mathematically the marginal
condition for Pareto efficiency in consumption, or,
Exchange. Let us suppose that the utility functions of
the two consumers I and II are respectively,
u1 =u1 (q21, q12)
and u2 = u2 (q21, q22) (21.12)
where q11 and q12 are the quantities of Q 1 and
Q2 consumed by consumer I and q 21 and q22 are the
quantities of the two goods consumed by individual II.
If and q2 are the given quantities of the two goods,
then we have:
q11 +q21 =q01
and q12+q22=q02 (21.13)
It is evident from (21.12) that the utility level of each
consumer depends only upon the quantities consumed
by him and not upon the quantities consumed by the
other. That is, it has been assumed here that external
effects are absent.
Pareto-efficiency in consumption implies that u 1 is
maximised subject to a given u 2 = u02, or, the other way
round. Let us then form the relevant Lagrange function,
V, for the constrained maximisation of u 1 as
V = u1 (q11,q12) + λ[u2(q2(q21, q22)-
u02] (21.14)
where λ is the Lagrange multiplier.
Now, the first-order conditions for the constrained
maximisation of u 1 subject to u2 = u02 are:

Pareto-efficiency condition (21.11) or (21.16) gives us

that the given quantities of the two goods should be
distributed among the two consumers in such a way that
the MRS between the goods may be the same for the
two consumers.
We may now see with the help of a simple example why
condition (21.11) is necessary for Pareto efficiency in
consumption.
Let us suppose that:
for individual I, => MRS Q1,Q2 = 2 and
for individual II, => MRS Q1,Q2 = 1
i.e., the MRS is not the same for the two individuals.
This means that individual I is willing to exchange 2
units of Q2 for getting 1 unit of Q 1 and individual II is
willing to exchange 1 unit of Q 2 for getting 1 unit of Qi.
In such a case, where the MRS is not the same for the
two individuals, we may redistribute the goods to make
at least one of them better off without making the other
consumer worse off.
What we have to do here is to take away 1 unit of
Q1 from consumer II and give it to I who will give us 2
units of Q2 in exchange. Now we give one of these units
to B to keep his utility level constant—he wants to have
1 unit Q2 for giving up 1 unit of Q 1.
But we have now 1 unit of Q 2 left. We can give it to
either I or II, and thus make either I or II better off
without making the other person worse off. Thus, the
initial allocation was not efficient.
The above example shows us that if the MRS of the two
individuals are not equal, if the MRS of II is lower, say,
than that of I, then we have to take away the marginal
unit of good Q, from individual II and give it to I whose
MRS is higher, and take away from him good Q 2 in
exchange.
As we continue the process, the MRS of II would rise as
the quantity of Q 1 with him decreases and the MRS of I
would decrease as the quantity of Q 1 with him increases,
and, as we have seen, the distribution becomes better in
the Pareto sense. Therefore, if we are to reach the
Pareto-efficient situation, we have to continue the
process till MRS of the two persons become equal.
For when the MRS of the two persons are equal, no
further redistribution will be able to do good to at least
one of them without harming the other. To understand
this, let us suppose that MRS of both the persons are
equal, and it is equal to 4.
In that case, if we take away 1 unit of Q 1 from consumer
II and give it to consumer I, the latter would give us 4
units of Q2 in exchange in order to keep his utility level
intact. If we now give these 4 units of to individual II,
his utility would assume the initial level. That is, by
means of a redistribution of the goods, we have not been
able to improve the utility level of at least one of the
persons. On the contrary, a redistribution of the goods
would keep the individuals on their initial utility levels.

5. Pareto Optimality in Consumption or Exchange and

Perfect Competition:
It can be easily shown that Pareto optimality in
consumption is automatically achieved under perfect
competition. For under perfect competition, the prices
P1 and P2 of the two goods are given to the consumers,
and each utility-maximising consumer equates his MRS
of Q1 for Q2 to the ratio of the prices of the goods.
That is, for consumer I, we get:
which is nothing but the Pareto-efficiency condition
(21.16) or (21.11).
Thus, perfect competition guarantees Pareto-efficiency
in the distribution of commodities among the
consumers.

6. Pareto Optimality Conditions when the External

Effects are Present:
The marginal condition for a Pareto-efficient
distribution of given amounts of two goods (Q 1 and Q2)
between the two individuals (I and II) as given by
(21.18) has been obtained on the basis of the assumption
that externalities in consumption are absent.
We shall now see that if the external effects are present,
the Pareto optimality condition in consumption would
generally be different from the marginal condition
(21.18).
Let us assume that the external effects are present in
consumption in the sense that the utility level of one
consumer depends also on the consumption of another.
Let us assume that the two consumers’ utility
functions are given by:

Pareto optimality will be achieved if u 1 is maximum

subject to a given level of u 2 = u02.
In order to derive the conditions for this constrained
maximisation, we have to form the Lagrange
function:
Equation (21.23) is the necessary’ condition for Pareto
optimality in consumption when external effects are
present. It generally differs from the Pareto optimality
marginal condition as given by (21.18) or (21.16) or
(21.11).
Perfect completion guarantees the attainment of (21.11)
but not of (21.23). It is evident from (21.23) that if the
external effects were absent, we would have ∂u 1/∂q21,
∂u1/∂q22, ∂u1/∂q11 and ∂u2/∂q12, all equal to zero, and
then (21.23) would have reduced to (21.11).
Since we have assumed here that the partial derivatives
of the utility functions are functions of all variables,
viz., q11, q12, q21 and q22, the optimum position of each
consumer depends upon the consumption level of the
other.
For example, if we assume that the only external
effect present in the two-consumer model is
∂u2/∂q11 <; 0, then equation (21,23) becomes:

intuitively understood why this is so. If consumer I’s

consumption of Q 1 increases, then the utility level of
consumer II declines. This implies that the marginal
significance of Q 1 to consumer II is relatively large,
which, again, implies that the MRS Q1,Q2 of consumer II
should be smaller at the state of optimal distribution of
the goods.
For, at this distribution as compared with the MRS-
equating distribution, the quantity of Q 1 possessed by
consumer II would be larger than that possessed by
consumer I.
It can be shown diagrammatically with the help of Fig.
21.3 that condition (21.16) does not necessarily ensure
Pareto optimality in the presence of external effects.
Figures 21.3(a) and 21.3(b) give us the indifference map
of consumers I and II, respectively. Let us assume that
initially, consumer I consumes the combination A and
consumer II consumes the combination E.
The MRSQ1,Q2 of the two consumers are equal at their
utility maximising points, given the prices of the goods.
Let us now assume that there are no external effects for
consumer I, i.e., I’s utility level is not affected by the
consumption of II.
Although, consumer II’s utility level is affected by the
consumption of consumer I. Let us suppose, as we have
done above, that as I consumes more of Q 1, II’s utility
level declines, i.e., ∂u 2/∂q11 < 0. This is the external
effect present here.
Now, in Fig. 21.3(b), consumer II’s indifference curves
(solid ones) have been drawn on the assumption that I’s
consumption is given by combination A. In their
individual equilibrium situations, consumer I’s utility
index is 100 and that of II is 80.
Let us now redistribute the commodities between the
two individuals such that their aggregate quantities
remain unchanged and I moves to point C having less of
Q1 and more of Q 2 and II moves to point G having more
of Q1 and less of Q 2 (AB = FG and BC = EF). The
utility level of consumer I has not changed because of
this redistribution—he remains on the same IC.
However, since consumer I’s consumption of Q 1 has
decreased, consumer II’s preference- indifference
pattern would be affected. His new ICs are given by the
dotted curves. Also, at the point G, consumer II’s utility
level has increased to 90 since I is now consuming less
of Q1.
Therefore, by means of the redistribution, we have been
able to raise II’s utility level, I’s level remaining
constant. That is, the initial equilibrium positions at A
and E where the MRS of the consumers had been equal,
were Pareto non-optimal. Therefore, we have seen that
equality of MRS of the two consumers does not ensure
Pareto optimality.
In the present equilibrium situations, the MRS of
consumer I has increased since he has moved north-
westward along the same IC, and the MRS of II has
decreased since he has moved southeastward, not along
the same IC, but along an almost parallel IC.
That is, if the said external effect is present, consumer
II’s MRS would be less than that of consumer I. This
result we have already obtained in the mathematical
analysis given above.
7. Efficiency in the Allocation of Factors among
Commodities, or, Efficiency in Product-Mix or
Composition of Output:
A composition of output or product-mix is Pareto-
efficient if it is impossible to increase the utility of one
individual without reducing the utility of the other by
reallocating the factors among the commodities, leading
to a different product-mix.
The marginal condition for a Pareto-efficient product-
mix states that the marginal rate of product
transformation (MRPT) of Q 2 into Q1 must be the same
as the marginal rate of substitution (MRS) of Q 1 for Q2,
for each consumer.
Here, the MRPT of Q 2 into Q1 is equal to the quantity
by which the production of Q 2 has to be reduced in
order to produce one more (or the marginal) unit of
Q1 and, as such, it is equal to the numerical slope of the
economy’s production possibility curve or frontier (PPC
or PPF).
An economy’s PPC passes through all the combinations
of the two goods (Q 1 and Q2) that the available
quantities of the two inputs (X 1 and X2) can produce
Pareto-efficiently. That is, any combination of the two
goods that lie on the PPC gives us the maximum
quantity of Q1 that can be produced subject to the
production of a given quantity of Q 2, or, the maximum
of Q2 subject to a given quantity of Q 1.
In other words, the combinations of the two goods that
lie on the PPC are those that lie on the Edge-worth
contract curve for production (CCP) [Fig. 21.1]. That is,
there is a one-to-one correspondence between the points
on the CCP and those on the PPC. Since, as we move
along the CCP, the quantity of one of the goods
increases and that of the other decreases, the slope of
the PPC would be negative.
Also, as more and more inputs are removed from the
production of Q 2 and are engaged in the production of
Q1, Q2 may be transformed into Q 1 at a constant rate in
which case the PPC would be a negatively sloped
straight line with its numerical slope or MRPT being a
constant, or, which is more likely, Q 2 may be
transformed into Q 1 at an increasing rate owing to the
law of diminishing marginal product, in which case the
PPC would be concave to the origin with its numerical
slope or MRPT rising as Q 1 increases and
Q2 diminishes, i.e., as we move southeastward along the
curve. We have shown these two types of PPC in Fig.
21.4.
Now, since the MRPT shows the rate at which a good
can be transformed into another in production and the
MRS shows the rate at which the consumers are willing
to exchange one good for another, the Pareto-efficient
product-mix cannot be obtained unless the two rates are
equal. Only then the production sector’s plans may be
consistent with the household sector’s plans, and the
two are in equilibrium.
We may illustrate the argument with the help of a
simple numerical example. Let us assume that at any
particular product composition, the MRPT is 7, i.e., 7
units of Q2 can be transformed into 1 unit of Q 1.
On the other hand, at this product composition, the MRS
for each consumer is, say, 3. That is, for substituting an
additional (or the marginal) unit of Q 1, each consumer is
willing to forego 3 units of Q 2 so that his utility level
might remain constant.
To improve the welfare situation, what we may do in
this case is: we may take away from each consumer 1
unit of Q1 and in its place we may have 7 units of
Q2 and then, out of these 7 units, we may give 3 units to
the consumer to compensate for his loss of 1 unit of Q 1.
We are then left with 4 units of Q 2 for each consumer.
If their number is 2, then we are left with 8 units of
Q2 some of which we may give to consumer I and some
to consumer II. Thus the utility level of both the
consumers would increase. This shows us that the initial
situation of MRPT ≠ MRS was Pareto-non-optimal.
Now, as we take away Q 1 from each consumer, his
MRSQ1,Q2 would increase (from 3) and as we move
northwestward along the PPC curve to have Q 2 in its
place, the MRPT would decrease (from 7). We have to
continue the process unless at some product
composition MRPT becomes equal to MRS.
Therefore, the marginal condition for the Pareto-
efficient product-mix gives us that the MRPT between
the products should be equal to the MRS of each
consumer. It may very well be seen that once these two
become equal, no improvement in welfare can be
achieved by any further change in product composition.
For example, if both MRPT and MRS are equal to 5,
say, then, if we take away 1 unit of Q 1 from each
consumer, 5 more units of Q 2 would be obtained in its
place, and all of these 5 units would have to be given to
the consumer to compensate for his loss of 1 unit of
Q1—to keep him on his initial utility level. Thus,
nothing would be available for any improvement.
On the basis of the above analysis, we may write the
marginal condition for the Pareto- efficient product-mix
or composition of output as
MRPTQ2 into Q1 = MRSQ1,Q2 of consumer I = MRS Q1,Q2 of
consumer II (21.25)

8. Pareto-Optimal Composition of Outputs and Perfect

Competition:
Like the other two marginal conditions, the third
marginal condition of Pareto-efficient composition of
output is also guaranteed by perfect competition, where
the prices p1 and p2 of the goods Q 1 and Q2, are given to
the two firms and two consumers.
Also, in profit-maximising equilibrium under perfect
competition, we have the marginal cost of production
(MC1) of Q1 equal to pi and the marginal cost of
production (MC2) of Q2 equal to p2 (i.e., p1 = MQ and
P2 = MC2).

We have seen above that the Pareto-efficient product-

mix cannot be obtained unless the MRPT of Q 2 into
Q1 and the MRS of Q 1 for Q2 for each consumer are
equal, and that this condition is guaranteed under
perfect competition. We may now see graphically how
eqn. (21.28) can be solved for the combination of the
two goods that would make the production sector’s
plans consistent with the household sector’s plans.
We may now come to the distribution of the goods
between the two consumers, I and II. They have to be so
distributed that the Pareto-efficiency in consumption is
achieved, i.e., the marginal condition for such efficiency
is satisfied.
As we know, this marginal condition is:

We also know that the satisfaction of this condition is

guaranteed under perfect competition, since both of
them would be equal to p1/p2 which is given and
constant:
In Fig. 21.5, the Pareto-efficient distribution of the
goods is obtained at the point e on the Edgeworth
contract curve for consumption (CCC), for, at this point,
both the indifference curves (ICs) of the two consumers
have touched the line A’B’ which is parallel to the line
AB.
That is, in order to obtain the Pareto-efficient
distribution of the goods, we have to find out the point
(like e) on the Edgeworth CCC at which the numerical
slopes of the ICs of the two consumers are equal to
p1/p2 which is here the numerical slope of the line AB.
To be more specific, as the solution of eqn. (21.26), we
have obtained the economy’s production of the two
goods to be E(q01q02) and by solving (21.17), we would
obtain the distribution of these quantities between the
two consumers (at the point e) to be (q011, q012) for the
first consumer and (q021,q022) for the second consumer.
We have obtained, therefore, that the equilibrium
commodity combination for our society consisting of
two profit-maximising firms and with given quantities
(x01 and x02) of two inputs, is the one where the
condition given by equation (21.27) or equation (21.28)
is satisfied.
We might remember at this point that the PPC passes
through the commodity combinations implicit at the
points on Edgeworth contract curve for production
(CCP), i.e., these commodity combinations on the CCP
have been mapped into the PPC, or, there is a one-to-
one correspondence between these commodity
combinations implicit at the points on the CCP and
those lying on the PPC.
(21.27) gives us that the point where the condition for
equilibrium commodity combination is satisfied is the
point of tangency between the PPC curve and line of
slope –p1/p2. In Fig. 21.5, AB is this line, say, and it has
touched the PPC curve at the point E. Therefore, the
society’s equilibrium production point is the point E,
and it should produce q 01 and q02 of the two
commodities.

Conditions of Pareto Optimality (With Diagram)

1. Efficiency in Exchange:

The first condition for Pareto optimality relates to

efficiency in exchange. The required condition is that
“the marginal rate of substitution between any two
products must be the same for every individual who
consumes both.”
It means that the marginal rate of substitution (MRS)
between two consumer goods must be equal to the ratio
of their prices. Since under perfect competition every
consumer aims at maximising his utility, he will equate
his MRS for two goods, X and Y to their price ratio
(Px/Py).
Suppose there are two consumers A and В who buy two
goods X and Y, and each faces the price ratio P x/Py…
Thus A will choose X and Y such that his AMRSxv =
Xx/Py. Similarly В will choose X and Y such that his
MRSXY =Px/Py. Therefore, the condition for efficiency
in exchange is AMRSxv = BMRSxv –Px/Py.
The box diagram Figure 1 explains the optimum
condition of exchange. Take two individuals A and В
who possess two goods X and Y in fixed quantities
respectively. O a is the origin for consumer A and O b the
origin for В (turn the diagram upside down for its
understanding).
The vertical sides of the two axes, O a and Ob, represent
good Y and the horizontal sides, good X. The
indifference map of A is represented by A the curves
A1 A2 and A3 and B’s map by B1 B2and B3 indifference
curves.
Any point within this box represents a possible
distribution of the two goods between the two
individuals. Take point E where the two indifference
curves A 1 and B1 intersect. At this position, A
possesses OaYa units of Y and O aXa of good X. В
receives ObYb of Y and Ob Xb of X.
At point E the marginal rate of substitution between the
two goods is not equal to the ratio of their prices
because the two curves do not have the same slope. So
E is not the point of у optimum exchange of the two
goods X and Y between the two individuals A and B.
Let us try to find out such a point where one individual
becomes better off without making the other worse off.
Suppose A would like to have more of X and В more of
Y. Each will be better off without making the other
worse off if he moves to a higher indifference curve. Let
them move from point E to R. At R, A gets more of Х
by sacrificing some Y, while В gets more of Y by
sacrificing some amount of X.
There is no improvement in B’s position because he is
on the same indifference curve B 1 but A is much better
off at R having moved to a higher indifference curve
from A1 to A3 If, however, A and В move from E to P,
A is as well off as before for he remains on the same
indifference curve A 1 В becomes much better off having
moved from B1 to B3.
It is only when they move from E to Q that both are on
higher indifference curves. P, Q and R are, thus, the
three conceivable points of exchange, The contract
curve CC is the locus of these points of tangency which
shows the various positions of exchange that equalize
the marginal rates of substitution of X and Y.
Any point on the CC curve, therefore, satisfies this
optimum condition of exchange. But a movement along
the contract curve in either direction always tends to
make one individual better off at the expense of the
other. Thus each point on the contract curve represents
optimum social welfare in the Paretian sense.

2. Efficiency in Production:

The second condition for Pareto optimality relates to

efficiency in production. There are three allocation rules
for demonstrating efficiency in production under perfect
competition. Rule one relates to the optimum allocation
of factors. It requires that the marginal rate of technical
substitution (MRTS) between any two factors must be
the same for any two firms using these factors to
produce the same product.
Suppose there are two firms A and В that use two
factors: labour (L) and capital (K) and produce one
product. Given the prices of the two factors, a firm is in
equilibrium under perfect competition when the slope of
an isoquant equals the slope of the iso-cost line.
The slope of an isoquant is the MRTS of labour and
capital, and the slope of the iso-cost line is the ratio of
the prices of labour and capital. Thus the condition of
equilibrium for firm A is AMRTSLK. = PL/PK, and that of
firm В is BMRTSLK, = PLPK. Therefore, rule one for
efficiency in production is AMRTSLK = BMRTSLK=
PL/PK.
Rule two states that the marginal rate of transformation
between any factor and any product must be the same
for any pair of firms using the factor and producing the
product. It means that the marginal productivity of any
factor in producing a particular product must be the
same for all firms.
A firm under perfect competition will employ a factor of
production up to the point at which its marginal value
product (VMP) equals it price. If MPP is the marginal
physical product of factor L (labour) in the production
of good X in firm A, then its VMP is the marginal
physical productivity multiplied by the price of X, that
is VMP = A MPPXL;. PX Thus the price of labour (P L) in
firm A is
PL = A MPPXL. PX or PL/PX, = AMPPXL … (1)
Similarly, in firm В the price of labour is
PL = BMPPXL. P, or PJPX = BMPPXL … (2)
Since the price of the product (P x) and the price of
labour (P,) are the same in both the firms, each firm will
equate its marginal physical productivity to P L/ PX Thus
from equations (1) and (2), we have
АМРРXL = BMPP = PL/Px.
Thus in equilibrium each firm has the same marginal
physical productivity of factor L in producing the same
product X. Rule three for efficiency in production
requires that the marginal rate of transformation (MRT)
between any two products must be the same for any two
firms that produce both. This condition requires that if
there are two firms A and B, and both produce two
products X and Y, then AMRTXY = BMRTXY
A profit maximising firm under perfect competition will
be in equilibrium when the iso-revenue line is tangent to
its transformation curve. It means that for equilibrium
the marginal rate of transformation between two
products X and Y must equal their price ratio, i.e.,
MRTXY= PX/Py . Thus the optimum condition in the case
of firm A will be BMRTXY, = PX/Py. And in the case of
the firm В it will be BMRTXY= PXPY Thus, AMRTXY,
= BMRTXY = PXPY.
This rule is explained in terms of Figure 2. The MRT
between any two products is the rate at which one
product would have to be sacrificed in order to produce
more of the other product with the same quantity of
resources. It is measured on the diagram by the slope of
the transformation curve PP 1 at any point. TR is the iso-
revenue line whose slope 1 shows P XPY. At point E the
slopes of the transformation curve PP 1 and the iso
revenue line TR are equal so that MRT XY, = PXPY Thus
each firm maximises its output by producing and selling
OX1 of commodity X and OY 1 of commodity Y.
In fact, the MRT of X for Y is equal to the ratio of the
marginal cost of product X (MC X) to that of product Y
(MCX). But each firm produces that level of output at
which its marginal cost is equal to its market price.
Therefore, for each firm P x = MCX and Py = MCY Hence
MCX/MCY = PX/Py.
Efficiency in Exchange and Production (Product
Mix):
Pareto optimality under perfect competition also
requires that the marginal rate of substitution (MRS)
between two products must equal the marginal rate of
transformation (MRT) between them. It means
simultaneous efficiency in consumption and production.
Since the price ratios of the two products to consumers
and firms are the same under perfect competition, the
MRS of all individuals will be identical with MRT of all
firms consequently, the two products will be produced
and exchanged efficiently. Symbolically, MRSXY =
PX/PY, and MRTxy = Px/Py. Therefore, MRS XY = MRTxy.

Figure 3 illustrates overall Pareto optimality in

consumption and production. PP ; is the transformation
curve or the production possibility frontier for two
goods X and Y. Any point on the PP curve shows the
marginal rate of transformation (MRT) between X and
Y which reflects the relative opportunity costs of
producing X and Y, that is MC x/MCy . Curves I1 and
I2 are the indifference curves which represent consumer
tastes for these two goods.
The slope of an indifference curve at any point shows
the marginal rate of substitution (MRS) between X and
Y. Pareto optimality is achieved at point E where the
slopes of the transformation curve PP t and the
indifference curve 1 2 are equal. This equality in slopes
is shown by the price line cc which indicates that at
point £ the MRS xy = MRTxy = Px/Py or
MUx/MUy_=MCx/MCr = Px/Py.
Given the production possibility frontier PP 1, there is no
other indifference curve which satisfies Parteo
efficiency. Point A is of inefficient production because
it is below the PP I curve. Point B is on the production
possibility frontier but it is on a lower indifference
curve I1, where the consumer satisfaction is not
maximised. Therefore, Pareto optimality exists only at
point E, where there is efficiency in both consumption
and production when the society consumes and
produces OX1 of good X and OY 1 of good Y.
Thus the conditions necessary for the attainment of
Pareto optimality relate to efficiency in consumption,
efficiency in production, and efficiency in both
consumption and production.
These Pareto optimality conditions will be achieved
if:
(1) second-order conditions are satisfied for each
consumer and producer,
(2) No consumer is satiated,
(3) There are no external effects either in consumption
or production,
(4) There are no indivisibilities, and
(5) There are no imperfections in factor and product
markets.

Market Failure of Pareto Optimality and Measures to

Correct It

Market Failure or Non-Attainment of Pareto

Optimality:
In the real world, there is non-attainment of Pareto
optimality (or optimum welfare) due to a number of
constraints in the working of perfect competition. These
lead to market failure. Market failure refers to the
circumstances under which markets fail to allocate
resources efficiently.
They are discussed as under:

1. Monopoly or Imperfect Markets:

Whenever markets are imperfect, as under monopoly,

monopolistic competition or oligopoly, the perfect
market will fail to achieve the Paretion optimum
conditions. The main condition for Pereto optimality
under perfect competition is the equality of marginal
rate of substitution (MRS) and marginal rate of
transformation (MRT) between two products X and Y
and their price ratios P x/Py. Thus
(MRS)XY = Px/Py
and (MRS)XY = Px/P
(MRS) = (MRS)xy
But under monopoly, MRS XY will not equal MRS XY and
both will not equal the ratio of their prices (P X/PY).
To explain this, consider Figure 4 where the Pareto
efficiency conditions for exchange and production are
fulfilled at point E. At this point, the MRS xy =MRTxy,
because the slope of the transformation curve PP 1 equal
the slope of the indifference curve I 2 , as shown by the
tangent CC.
Here MRTxy = MCx/MCy = P/Py = MRSxy, Now suppose
that there are perfectly competitive conditions. Since
good X is being produced under monopoly conditions,
price of good X is higher than its marginal cost, i.e.,
PX > MCX But good Y is being produced under perfect
competitive where PY = MC Y Therefore, MCX/MCy =
PX/PY Since MCX/MCY = MRTXY if follows that under
monopoly production MRT XY = PX/PY. (Fig. 61.4)

But the consumers will equate MRS XY with PX/PY .Thus

under monopoly MRT XY, < MRSXY The monopoly
production will take place at point В where less of good
X and more of good Y will be produced than under
competitive conditions.
Under perfect competition, OX of X and OY of Y is
produced at point E, whereas under monopoly OX y of X
and OYx of Y is produced at point B. Thus the existence
of monopoly leads to the non-fulfilment of Pareto
optimality because less of good X by XX 1 is produced
than under perfect competition.

2. Externalities:

The presence of externalities in consumption and

production also lead to market failure. Externalities are
market imperfections where the market offers no price
for service or disservice. These externalities lead to mal-
allocation of resources and cause consumption or
production to fall short of Pareto optimality.
Externalities, also known as external economies and
diseconomies, lead to the divergence of social costs
from private costs and of social benefits from private
benefits.
When social costs and private costs and benefits
diverge, perfect competition will not achieve Pareto
optimality. Because under perfect competition private
marginal cost (PMC) is equated to private marginal
benefit (i.e. the price of the product). We discuss below
how external economies and diseconomies of
consumption and production affect adversely the
allocation of resources and prevent the attainment of
Pareto optimality.
External Economies of production:
These economies accrue to other firms in the industry
with the expansion of a firm. They may be the result of
reduced input costs which lead to pecuniary external
economies or the result of a new technique of
production (technological economies by one firm.
Whenever external economies exist, social marginal
benefit (SMB) will exceed private marginal benefit
(PMB) and private marginal cost (PMC) will exceed
social marginal cost (SMC).
So when under perfect competition, private marginal
cost is equated to price which is also private marginal
benefit, social marginal benefit will be higher than
social marginal cost because of external economies of
production. The firms will produce less than the socially
optimum level of output. This is illustrated in Fig. 5
where PMC is the private marginal cost curve of firm.
SMC is the social marginal cost curve. D is the demand
curve which intersects the PMC curve at point E and
determines the competitive price OP and output OQ.
But the socially (Paretian) optimum output is OQ 1 and
price is OP1 as determined by the intersection of the
SMC curve and the D curve at point E 1. Thus the
industry is producing Q 1Q less than the socially
optimum output OQ 1 Since for every unit of output
between g, and Q1 social marginal cost (SMC) is less
than the competitive market price OP 1 its production
involves a social gain.
External Diseconomies of Production When there are
external diseconomies of production, social marginal
cost is higher than social marginal benefit, and firms
will produce more than the socially optimal level of
output.
A factory situated in a residential area emits smoke
which affects adversely health and household articles of
the residents. In this case, the factory benefits at the
expense of residents who have to incur extra expenses to
keep themselves healthy and their households clean.
These are social marginal costs because of harmful
externalities which are higher than private marginal cost
and also social marginal benefit.

This is illustrated in Figure 6 where the SMC curve is

above the PMC curve which intersects the D curve at
point E and determines the competitive price OP and
output OQ. But the socially optimum output is OO 1 and
price is OP1, as determined by the intersection of SMC
and D curve sat point E 1. Thus the firms are producing
Q1Q more than the social optimal output OQ 1 In this
case, for every unit between Q 1 and Q, social marginal
cost (SMC) is more than the competitive market price
OP. Thus its production involves a social loss.
Externalities in Consumption:
They lead to non-attainment of Pareto optimality. In the
case of external economies in consumption, the
consumption of a good or service leads to increase in
utility (or welfare or satisfaction) of other consumers.
When an individual installs a TV set, the satisfaction of
his neighbours increases because they can watch TV
programmes free at his place.
Here social benefit is larger and social cost is lower than
private benefit and cost. But the TV owner is likely to
use his TV set to a smaller extent than the interests of
society require because of the inconvenience and
nuisance caused by his neighbours to him.
External diseconomies of consumption arise when the
consumption of a good or service by one consumer
leads to reduced utility (or dissatisfaction or loss of
welfare) of other consumers. Consumption
diseconomies arise in the case of dress, fashions and
articles of conspicuous consumption which reduce their
utility to some consumers.
Smokers cause disutility to non-smokers, and noise
nuisance from stereo systems to neighbours are other
examples. Such diseconomies of consumption prevent
the attainment of Pareto optimality. This is explained in
terms of Figure 7. Let there be two consumers A and В
who buy two goods X and Y.

Consumer A is in equilibrium at point E on the IС curve

80 (utility) in Panel (A). Consumer В is in equilibrium
at point С on the IС curve 50 (utility) in Panel (B),
when there are no externalities in
consumption AMRSXY = BMRSXY. This is because the
tangents at points E and С are parallel to each other.
Suppose that (i) A’s utility is not affected by B’s
consumption; and (ii) B’s utility is affected by A’s
consumption of good X, but not of Y. Given these
conditions, assume that redistribution takes place such
that there is decrease in the consumption of good X by
consumer A. He now moves from point E to D on the
same 1C curve 80.
Since B’s utility is dependent on A’s consumption of X,
he moves from point С on the IC curve 50 to F on the
1C curve 60. B’s utility of good X has increased. As a
result of the shift of IC curve of В from 50 to 60
(utility), the total welfare (utility) increases from 130
(=A’s 80 + B’s 50) to 140 (= A’s 80 + B’s 60), despite
the fact that at the new equilibrium the MRS is not the
same for both A and B.
This is because the tangents at points D and F on these
IC curves are not parallel to each other. Consumer A is
on the same IC curve 80 but consumer В has moved on
a higher IC curve with higher utility 60. Thus Pareto
optimality is not attained because the utility of one
consumer В has been increased without reducing the
utility level of the other consumer A.

3. Public Goods:

Another cause of market failure is the existence of

public goods. A public good is one whose consumption
or use by one individual does not reduce the amount
available for others. Examples are city parks, defence,
police, ocean or lake fishing, etc.
Public goods have two characteristics: non-excludable
and non-rivalrous. A good is non-excludable if it can be
consumed by any one. It is non-rivalrous if no one has
an exclusive right over its consumption. Its benefit can
be provided to an additional consumer at zero marginal
cost.
Thus public goods being both no excludable and non-
rivalrous are not sold in a free market like private
goods. They lead to market failure in the following
ways.
The consumption of a public good is always ‘joint and
equal. The Paretian condition for a public good is that
its marginal social benefit should equal its marginal
social cost (MSB = MSC). But the characteristics of a
public good are such that the economy will not reach a
point of Pareto optimum in a perfectly competitive
market. Public goods create positive externalities.
The externality starts when the marginal cost of
consuming or producing an additional unit of the public
good is zero but a price above zero is being charged.
This violates the Paretian welfare maximisation
criterion of equating marginal social cost and marginal
social benefit. This is because the benefits of a public
good must be provided at a zero marginal social cost.
Again, public goods are not subject to the “exclusion
principle” which means that their benefits are available
to everybody whether a person pays for them or not. But
in the case of some public goods, exclusion is practiced.
Take the example of a bridge as the public good whose
use is restricted to those who pay a toll tax.
This does not lead to Pareto optimality because the toll
tax restricts the services of the bridge to only those who
pay the toll tax. For Pareto optimality, its services
should be available to every consumer at a zero price.
In the case of some public goods where exclusion
cannot be practiced, all payments for their services are
purely voluntary. In such a situation, many users have
the tendency to avoid paying for their services when
they know their benefits can be obtained free.
All such users are known as “free riders”. Therefore,
when such a public goods is produced much less than
the optimum quantity would be available to its users.
The use of Star TV signals by TV owners with their
own “dish” antennas is an example of free riders
because they do not pay anything for signals whereas
cable operators pay.
The market failure in the case of public goods can be
summed up in terms of the efficiency conditions of
Pareto optimality. Suppose there are two individuals A
and В and two goods X and Y with X being a public
good in the economy.
The Paretian efficiency condition is fulfilled when
MCX/MCy = MRTxy =AMRSXY = BMRSXY .Since both
individuals A and В can use the public good X at the
same time, the equilibrium condition for maximum
welfare becomes MC X/MCY =
MRTxy = AMRSXY + BMRSxy. This equation shows that
there will be underproduction as well as under
consumption in the case of public good X because both
A and В use it at the same time.
Thus Pareto optimality is not attained. This is illustrated
in Fig. 8 where X is a public good and D A and Du are
the demand curves of two individuals A and В
respectively. MCX is the marginal cost curve of the
public good and MC X =AMRSXY + BMRSxy. The curve
ΣD is the vertical summation of D A and DB curves.
The curves MCX and ΣD intersect at point ΣD which
determines OP price and OQ quantity of public good.
The two consumers are charged the price OP = OP A +
OPB. But each consumer is being charged a different
price. This is a case of price discrimination because
OPA >OPH. Hence there is market failure.

4. Increasing Returns to Scale:

There are increasing returns to scale or decreasing costs

due to technical externalities that lead to market failure
under perfect competition. When there are increasing
returns to scale in a perfectly competitive market, they
either lead to monopoly or to losses.
As output increases under increasing returns to scale,
the long run average cost (LAC) curve falls over the
relevant range. When the LAC curve falls, the LMC
curve lies below it (LMC< LAC) and firms under
perfect competition incur losses.
But they cannot remain under losses in the long run and
leave the industry. If this situation persists for some
time, there will emerge either oligopoly firms or a
monopoly firm. Figure 9 illustrates the situation of
market failure when there are increasing returns to
scale. The LMC curve lies below the LAC curve over
the relevant range.
The LMC curve (which is the supply curve under
perfect competition) intersects the AR curve (which is
the demand curve under perfect competition) at point P
so that OQ quantity of the product is produced at QP
price. Since the LAC curve is above the price QP, there
is PA per unit loss which will compel the firms to leave
the industry.
Since under perfect competition P = LMC = LAC, the
present condition of P = LAC > LMC leads to non-
fulfilment of Pareto optimality.
5. Indivisibilities:

The Paretian optimality is based on the assumption of

complete divisibility of products and factors used in
consumption and production. In reality, goods and
factors are not infinitely divisible. Rather, they are
indivisible. The problem of indivisibility arises in the
production of those goods and services that are used
jointly by more than one person. An important example
is the use of a particular road by a number of persons in
a locality.
Every person residing there uses the road. But the
problem is how to share the costs of repairs and
maintenance of the road. In fact, none will be interested
in its repairs and maintenance. Thus marginal social
costs and marginal social benefits will diverge from
each other and Pareto optimality will not be achieved.

6. Common Property Right:

Another cause of market failure is a common property

resource. It most common example is fish in a lake.
Anyone can catch and eat it bout no one has an
exclusive property right over it. It means that a common
property resource is non-excludable (any one can use it)
and non-rivalrous (no one has an exclusive right over
it).
The lake is a common property for all fishermen. When
a fisherman catches more fish, he reduces the catch of
other fishermen. But he does not count this is a cost, yet
it is a cost to society.
Because the lake is a common property resource where
there is no mechanism to restrict entry and to catch fish.
The fishermen who catch more fish impose a negative
externality on other fishermen so that the lake is over
exploited.
This is called the tragedy of the commons which leads
to the elimination of social gains due to the overuse of
common property. Thus when property rights are
common, indefinite or non-existent, social costs will be
more than private costs and there will not be Pareto
optimality.

7. Asymmetric or Incomplete Information:

Consumers, producers and resource owners have perfect

knowledge about market conditions under perfect
competition. But in the real world, there is asymmetric
or incomplete information due to ignorance and
uncertainty on the part of buyers and sellers of goods
and services.
Thus they are unable to equate social and private
benefits and costs this is because consumers are
ignorant about the quality of goods that they buy
benefits of goods.
Similarly, firms are ignorant and uncertain about future
prices costs sales, actions of rivals, etc. In some cases,
information about market behaviour in the future may
be available but that may be insufficient or incomplete.
Thus market failure is inevitable.

8. Incomplete Markets:

Markets for certain things are incomplete or missing

under perfect competition. The absence of markets tor
such things as public goods and common property
resources is a cause of market failure. There is no way
are benefits and costs either in the Present or in the
future because their markets.

Measures of Correct Market Failure:

To correct market failure in each case discussed
above, economists suggest the following measures:

1. Control of Monopoly Power:

Monopoly power can be controlled by the government

by anti-monopoly laws and restrictive trade practices
legislation. These aim at removing unfair competition,
preventing unfair price discrimination and fixing prices
equal to competitive prices.
The governments can also being down monopoly price
to the competitive level by price regulation and taxation.
It may impose price ceiling so that monopoly price
should be near or equal to competitive price regulating
authority of commission which fixes a pie tor the
monopoly product below the monopoly price.
Taxation is another way of controlling monopoly power.
The tax may believe Lump sum without any regards to
the output of the monopolist. Or it may be proportional
to the output, the amount of tax rising with the increase
in output. In either case, the aim is to bring monopoly
price to the competitive level. Lastly Prof Pisou
favoured nationalisation of monopoly to put an end to
monopoly power.

2. Externalities:

To achieve optimal allocation of resources in the face of

externalities, Pigou suggested social control measures
and the use of taxes and subsidies. The state can
interfere in all cases of external diseconomies of
production to remove the divergence between private
and social costs and benefits.
For instance it can ask the factory owner to move out of
the residential area by providing appropriate facilities to
the smoke emitting factory. In the case of external
diseconomies of consumption, the state can put an end
to noise nuisance by banning the use of loud speakers
except for special occasions during specific hours with
prior permission.
Pigou further suggested that the state should encourage
production of goods with positive externalities by the
subsidy on per unit of commodity to the producer. It can
be help consumers in maximizing their satisfactions by
tax concessions so that they consume more
commodities. It can help consumers in maximising their
satisfactions by tax concessions so that they consume
more commodities.
In the case of negative externalities it should discourage
their consumption and production by leaving taxes. For
instance, the state can levy a tax on every family in the
area and pay the sum so collected to the smoke matting
factory to move away Thus taxes and subsidies help to
bridge the gap between private and social costs and
benefits.
Another measure commonly suggested is internalisation
or unitization of externalities in production For example
firms that are engaged in oil operations in the same filed
lead to inefficient over-drilling and over pumping. With
unitization or merger of firms, oil is produced most
efficiently without diseconomies of production.

3. Public Goods:

Because public goods are non-excludable and non-

rivalrous, they are not sold in a free market like private
goods. Therefore, they cannot be provided by private
firms. In this situation, they can be provided by some
public authority.
As the benefits of public goods are indivisible, the state
should make people share the costs of public goods so
that everyone is made better off. “One way to pay for a
public good is to charge each person the same
proportion of the maximum amount he or she would be
prepared to pay rather than go without the good, while
fixing that proportion so as to cover the total costs of
production”.
In the case of some public goods such as materials for
defence, the government can either itself produce them
or it can pay private firms to produce them. So far as the
free rider problem is concerned whereby such services
as defence, police, etc. are provided free to every user,
they can be provided by the government out of tax
revenue.

4. Increasing Returns to Scale:

For the problem of increasing returns to scale (or
decreasing costs), opinions differ concerning
government’s role in providing solution to market
failure. Some economists opine that government should
nationalise such industries which operate under
decreasing cost and lead to over production.
Others do not approve of it because they feel that
government control would make conditions worse. Still
others suggest that private firms should produce goods
and government should enforce price regulation and tax
them so that social and private costs and benefits are
equalised.

5. Indivisibilities:

The solution to the problem of indivisibility in the case

of goods and services used jointly by more than one
person such as street lighting or road, the local body
such as Municipal Corporation should either spend on
its repairs and maintenance or tax the residents or users
of the road or street lighting.

6. Property Rights and the Coase Theorem:

Common property rights lead to externalities. Property

rights relate to “who owns property, to what uses it can
be put, the rights people have over it and how it may be
transferred.” One solution is to extend property rights so
completely that everyone has the right to prevent people
from imposing any costs on them.
This can be done in the case of public property like
parks, libraries, etc. The second solution is to distribute
the property of the rich to the poor. But it is more a
question of altering property rights rather than
extending the ownership rights. But such a solution will
be impractical.
The third solution is for the government to charge the
damages and compensate for the damages. But it
involves the problem of compensating those who
acquired property at a lower cost because of the
damage. The fourth solution is to file a legal suit for
monetary damages by the party that has been harmed by
the externality (say smoke).
Another solution has been suggested by Prof. Ronald
Coase (who received the Nobel Prizein Economics in
1991). According to him, market failure due to property
rights can be eliminated through private bargaining
among the affected parties.
He points out that if property rights are clearly defined
and marketable and transaction costs are zero, a
perfectly competitive economy will allocate resources
optimally, even under externalities.
This is called the Coase Theorem. By transactions costs
he means costs of negotiating or enforcing a contract.
According to Coase, if it is possible to carry out such
negotiations at little or no cost, the parties responsible
for an external benefit or cost can negotiate with the
parties affected by an externality.
The sufferer from an externality should levy a charge or
offer a bribeto the party which is getting the maximum
benefit from the common property. Thus in the absence
of transaction costs, the externality will be internalised
and the socially optimal level of output will be
achieved.

7. Aymmetric or Incomplete Information:

Market failure can be eliminated when rules are framed

by regulating authorities by requiring producers to
describe correctly about their products and prices. This
will provide people with correct and relevant
information about products.
Market failure can also be corrected if produces produce
high quality standard products and offer guarantees and
warranties to buyers. This requires widespread publicity
on the part of sellers so as to provide correct
information to consumers.
In case where ignorance is the reason for incomplete
information, the direct provision of information by the
government may help to correct market failure. For
example, employment exchanges provide information
on jobs to those looking for work and ask firms to get in
touch with them for the supply of suitable labour.
This will help the labour market to work efficiently.
Similarly, government providing statistics on prices,
costs, employment, sales trends, exports, imports, etc.
help firms to plan their production with greater
certainty. Some private organisations can also help in
providing useful data on them.

8. Missing Markets:

To correct market failure in the case of missing or

incomplete markets where two goods are jointly
produced two Nobel laureates K. Arrow and G. Debreu
suggest a separate market for each in which each good
and service can be traded to the point where the social
and private marginal benefit equals the social and
private marginal cost. This condition will lead to
optimal allocation of resources.