Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

Conditions of Pareto Optimality: 
An allocation is Pareto optimal if it is not possible to 
reallocate resources without making at least one person worse off. 
The conditions of Pareto optimality related to efficiency in exchange 
(or consumption), efficiency in production, and overall Pareto 
efficiency (or efficiency in both consumption and production). 
6.4.1 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 
substitution (MRS) between two consumer‘s 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 (P
X
/ P
Y
). 
Suppose there are two consumers A and B who buys two 
goods X and Y, and each faces the price ratio P
X
/ P
Y
. Thus A will 
choose X and Y such that MRS
XY
= P
X
/ P
Y
. Similarly B will choose 
X and Y such that MRS
XY
= P
X
/ P
Y
. Therefore, the condition for 
efficiency in exchange is 
A
B
MRS
MRS
P
/ P
X
Y
XY
XY

---

0
1
2
3
4
5
6
7
8
1
2
3
4
5
6
7
8
9
Commodity X
Com
m
od
it
y Y
FIGURE 6.2: EFFICIENCY IN EXCHANGE 
 
The Edge worth box diagram explains the optimum condition 
of exchange. There are two individuals A and B who possess two 
commodities X and Y in fixed quantities respectively. O
A
is the 
origin for consumer A and O
B
the origin for B. The indifference 
curve of A represented by the curves from A
1
, A
2
and A
3
and B‘s by 
B
1
, B
2 
and B
3
indifference curve. At point E, where two indifference 
curve A1 and B1 intersect. At this position, A possesses O
A
Y
a
units 
of Y and O
A
X
a
of commodity X. B receives O
B
Y
b
of Y and O
B
X
b
of 
X. At point E the marginal rate of substitution between the two 
commodities 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 
optimum exchange of the two commodities X and Y between the 
two individuals A and B.
Suppose A would like to have more of X and B more of Y. 
Each will be better off without making the other worse off if he 
moves to a higher indifference curve. At point R, A gets more of X 
by sacrificing some Y, while B 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 A
1
to A
3
. If 
however, A and B move from E to P, A is well off as before for he 
remains on the same indifference curve A
1
. B becomes much better 
3