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

6.4.3 Efficiency in Exchange and Production: 
Pareto optimality under perfect competition also requires that 
the marginal rate of substitution between two products must equal 
the marginal rate of transformation between them. It means 
simultaneously 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. As a result, the two products will be 
produced and exchanged efficiently. Symbolically, MRS
XY
= P
X
/ P
Y
, 
and MRT
XY
= P
X
/ P
Y
. Therefore, MRS
XY
= MRT
XY
.
A
B
XL
XL
L
X
MP
MP
P / P

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FIGURE 6.3: EFFICIENCY IN EXCHANGE AND PRODUCTION 
The above figure illustrates overall Pareto optimality in 
consumption and production. PP
1
is the transformation curve or the 
production possibility frontier for two commodities X and Y. Any 
point on the PP
1 
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
/MC
Y
. IC
1
and IC
2
are the 
indifference curve which represents consumer tastes for these two 
commodities. The slopes of 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 slope of the 
transformation curve PP
1
and the indifference curve IC
2
are equal.
This equality is slope is shown by the price line cc which 
indicates that at point E the MRS
XY
= MRT
XY
= P
X
/ P
Y
or MU
X
/ 
MU
Y
= P
X
/ P
Y
. 
Given the production possibility frontier PP
1
, there is no other 
indifference curve which satisfies Pareto efficiency. Point A is of 
inefficient production because it is below the PP
1
curve. Point B is 
on the PPF but it is on a lower indifference curve IC
1
, 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 consumers and 
produces OX
1
of commodity X and OY
1
of commodity Y.