Question from Past Microeconomics Qualifying Exam[]

Fall 2004 - Section I, Question one, George Mason University

T, F, U. State first whether the following statements are true, false or uncertain. Then briefly explain your reasoning in four or five sentences. You may use a graph if it helps clarify your answer.

The first Welfare Theorem holds that a market equilibrium is Pareto efficient. An implication is that market equilibrium is also Kaldor-Hicks efficient. Include a brief definition of Pareto vs. Kaldor-Hicks efficiency.



A situation is Pareto efficient if no one person can be made better off without making another person worse off. A Pareto improvement will make someone better off without making anyone else worse off.

A situation is Kaldor-Hicks efficient if it is socially optimal. A Kaldor-Hicks improvement is any increase in social benefit independent of its implications for the individual.

Every Pareto improvement is also a Kaldor-Hicks improvement, but almost no Kaldor-Hicks improvement is a Pareto improvement. A situation that is Kaldor-Hicks efficient is also Pareto efficient, but a Pareto efficient situation is most of the time not Kaldor-Hicks efficient.

Market equilibria are mostly Pareto efficient, because the market guarantees that resources are put to their highest valued use. However, most market equilibria could be Kaldor-Hicks improved through redistribution.

From Caplan's notes[]

Assumption 1: Ui(p) has a unique solution for all i and all p.

Assumption 2: Total demand for good k exceeds total endowment for a small enough pk, and falls short of total endowment for a large enough pk.

Assumption 3: The total demand function for k is continuous in pk for 0<pk<1.

First Welfare Theorem: Under the previous assumptions, the general equilibrium allocation is Pareto efficient.

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