2. An economy is currently made up of a firm that produces bread, a firm that pr

Question

2. An economy is currently made up of a firm that produces bread, a firm that produces butter, and a consumer who consumes both bread and butter. Current production is 100 units of bread, 50 units of butter which the consumed by the consumer. If the output changed to 75 units of bread and 60 units of butter, the profit of the butter firm would go up by $42. The profit of the bread firm would go down by $76. The consumer prefers 75 bread and 60 butter to 100 bread and 50 butter. It is so much better that the consumer would pay $40 more to have 75 bread and 60 butter rather than have 100 bread and 50 butter. Explain, using the definition, why you know it is not Pareto Efficient to have the economy produce 100 bread and 50 butter. (2 points)

Explanation / Answer

Pareto Efficiency implies that we cannot improve everyone's utility by making a change. Let's call 100 units of bread and 50 units of butter "bundle A" and 75 units of bread and 60 units of butter "bundle B." If we switch from A to B, the bread guy makes $42 more, the butter guy makes $76 less and the consumer benefits by $40. That means, there would be a net-benefit of 42+40-76 = $6. Since there is a positive net benefit from switching from A to B, A cannot be Pareto optimal. To be sure, B is not a Pareto improvement because the butter guy is worse off. An example of a Pareto improvement would be bundle C, which is bundle B with a transfer of $38 from the bread guy to the butter guy and a transfer of $38 from the consumer to the butter guy. If a Pareto improvement exists, then Bundle A cannot be Pareto optimal.

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