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Pareto Optimality Conditions

 Pareto Optimality and Market Failure

        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 relate to efficiency in exchange or consumption, efficiency in production and overall Pareto optimality relate to efficiency or efficiency in both consumption and production.

Market Failure or Non-Attainment of Pareto Optimality

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

  1. Indivisibilities

       The Paretian optimality is based on the postulation 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.

  1. Common Property Right

        Another cause of market failure is a common property resource. It most common example is fish in a lake. Any one 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 and non-rivalled. The lake is a common property for all fishermen. When a fisher man catches more fish, he reduces the catch of other fishermen. But he does not count this as a cost, yet it is a cost to society.

        Since 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 known as ‘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.

  1. 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 for the reason that consumers are ignorant about the quality of goods that they buy.

          Advertisements also mislead them about the benefits of goods. Likewise, 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.

  1. Incomplete Markets

        Markets for certain things are incomplete or missing under perfect competition. The absence of markets for such things as public goods and common property resources is a cause of market failure. There is no way to equate their social and private benefits and costs either in the present or in the future for the reason that markets are incomplete or missing.

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