(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 634

CHAPTER 16 • General Equilibrium and Economic Efficiency 609

the prices of the goods are determined by the combined choices of demanders
and suppliers of goods.

The Economic Efficiency of Competitive Markets
We can now understand one of the fundamental results of microeconomic analysis. We can see from point C in Figure 16.7 that the allocation in a competitive
equilibrium is Pareto efficient. The key reason why this is so is that C must occur
at the tangency of two indifference curves. If it does not, one of the Jameses or
one of the Karens will not be achieving maximum satisfaction; he or she will be
willing to trade to achieve a higher level of utility.
This result holds in an exchange framework and in a general equilibrium setting in which all markets are perfectly competitive. It is the most direct way of
illustrating the workings of Adam Smith’s famous invisible hand, because it tells
us that the economy will automatically allocate resources in a Pareto efficient
manner without the need for regulatory control. It is the independent actions
of consumers and producers, who take prices as given, that allows markets
to function in an economically efficient manner. Not surprisingly, the invisible-hand result is often used as the norm against which the workings of all
real-world markets are compared. For some, the invisible hand supports the
normative argument for less government intervention; they argue that markets
are highly competitive. For others, the invisible hand supports a more expansive role for government; they reply that intervention is needed to make markets more competitive.
Whatever one’s view of government intervention, most economists consider the invisible-hand result important. In fact, the result that a competitive
equilibrium is Pareto efficient is often described as the first theorem of welfare
economics, which involves the normative evaluation of markets and economic
policy. Formally, the first theorem states the following:
If everyone trades in the competitive marketplace, all mutually beneficial
trades will be completed and the resulting equilibrium allocation of resources
will be Pareto efficient.
Let’s summarize what we know about a competitive equilibrium from the
consumer’s perspective:
1. Because the indifference curves are tangent, all marginal rates of substitution between consumers are equal.
2. Because each indifference curve is tangent to the price line, each person’s

MRS of clothing for food is equal to the ratio of the prices of the two
goods.
To be as clear as possible, we will use the notation MRSFC to denote the MRS of
food for clothing. Then, if PC and PF are the two prices,
MRS JFC = PF/PC = MRSKFC

(16.1)

To achieve a Pareto efficient allocation when there are many consumers
(and many producers) is not easy. It can be done if all markets are perfectly

• welfare economics
Normative evaluation of markets
and economic policy.