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What is Pareto efficiency?

A situation, allocation or outcome is Pareto efficient if no one party can be made better off without another being made worse off. The outcome of a perfectly competitive market is Pareto efficient whereas that of a monopoly is not. The INDUSTRY supply and demand diagram for a perfectly competitive market shows a downward-sloping demand schedule and an upward sloping supply curve. Market-clearing or equilibrium price is determined by the intersection of market supply and demand. At this price consumer surplus is represented by the right-angled triangle above the equilibirum price and below the market demand curve and producer surplus by the right-angled triangle below the equilbrium price and above the market supply curve. At this price total surplus or welfare gains are maximised and neither the producers nor the consumers can be made better off i.e. experience an increase in surplus without the other experiencing a loss in surplus. Consumer surplus is the difference between what the consumers are willing to pay and what they actually pay. Producer surplus is the difference between what the producers are willing to accept and what they actually accept in return for their output.The market outcome of perfect competition is therefore Pareto efficient. In a monopoly however the profit-maximising monopolist sets price where MC=MR, restricting output and raising price above the market-clearing level. This diminishes consumer surplus and increases producer surplus. However at the current market price there are consumers who are willing to pay more than marginal cost for additional units. The monopolist can therefore increase its profit by producing more units and this would increase consumer surplus as well. Both the monopolist and the consumers can be made better off. This means that the outcome of a monopoly is Pareto INefficient because either the supplier or the consumers or, in fact, both parties can be made better off without the other being made worse off.

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