Market Efficiencies and Market Failures

Question 1

Pareto Efficiency

Answer 1

No one can be made better off without making someone else worse off.

Question 2

Deadweight Loss (DWL)

Answer 2

Occurs when mutually beneficial trades don’t happen — a key sign of inefficiency.

Question 3

First Welfare Theorem

Answer 3

Under perfect competition, markets naturally reach Pareto-efficient outcomes.

Question 4

Perfect Competition

Answer 4

1. Prices are set by the market (No one has the
   power to “set prices”)
2. Entry of new firms (or exit of unprofitable
   firms) drives profits to zero.
3. Buyers and sellers have all relevant information

Question 5

2 Main Types of Efficiency

Answer 5

1. Management Efficiency : This is about doing things in the smartest, least wasteful way.
2. Pareto Efficiency : Making the right stuff in the right amounts for the right people.

Question 6

X-inefficiency

Answer 6

Examples where management efficiency was NOT achieved

X-inefficiency — meaning internal slack, laziness, or poor use of resources within organizations.

Question 7

Deadweight Loss

Answer 7

“money left on the table” — it’s value that nobody gets, not consumers, not producers, not the government. It just disappears.

Visually, DWL is usually shown as a triangle on supply and demand graphs.

Question 8

Pareto Improvement

Answer 8

At least one person is better off , and no one is worse off

Question 9

Potential Pareto Improvement

Important note:

Answer 9

a policy may make some people better off and others worse off. But if the winners could, in theory, compensate the losers and still be ahead, it’s a potential Pareto improvement.

Important note: The compensation doesn’t have to happen — it just needs to be possible.

The compensation doesn’t have to happen — it just needs to be possible.

Question 10

Second Walfare Theorem

Answer 10

Social welfare can be maximised through
redistribution of endowments.

Redistribute endowments to poor people to maximize social welfare, diminishing marginal utility

Question 11

Relationship between Social Welfare and Pareto Optimal Allocation

Answer 11

Pareto improvement must increase social
welfare, but a net increase in social welfare
isn’t necessarily a Pareto improvement

Question 12

Nash Equillibrium

Answer 12

Each player chooses the action that maximizes his utility, taking the other players action as given. Has to be a stable point

Question 13

Equillibrium

Answer 13

Best response to a Best response

Question 14

Prisoners Dilema

Answer 14

When everyone acts in their own self-interest, they can all end up worse off — even though there’s a better option available.

Question 15

Welfare-maximizing outcome

Answer 15

Both get a light punishment.

If they could trust each other, this would be the best for both.

Question 16

Solutions to the Prisioners Dilema

Answer 16

Tit-for-Tat: Start by cooperating. Then do whatever the other player did last time. If they defected, you punish. If they cooperate again, you forgive.

💡 Why it works: It’s fair, clear, and forgiving, so it builds trust over time.

Grim Strategy: Cooperate until the other defects.
Then defect forever.

💡 Why it works: The threat is strong — one betrayal ends the relationship permanently.

Institutions that enforce rules (e.g. banning
athletes that take drugs)

Outside intervention to restructure the payoffs
(e.g. The mob boss who kills anyone who
talks)

Signalling (e.g. Split or Steal)
Trust or social conventions (informal
institutions)