14.7 : Exchange Efficiency: Gains from Trade I

Assessing the efficiency of resource allocations requires an understanding of individual preferences, often represented by indifference curves. These curves illustrate the combinations of two goods that provide the same level of satisfaction for a person. When analyzing such allocations between two individuals, tools like the Edgeworth Box are useful to compare their preferences and identify potential improvements.

Each individual’s indifference curves are unique, reflecting their preferences. For instance, one person may prefer good A over good B, leading to a curve that is shaped according to their priorities. An allocation is efficient when no adjustments can make one person better off without making the other worse off. This state is called Pareto efficiency.

Imagine two people, Jamie and Morgan, sharing two goods: water and food. At a specific allocation, Jamie and Morgan each receive a certain amount of these goods. To determine if this allocation is efficient, we ask whether both could be made better off by reallocating water and food. If reallocating water to Jamie and food to Morgan moves both to higher indifference curves, the original allocation is inefficient. This indicates that there is potential for gains from trade.

For an allocation to be Pareto-efficient, no redistribution should exist that benefits both individuals. If such possibilities remain, the allocation is inefficient.