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This may be one of the more 'elementary' questions on this site.. But I really can't wrap my head around it and a search on the web hasn't yielded much.

Given that Pareto efficiency is defined as when the allocation cannot make any party better off without making anyone worse off, it seems that something like breaking up monopolies is in fact not a Pareto improvement, as it's making the consumers better off by making the monopolist worse off?

I'm inclined to say that antitrust measures are (theoretically) a Pareto improvement, because that's moving closer to the allocative efficient level in a perfectly competitive market. However I don't know how to incorporate the definition of Pareto improvement into this.

Would be extremely grateful for any help!!

Many many thanks, Shine

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First of all good question. I tried myself on that one, but if any other member of this wonderful site has additional input please also answer :)

In a monopol we know there exists a consumer who would be willing to pay a price for an additional unit of the good that is higher than the additional cost to produce that unit. Possibility of Pareto improvement: monopolist produces one additional unit and receives marginal cost from consumers. Giving away one unit for marginal costs does not make the monopolist worse off in the first case. But if the monopolist wants to sell an additional unit, he must lower the price not only for the last unit, but also for all remaining units. This is the result of one critical assumption: no perfect price discrimination. But from the perspective of a social planner one could produce an additional unit and find a trade where $MC \leq P$ by allowing the monopolist only to change price for its last produced unit. In absence of such a planner the monopolist falls back to the old logic.

This leads us to the definition of market failure: individual rational behaviour leads to collective irrational outcomes.

Pareto optimality is also a very narrow definition, take for example the Kaldor Hicks criteria which states: An economic policy measure is welfare increasing, if in the society as a whole, increases in benefits outweighs the losses of benefits. This simply means winners could compensate losers, or in other words the sum of gains needs to be greater than the sum of losses (independent from individual changes). This holds true for the destruction of the monpoly because sum of consumer and producer surplus will increase. The pareto criterium is often criticised to favourite the status quo, while Kaldor Hicks creates more possibilities for restructuring in exchange for violating the methodological individualism.

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  • $\begingroup$ Thanks! Would I be right to say that had it been a monopolist with first degree price discrimination, then that would be an available Pareto improvement over the simple monopolist equilibrium? And if we were to define Pareto efficiency using the Kaldor Hicks criteria then that would agree with our instinct of antitrust measures being Pareto improvements? Thanks a lot for your help! $\endgroup$
    – shine yang
    Jan 10, 2021 at 3:30
  • $\begingroup$ @shine yang yes the monopolist with perfect price discrimination creates a pareto optimal outcome. Regarding the second question i assume you mean the right thing but efficiency is the general concept and you can operationalise it by either using the the difinition that was proposed by Pareto or that one brought up by Kaldor Hicks. You cannot define Paretos solution to be the Kaldor Hicks definition nor the other way around. $\endgroup$ Jan 10, 2021 at 12:07
  • $\begingroup$ There is some miscommunication here. "perfect price discrimination creates a pareto optimal outcome" is true, but does not answer the question "a monopolist with first degree price discrimination, then that would be an available Pareto improvement over the simple monopolist equilibrium". It would not be a Pareto improvement, consumer welfare would decrease. $\endgroup$
    – Giskard
    Feb 26 at 8:06
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Most of the discussion on Pareto optimum misses the very basis of the model. It is simply a model describing how a set of producers and consumers moves to an equilibrium in a given market situation.

More specifically it does not describe if the equilibrium is equal, it does not describe if the equilibrium is stable over time, it does not describe why the market is a good way to reach the equilibrium, it does not describe why a monopoly should be good or bad, and so on. All these "limits" of the model has to be added if you want to understand what the model really implies and what reaching equilibrium really entails.

So given a very narrowly defined, very specific situation, reaching Pareto optimum is generally considered to be beneficial to the parties in the model. As soon as you add other circumstances or parties to the model the optimum might not a good place for the market to be. Typically Pareto models totally disregards effects outside of the model: say effects on environment, effects on social equality, effects on common goods and so on.

So if you have a situation with a monopoly the equilibrium will be at one point. If you break up the monopoly the equilibrium will be at another point. Whether one or the other is better or not is not part of the Pareto optimum model as such, you need to evaluate that outside of that model. You might create a different model taking into account the effects you want to consider and it that model have one parameter showing a gliding scale from "free for all" with lots of producers over to a producer monopoly. This would probably be a multi factor model, which has the problem that it is difficult to draw on the board in a school situation and hence difficult to teach. The Pareto model is simple to draw and simple to grasp, but has severe limitations.

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