Pareto Improvement andBenefit-Cost Ratio - Assignment Example

The paper "Pareto Improvement and Benefit-Cost Ratio" is a wonderful example of an assignment on macro and microeconomics.

1. Actual Pareto Improvement

A change in the economy can be considered a Pareto improvement if at least one person is made better off without making another person worse off. For instance, if a person desires to buy cheese from a store and actually buys it, this is considered a Pareto improvement because it is a voluntary market transaction. More importantly, the cheese consumer and the producer are made better off. However, in the event that the government forces her citizens to purchase something, this will be considered not to be an actual Pareto improvement because one party (the seller) will be better off while the purchaser will be made worse off.

1. A potential Pareto Improvement

Change in the economy is considered a potential Pareto improvement only when it is possible for the winners to compensate the losers in that after compensation both winners and losers can be made better off. This situation; potential Pareto improvement essentially does not require actual compensation. The current global society rarely compensates losers. For example, in any event, that the economy moves from autarky to free, then it is a Pareto improvement. For instance, the total surplus has the potential to increase, however, losers are not compensated by gainers. Furthermore, if a country’s government allows imports of commodities from another country, the domestic producers of the same commodities will lose while consumers will. In this regard, if free trade is allowed the total social surplus will automatically increase. It is important to note that, it is less likely for losers to be compensated; policy choices are collectively made by society.  

• The Kaldor-Hicks Criterion

This is an economic efficiency measure that captures the intuitive appeal of Pareto efficiency; however, its criteria are less stringent and thus it can be applied to more circumstances. The Kaldor-Hicks efficiency states that an outcome is more efficient only if a Pareto optimal outcome can be achieved through the arrangement of sufficient compensation from those that are made better off to those that are made worse off in order for the gainers and losers would end up no worse off than before. In this regard, the outcome is only more efficient if those made better off could in theory pay those made worse off in order to attain a Pareto improving outcome results. For example, a voluntary transaction that results in pollution is considered a Kaldor-Hicks improvement particularly the buyers and sellers are determined and willing to carry out the transaction regardless of having to fully compensate the pollution victims.

Q1 b)

Both Pareto efficiency and Kaldor-Hicks efficiency should be used; this because Pareto efficiency is extensively essential in demonstrating that competitive markets always result in allocative efficiency while Kaldor-Hicks efficiency is used a test of Pareto efficiency. For instance, it determines an activity that will move the economy towards Pareto efficiency. There is no way one criterion can be used more than the other: one is a test of the other.

Q2 a) Choice Criterion

Net present value (NPV)

This is the difference between the present value of cash inflows and the present value cash outflows. In finance, for instance, the (NPV) of a time series of incoming and outgoing cash flows is the sum of the present values of individual cash flows of the same entity. For example, in the event that all future cash flows are incoming and the only outflow of cash is the purchase price then the NPV will be calculated by subtracting the purchase price (own PV) from the PV of the future cash flows. NPV is a vital tool in the discounted cash flow (DCF) analysis as well as is a standard procedure for using the time value of money to appraise long-term projects. It is also essentially useful in capital budgeting as it measures both the excesses and shortfalls of cash flows in present value terms after financing charges have been met.

Benefit-cost ration (BCR)

This ratio attempts to identify the link or relationship between the cost and benefits of a proposed project. An indicator is used in cost-benefit analysis attempting to summarize the overall value of money of a project or proposed project. The benefits and costs in their entirety should be expressed in discounted present values.  

Q2 b)

NPV is used as an indicator of the level of value that an investment will bring to the investing firm. For example, if the NPV is calculated and found to be more than zero (NPV > 0) the investment undertaken will add value to the firm, and thus the project is worth undertaking. If NPV is less than zero (NPV < 0) then the investment will automatically subtract value from the firm and the project should be rejected. On the other hand if NPV = 0 then the investment will neither add nor gain value for the firm and hence does not a clear direction and hence the investment decision should be based on other criteria such as strategic position.

Benefit-Cost Ratio (BCR) is particularly used in corporate finance in order to detail the relationship between the possible benefits and costs qualitatively and quantitatively for undertaking a new project or replacing old ones. The latter measures the qualitative and quantitative factors because benefits and costs are not always exclusively measure in financial terms. In the event that all are possible, however, it is recommended that qualitative factors be translated into quantitative terms in order for the outcomes to be made easier for understanding and to be tangible. It is important to note that, BCR always takes into account the amount of monetary gain achieved by undertaking the project compared to the amount it costs to execute the project. In this regard, investment is more viable when BCR is higher. For instance, if the benefit is higher than the cost, then the project worth undertaking: this is the general rule.