Teaching Pareto Optimality in a Supply and Demand Framework:

An Active Learning Exercise

Warren D. Richards

Timothy S. Sullivan

Department of Economics & Finance

Southern Illinois University Edwardsville

Prepared for the 41st annual meeting of the Missouri Valley Economics Association Nashville, TN, October 14, 2004

What is active learning?

• Active learning “involves putting our students in situations which compel them to read, speak, listen, think deeply and write.”

– Bernie Dodge (Department of Educational Technology, San Diego State University)

http://edweb.sdsu.edu/people/bdodge/Active/ActiveLearning.html, accessed October 4, 2004.

Value of active learning

• Education research suggests that active learning is effective:– Becker, William E. (1997 & 2000)– Frank, Bjorn (1998)

Pareto Optimality

• Pareto Optimality/Dead-Weight Loss are important concepts in Principles of Microeconomics:– Used to evaluate government policies (price

ceilings and floors, tariffs, excise taxes).– Used to evaluate market structures.– Used to describe gains to international trade.

Pareto Optimality

• Even when students can define Pareto Optimality and/or locate dead-weight loss on a diagram, they, often, don’t truly understand the concepts, or appreciate their importance!

An active learning exercise

• It takes about twenty minutes of class time.

• It reinforces the “chalk and talk” diagrams and discussion.

• It clearly illustrates the concepts of Pareto Optimality and dead-weight loss in a way that the students seem to retain.

Step one: review

• Review the concept of a price ceiling.

• Review basic geometry:– Area of rectangle = (base × height)– Area of triangle = ½(base × height)

Step two: show the diagram

Step three: calculate

Equilibrium Price ceiling

Consumer surplus $12.50 $16.50

Producer surplus $12.50 $4.50

Total surplus $25 $21

Step four: form groups

• Ideally, each group should consist of between three and five students.

• Each group consists of:– producers (one or two students),– consumers (one or two students),– one “judge” (who proxies for a government

policy maker).

Step five: explain the game

• Producers are given a total of $4.50 (their surplus under a price ceiling).

• Consumers are given a total of $16.50 (their surplus under a price ceiling).

• The judge has the option of removing the price ceiling, in which case the instructor will give the group the additional money (representing the surplus available under a free market), but only if they can satisfy the following rule: No one can be made better off without making someone worse off.

Step six: allow discussion

• Students are encouraged to discuss and/or negotiate a settlement.

• Instructor should limit his or her involvement to re-explaining the rules of the game.

• Set a time limit of about ten minutes.

What usually happens

• Initially, the producers want to remove the price ceiling (to gain $8), but consumers object (because they will lose $4).

• Eventually, most producers develop the idea of compensating the consumers (by $4, or more) for agreeing to remove the price ceiling. Several use the term “rebate” to describe the deal.

What usually happens

• Groups eventually realize that the total given to the group will be larger without the price ceiling, and that they can divide up the additional money, making both groups better off.

• Most groups end up finding a compensation scheme they both support, allowing the judge to remove the price ceiling.

Step seven: class discussion

• Apply (translate) the insights of the game to the theory discussed in class:– The extra $4 given to the group, after they remove the

ceiling, represents the dead-weight loss of the original ceiling.

– The rule requiring that no group be made worse off is now introduced as Pareto Optimality.

– The fact that both groups could agree to removing the price ceiling indicates that the ceiling was Pareto Inefficient.

– Students are reminded that government can achieve the students’ result by taxing at the market equilibrium (rather than a price ceiling).

What we’ve learned

• Try to provide extra motivation to the groups by offering an appropriate reward (e.g., bonus points, candy)

• Active learning methods work best when they are not unusual or unique to one class period.