What would happen if politicians practiced the concept of Pareto Optimality?  Debt reduction might be agreed upon and economic growth refueled.  Remember in August, S&P downgraded our nation’s credit ratings, citing the inability of US leaders to reach across the table and work together.  So, here we ponder – what would happen if our leaders played nicely in the Edgeworth Box?

Let’s really make this simple.  What if … the US owed $5 to others (stop dreaming, it’s just a hypothetical – we’re economists, remember?  Hypotheticals are our business!)

• Obama’s preferences.   The president’s preferences for reducing the federal deficit include increasing tax revenue  by $3.50 and cutting government spending by $1.50.  Obama’s preferences for different combinations of tax increases and government spending cuts are shown by the blue “indifference curves” in the graph.

• GOP preferences.   Say the GOP’s preferences for reducing the federal deficit include increasing tax revenue by $1.50 and cutting government spending by $3.50.  Their preferences for different combinations of tax increases and government spending cuts are shown by the red “indifference curves” in the graph.

• An Edgeworth BOX.  The potential gains from trade by Obama and the GOP can be shown in the Edgeworth box, below. The GOP and Obama plans to cut the deficit gain from trading tax revenue and spending cuts with each other.

Obama trades the GOP some tax revenue for some government spending and ends up better off than where he started.  The GOP trades Obama some government spending cuts for some tax revenue and also is better off.  ALL AMERICANS ARE BETTER OFF and the FEDERAL DEFICIT IS REDUCED!  (Fireworks and national happiness ensue.)  S&P likes that our nation’s leaders have figured out how to work together to reach solutions and the US debt rating improves again.  This new point we have arrived at is called the “Pareto Optimal” point.