Fundamental Theorems Of Welfare Economics
There are two fundamental theorems of welfare economics. The first states that any competitive equilibrium or Walrasian equilibrium leads to a Pareto efficient allocation of resources. The second states the converse, that any efficient allocation can be sustainable by a competitive equilibrium.
The first theorem is often taken to be an analytical confirmation of Adam Smith's "invisible hand" hypothesis, namely that competitive markets tend toward an efficient allocation of resources. The theorem supports a case for non-intervention in ideal conditions: let the markets do the work and the outcome will be Pareto efficient. However, Pareto efficiency is not necessarily the same thing as desirability; it merely indicates that no one can be made better off without someone being made worse off. There can be many possible Pareto efficient allocations of resources and not all of them may be equally desirable by society.
The ideal conditions of the theorems, however are an abstraction. The Greenwald-Stiglitz theorem, for example, states that in the presence of either imperfect information, or incomplete markets, markets are not Pareto efficient. Thus, in real world economies, the degree of these variations from ideal conditions must factor into policy choices.
The second theorem states that out of all possible Pareto-efficient outcomes, one can achieve any particular one by enacting a lump-sum wealth redistribution and then letting the market take over. This appears to make the case that intervention has a legitimate place in policy – redistributions can allow us to select from all efficient outcomes for one that has other desired features, such as distributional equity. The shortcoming is that for the theorem to hold, the transfers have to be lump-sum and the government needs to have perfect information on individual consumers' tastes as well as the production possibilities of firms. An additional mathematical condition is that preferences and production technologies have to be convex.
Read more about Fundamental Theorems Of Welfare Economics: Proof of The First Fundamental Theorem, Proof of The Second Fundamental Theorem
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