General Equilibrium - Welfare Theorems

Question 1

First Theorem of Welfare Economics

Answer 1

All market equilibria are Pareto efficient. (Makes sense as tangental)

(I.e no more trades agents would prefer once at the competitive equilibrium)

Question 2

But is a pareto efficient allocation always a market equilbrium

Answer 2

No, since there can be multiple pareto efficient points and so there may an incentive to switch to a higher utility pareto efficient point.

Question 3

Second theorem of welfare economics

Answer 3

If all agents have convex preferences, any Pareto efficient allocation is achievable as a market equilibrium, since prices can be found to match the IC slope and budget constraints. (Clear the market)

Question 4

Assumptions made in the First Theorem (all market equilibrium are pareto efficient) (4)

Answer 4

Competition is needed.

No externalities
Market clears
Agents operate in self interest

Question 5

How do policymakers execute the 2nd theorem of welfare economics (any Pareto efficient outcome can be found by finding endowment and prices to achieve it - as long as convex!!!)

Answer 5

By targeting endowments through policy e.g lump sum taxation) to tackle distributional goals