Lecture 1

Question 1

The First fundamental theorem of welfare economics

Answer 1

Every equilibrium allocation is pareto efficient
Given:
- All producers and consumers are perfect competitors
- A market exists for every commodity
A competitive economy allocates resources efficiently without any need for centralized direction
All the information relevant for achieving market efficiency is embedded in the market prices

Question 2

Utilitarism

Answer 2

If the objective is to maximize W, the government can do that simply by increasing the income of any individual, not necessarily the poorest
Social welfare function seems neutral from an equity/distributive perspective
Assumptions:
1. Utility depends solely on income
2. When the income of an individual increases, the utility increases, but
less and less so (decreasing marginal utility of income)
3. There are no costs on redistributing income across individuals

Question 3

Maxmin Social Welfare

Answer 3

W=min(U1, U2,…,Un)
Social Welfare depends ONLY on the utility of the individual who is worse off
Society has the objective to maximize the utility of this individual

Question 4

Second fundamental Theory of Welfare Economics

Answer 4

Society can attain ANY Pareto efficient allocation of resources – e.g. one that is more equitable – by redistributing the initial allocation of resources and then letting people freely trade

Question 5

Implications of the Second Welfare Theorem

Answer 5

A first judgement over which social welfare function the society would like to adopt
A subsequent redistribution of resources considering the interpersonal comparison of utilities

Question 6

Issues with the first and second welfare theorem

Answer 6

Implementability of transfers based on individual characteristics (those are often private information, like skills or abilities)
The market is not always able to achieve allocative efficiency due to the presence of market failures
public good, externality, asymmetric information