Welfare Properties of General Equilibrium Flashcards
What is the first theorem of welfare economics?
A competitive general equilibrium is Pareto Optimal
i.e. prices determined in competitive markets lead to an efficient outcome in context of Pareto
Which 3 conditions need to be satisfied for Pareto Optimality?
Exchange : MRS^Ayx = MRS^Byx
= relative goods prices
Production: MRTS^xKL = MRTS^YKL
= relative factor prices
(slope of isoquants)
Product Mix: MRS^comyx = MRTyx
= slope of CIC = slope of PPC
The general equilibrium is a set of prices that generates these conditions such that all markets clear.
Decentralised competitive market economy produces an efficient outcome.
Show an efficient outcome in an exchange economy
Page 9
Show an efficient outcome in a production economy
Page 9
Show general equilibrium mix in a diagram
Page 9
What does the First Theorem of Welfare Economics tell us ?
Competitive market economy puts us on upf (i.e. Pareto Optimal)
but this may NOT be welfare optimum
What is the Second Theorem of Welfare Economics ?
Any Pareto Optimal position can be represented by a competitive general equilibrium provided there is a suitable redistribution of income
i.e. appropriate initial endowment for each individual - correct allocation of L and K which could take us to the welfare optimum
What are the necessary conditions to reach the welfare optimum?
- *** a. 3 conditions of GET which puts us on upf and gives us Pareto optimality
b. Fourth Optimality condition - the tangency condition which also gives welfare optimum
Show the Exchange Economy proof of welfare optimum
Handout 3 / page 10
What does the Fourth Optimality Condition tell us about welfare?
It tells us that welfare cannot be improved by giving last unit of x to A rather than giving this last unit of x to B and likewise for the marginal unit of y
