Welfare Theorems Flashcards
First Welfare Theorem
Known as the Invisible Hand Theorem
Any competitive equilibrium leads to a Pareto efficient allocation of resources.
As long as the market mechanism is working, and relative prices are changing, we’ll reach a point where both markets are in equilibrium.
3 Assumptions behind the First Welfare Theorem
- There are no externalities and no consumption externalities. No interdependence between two people’s utilities.
- Efficiency is the only objective.
- No price distortions. Everyone is a price taker and there is perfect information.
Second Welfare Theorem
The inverse of the first theorem.
If we take a Pareto efficient outcome, it can be a competitive equilibrium. But, this is only if the government can redistribute endowments without shrinking the economy in the process.
We can pick any Pareto optimal point outside of the core, and make it a competitive equilibrium.
Why do governments intervene within the Edgeworth Box?
Gov may want consumers to consume a Pareto efficient outcome outside the core. Gov intervention is needed bc it may not be mutually beneficial.
The government needs to redistribute resources between the consumers, without shrinking the economy. The price mechanism then kicks in, and we arrive at the government’s preferred Pareto optimal point.
How does the government redistribute resources?
They will determine their preferred Pareto optimal point along the contract curve, and redistribute wealth (via taxes or subsidies), in order to create a new initial endowment point.
The new budget constraint will pass through the new endowment point and the preferred Pareto optimal point.
Per Unit Taxes and impacts
Most common way of redistribution. It changes the opportunity cost of consuming a good when the price ratio changes. This creates a substitution effect which creates a deadweight welfare loss, as consumers change their consumption point based on the price ratio, not their utility.
Non Convex Preferences
If preferences aren’t convex, then it becomes possible that a Pareto efficient outcome may not be made a competitive equilibrium. There could be no prices which both agents will want to consume.
