Fundamental Theorems of Welfare Economics Flashcards
(11 cards)
What is a social planner’s problem in microeconomics?
A centralised optimisation problem: choose an allocation of resources to maximise total utility, subject to feasibility (resource constraints).
What is Pareto efficiency?
An allocation where no one can be made better off without making someone else worse off.
What does the First Welfare Theorem state?
Any competitive equilibrium is Pareto efficient, assuming:
Perfect competition
Complete markets
No externalities
Convex preferences
Why does the First Welfare Theorem hold?
Because individual maximisation and market-clearing prices align incentives — each consumer reaches their highest indifference curve, and MRS equals the price ratio.
When might the First Welfare Theorem fail?
Externalities
Non-convexities (e.g. increasing returns)
Market power (e.g. monopoly)
Public goods
Incomplete markets
What does the Second Welfare Theorem state?
Any Pareto efficient allocation can be achieved as a competitive equilibrium, given an appropriate redistribution of initial endowments.
What assumptions are needed for the Second Welfare Theorem?
Convex preferences
Continuity
Perfect competition
No externalities
Lump-sum transfers (no distortion)
What is the intuition behind the Second Welfare Theorem?
We can separate equity and efficiency:
Use redistribution to address fairness
Then let markets efficiently allocate resources
What’s the difference between the First and Second Welfare Theorems?
First: Competitive equilibrium ⇒ efficient
Second: Efficient allocation ⇒ can be decentralised as a competitive equilibrium with redistribution
What are the policy implications of the welfare theorems?
First: Free markets are efficient under ideal conditions
Second: Equity can be addressed via redistribution without harming efficiency if lump-sum transfers are possible
