Question

Illustrate and explain how the two fundamental theorems of welfare economics describe the relationship between competitive markets and Pareto efficiency.

Answer 1

The welfare economics have two fundamental theorems the first theorem is known as the “Invisible Hand Theorem”. The theorem says that any competitive equilibrium leads to Pareto efficient allocation of resources. It says that the market leads to social optimum. No government intervention is required and it embrace laissez faire policies. Although some people do support the government intervention because they feel that the assumption of this theorem rarely seen in real life.

Pareto efficient distribution is a situation where one individual holds very good and the remaining population holds nothing. This can’t be consider perfect under any of the welfare definition.

The second theorem gives more reliable definition of welfare as it allows for the separation of distribution and the efficiency matters. The efficiency and distribution matters are separate in this. In the competitive market the government policies will lead to redistribution of initial endowments.