Question

Demonstrate the First Fundamental Welfare Theorem for the following topics: Price Controls, Taxes and Subsidies, and Monopoly. Detail how each meets the three requirements for the First Fundamental Welfare Theorem.

Answer 1

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Abstract

There are two fundamental theorems of welfare economics. The first theorem states that a market will tend toward a competitive equilibrium that is weakly Pareto optimal when the market maintains the following two attributes

1. Complete markets with no transaction costs, and therefore each actor also having perfect information.

2. Price-taking behavior with no monopolists and easy entry and exit from a market.

Furthermore, the first theorem states that the equilibrium will be fully Pareto optimal with the additional condition of:

3. Local nonsatiation of preferences such that for any original bundle of goods, there is another bundle of goods arbitrarily close to the original bundle, but which is preferred.

The second theorem states that out of all possible Pareto optimal outcomes one can achieve any particular one by enacting a lump-sum wealth redistribution and then letting the market take over.

A) Price Controls

The theorem supports a case for non-intervention in ideal conditions: let the markets do the work and the outcome will be Pareto efficient. However, Pareto efficiency is not necessarily the same thing as desirability

Despite the frequent use of price controls, however, and despite their appeal who sell their extra tickets and improving the well-being of those who buy. they were being used to “buy time” while more fundamental cures for inflation were in place.

• Price ceilings prevent a price from rising above a certain level.

• When a price ceiling is set below the equilibrium price, quantity demanded will exceed quantity supplied, and excess demand or shortages will result.

• Price floors prevent a price from falling below a certain level.

• When a price floor is set above the equilibrium price, quantity supplied will exceed quantity demanded, and excess supply or surpluses will result.

• When government laws regulate prices instead of letting market forces determine prices, it is known as price control.

B) Taxes and Subsidies

A subsidy, often viewed as the converse of a tax, is an instrument of fiscal policy. Potential is at its best when they are transparent, well targeted, and suitably designed for practical implementation. Subsidies are helpful for both economy and people as well. Subsidies have a long-term impact on the economy; the Green Revolution being one example. Farmers were given good quality grain for subsidized prices. Likewise, we can see that how the government of India is trying to reduce air pollution to subsidies LPG

C) Monopoly

There often exist monopolies (single firm) or monopolies (single consumer) in which either firms or consumers have great power in affecting, or even setting prices. The degree to which markets diverge from the assumptions behind the fundamental theorems determines the extent to which the fundamental theorems are applicable

Finally, one powerful way in which the fundamental theorems fail is that they do not account for externalities, or costs or benefits to third-parties who did not choose to incur such costs or benefits. For example, a consumer who chooses to consume one gallon of gasoline will pollute the environment and lower the utility of every other consumer. The fundamental theorems, however, assume that a consumer’s utility is solely a function of that consumer’s consumption bundle. It does not account for the possibility that one’s utility can be affected by the consumption bundle of another consumer.

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