Question

why is it important that a competitive market is Pareto efficient? and what does the first fundamental theorem of welfare economics tell us about market fail?

Answer 1

Pareto-efficiency occurs when the achievement of an allocation of resources in in such a way that no one can be made better off without making someone else worse off, thus, all painless gains have to been made. In order to achieve Pareto-efficiency, any economic system are required to satisfy three broad categories of conditions, conditions for efficiency in consumption, for efficiency in production, and for efficiency in the product-mix.

For efficiency in the product-mix, every consumer’s marginal rate of substitution must also equal the marginal rate of transformation, the absolute value of the slope of the economies production possibilities frontier. Perfectly competitive markets do satisfy all three sets of conditions for Pareto-efficiency.

--The first optimality theorem of welfare economics states that all perfectly competitive equilibria are Pareto-efficient.

--The second optimality theorem of welfare economics states that any desired Pareto-efficient allocation can be achieved as a competitive equilibrium with the use of suitable lump sum taxes and transfers.

--Although the practical implications of the optimality theorems are limited, and are not met by real market economies because of the fact that many of the required conditions. Further, the theory of second best states that, if even one of the conditions for Pareto-efficiency is not met then it may no longer be desirable to try to satisfy the other conditions for Pareto-efficiency