Question

Recall from the lectures that the first fundamental welfare theorem states that equilibrium in competitive markets is Pareto Optimal. The second fundamental welfare theorem states that any Pareto efficient allocation can be achieve by the competitive equilibrium with the appropriate redistribution of initial endowments.

Now consider a situation of a small country that is considering opening to international trade. You are the leader of this country and your economists are telling you that if you open up to international trade, the natural resource sector will gain over a billion dollars in annual revenue. However, your economists are also telling you that the manufacturing sector will lose half a billion in revenue.
With what you have learned so far in this course and in the economics program, what decision would you make? Make sure to make some reference to competitive markets and logic expressed in the first and second welfare theorem.

Answer 1

First fundamental theorem of welfare economics (also known as the “Invisible Hand Theorem”):

any competitive equilibrium leads to a Pareto efficient allocation of resources.

The main idea here is that markets lead to social optimum. Thus, no intervention of the government is required, and it should adopt only “laissez faire” policies. However, those who support government intervention say that the assumptions needed in order for this theorem to work, are rarely seen in real life.

It must be noted that a situation where someone holds every good and the rest of the population holds none, is a Pareto efficient distribution. However, this situation can hardly be considered as perfect under any welfare definition. The second theorem allows a more reliable definition of welfare

-Second fundamental theorem of welfare economics:

any efficient allocation can be attained by a competitive equilibrium, given the market mechanisms leading to redistribution.

This theorem is important because it allows for a separation of efficiency and distribution matters. Those supporting government intervention will ask for wealth redistribution policies.

As the leader of this country and as per the advice of my economists I will open up to international trade,

This is because the natural resource sector will gain over a billion dollars in annual revenue.

However, the manufacturing sector will lose half a billion in revenue.
But this would be an improvement in welfare because I can compensate for the loss of manufacturing sector with the gains I receive from the natural resource sector.

On the whole, the country would be better off than before.