Question

10. (a) What is the First theorem of Welfare Economic. (b) In what sense does it relate to Adam Smith’s notion of “an invisible hand.” (c) Does the theorem hold if there are some pecuniary externalities? (d) Does the theorem hold if there are some real externalities? (e) What is the distinction between pecuniary and real externalities?

Answer 1

a)

First theorem of Welfare Economic is that a market in equilibrium and perfect competition will be Pareto optimal. That means that without making another worse off, no further exchange would make one person better off. This is based on following conditions of perfect competition.

1) No externalities and no transaction costs will be there and everyone has perfect information.

2) Firms are only prices takers and they cannot decide the price of the good/service.

b)

By the notion of “an invisible hand” Adam Smith means that an economy will function well if there are no government regulations and will allow people to buy and sell freely among themselves. That means a customer will buy from someone who charges less. So for somebody to sell a product/service, he has to lower price or offer something better than his competitor. Whenever there is enough demand for something, it will be supplied by the market and everyone will be happy. The seller will get the price and the buyer will get better goods at reasonable price.

c)

The theorem does hold even if there are some pecuniary externalities. If someone buys a product in large quantities say whiskey, it causes a rise in the price of whiskey. This causes a loss to other consumers who wants whiskey. But the manufacturers have same amount of profit which equals to the loss of other consumers due to the increase in price of whiskey. Hence this is not against Pareto optimal concept.

d)

The theorem does not hold if there are some real externalities because real externalities have a direct resource effect on a third party. A harmful effect on the environment due to pollution from a factory is an example.