Question

Explain the First and the Second Fundamental Theorems of Welfare Economics.

Answer 1

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

It says that a 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:

It says that any efficient allocation can be attained by a competitive equilibrium, given the market mechanisms leading to redistribution. It explains that if all consumers have convex preferences and all firms have convex production possibility sets then Pareto efficient allocation can be achieved. The equilibrium of a complete set of competitive markets are suitable for redistribution of initial endowments.

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.