Question

1. Briefly critique the following statements : (No more than five sentences!) (a) The First Welfare Theorem demonstrates that a free market in equilibrium is Pareto efficient. We, therefore, know that the distribution of goods in equilibrium is fair. (b) The Second Welfare Theorem demonstrates that any Pareto Efficient allocation of resources can be maintained by the free market system. Hence, what we need to do for the purpose of efficient public policy is to tax people until we get the desired allocation. (For example: by taxing shelter so that it becomes more expensive relative to food and using the tax revenues to buy shelter for the poor.)

Answer 1

First fundamental theorem also known as invisible hand which says that any competitive equilibrium will give us Pareto efficient outcome. The idea over here is that market automatically goes toward social optimum point. There is no need of government to interfare to redistribute resources in the economy. There are three assumptions of this theorem.

• Every one have equal information about products and goods in the market
• There is perfectly competitive market prevailing and no entry/exit cost be the firm.
• Any more quantity of good is always preferred to less quantity of goods, non satiation consumer.

It works on the Adam' Smith theory Invisible hand which says that the demand and supply for complete market reaches equilibrium automatically. There is nothing to be done, in long run price and quantity will reach to equilibrium prices.

This complete model is working on Adam' smith Theory but there is no specific reason described that the market will get Pareto efficient outcome without government intervention, so there was second fundamental theorem introduced.

The second fundamental theorem states that, any Pareto efficient outcome can be supported as a competitive market equilibrium by using a system of lump sum transfers to ensure that the best Pareto efficient allocation was supported as a competitive equilibrium for some set of prices. These assumptions seems more powerful than first fundamental theorem, with convexity of preferences (states that averages are better than extremes) and production functions a sufficient but not necessary condition. Simply it says that redistribution of income and resources should be allocated to people without disturbing prices in the market.