Question

Explain, using the Edgeworth Box diagram, how relative prices adjust to ensure that a general equilibrium is achieved in a competitive market economy. Discuss the First and Second Fundamental Theorems of Welfare Economics.

Answer 1

If the economy attains equilibrium at the allocation specified in the diagram along with the price vector p*, any other price vector will not lead to this allocation. In fact, any other price vector such as p will not lead to any equilibrium allocation. That is, at any other price vector, Walras' Law will not be satisfied; total demand for the goods will not be equal to the total endowment of the two goods. If the economy starts off from price vector p, it will gradually move toward the price vector p* to attain WEA at the allocation in the diagram till Walras' Law is satisfied.

First Fundamental Theorem of Welfare Economics:
According to this theorem, if consumer preferences are strictly increasing, strictly quasi concave, and continuous, any competitive equilibrium allocation will be Pareto Efficient and will belong to the core of the economy. That is:

Second Fundamental Theorem of Welfare Economics:
According to this theorem, if consumer preferences are strictly increasing, strictly quasi concave, and continuous, any Pareto Efficient allocation can be induced as a Competitive Equilibrium Allocation by appropriate transfer of wealth, or purchasing power. The transfer of purchasing power entails redistribution of endowment among the consumers.