Fundamental theorems of welfare economics

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There are two fundamental theorems of welfare economics. The first states that any competitive equilibrium or Walrasian equilibrium leads to a Pareto efficient allocation of resources. The second states the converse, that any efficient allocation can be sustainable by a competitive equilibrium.

The first theorem is often taken to be an analytical confirmation of Adam Smith's "invisible hand" hypothesis, namely that competitive markets tend toward an efficient allocation of resources. The theorem supports a case for non-intervention in ideal conditions: let the markets do the work and the outcome will be Pareto efficient. However, Pareto efficiency is not necessarily the same thing as desirability; it merely indicates that no one can be made better off without someone being made worse off. There can be many possible Pareto efficient allocations of resources and not all of them may be equally desirable by society.[1]

The second theorem states that out of all possible Pareto-efficient outcomes, one can achieve any particular one by enacting a lump-sum wealth redistribution and then letting the market take over. This appears to make the case that intervention has a legitimate place in policy – redistributions can allow us to select from all efficient outcomes for one that has other desired features, such as distributional equity. The shortcoming is that for the theorem to hold, the transfers have to be lump-sum and the government needs to have perfect information on individual consumers' tastes as well as the production possibilities of firms. An additional mathematical condition is that preferences and production technologies have to be convex.[2]

Because of welfare economics' close ties to social choice theory, Arrow's impossibility theorem is sometimes listed as a third fundamental theorem.[3]

The ideal conditions of the theorems, however are an abstraction. The Greenwald-Stiglitz theorem, for example, states that in the presence of either imperfect information, or incomplete markets, markets are not Pareto efficient. Thus, in real world economies, the degree of these variations from ideal conditions must factor into policy choices.[4] Further, even if these ideal conditions hold, the First Welfare Theorem fails in an overlapping generations model.

Proof of the first fundamental theorem[edit]

The first fundamental theorem of welfare economics states that any competitive equilibrium is Pareto-efficient. This was first demonstrated graphically by economist Abba Lerner and mathematically by economists Harold Hotelling, Oskar Lange, Maurice Allais, Kenneth Arrow and Gérard Debreu. The theorem holds under general conditions.[2]

The theorem relies only on three assumptions: (1) complete markets (i.e., no transaction costs and where each actor has perfect information), (2) price-taking behavior (i.e., no monopolists and easy entry and exit from a market), and (3) the relatively weak assumption of local nonsatiation of preferences (i.e., for every bundle of goods there is another similar bundle that would be preferred).

The formal statement of the theorem is as follows: If preferences are locally nonsatiated, and if (x*, y*, p) is a price equilibrium with transfers, then the allocation (x*, y*) is Pareto optimal. An equilibrium in this sense either relates to an exchange economy only or presupposes that firms are allocatively and productively efficient, which can be shown to follow from perfectly competitive factor and production markets.[2]

Suppose that consumer i has wealth w_i such that \Sigma _i w_i = p \cdot \omega + \Sigma _j p \cdot y^*_j where  \omega is the aggregate endowment of goods and y^*_j is the production of firm j.

Preference maximization (from the definition of price equilibrium with transfers) implies:

if x_i >_i x^*_i then p \cdot x_i > w_i

In other words, if a bundle of goods is strictly preferred to x^*_i it must be unaffordable at price p. Local nonsatiation additionally implies:

if x_i \geq _i x^*_i then p \cdot x_i \geq w_i

To see why, imagine that x_i \geq _i x^*_i but p \cdot x_i < w_i. Then by local nonsatiation we could find x'_i arbitrarily close to x_i (and so still affordable) but which is strictly preferred to x^*_i. But x^*_i is the result of preference maximization, so this is a contradiction.

Now consider an allocation  (x, y) that Pareto dominates (x^*, y^*). This means that x_i \geq _i x^*_i for all i and x_i >_i x^*_i for some i. By the above, we know p \cdot x_i \geq w_i for all i and p \cdot x_i > w_i for some i. Summing, we find:

\Sigma _i p \cdot x_i > \Sigma _i w_i = p \cdot \omega + \Sigma _j p \cdot y^*_j

Because  y^* is profit maximizing, we know  \Sigma _j p \cdot y^*_j \geq \Sigma _j p \cdot y_j , so \Sigma _i p \cdot x_i > p \cdot \omega + \Sigma _j p \cdot y_j. Hence, (x,y) is not feasible. Since all Pareto-dominating allocations are not feasible, (x^*,y^*) must itself be Pareto optimal.[2]

Proof of the second fundamental theorem[edit]

The second fundamental theorem of welfare economics states that, under the assumptions that every production set Y_j is convex and every preference relation \geq _i is convex and locally nonsatiated, any desired Pareto-efficient allocation can be supported as a price quasi-equilibrium with transfers.[2] Further assumptions are needed to prove this statement for price equilibriums with transfers.

The proof proceeds in two steps: first, we prove that any Pareto-efficient allocation can be supported as a price quasi-equilibrium with transfers; then, we give conditions under which a price quasi-equilibrium is also a price equilibrium.

Let us define a price quasi-equilibrium with transfers as an allocation (x^*,y^*), a price vector p, and a vector of wealth levels w (achieved by lump-sum transfers) with \Sigma _i w_i = p \cdot \omega + \Sigma _j p \cdot y^*_j (where  \omega is the aggregate endowment of goods and y^*_j is the production of firm j) such that:

i. p \cdot y_j \leq p \cdot y_j^* for all y_j \in Y_j (firms maximize profit by producing y_j^*)
ii. For all i, if x_i >_i x_i^* then p \cdot x_i \geq w_i (if x_i is strictly preferred to x_i^* then it cannot cost less than x_i^*)
iii. \Sigma_i x_i^* = \omega + \Sigma _j y_j^* (budget constraint satisfied)

The only difference between this definition and the standard definition of a price equilibrium with transfers is in statement (ii). The inequality is weak here (p \cdot x_i \geq w_i) making it a price quasi-equilibrium. Later we will strengthen this to make a price equilibrium.[2] Define V_i to be the set of all consumption bundles strictly preferred to x_i^* by consumer i, and let V be the sum of all V_i. V_i is convex due to the convexity of the preference relation \geq _i. V is convex because every V_i is convex. Similarly Y + \{\omega\}, the union of all production sets Y_i plus the aggregate endowment, is convex because every Y_i is convex. We also know that the intersection of V and Y + \{\omega\} must be empty, because if it were not it would imply there existed a bundle that is strictly preferred to (x^*,y^*) by everyone and is also affordable. This is ruled out by the Pareto-optimality of (x^*,y^*).

These two convex, non-intersecting sets allow us to apply the separating hyperplane theorem. This theorem states that there exists a price vector p \neq 0 and a number r such that p \cdot z \geq r for every z \in V and p \cdot z \leq r for every z \in Y + \{\omega\}. In other words, there exists a price vector that defines a hyperplane that perfectly separates the two convex sets.

Next we argue that if x_i \geq _i x_i^* for all i then p \cdot (\Sigma _i x_i) \geq r. This is due to local nonsatiation: there must be a bundle x'_i arbitrarily close to x_i that is strictly preferred to x_i^* and hence part of V_i, so p \cdot (\Sigma _i x'_i) \geq r. Taking the limit as x'_i \rightarrow x_i does not change the weak inequality, so p \cdot (\Sigma _i x_i) \geq r as well. In other words, x_i is in the closure of V.

Using this relation we see that for x_i^* itself p \cdot (\Sigma _i x_i^*) \geq r. We also know that \Sigma _i x_i^* \in Y + \{\omega\}, so p \cdot (\Sigma _i x_i^*) \leq r as well. Combining these we find that p \cdot (\Sigma _i x_i^*) = r. We can use this equation to show that (x^*,y^*,p) fits the definition of a price quasi-equilibrium with transfers.

Because p \cdot (\Sigma _i x_i^*) = r and \Sigma _i x_i^* = \omega + \Sigma _j y_j^* we know that for any firm j:

p \cdot (\omega + y_j + \Sigma_h y_h^*) \leq r = p \cdot (\omega + y_j^* + \Sigma_h y_h^*) for h \neq j

which implies p \cdot y_j \leq p \cdot y_j^*. Similarly we know:

p \cdot (x_i + \Sigma_k x_k^*) \geq r = p \cdot (x_i^* + \Sigma_k x_k^*) for k \neq i

which implies p \cdot x_i \geq p \cdot x_i^*. These two statements, along with the feasibility of the allocation at the Pareto optimum, satisfy the three conditions for a price quasi-equilibrium with transfers supported by wealth levels w_i = p \cdot x_i^* for all i.

We now turn to conditions under which a price quasi-equilibrium is also a price equilibrium, in other words, conditions under which the statement "if x_i >_i x_i^* then p \cdot x_i \geq w_i" imples "if x_i >_i x_i^* then p \cdot x_i > w_i". For this to be true we need now to assume that the consumption set X_i is convex and the preference relation \geq _i is continuous. Then, if there exists a consumption vector x'_i such that x'_i \in X_i and p \cdot x'_i < w_i, a price quasi-equilibrium is a price equilibrium.

To see why, assume to the contrary x_i >_i x_i^* and p \cdot x_i = w_i, and x_i exists. Then by the convexity of X_i we have a bundle x''_i = \alpha x_i + (1 - \alpha)x'_i \in X_i with p \cdot x''_i < w_i. By the continuity of \geq _i for \alpha close to 1 we have \alpha x_i + (1 - \alpha)x'_i >_i x_i^*. This is a contradiction, because this bundle is preferred to x_i^* and costs less than w_i.

Hence, for price quasi-equilibria to be price equilibria it is sufficient that the consumption set be convex, the preference relation to be continuous, and for there always to exist a "cheaper" consumption bundle x'_i. One way to ensure the existence of such a bundle is to require wealth levels w_i to be strictly positive for all consumers i.[2]

See also[edit]


  1. ^ Stiglitz, Joseph E. (1994), Whither Socialism?, MIT Press, ISBN 0-262-69182-5 
  2. ^ a b c d e f g Mas-Colell, Andreu; Whinston, Michael D.; Green, Jerry R. (1995), "Chapter 16: Equilibrium and its Basic Welfare Properties", Microeconomic Theory, Oxford University Press, ISBN 0-19-510268-1 
  3. ^ * Feldman, Allan M. (2008), "Welfare Economics", The New Palgrave: A Dictionary of Economics (online ed.) 4, pp. 889–95, retrieved 9 June 2014 
  4. ^ Stiglitz, Joseph E. (March 1991), The Invisible Hand and Modern Welfare Economics. NBER Working Paper No. W3641. (PDF), National Bureau of Economic Research (NBER)