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Concept
Fundamental theorems of welfare economics
Summary
There are two fundamental theorems of welfare economics. The first states that in economic equilibrium, a set of complete markets, with complete information, and in perfect competition, will be Pareto optimal (in the sense that no further exchange would make one person better off without making another worse off). The requirements for perfect competition are these:
There are no externalities and each actor has perfect information.
Firms and consumers take prices as given (no economic actor or group of actors has market power).
The theorem is sometimes seen as an analytical confirmation of Adam Smith's "invisible hand" principle, namely that competitive markets ensure an efficient allocation of resources. However, there is no guarantee that the Pareto optimal market outcome is socially desirable, as there are many possible Pareto efficient allocations of resources differing in their desirability (e.g. one person may own everything and everyone else nothing).
The second theorem states that any Pareto optimum can be supported as a competitive equilibrium for some initial set of endowments. The implication is that any desired Pareto optimal outcome can be supported; Pareto efficiency can be achieved with any redistribution of initial wealth. However, attempts to correct the distribution may introduce distortions, and so full optimality may not be attainable with redistribution.
The theorems can be visualized graphically for a simple pure exchange economy by means of the Edgeworth box diagram.
In a discussion of import tariffs Adam Smith wrote that:
Every individual necessarily labours to render the annual revenue of the society as great as he can... He is in this, as in many other ways, led by an invisible hand to promote an end which was no part of his intention... By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.Note that Smith's ideas were not directed towards welfare economics specifically, as this field of economics had not been created at the time.
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