Fundamental theorems of welfare economics

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:^[1]

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 equitative, 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).^[2]

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.^[3]

The theorems can be visualized graphically for a simple pure exchange economy by means of the Edgeworth box diagram.

^ https://web.stanford.edu/~hammond/effMktFail.pdf ^{[bare URL PDF]}
^ Stiglitz, Joseph E. (1994), Whither Socialism?, MIT Press, ISBN 978-0-262-69182-6
^ See the discussion on pp. 556 f of Mas-Colell et al.

[1] ttps://web.stanford.edu/~hammond/effMktFail.pdf ^{[bare URL PDF]}

[2] Stiglitz, Joseph E. (1994), Whither Socialism?, MIT Press, ISBN 978-0-262-69182-6

[3] See the discussion on pp. 556 f of Mas-Colell et al.

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