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OVERVIEW OF WELFARE
ECONOMICS

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 OUTLINE

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Pareto Optimality and Competitive Markets

Theorems of Welfare Economics

Theory of Second Best.

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 PARETO OPTIMALITY AND COMPETITIVE
MARKETS

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 In most modern industrial economies,
primary reliance for the production and
distribution of goods lies in the private
rather than the public sector
 Adam Smith, in The Wealth of Nations-
argued that competition would lead the
individual in the pursuit of his or her private
interests (profits) to pursue the public
interest, as if by an invisible hand
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 Welfare economics is the branch of economics
that focuses on what were termed normative
issues
 The most fundamental normative issue for
welfare economics is the economy’s
organization—what should be produced, how
it should be produced, for whom, and who
should make these decisions
 Most economies today are mixed, with some
decisions made by the government but most 4
left up to the myriad firms and households
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 Most economists embrace a criterion called
Pareto efficiency, named after the great Italian
economist and sociologist Vilfredo Pareto (1848–
1923)
 Resource allocations that have the property that
no one can be made better off without someone
being made worse off are said to be Pareto
efficient, or Pareto optimal
 Pareto improvement; is, a change that makes
some individuals better off without making
anyone worse of
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 Assume, for instance, that the government is
contemplating building a bridge.
 Those who wish to use the bridge are willing to pay
more than enough in tolls to cover the costs of
construction and maintenance.
 The construction of this bridge is likely to be a
Pareto improvement; that is, a change that makes
some individuals better off without making anyone
worse off .
 We say “likely” because there are always others
who might be adversely affected by the construction
of the bridge. Eg reduction in business because of 6

changes in traffic flow etc

THE FUNDAMENTAL THEOREMS OF
WELFARE ECONOMICS

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 Two of the most important results of welfare
economics describe the relationship between
competitive markets and Pareto efficiency
 These results are called the fundamental
theorems of welfare economics

 The first theorem tells us that if the economy is

competitive (and satisfies certain other
conditions), it is Pareto efficient

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SECOND WELFARE THEOREM

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 Every Pareto efficient resource allocation can be
attained through a competitive market
mechanism, with the appropriate initial
redistributions
 The second theorem asks the reverse question.
There are many Pareto efficient distributions.
 By transferring wealth from one individual to
another, we make the second individual better off
and the first worse off .
 After we make the redistribution of wealth, if we
let the forces of competition freely play themselves
out, we will obtain a Pareto efficient allocation of 8

resources
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 Thus, if we do not like the income distribution
generated by the competitive market, we need
not abandon the use of the competitive market
mechanism.
 All we need do is redistribute the initial wealth,
and then leave the rest to the competitive market

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 The second fundamental theorem of welfare economics

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has the remarkable implication that every Pareto
efficient allocation can be attained by means of a
decentralized market mechanism vs centralized system
 In a decentralized system, decisions about production
and consumption (what goods get produced, how they
get produced, and who gets what goods) are carried out
by the myriad firms and individuals that make up the
economy
 In contrast, in a centralized allocation mechanism, all
such decisions are concentrated in the hands of a single
agency—the central planning agency—or a single 10
individual, who is referred to as the central planner
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 The second fundamental theorem of
welfare economics says that to attain an
efficient allocation of resources, with the
desired distribution of income, it is not
necessary to have a central planner
 This theorem thus provides a major
justification for reliance on the market
mechanism.

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 The fundamental theorems of welfare
economics provide conditions under which
a competitive economy is Pareto efficient,
and under which every Pareto efficient
allocation can be obtained through
markets, provided that the appropriate
redistribution of initial endowments
(incomes) occurs

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BASIC CONDITIONS FOR PARETO
EFFICIENCY

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 1. Exchange efficiency: The marginal rate of
substitution between any two goods must be the
same for all individuals.
 2. Production efficiency: The marginal rate of
technical substitution between any two inputs
must be the same for all fi rms.
 3. Product mix efficiency: The marginal rate
of transformation must equal marginal rate of
substitution.
 Competitive economies satisfy all three
conditions
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EXCHANGE EFFICIENCY

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EXCHANGE EFFICIENCY

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 Exchange efficiency means that, given the set of
goods available in the economy, no one can be
made better off without someone else being made
worse off
 It requires that all individuals have the same
marginal rate of substitution between any pair of
commodities.
 Competitive markets in which individuals face
the same prices always have exchange efficiency

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PRODUCTION EFFICIENCY

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PRODUCTION EFFICIENCY

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 Production efficiency requires that, given the set
of resources, the economy not be able to produce
more of one commodity without reducing the
output of some other commodity
 The economy must be operating along its
production possibilities curve.
 Production efficiency requires that all firms have
the same marginal rate of technical substitution
between any pair of inputs
 Competitive markets in which firms face the
same prices always have production efficiency.
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PRODUCT MIX EFFICIENCY

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PRODUCT MIX EFFICIENCY

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 Product mix efficiency requires that the marginal
rate of transformation—the slope of the
production possibilities curve—equal individuals’
marginal rate of substitution.
 Competitive markets have product mix efficiency

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THEORY OF THE SECOND BEST

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 The theory of the second best was formalized by
Richard Lipsey and Kelvin Lancaster in 1956.

 The primary focus of the theory is what happens

when the optimum conditions are not satisfied in
an economic model.

 When it is not possible to fulfil the pareto optimal

conditions to maximize the welfare, we should
focus upon achieving the second best equilbrium
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THEORY OF THE SECOND BEST…

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 The theory of the second best is concerned with
the design of government policy in situations in
which the economy is characterized by some
important distortions that cannot be removed

 This is in contrast to “first-best” economies, in

which all the conditions for Pareto efficiency can
be satisfied.
 Second-best considerations say that it may not be
desirable to remove distortions in sectors in
which they can be removed
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THEORY OF THE SECOND BEST…

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 The general theorem of the second best states
that if one of the Paretian optimum conditions
cannot be fulfilled a second best optimum
situation is achieved only by departing from all
other optimum conditions.

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