Market -Welfare The First Welfare theorem In the last lecture troduced: Pareto efficiency and general equilibrium. How do they relate? Theorem: The first welfare theorem states that every general equilibrium involves a Pareto efficient allocation. equilibrium. This point cannot lie on the contract curve(the dashed line)since it is not effice also a general The proof works by contradiction. Suppose there was a non-Pareto efficient allocation which Suppose it was a point like IA. If it is a general equilibrium as well, consumer A must be maximising given prices (illustrated by the budget line). But consumer B must be maximising also- say at point IB IA cannot be equal to Ig as it is not on the contract curve. Therefore Ig is a different point. But now the market for good 2 does not clear: x4+x2>44+42-a contradiction(this is not an equilibrium Market- welfare Market failure Assumptions need to be made for this theorem to work. There are three crucial ones. 2. Price Taking Behaviour: Each agent in the economy behaves as a price taker. any other agent No Externalities: Each agents consumption decision does not affect the utility of 3. Prices are Known: All the prices for each of the goods must be known to each of the agents. Importantly, the onsumers do not have different (asymmetric) information concerning the goods The first assumption is critical. The next lecture deals with the case of externalities in more depth The last is the minimal information requirement. Agents need only know price. They need not know the demand or output decisions of others. or how much of a good is available. They behar Market failure arises when any of these assumptions is not met. Externalities, market power and asymmetric information examples of market failureMarket — Welfare 1 The First Welfare Theorem • In the last lecture two concepts were introduced: Pareto efficiency and general equilibrium. How do they relate? • Theorem: The first welfare theorem states that every general equilibrium involves a Pareto efficient allocation. ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... . . . . . . . . . . . . . . . . . . . . . . . . ....................................................................................................................................................................................................................................................................................................................................................................................................................... ....................................................................................................................................................................................................................................................................................................................................................................................................................... . . . . . . . ......................................................................................................................................... ........................................................................................................................................... A B • • xA • x xB 2 A x 2 B • The proof works by contradiction. Suppose there was a non-Pareto efficient allocation which was also a general equilibrium. This point cannot lie on the contract curve (the dashed line) since it is not efficient. • Suppose it was a point like xA. If it is a general equilibrium as well, consumer A must be maximising given prices (illustrated by the budget line). But consumer B must be maximising also — say at point xB. • xA cannot be equal to xB as it is not on the contract curve. Therefore xB is a different point. • But now the market for good 2 does not clear: x 2 A + x 2 B > ω 2 A + ω 2 B — a contradiction (this is not an equilibrium). Market — Welfare 2 Market Failure • Assumptions need to be made for this theorem to work. There are three crucial ones. 1. No Externalities: Each agent’s consumption decision does not affect the utility of any other agent. 2. Price Taking Behaviour: Each agent in the economy behaves as a price taker. 3. Prices are Known: All the prices for each of the goods must be known to each of the agents. Importantly, the consumers do not have different (asymmetric) information concerning the goods. • The first assumption is critical. The next lecture deals with the case of externalities in more depth. • The last is the minimal information requirement. Agents need only know price. They need not know the demand or output decisions of others, or how much of a good is available. They behave “selfishly” given the known prices. • Market failure arises when any of these assumptions is not met. Externalities, market power and asymmetric information are all examples of market failure