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1.1

Welfare Theorems
The rst welfare theorem

If every relevant good is traded in a market at publicly known prices (i.e. if there is a complete set of markets ), and if households and rms act perfectly competitive (i.e. as prices takers ), then the market outcome is Pareto optimal. That is, when markets are complete, any competitive equilibrium is necessarily Pareto optimal. Assumptions: The denition of market equilibrium and the denition of Pareto eciency. Implicit assumptions: no externalities (utility and production) Agents are price takers and adjust quantities. No monopolists. No asymmetric information. Interpretation: The market mechanism does always achieve an ecient allocation. The market mechanism is not necessarily the only mechanism that achieves an ecient allocation. But it is a very simple one: Every individual simply maximizes its own utility while only knowing its own preferences and the market prices. (Smith: Invisible Hand). Other allocation mechanisms require much more information (especially in a big economy with lots of markets and agents).

1.2

The second welfare theorem

If household preferences and rm production sets are convex, there is a complete set of markets with publicly known prices, and every agent acts as a price taker, then any Pareto optimal outcome can be achieved as a competitive equilibrium if appropriate lump-sum transfers of wealth are arranged. Additional Assumptions: Technical: Preferences are monotonous, convex, and continuous. Information: If a social planner wants to have a certain Pareto ecient allocation by using the market mechanism he needs to know the preferences of all agents and the production sets of all rms. Interpretation: A certain allocation is achieved by assigning a certain level of initial wealth to all agents . The market mechanism ensures eciency. It is not necessary to have price interventions. Prices play a distributive and a allocative role.