Theorem Of Welfare Economics

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State the two fundamental theorems of welfare economics and briefly explain why they hold.

Pareto efficiency
An allocation in an economy is Pareto efficient(sometimes called Pareto optimal) if it is impossible to reallocate resources to make someone better off without making someone else worse off.

The set of Pareto efficient allocations is given by the line between 0a and 0b. It is called the contract curve.

Subject to certain conditions (see later) we have the following two theorems:

First Theorem of Welfare Economics:
All competitive market equilibria are Pareto efficient.
Second Theorem of Welfare Economics:
Every Pareto efficient allocation is a competitive equilibrium (under certain conditions including the ability to make non-distortionary transfers).

The first theorem of welfare economics depends on several special circumstances. These include:
 There must be no externalities, e.g., pollution. This point includes the fact that consumers must not care about others consumption levels. This is a complex issue since if consumers do not care about the welfare of others then why do we vote for redistributive taxes?
 There must be no public goods.
 Consumers must behave competitively, there must be no monopoly power.
 There must be no asymmetric information.

The First Theorem of Welfare Economics ‘suggests’ that markets and competition is ‘good’ for society. This theorem is a formal statement of a view that has had a big influence over the years on political debate. The point that markets require little information (which I made earlier in the lecture) is to some extent a separate point but leads to similar conclusions. But is Pareto efficiency something that is desirable? How does one choose between two alternative distributions of society’s wealth?

The Second Theorem of Welfare Economics implies that efficiency and distribution can be separated. It suggests that governments, if they are purely concerned about individual welfare, should try not to intervene on prices, i.e., should not be paternalist. Instead they should redistribute endowments and let the market then decide what is purchased. The tax example, in the previous subsection, part (iii), is an example of the problems that arise when governments do not do this.

Explain the terms moral hazard and adverse selection

 Adverse selection (sometimes called a hidden information problem)
One of the parties has superior information about some exogenous variable before engaging in a contractual agreement
 Moral hazard (sometimes called a hidden action problem)
One of the parties takes some action that is unobserved by the principle

A numerical example of adverse selection - efficiency wages
Worker Productivity Supply Proportion type 1 1  0 if w≥1 ½ = 0 if w1 2 2  0 if w≥1.25 ½ = 0 if w1.25
Firms: need to produce 300; cannot identify type of workers.
(i) Suppose all firms offer w 1.25
Firm employs 200 workers
E(Output) 1002 1001 300 The total cost is 2001.25  250
(ii) Consider w 1 Firm employs 300 workers Output  3001 300
The total cost is 3001 300
The central point is that (i) cheaper then (ii) so firms prefer (i) even though the wage is lower in (ii) and there is excess supply of workers at the higher wage.

A numerical example of credit rationing
Two projects:
Project 1 30 with probability 0.33 15 with probability 0.33 0 with probability 0.33
Project 2 40 with probability 0.2 0 with probability 0.8
Project 1 better then project 2 since less risky and E(1) 15
Whereas E(2)  8.

Information:
Lenders do not know which project is undertaken.
Firm owners know which project is undertaken.

Case A: Money is given for project and repayment set at 14
Owners expected return is:
Owners expected return will depend on which project is
undertaken.
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