First Welfare Theorem

From Freepedia

In welfare economics, the First Welfare Theorem is that a system of free markets will lead to a Pareto efficient equilibrium. This was first demonstrated mathematically by economists Kenneth Arrow and Gerard Debreu, although the restrictive assumptions necessary for the proof mean that the result may not necessarily reflect the workings of real economies.

A fuller statement of this theorem is available here.

Conditions for the theorem

• Markets exist for all possible goods.
• Markets are perfectly competive.
• Transaction costs are negligible.
• There are no externalities.

Implications of the theorem

Under idealized conditions, the first welfare theorem implies that Pareto efficiency can be obtained with very little government action - the function of government can be restricted that of protecting property rights and allowing trade. Solely by changing the initial distribution of resources, any pareto-efficient outcome can be attained. It should be clear however, that Pareto efficiency is not the only possible goal to attain. Some people could tolerate eventual inefficiencies, if the income distributions had some desirable characteristics. The real meaning of the theorem is that the result of free markets, under the conditions mentioned, will be efficient. Thus there is nothing we can do to change this result without hurting some participants. The question if we want to accept this result, believing in the value of individual rights, or if we think the state should change it to attain some other goal, is rather philosophical. The answer should be found in the works of Robert Nozick or John Rawls.