Second Welfare Theorem

Dr. Noha Nagi Elboghdadly

ESPS , Alexandria University
Second Semester 2021

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Lecture 6 Outline
In this lecture, we will cover:

• Recap of the First Welfare Theorem

• The Second Welfare Theorem
• Efficiency and Equity trade-off
• Implications of Second Welfare Theorem

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Recap: First Welfare Theorem
• Given certain conditions/assumptions (no externalities, perfect competition, full
information,..), the First Welfare Theorem guarantees that a competitive market
will exhaust all of the gains from trade: an equilibrium allocation achieved by a
set of competitive markets will necessarily be Pareto efficient. In other words, the
First Welfare Theorem says that the equilibrium in a set of competitive markets is
Pareto efficient.

• In pure exchange economy, the market mechanism automatically distributes goods

among people in an optimal way. The person who likes coffee will end up with a
lot of coffee, while the one who likes tea will end up with a lot of tea. Each
consumer will get the bundle of goods he likes best (given his budget constraint),
and those consumption bundles are consistent such that total demand of each good
is equal to total available supply.
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Recap: First Welfare Theorem
• Note that the competitive equilibrium depends on the initial endowment
allocation. Why?
• That is, the competitive allocation is determined by the initial allocation as well as by
preferences, and if, for example, the initial allocation is very unequal, so will be the competitive
allocation.
• The Question Now: Does the First Welfare Theorem guarantees that the market
allocation will be “fair” or equitable?
• Some people have lots of capital to rent, and some people have very valuable labor to sell. (think of football
players, and movie stars) . And some people have no capital to lend or rent, and very little valuable labor to sell.
The free competitive market mechanism will produce a distribution of goods that gives homes in rich new cities to
movie stars. But it will give poverty and hunger to those with no skills or talents. And the result will very likely be
Pareto optimal.
• First Welfare Theorem says nothing about the distribution of economic benefits of
trade. An allocation might be efficient but is not fair.
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Choosing a desirable allocation
Any general competitive equilibrium is Pareto efficient.
Yet, there can be many possible Pareto efficient allocations of resources and
not all of them may be equally "desirable" by society.
Is it possible for the policymaker to choose a desirable allocation, implement
an appropriate economic policy, then let the markets freely work and obtain
the desired allocation?
The answer is: yes, under certain conditions.

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Efficiency Vs Equality
Is there a trade-off between efficiency and equality?
• Given a Pareto efficient allocation, can we find prices such that it is a market
equilibrium? In other words, can any Pareto efficient allocation be supported
as a competitive equilibrium?
If the answer to the above questions is yes, then there is no trade-off between efficiency
and equality.
If the answer is no, then clearly there is a trade-off.
According to the second welfare theorem, the answer to the above question yes.

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Second Welfare Theorem
Second Welfare Theorem says:
If all agents have convex preferences, then there will always be a set
of prices such that each Pareto efficient allocation (i.e., any point on
the contract curve) is a market equilibrium provided that endowments
are first appropriately rearranged among the consumers.
In other words:
For any Pareto optimal allocation there are prices and an allocation of
the total endowment that makes the Pareto optimal allocation
implementable by trading in competitive markets.

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Second Welfare Theorem
Show the second welfare theorem graphically using Edgeworth box.
Steps:
1. Let us pick a Pareto efficient allocation X. (This implies that the two ICs are tangent)
2. Let us draw in the straight line that is their common tangent,
3. Suppose that the straight line represents the agents’ budget sets. (We know that each agent
chooses the best bundle on his or her budget set)
4. The slope of this line gives us the relative prices.
5. Calculate the corresponding equilibrium prices to the considered allocation
6. Redistribute endowments to anywhere along the (constructed) budget line.
7. Any endowment that puts the two agents on this line will lead to the final market equilibrium
being X. That is market trade will automatically achieve efficiency (by the first theorem).

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Second Welfare Theorem
Show the second welfare theorem graphically using Edgeworth box.

Copyright © 2019 Hal R. Varian

Noha Nagi Welfare Economics

Second Welfare Theorem
• The following three figures explains in more details how the second
welfare theorem works.

Noha Nagi Welfare Economics

Second Welfare Theorem

Copyright © 2019 Hal R. Varian

Noha Nagi Welfare Economics
Second Welfare Theorem

Copyright © 2019 Hal R. Varian

Noha Nagi Welfare Economics
Second Welfare Theorem

Copyright © 2019 Hal R. Varian

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Implications of the Second Welfare Theorem
• The Second Theorem of Welfare Economics asserts that under certain conditions, every Pareto
efficient allocation can be achieved as a competitive equilibrium.
What is the meaning of this result?
• The Second Welfare Theorem implies that the problems of distribution and efficiency can be
separated.
Whatever Pareto efficient allocation you want can be supported by the market mechanism.
• Prices play two roles in the market system: an allocative role and a distributive role.
The allocative role of prices is to indicate relative scarcity;
the distributive role is to determine how much of different goods different agents can purchase.
The Second Welfare Theorem says that these two roles can be separated: we can redistribute
endowments of goods to determine how much wealth agents have, and then use prices to indicate
relative scarcity.

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Implications of the Second Welfare Theorem
If we don’t like the distribution of wealth in the market equilibrium, how do we change it?
Lump-sum redistribution (transfers) (Lump-sum tax/subsidy)
In the case of a tax, this means that the government takes away some fixed amount of money,
regardless of the individual’s behavior.
• According to the Second Welfare Theorem, this kind of lump-sum taxation would be non-
distortionary (i.e. doesn’t lead to efficiency loss).
• Essentially any Pareto efficient allocation could be achieved by such lump-sum redistribution
Manipulation of price ratios
• Ex: senior citizens should have access to less expensive telephone service, or that small users
of electricity should pay lower rates than large users.
• These are basically attempts to redistribute income through the price system by offering some
people lower prices than others.
• Taxation which changes the price-ratio is distortionary, (i.e. leads to efficiency loss)
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Notes for your information (Read)
• Lump-sum tax and transfers are neutral with respect to efficiency, in the sense
that they will not result in any behavior distortions which prevent consumers
from maximizing gain from trade at the new distribution of income.
• The key feature of lump-sum tax (transfers) is that they don’t influence relative
prices, in the sense that they don’t provide incentives for individual to substitute
one good for another.
• Lump-sum taxes (subsidies) are neutral in the sense that they result only in
change in income (i.e. results only in income effect not substitution effect).
• Lump-sum transfers can be used to reach a new efficient allocation

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Appendix (Read only )

• A situation where a Pareto-

efficient allocation is not an
equilibrium because non-
convex indifference curve

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Summary of Efficiency in Pure Exchange
Economy
• Pareto-efficiency condition in a Pure exchange economy is that MRS of consumers are equal.
• The contract curve is the set of Pareto-optima allocations.
• Pareto-improving allocations depend on the initial endowment allocation
• General equilibrium refers to the study of how the economy can adjust to have demand equal
supply in all markets at the same time.
• If the demand for each good varies continuously as prices vary, then there will always be some
set of prices where demand equals supply in every market; that is, a competitive (Walrasian)
equilibrium.
• The First Theorem of Welfare Economics states that a competitive equilibrium is Pareto
efficient.
• The Second Theorem of Welfare Economics states that as long as preferences are convex, then
every Pareto efficient allocation can be supported as a competitive equilibrium.

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