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There are two fundamental theorems of welfare economics. The first states that in economic equilibrium , a set of complete markets , with complete information , and in perfect competition , will be Pareto optimal (in the sense that no further exchange would make one person better off without making another worse off).
The second theorem states that with further restrictions, any Pareto efficient outcome can be achieved through a competitive market equilibrium, [3] provided that a social planner uses a social welfare function to choose the most equitable efficient outcome and then uses lump sum transfers followed by competitive trade to achieve it.
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Fig. 7. The second welfare theorem. Now consider an economy in which the consumers have endowments ω as shown in Fig. 7. Left to itself a free market will take them to ω'. But suppose that some other position in the box – say α' – is considered socially preferable. We can assume that the socially desired position is Pareto optimal.
The second welfare theorem is essentially the reverse of the first welfare theorem. It states that under similar, ideal assumptions, any Pareto optimum can be obtained by some competitive equilibrium , or free market system, although it may also require a lump-sum transfer of wealth.
In welfare economics, the theory of the second best concerns the situation when one or more optimality conditions cannot be satisfied. [1] The economists Richard Lipsey and Kelvin Lancaster showed in 1956 that if one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the values that would ...
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Fundamental theorems of welfare economics [ edit ] In 1951, Arrow presented the first and second fundamental theorems of welfare economics and their proofs without requiring differentiability of utility, consumption, or technology, and including corner solutions.