Welfare Economics & Pareto Efficiency
When is an allocation efficient, when is it fair, and why the two welfare theorems matter.
Definition
An allocation is Pareto efficient when nobody can be made better off without making someone worse off. The welfare theorems link efficiency to competitive markets.
Key equation
First Welfare Theorem: competitive equilibrium ⇒ Pareto efficient; Second: any efficient point is reachable via lump-sum transfers
The intuition
Efficiency says nothing about fairness, giving one person everything is Pareto efficient. The deep result is that prices alone, with no planner, exhaust every mutually beneficial trade; redistribution is then a separate, lump-sum job.
Exam tip
Never argue an allocation is inefficient because it's unequal, examiners set that trap deliberately.
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