Implications of the Welfare Theorems:

The welfare theorems are important, not because they are good description of reality, but rather because they specify the conditions under which general market equilibrium is efficient. This ideal situation is called a “first-best”, but reality is characterized by “second-best”, i.e., one or more of the necessary conditions do not hold. Welfare theory is a platform from which we can take further steps when analyzing various problems occurring in a market economy, i.e., so called market failures, and discuss the best measures to take to correct these failures.

One crucial requirement for “first-best”, which I’ve mentioned in passing above, is that no single actor can influence, or manipulate, market prices; we say that economic actors are atomistic. This condition is violated when one single supplier (firm) dominates a market, i.e., a monopoly. The fact that monopolies exist may be due to significant economies of scale in production, which limits the number of firms that can be active on the market at the same time. It may also be due to innovations which have given one firm an edge over its competitors. In both cases, society may be better off accepting the monopoly; however, most countries have tried to put watchdogs on these monopolies so that they do not abuse their dominant positions. Anyway, this points to one role for government intervention in the market system, but it also indicates a more basic point: That all private transactions on individual markets must be supported by a legal framework that everyone accepts and obey.

Another reason for a second-best situation to occur is that both consumption and production activities give rise to so called external effects. This means that one person’s consumption activities affects (negatively or positively) the utility that another person gets from his/her consumption. Since the first person does not, in general, take this effect into account, he/she will consume too much, or too little, of the good that give rise to the external effect. The price system will not, in general, fix this problem, and there is a role for government intervention (or for the legal system). Public goods is an extreme example of (positive) external consumption effects, since if I buy such a good, all other persons can consume the same amount of the good (without paying). The latter fact (that other people can free ride on my consumption) may piss me off, and induce me not to buy this good and wait for someone else to pay the bill. It can easily be the case that no-one wants to buy the good, even though they would get a positive (net) surplus by doing so. Again, there is a role for collective decision making.

Yet another requirement for the welfare theorems to hold is that all actors have costless and equal access to information, in particular to accurate (relative) prices of goods. This is of course not fulfilled in reality; in practice there is cost to using the market systems, in particular to acquire the relevant information. Many of the institutions we observe in our economy is a response to such transactions costs. A particular, and very important, form of information problem is so called asymmetric information problems. When two persons make an agreement of exchanging goods it is crucial that they, for example, both have the same information about the quality of the goods to be exchanged. E.g., if the seller knows that there is some problem with the good, his reservation price may be lower than for other goods of the same type, and he/she is more likely to offer just this particular good for sale (while keeping the good ones). A smart buyer knows this and is reluctant to buy, unless he/she can get some quality guarantee. (This is thus an example of the institution of giving guarantees to buyers).

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