Nova workboard

a blog from young economists at Nova SBE

Efficiency and the competitive equilibrium

The first theorem of welfare economics (FTWE), states that prices of the competitive equilibrium will lead to a Pareto optimal allocation. Disregarding the possible flaws in the Pareto optimal allocation, (social inequality for instance), with the assumption of agents being price takers and the completeness of markets we can guarantee the Adam Smith “invisible hand”, or at least a simplified version of it, without taking into account the other achievements of markets, as innovation or its growth incentives.

The graphical and mathematical prove is possible, even in a general equilibrium context and therefore it would be best for the market to regulate for themselves. But then again, the Greenwald-Stiglitz theorem states that for an incomplete market, or in an imperfect information context, markets are not Pareto efficient. So the question that imposes is whether is it plausible to assume perfect information and completeness of markets, and if not if this will actually change the result of the competitive equilibrium, as stated by the FTWE.

Well it is hard to find a market that fulfills the assumptions, as perfect information is a rare thing, and there is no big number of suppliers in many markets, (perfect competition markets are mostly ideological), nevertheless by the violation of these assumptions it doesn’t mean that the reverse of the theorem holds, that is, that markets can’t be efficient – the assumptions of the first theorem are sufficient and not necessary.

On one hand we have Stiglitz defending the need of perfect information and completeness of markets so that markets can achieve a Pareto optimum outcome, on the other hand works from economists like Vernon Smith defending that even in a market with few producers and irrational consumers, markets can be efficient.

Probably markets without satisfying the assumptions of the first theorem of welfare economics won’t be Pareto efficient, but nothing proves that they won’t achieve the most efficient outcome, as Pareto efficiency is hardly a achievable efficiency. The question that stays to answer is which is a policy more efficient than markets. It is not because something is not efficient that it is not the most efficient tool existing.

The reason why most of the times markets do not operate on their own is that the efficiency optimum is not the social optimum – the need of equality in the politic agenda is something that from a society point of view is extremely important, and the loss of some efficiency in order to get some equality is necessary. We can see equity as a benefit, and the loss of efficiency a cost, in economy this optimum should be when the marginal benefit of equity gain is the same as the marginal cost of the loss of efficiency.

But then again we have an additional problem – where should the policy stop and markets run freely? Now this is a question of point of view, not withstanding the fact that there will be lost of efficiency with overprotective policies.

Maria Roque Martins – nº540

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Author: studentnovasbe

Master student in Nova Sbe

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