Chapter Summary

One of the simplest possible general equilibrium models is a pure exchange economy with only two consumers and two goods. For any given initial allocation of the two goods between the two consumers in this model, a competitive exchange process will always exhaust all possible mutually beneficial gains from trade. This result is known as the invisible hand theorem and is also called the first theorem of welfare economics.

If consumers have convex indifference curves, any efficient allocation can be sustained as a competitive equilibrium. This result is known as the second theorem of welfare economics. Its significance is that it demonstrates that the issues of efficiency and distributional equity are logically distinct. Society can redistribute initial endowments according to accepted norms of distributive justice, and then rely on markets to assure that endowments are used efficiently.

An economy is efficient in production if the marginal rate of technical substitution is the same for all producers. In the input market, too, competitive trading exploits all mutually beneficial gains from exchange.

Even though international trade leaves domestic production possibilities unchanged, its immediate effect is to increase the value of goods available for domestic consumption. With a suitable costless redistribution of initial endowments, a free trade economy will always be Pareto superior to a non-free trade economy.

Taxes can interfere with efficient resource allocation, usually because they cause consumers and producers to respond to different price ratios. The costs of tax-induced distortions must always be balanced against the benefits derived from the government expenditures financed by taxes, including government provision of public goods. The practical significance of this result is to guide us in the search for taxes that minimize distortions. The best tax, from an efficiency standpoint, is one levied on an activity that would otherwise be pursued too intensively.

Monopoly, externalities, and public goods are three other factors that limit society's capacity to achieve an efficient allocation of resources using the market mechanism alone.