Fundamental Theorems of Welfare Economics:

There are two fundamental theorems of welfare economics. The first fundamental theorem of welfare economics states that any competitive equilibrium leads to efficient allocation of resources. Thus Pareto efficiency is realized when perfect competition prevails in the market. If Pareto efficiency prevails in the economy it is not possible to increase total social welfare - it is not possible to someone better off without making another person worse off. Thus the first fundamental theorem of welfare economics makes a case for non-intervention in the market. The theorem confirms the proverbial 'invisible hand' mentioned by Adam Smith and points out that the market, if left to itself, will automatically achieve efficiency. The second fundamental theorem of welfare economics, however, contradicts the first theorem. According to this theorem, efficiency is not the only thing the society should care about. Pareto efficiency can take place even when there is extreme inequality in distribution of resources. In terms of the Edgeworth box, equilibrium can take place towards a comer, not necessarily at the middle of the contract curve. Of the several efficient outcomes, the desired one (with lesser inequality) can be achieved by making a one-time transfer of wealth from the rich to the poor and then leaving it to market conditions. Therefore, the second theorem suggests the need for government intervention. The theorem, however, is silent on how the transfer of wealth from the rich to the poor should take place. The option before the government is to impose taxes on the rich. As you know from the basic tenets of taxation, it has to be a lump sum transfer; imposition of proportional taxes would distort prices and output. Secondly, for carrying out the extent to which transfer should take place, the government should have perfect information on consumer preferences and firm's production function