Wednesday, August 15, 2007

Who's Abusing the First Welfare Theorem?

In an earlier post, I discussed (and seconded) Dani Rodrik's criticism of those who leap to the conclusion that "free markets" always lead to an optimal outcome. A problem with that way of thinking is that applies the conclusion of the first welfare theorem - that markets lead to a efficient outcome - without considering the conditions required for the theorem to hold (including perfect competition and perfect information).

Marginal Revolution's Alex Tabarrok has a riposte. He argues that Rodrik is guilty of misusing the theorem: just because the conditions required for the theorem aren't met in reality does not imply the existence of welfare-improving policy interventions. He writes:
Since the conditions required for the theorem's proof are unlikely to hold in the real world it's common for people to reverse the theorem to suggest that markets cannot be efficient. Thus Rodrik says:

The First Fundamental Theorem of Welfare Economics is proof, in view of its long list of prerequisites, that market outcome can be improved by well-designed interventions.

Now what is wrong with this is very simple. The First Theorem gives sufficient conditions for a market to be efficient it does not give necessary conditions.

Thus, as a matter of logic, the fact that the theorem's conditions are not satisfied does not prove that market outcomes can be improved, even by "well-designed" interventions.

A valid point, I think. So we've identified two ways to abuse this proposition: (i) to argue that "free market" outcomes are automatically optimal and (ii) to argue that because the theorem's assumptions do not hold, welfare-improving policy interventions must exist. Although many non-economists fail to appreciate the benefits of markets at all, within the world of economics I see the first type of abuse much more often than the second.


ZTN said...


you have no point on Alex. He never argued the markets are always optimal. He stated this.

Bill C said...

I didn't intend to imply that he did - I thought he made a good point and found a real flaw in Rodrik's argument. However, I do think its common for people to mis-apply their microeconomics lessons and assume efficiency where it doesn't necessarily exist. That's not a specific knock on Tabarrok - more of a general observation about what I've seen in my (brief) career as an economist.