On markets and equality: in praise of the 2nd theorem

It is widely known that economists predict that, under certain assumptions, competitive markets are efficient – that is, nobody can be made better off without making somebody else worse off. This result – which is knows as the First Fundamental Theorem of Welfare Economics – is the basis of the view held by economists since Adam Smith that competitive markets result in a socially desirable outcome, even though the market is composed of individuals acting in their own self interest.

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. Adam Smith, The Wealth of Nations

But there is a less well-known Second Fundamental Theorem of Welfare Economics which is, in my view, even more important. This theorem states that any efficient allocation can be achieved as a result of competitive markets, given a suitable allocation of initial endowments. Why is this important? It tells us that there are many possible efficient market outcomes, not a single, pre-determined equilibrium; and the one we end up with depends on where we start. If you have a large endowment at the outset, you will probably be better off in the resulting market outcome. It tells us that we can and should think about what sort of society we want to live in, and that we can move towards that outcome that by changing the hands we are all dealt, and then allowing the free market to do the rest. In other words, growing inequality and economic injustice are not the necessary and inevitable outcome of liberalised markets. The First Fundamental Theorem tells us that a competitive markets will lead to a pareto-efficient equilibrium – but there is an infinite number of such outcomes. The Second Fundamental Theorem tells us that we can choose what sort of society we want, and that, when we have done so, we can still rely on competitive markets to deliver an outcome that is economically and socially efficient.

1 thought on “On markets and equality: in praise of the 2nd theorem”

  1. Outside of the textbook 2-person, 2-commodity, general equilibrium models, people have the ability to invest endowments in interest yielding assets and through entrepreneurship, create profitable enterprises. Through differences in talents, skills, preferences and luck, inequality will increase to a large or small degree over time even with equal initial conditions. Would such a state of affairs be unjust, and would it be wise to equalise conditions on a regular basis?

    Inequality is an important concern for developing countries in which poor citizens may find precautionary saving or the attainment of credit impossible. Endowment redistribution through land reform for example, may be beneficial. For a relatively wealthy country such as the UK with little or no absolute poverty, I’d be more concerned with improving access to education (vital for social mobility) than with income/wealth disparities at a given point in time.

    Owen replies: I think that we should be concerned with equality of outcome, and not just equality of opportunity; but I do not advocate complete equality (nor does anyone else, I think). In general, I think we should be concerned with intra-generational equity: we should take some steps to ensure that we do not see some people born into a world in which, because of their endowments, they have little prospect of leading fulfilling and prosperous lives.

    I agree that education matters. I also think we should pay more attention to distribution of capital, both for reasons of equity and economic efficiency. (I think Hernando De Soto has a good point on this.)

Leave a Reply

Your email address will not be published. Required fields are marked *