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.