Second Welfare Theorem

Econ 2100, Fall 2013

Lecture 19, 4 November
Outline
1
Second Welfare Theorem
Second Welfare Theorem: Preliminaries
We want a theorem that says that any Pareto optimal allocation is part of a
competitive equilibrium.
In order to prove this is the case, one needs to nd the corresponding price
vector since an equilibrium species allocation and prices.
Last class we saw we cannot hope to go from a Pareto optimum to an
equilibrium without ajusting the income levels.
Thus, we amend the notion of equilibrium so that transfers make it possible to
go from the initial endowment to the appropriate income level.
This is a consequence of the fact that Pareto optimality does not depend on
private ownership while a Walrasian (competitive) equilibrium does.
Equilibrium With Transfers
Denition
Given an economy
_
X
i
; %
i

I
i =1
; Y
j

J
j =1
; !
_
, an allocation (x

; y

) and a price
vector p

constitute a price equilibrium with transfers if there exists a vector of

wealth levels
w = (w
1
; w
2
; :::; w
I
) with

i
w
i
= p

! +

j
p

j
such that:
1
For all j = 1; :::; J: p

y
j
_ p

j
for all y
j
Y
j
.
2
For all i = 1; :::; I : x

i
%
i
x
i
for all x
i
B
i
(p

; w
i
) = x
i
X
i
: p

x
i
_ w
i

i
x

i
=

i
!
i
+

j
y

j
Aggregate wealth is divided among consumers by the planner.
A Walrasian equilibrium satises the denition: w
i
= p !
i
+
P
j

ij
(p y

j
)
Next, more things than can go wrong in trying to establish the second welfare
theorem.
Need convex preferences for the Second Welfare Theorem
x*

2
x* is Pareto optimal, but one can see it is not an equilibrium at prices p
p
Y
Need convex production sets for Second Welfare Theorem
xis the preferences maximizing
bundle at the given prices
xdoes not maximizes profits in
production set Y at the given prices
(not even locally)
x

1
One Producer One Consumer Economy (Robinson Crusoe)
Convexity
Convexity of production sets and better-than sets is something we have
already seen.
Convexity makes it possible to nd an hyperplane that supports all
consumers better than set at the same time.
Convexity makes it possible to nd an hyperplane that supports all
producers better than set at the same time.
This hyperplane is the price vector that makes a Pareto optimal allocation an
equilibirum.
Denition
An allocation x in an exchange economy is supported by a non-zero price vector p
if: for each i = 1; :::; I
y %
i
x
i
== p y _ p x
i
Draw a picture.
Boundary Issues and Existence
is the initial endowment
Consumer 1 owns all of good 2
Consumer 2 owns all of good 1

2
For any p0,
- 2 demands
2
when her wealth is w
2
;
- but
1
is never optimal for 1 if
p0 she would demand an infinite
quantity of good 1
p=(1,0)
is the candidate
Equilibrium
price vector
There is no Walrasian equilibrium in this case
Consumer 1 preferences have
infinite slope at
1
Consumer 2 only
cares about good 1
! is the unique Pareto optimal
allocation, hence the only
candidate for an equilibrium.
The unique price vector that
can support it as equilibrium
(normalizing the price of the
rst good to 1) is p = (1; 0).
The corresponding wealth is
w
1
= (1; 0) (0; !
2
) = 0.
However, !
1
is not maximial for
consumer 1 at p since she
would like more of good 2 (it
has zero price, hence she can
aord it).
Quasi-Equilibrium
We x the boundary problem by slightly changing the equilibrium denition.
Denition
Given an economy
_
X
i
; %
i

I
i =1
; Y
j

J
j =1
; !
_
, an allocation (x

; y

) and a price
vector p

constitute a quasi-equilibrium with transfers if there exists a vector of

wealth levels
w = (w
1
; w
2
; :::; w
I
) with

i
w
i
= p ! +

j
p y

j
such that:
1
For each j = 1; :::; J: p

y
j
_ p

j
for all y
j
Y
j
.
2
For every i = 1; :::; I :
if x ~
i
x

i
then p x _ w
i
3

i
x

i
= ! +

j
y

j
Any equilibrium with transfers is a quasi-equilibrium. Why?
one would have p x > w
i
in an equilibirum with transfers).
Second Welfare Theorem: Preliminaries
We have seen a few counterexamples to a possible second welfare theorem.
To show that for any Pareto optimal allocation one can nd prices that
make it into a competitive equilibrium requires a few more assumptions
We need to consider equilibrium with transfers to overcome the limitations
imposed by private ownership.
We need convexity of production sets.
We need convexity and local non-satiation of preferences.
We need to eliminate boundary issues.
Second Welfare Theorem
Theorem (Second Fundamental Theorem of Welfare Economics)
Consider an economy
_
X
i
; %
i

I
i =1
; Y
j

J
j =1
; !
_
and assume that Y
j
is convex for
all j = 1; :::; J, and %
i
is convex and locally non-satiated for all i = 1; :::; I .
Then, for each Pareto optimal allocation (x

; y

) there is a price vector p

,= 0
such that (x

; y

) and p

form a quasi-equilibrium with transfers.

The proof uses the separating hyperplane theorem.
If an allocation is Pareto optimal there is an hyperplane that simultaneously
supports the better-than sets of all consumers and all producers.
That hyperplane yields a candidate equilibrium price vector.
The proof involves three parts: aggregation, separation, and decentralization.
Proof of the Second Welfare Theorem: Aggregation
Dene the following sets:
V
i
= x
i
X
i
: x
i
~
i
x

i
R
L
and V =

i
V
i
V is the set of bundles strictly preferred to x

by every consumer.
claim: V is convex.
Take x,x
00
V
i
(so both are strictly preferred to x

i
) and w.l.o.g. assume
x
0
%
i
x
00
.
Since preferences are convex
x
0
+ (1 ) x
00
%
i
x
00
for any [0; 1].
By transitivity, we have
x
0
+ (1 ) x
00
%
i
x
00
~
i
x

i
Therefore, x
0
+ (1 ) x
00
is an element of V
i
and therefore each V
i
is convex.
Hence, V is convex since it is the sum of I convex sets.
Proof of the Second Welfare Theorem: Aggregation
Dene the aggregate production set as
Y =

j
Y
j
=
_
_
_

j
y
j
R
L
: y
1
Y
1
; :::; y
I
Y
I
_
_
_
The set of consumption bundles that can be allocated to consumers is
Y +!
This set is convex since it is the sum of J + 1 convex sets.
Draw V and Y +!
V=
i
V
i
=
i
{x
i
in X
i
: x
i
>x
i
*
}
Y +
This is the set of
consumption bundles
strictly preferred to x
*
by all consumers
This is the set of attainable
consumption bundles given
the aggregate production set
and the aggregate endowment
x
*
is a Pareto optimal
consumption bundle

i
x
i
*
Proof of the Second Welfare Theorem: Separation
Since (x

; y

) is a Pareto optimal allocation, V Y +! = O.

If not, consumers can obtain a consumption bundle preferred to x

,
contradicting its Pareto optimality.
We now apply the Separating Hyperplane Theorem to V and Y +!.
By the Separating Hyperplane Theorem, there exist a p R
L
with p ,= 0 and an
r R such that
p z _ r for all z V,
and
p z _ r for all z Y +!
Proof of the Second Welfare Theorem: Separation
Separation yields
p z _ r for all z V,
claim: if x
i
%
i
x

i
for all i , then p (

i
x
i
) _ r
remember this
we will use it again later
Take an x
i
%
i
x

i
for all i .
By local non-satiation, for each i there exists an ^ x
i
(near x
i
) such that ^ x
i
~
i
x
i
.
Hence, ^ x
i
V
i
and
P
i
^ x
i
V.
So, p
P
i
^ x
i

r (by separation) and taking the limit as ^ x

i
goes to x
i
implies
p
P
i
x
i

r .
So, x

i
%
i
x

i
implies
p
_

i
x

i
_
_ r
Geometrically, this shows that

i
x
i
X
i
: x
i
%
i
x

i
belongs to the closure
of V which is contained in the half-space
_
z R
L
: p z _ r
_
.
Draw a picture.
V
Y +
This is the set of
consumption bundles
strictly preferred to x
*
by all consumers
This is the set of attainable
consumption bundles given
the aggregate production set
and the aggregate endowment
x
*
is a Pareto optimal
consumption bundle

i
x
i
*
p
Proof of the Second Welfare Theorem: Separation
Separation says
p z _ r for all z Y +!
and feasibility says

i
x

i
=

j
y

j
+ ! Y +!
Hence we have
p
_

i
x

i
_
_ r
This and the previous (opposite) inequality give:
p
_

i
x

i
_
= r
V
Y +
This is the set of
consumption bundles
strictly preferred to x
*
by all consumers
This is the set of attainable
consumption bundles given
the aggregate production set
and the aggregate endowment
x
*
is a Pareto optimal
consumption bundle

i
x
i
*

j
y
j
*
+
p
Second Welfare Theorem Proof: Decentralization
We have shown that
p
_

i
x

i
_
= p
_
_
! +

j
y

j
_
_
= r
claim: x

satises the consumers condition in a quasi-equilibrium with transfers

at prices p

= p.
For any consumer i , consider an x
i
such that x
i
~
i
x

i
We need to show that p

x _ w
i
As shown previously,
p

0
@
x
i
+
X
n6=i
x

n
1
A
| {z }
this satises x
i
%
i
x

i
for all i
r = p

0
@
x

i
+
X
n6=i
x

n
1
A
Hence: p

x
i
_ p

i
and setting w
i
= p

i
we have p

x
i
_ w
i
as desired.
Second Welfare Theorem Proof: Decentralization
We have shown that
p

i
x

i
_
= p

_
_
! +

j
y

j
_
_
= r
claim: y

maximizes prots at prices p

.
For any rm j and any y
j
Y
j
, we have
y
j
+

k6=j
y

k
Y
Hence, by separation and the equation above we have
p

0
@
! + y
j
+
X
k6=j
y

k
1
A
r = p

0
@
! + y

j
+
X
k6=j
y

k
1
A
Therefore
p

y
j
p

j
:
which implies y

j
maximizes prots at prices p

.
Proof of the Second Welfare Theorem: End
Summary
We have shown that x

satises the consumers condition in a

quasi-equilibrium with transfers at prices p

and income w
i
= p

i
.
We have also shown that y

maximizes prots at prices p

.
Therefore
We have shown that the Pareto optimal allocation (x

; y

) and the prices p

form
a quasi-equilibrium with transfers.
The equilibirum prices are given by an hyperplane that simultaneously
supports all consumers better-than set and the aggregate production set.
Proof of the Second Welfare Theorem: Footnote
The last step is to show that a quasi-equilibrium is indeed an equilibrium.
You will prove this in Problem Set 11
First, you have to show that, under local non satiation, if there is a
consumption bundle cheaper than a consumers wealth, condition 2. of a
quasi-equilibrium with transfers is equivalent to condition 2. of an equilibrium
with transfers (there is nothing strictly cheaper than !
i
in our earlier
counterexample).
Then, add strict monotonicity (something else violated by our earlier
counterexample) and show that a quasi equilibrium with transfers which has
strictly positive wealth for all consumers is an equilibrium with transfers.
Welfare Theorems in the Dierentiable Case
Question
What are the rst order conditions that correspond to a competitive equilibrium
and to Pareto optimality?
Assumptions needed for dierentiability
Consumers
Let X
i
= R
L
+
and assume there exist u
i
(x) representing %
i
that satisfy strong
monotonicity and convexity for each i .
Normalize things so that u
i
(0) = 0.
Assume each u
i
(x) is twice continuously dierentiable, with \u
i
(x) 0 for
any x, and it is quasi-concave.
Producers
Assume each F
j
(y) is convex, twice continuously dierentiable and
\F
j
(y) 0 for any y, and also that F
j
(0) 0.
Remember production sets are Y
j
=

y 2 R
L
: F
j
(y) 0

, where F
j
(y) = 0
denes the transformation frontier.
Welfare Theorems in the Dierentiable Case
Given these assumptions, we have the following.
Remark
An allocation is Pareto optimal if and only if it is a solution to the following:
max
(x;y)2R
LI
R
LJ
u
1
(x
11
; x
21
; :::; x
L1
)
subject to
u
i
(x
1i
; x
2i
; :::; x
Li
) _ u
i
i = 2; 3; :::; I

i
x
li
_ !
l
+

j
y
lj
l = 1; 2; :::; L
F
j
(y
1j
; :::; y
Lj
) _ 0 j = 1; 2; :::; J
Next class, we will analyze the rst order conditions for this problem and
compare them to the rst order conditions that characterize a competitive
equilibirum.
Problem Set 11 (Incomplete)
Due Monday 11 November
1
Consider an exchange economy with two agents and two goods. Agents utility functions and initial
endowments are U
a
(x
a1
; x
a2
) = x
a1

1
x
a2
U
b
(x
b1
; x
b2
) = x
b1

1
x
b2
: and
!
a
= (10; 0) !
b
= (0; 12):
1 Find the competitive equilibria for this economy.
2 Now suppose that a rm is introduced into this economy. The rm has a production set
Y = |(y
1
; y
2
) R
2
: y
1
0; y
2
2y
1
(i.e. the rm can transform one unit of good 1 into 2 units of good
2). Each agent owns an equal share in the rm, so
a
=
b
=
1
2
. Find the competitive equilibria in this
economy with production.
2
This exercise completes the proof of the second welfare theorem, by showing that any Pareto optimal
allocation is part of an equilibirum with transfers.
1 Assume X
i
is convex and %
i
is continuous. Let x

i
X
i
, p, and w
i
be such that x
i
~ x

i
implies p x
i
w.
Prove that if there exists an x
0
X
i
such that p x
0
< w, then x
i
~ x

i
implies p x
i
> w.
2 Now assume %
i
also satises local non satiation and prove that the following are equivalent:
1 x
i
minimizes p x
i
for x
i
2 fx
i
2 X : x
i
% x

g
2 x

i
% x
i
for all x
i
2

x
i
2 X : p x
i
p x

3 Finally, consider an economy with continuous and strongly monotone preferences where X
i
= R
L
+
. Suppose
there exist y Y
j
such that
P
j
y
j
+! 0. Prove that any quasi-equilibrium with transfers that has
w = (w
1
; :::; w
I
) 0 must be an equilibrium with transfers.
4 Using these results and the theorem we proved in class, state all assumptions needed to prove that any Pareto
optimal allocation is (part of) a competitive equilibirum (you do not need to prove anything).