The Efficiency Theorems and Market Failure

The general equilibrium analysis of perfectly competitive markets plays a central role in most attempts by positive economics to describe what happens in a market economy. It is usually admitted that there may be barriers to competition, that markets may be incomplete, and information may be lacking. Nevertheless, as a theoretical ideal which may approximate reality, general equilibrium analysis is a widely used tool. In normative economics, however — often called “welfare economics” because of its claim to be about how to enhance well-being or welfare — general equilibrium analysis has been if anything even more important than in positive economics. The reason for this is the striking relationship between, on the one hand, allocations that emerge from complete markets in perfectly competitive equilibrium, and on the other hand, allocations satisfying the normative property of Pareto efficiency. The latter are defined as allocations which at least meet the following necessary condition for normative acceptability: it is impossible to reform the economic system in a way that makes any consumer better off without at the same time making some other consumer worse off. As I say, this seems like a necessary condition for normative acceptability because, if it were not met, one could re-design the economic system so that at least one consumer gains without anybody losing. It is surely not a sufficient condition, however, because Pareto efficiency is compatible with extremely unjust distributions of consumption goods and leisure. For example, suppose that one dictator is served by a group of slaves, and consumes everything except the minimum needed to keep these slaves alive. Such an arrangement will be Pareto efficient if there is no way in which the dictator could possibly be made better off, and if no slave could gain unless another