On the contract curve inside an Edgeworth box, the two consumers' indifference curves are:

Tangent to each other, i.e. their MRS between the two goods is equal

The Kaldor-Hicks criterion judges a change to be efficient if:

The gainers could hypothetically compensate the losers and still be better off, whether or not compensation is actually paid

No one is made worse off by the change

Compensation must actually be paid to every loser

Total output falls but is more equally distributed

The Second Fundamental Theorem of Welfare Economics achieves a chosen Pareto-efficient allocation as a competitive equilibrium through:

Lump-sum redistribution of initial endowments before trade, leaving prices themselves undistorted

Pareto-optimality requires which of the following conditions to hold simultaneously?

Efficiency in exchange — equal MRS across all consumers

Efficiency in production — equal MRTS across all firms

Efficiency in product-mix — MRT along the PPF equal to the common consumer MRS

Efficiency in exchange — equal MRS across all consumers

Efficiency in production — equal MRTS across all firms

Efficiency in product-mix — MRT along the PPF equal to the common consumer MRS

Equal income for every consumer

General Equilibrium, Efficiency Criteria, Welfare Economics and Asymmetric Information

Unit 1 closes with the four topics that connect market outcomes to social judgements about them: general equilibrium analysis, the competing efficiency criteria used to rank outcomes, the welfare theorems that link competitive markets to efficiency, and the asymmetric-information problems that break the standard efficiency results.

1. General Equilibrium Analysis

Partial equilibrium analysis studies one market at a time, holding all others constant; general equilibrium analysis studies all markets simultaneously, recognising that a change in one market's price shifts demand and supply in every other market linked to it through income or substitution. Walras' Law states that if all but one market are in equilibrium, the remaining market must also be in equilibrium — the sum of excess demands across all markets is identically zero, because every transaction is simultaneously a supply in one market and a demand in another. The Edgeworth box is the standard two-good, two-consumer diagram used to locate the set of Pareto-efficient exchange allocations (the contract curve).

ℹ️ Where the contract curve lives inside the Edgeworth box

Inside the box, every point where the two consumers' indifference curves are tangent — i.e. their MRS between the two goods is equal — is Pareto-efficient: from any point off this locus, some reallocation exists that makes at least one consumer better off without making the other worse off. The locus of all such tangency points is the contract curve, and competitive trading (with both parties free to reject any offer that leaves them worse off) is expected to settle somewhere on it.

2. Efficiency Criteria: Pareto-Optimality, Kaldor-Hicks and Wealth Maximization

An allocation is Pareto-optimal if no reallocation can make someone better off without making someone else worse off; it requires three simultaneous conditions — efficiency in exchange (MRS equal across all consumers for every pair of goods), efficiency in production (MRTS equal across all firms for every pair of inputs), and efficiency in product-mix (the marginal rate of transformation, MRT, along the production-possibility frontier equal to the common consumer MRS). Pareto's criterion is deliberately silent on distribution: many different Pareto-optimal allocations exist, differing entirely in who gets how much, and the criterion cannot rank one against another.

Pareto versus Kaldor-Hicks versus wealth maximization
Criterion	Test applied
Pareto-optimality	A change is an improvement only if it harms no one — an extremely demanding, rarely satisfied test in practice.
Kaldor-Hicks (potential Pareto improvement)	A change is an improvement if the gainers COULD hypothetically compensate the losers and still be better off — compensation need not actually be paid.
Wealth maximization (Posner)	Ranks outcomes purely by the total market value they generate, independent of how that value is distributed among individuals.

⚠️ Kaldor-Hicks does not require actual compensation

The commonest error is treating Kaldor-Hicks as requiring the losers to actually be paid off. It does not: the test is HYPOTHETICAL compensation — could the gain be large enough that compensation would be feasible? If actual compensation is never paid, the outcome is a potential (not actual) Pareto improvement, and it can leave some people genuinely worse off — this is precisely why Kaldor-Hicks efficiency and equity are separate questions.

3. Welfare Economics: The Fundamental Theorems and the Social Welfare Function

The First Fundamental Theorem of Welfare Economics states that, under standard assumptions (complete markets, perfect competition, no externalities), every competitive equilibrium is Pareto-efficient — the market's own price system, with each agent pursuing self-interest, decentralises the coordination needed to reach the contract curve. The Second Fundamental Theorem states the converse direction under convexity assumptions: any Pareto-efficient allocation can be achieved as a competitive equilibrium for SOME initial distribution of endowments, achieved via lump-sum (non-distortionary) redistribution before trade — separating the efficiency question from the distribution question. A Bergson-Samuelson social welfare function then aggregates individual utilities (W = W(U1, U2, …, Un)) to rank among the many Pareto-efficient points, since Pareto-optimality alone cannot choose between them.

🎯 Why the two theorems are stated as a pair

Together the two theorems make a strong policy claim: the FIRST says markets alone achieve efficiency; the SECOND says any desired (efficient) distribution can still be reached by a competitive market, PROVIDED redistribution happens through lump-sum transfers of initial endowments rather than through price-distorting taxes or subsidies. This is the theoretical basis for policy advice that favours redistributing endowments (or using lump-sum transfers) over intervening directly in market prices.

4. Asymmetric Information: Adverse Selection and Moral Hazard

The welfare theorems assume, among other things, that all parties to a transaction share the same information — asymmetric information breaks this and, with it, the standard efficiency result. Adverse selection is a HIDDEN-INFORMATION problem that exists BEFORE a contract is signed: Akerlof's 'market for lemons' shows that if sellers know a used car's quality but buyers do not, buyers offer only an average price, good-quality ('peach') sellers withdraw, the average quality on offer falls further, and in the extreme the market can unravel entirely. Moral hazard is a HIDDEN-ACTION problem that arises AFTER a contract is signed: once insured, an agent has weaker incentive to take costly precautions, because the insurer (not the agent) now bears the cost of a bad outcome.

Signalling and screening as remedies — the informed party can signal quality credibly (Spence's education signalling), or the uninformed party can screen by offering a menu of contracts that separates types (self-selection).
Moral hazard's remedies — deductibles, co-payments and no-claim bonuses in insurance all partly restore the agent's own stake in the outcome.

⚠️ Adverse selection versus moral hazard — the timing test

The reliable way to tell them apart is timing relative to the contract. If the hidden information (about a fixed characteristic — quality, health, driving skill) exists BEFORE the contract and creates a selection problem, it is adverse selection. If the hidden information is really a hidden ACTION the agent takes AFTER the contract that the other party cannot observe or verify, it is moral hazard. A question describing a used-car buyer unable to tell quality is adverse selection; one describing an insured driver becoming careless is moral hazard.

Key takeaways

General equilibrium studies all markets simultaneously; Walras' Law says the sum of excess demands across markets is identically zero, and the Edgeworth box locates Pareto-efficient exchange allocations on its contract curve.
Pareto-optimality requires exchange, production and product-mix efficiency together but is silent on distribution; Kaldor-Hicks asks only whether gainers COULD hypothetically compensate losers; wealth maximization ranks outcomes by total value alone.
The First Welfare Theorem: competitive equilibrium is Pareto-efficient. The Second: any Pareto-efficient allocation is reachable as a competitive equilibrium via lump-sum redistribution of endowments — separating efficiency from distribution.
A Bergson-Samuelson social welfare function ranks among the many Pareto-efficient points that Pareto's own criterion cannot choose between.
Adverse selection is hidden information before a contract (Akerlof's lemons market); moral hazard is hidden action after a contract — the timing test is the reliable way to tell them apart.

Practice questions (9)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

Walras' Law states that:
1. If all markets but one are in equilibrium, the remaining market must also be in equilibrium
2. Every market clears independently of every other market
3. Prices are always at their competitive level
4. Excess demand in one market has no effect elsewhere
Show answer
Answer: A — If all markets but one are in equilibrium, the remaining market must also be in equilibrium
Walras' Law follows from every transaction being simultaneously a demand in one market and a supply in another, so the value-weighted sum of excess demands across all markets is identically zero — if n−1 markets clear, the nth must too.
On the contract curve inside an Edgeworth box, the two consumers' indifference curves are:
1. Tangent to each other, i.e. their MRS between the two goods is equal
2. Intersecting each other
3. Parallel straight lines
4. Both vertical
Show answer
Answer: A — Tangent to each other, i.e. their MRS between the two goods is equal
Every point of tangency (equal MRS) between the two consumers' indifference curves is Pareto-efficient in exchange; off this locus, some reallocation exists that helps one without harming the other.
The Kaldor-Hicks criterion judges a change to be efficient if:
1. The gainers could hypothetically compensate the losers and still be better off, whether or not compensation is actually paid
2. No one is made worse off by the change
3. Compensation must actually be paid to every loser
4. Total output falls but is more equally distributed
Show answer
Answer: A — The gainers could hypothetically compensate the losers and still be better off, whether or not compensation is actually paid
Kaldor-Hicks is a HYPOTHETICAL compensation test — a potential, not actual, Pareto improvement — which is why it can rank a change as efficient even though some individuals end up genuinely worse off.
The First Fundamental Theorem of Welfare Economics states that:
1. Every competitive equilibrium, under standard assumptions, is Pareto-efficient
2. Every Pareto-efficient allocation is achievable through lump-sum redistribution
3. Government intervention always improves market outcomes
4. Monopoly equilibria are Pareto-efficient
Show answer
Answer: A — Every competitive equilibrium, under standard assumptions, is Pareto-efficient
The First Theorem says competitive markets (with no externalities, complete markets and price-taking behaviour) decentralise Pareto efficiency; the SECOND theorem, not the first, is the one that concerns achieving a chosen Pareto-efficient point via redistribution.
The Second Fundamental Theorem of Welfare Economics achieves a chosen Pareto-efficient allocation as a competitive equilibrium through:
1. Lump-sum redistribution of initial endowments before trade, leaving prices themselves undistorted
2. Price controls on final goods
3. Import tariffs
4. A minimum wage law
Show answer
Answer: A — Lump-sum redistribution of initial endowments before trade, leaving prices themselves undistorted
The theorem requires redistribution to happen through non-distortionary, lump-sum transfers of endowments rather than through price-distorting instruments, so that the resulting competitive equilibrium remains efficient.
Akerlof's 'market for lemons' is the classic illustration of:
1. Adverse selection
2. Moral hazard
3. The Kaldor-Hicks criterion
4. The Stackelberg model
Show answer
Answer: A — Adverse selection
Sellers know a used car's quality and buyers do not — hidden information that exists BEFORE any transaction — so buyers can only offer an average price, driving good-quality cars out of the market: the signature adverse-selection mechanism.
An insured driver becoming less careful because the insurer now bears the cost of an accident is an example of:
1. Moral hazard
2. Adverse selection
3. Pareto-optimality
4. The Second Welfare Theorem
Show answer
Answer: A — Moral hazard
The hidden action (reduced care) occurs AFTER the insurance contract is signed and cannot be fully observed or verified by the insurer — the timing test that identifies moral hazard rather than adverse selection.
Pareto-optimality requires which of the following conditions to hold simultaneously?
1. Efficiency in exchange — equal MRS across all consumers
2. Efficiency in production — equal MRTS across all firms
3. Efficiency in product-mix — MRT along the PPF equal to the common consumer MRS
4. Equal income for every consumer
Show answer
Answer: A — Efficiency in exchange — equal MRS across all consumers; B — Efficiency in production — equal MRTS across all firms; C — Efficiency in product-mix — MRT along the PPF equal to the common consumer MRS
The first three are the three simultaneous conditions for a full Pareto optimum; equal income is a distributional matter that Pareto-optimality is explicitly silent on — many unequal-income allocations can still be Pareto-efficient.
Name the social welfare function, of the general form W = W(U1, U2, …, Un), that aggregates individual utilities to rank among Pareto-efficient allocations.
Numerical answer — type the value.
Show answer
Answer: Bergson-Samuelson social welfare function
The Bergson-Samuelson social welfare function is the standard tool used to make an explicit interpersonal-comparison-based choice among the many allocations that Pareto's own criterion leaves unranked.