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Equilibrium models failed to
predict the crisis of 2008, which
began when Lehman Brothers
Bank collapsed and fired all its
staff. This led to criticisms of
the models’ basic assumptions.The theorem says that any of
these Pareto-efficient distributions
can be achieved using free
markets—a concept represented
by economists as a “contract
curve.” However, to achieve a
particular one of these allocations,
an initial redistribution of individual
endowments needs to be made.
Then trading can begin, and the
particular Pareto-efficient
allocation of resources occurs.
The practical implication
here is that a government can
redistribute resources—through
the levying of taxes—and can then
depend upon the free market
to ensure the eventual allocation
is efficient. Equity (fairness) and
efficiency go hand in hand.
Real-world limits
Arrow and Debreu’s results
depend on stringent assumptions:
when these don’t hold, efficiency
may be compromised, a situation
that economists call “market
failure.” For the theorems to hold,
individuals have to behave
according to economic rationality.
They need to respond perfectly to
market signals, something that is
clearly not the case in reality. The
behavior of firms has to be
competitive, while in practice the
world is full of monopolies.
In addition, welfare theorems
don’t hold when there are
economies of scale, such as in
situations in which there are large
firms with high set-up costs—for
example, in the case of many public
utilities companies. A further
important condition for the
efficiency of equilibrium is that
there should be no “externalities.”
These are costs and benefits that
do not register in market prices.
For example the noise from a
motorcycle workshop might hurt
the productivity of a firm of
accountants next door, but the
workshop owners do not take this
broader cost into account because
it doesn’t affect their private costs.
Externalities hamper efficiency.
Also, if individuals don’t have full
information about prices and about
the characteristics of the goods
they are buying, then markets are
likely to fail.What the theorems tell us
It is tempting to ask what is
the point of this model if its
assumptions are so removed fromreality as to be inapplicable to
any situation, but theoretical
models aren’t intended to be
faithful descriptions of reality: if
they were, Arrow and Debreu’s
model would be useless. Instead,
their theorems answer a central
question: under what conditions
do markets bring efficiency? The
stringency of these conditions,
then, tells us by how much and
in what ways real economies stray
from the benchmark of full
efficiency. Arrow and Debreu’s
conditions point to what we
might do to move closer to
efficiency. For instance, we might
try to price pollution to deal with
externalities, to break up
monopolies to make markets
more competitive, or to create
institutions to help inform
consumers about the goods
that they buy.
The work of Arrow and
Debreu formed the foundation
of much of our post-war economics.
Attempts were made to refine
their findings and to investigate
the efficiency of economies under
different assumptions. Large
macroeconomic models, both
theoretical and empirical, were
built using Arrow and Debreu’s
general equilibrium approach.
Some have criticized the
equilibrium approach for failing
to take into account the chaotic,
truly unpredictable nature of real-
world economies. These
voices have become louder
recently with the failure of these
kinds of models to predict the
2008 financial crash. ■POST-WAR ECONOMICS
An allocation of resources
could be efficient in a Pareto
sense and yet yield enormous
riches to some and dire
poverty to others.
Kenneth Arrow