First Fundamental Theorem of Welfare Economics

Theorem : Assume that all peoples preferences are locally

nonsatiated. If (x , y , p) is a Walrasian equilibrium, for some
distribution of endowments i (i = 1, 2, . . . , I) and distribution of
firm ownership ij (i = 1, 2, . . . , I; j = 1, 2, . . . , J), then the
allocation (x , y ) is Pareto optimal.
locally nonsatiated : the preference relation i on the
consumption set Xi is locally nonsatiated if for any x Xi and
any (Euclidean) distance  > 0 (however small), there is some
other consumption bundle x0 which is within distance  of x,
such that x0 i x
so local nonsatiation is weaker than strict monotonicity ; if i is
strictly monotonic, then x0 = x + (, , . . . , ) must be strictly
preferred to x

counterexamples to local nonsatiation : bliss point, thick

indifference curves

Proof of the Theorem

Suppose that (x , y , p) is a Walrasian equilibrium.
Now suppose that there is some other feasible allocation
(x0 , y0 ) which is Paretopreferred that is such that
(a) x0 i i xi for all i = 1, 2, . . . , I
and
0
(b) x h h xh for some person h
we must show this cant happen

(a) because each

person i chose bundle xi at prices p [with
P
income p i + Jj=1 ij (p yj )], it must be true that
0

p x i p xi
0

[This is where local nonsatiation comes in : if p x i < p xi ,

00
0
then there would be some other x i near x i which would be
both (i) strictly preferred to xi and (ii) inside person is budget
set, violating the fact that xi is person is mostpreferred
choice in her budget set.]
0

(b) because person h prefers x h strictly to xh , it must be true

that
0

p x h > p xh
0

[Otherwise person h would have chosen the (affordable) x h

instead of xh .]

(c) because yj was chosen by firm j to maximize its profits at

prices p, it must be true that
0

p yj p y j
(d) each person must be on her budget set [nonsatiation
again], so that
i

px =p +

J
X

ij (p yj )

j=1

(e) because

i = and
I
X
i=1

ij = 1, part (d) implies that

px =p+

J
X
j=1

p yj

(f ) from (c) and (e),

I
X

px p+

i=1

J
X

pyj

j=1

(g) from (a) and (b), plugged into (f ),

I
X

pxi >p+

i=1

J
X

pyj

(1)

j=1

Equation (1) shows that, as required, the Paretopreferred

allocation (x0 , y0 ) is not feasible. The requirement for feasibility
is
I
X
i=1

xi +

J
X

yj

(2)

j=1

and equations (1) and (2) cannot both hold when p 0 QED