Welfare economics evaluates economic outcomes against social welfare criteria. The central efficiency benchmark is Pareto efficiency, an allocation in which no one can be made better off without making someone worse off. A Pareto improvement is a change that benefits someone without harming anyone. Kaldor-Hicks efficiency relaxes this requirement by allowing changes that are potential Pareto improvements in which winners could in principle compensate losers. Allocative efficiency produces the mix of goods consumers most want, while productive efficiency produces at the lowest possible cost. The first welfare theorem states that a competitive equilibrium with no externalities is Pareto efficient, and the second welfare theorem shows that any Pareto-efficient allocation can be achieved through a competitive equilibrium with appropriate lump-sum transfers.
A market failure is a situation in which free markets allocate resources inefficiently, arising from externalities, public goods, market power, or asymmetric information. Externalities are costs or benefits imposed on third parties not involved in a transaction. A negative externality such as pollution imposes costs on others, while a positive externality such as vaccinations confers benefits. The socially optimal output occurs where social marginal benefit equals social marginal cost. A Pigouvian tax corrects a negative externality by internalizing its cost, aligning private and social incentives. The Coase theorem holds that with well-defined property rights and low or zero transaction costs, parties can bargain to efficient outcomes regardless of the initial assignment of rights. Public goods are non-rivalrous and non-excludable, like national defense, leading to the free-rider problem in which individuals benefit without paying. The tragedy of the commons describes how shared resources are overused when individuals act in self-interest. A Lindahl tax ties each person's payment to their marginal benefit from a public good, attempting to align contributions with benefits.
Asymmetric information occurs when one party in a transaction has more information than the other. Moral hazard arises when a party takes more risk because costs fall on others, as when insured individuals behave more riskily, and adverse selection occurs when asymmetric information leads to undesirable participation, as when high-risk individuals disproportionately buy insurance. Signaling involves actions taken to convey information, such as diplomas signaling ability, while screening involves an uninformed party inducing the informed party to reveal information. The principal-agent problem arises when an agent acts on behalf of a principal with different incentives, while the median voter theorem suggests that majority-rule voting tends to reflect the median voter's preference.
Government failure occurs when government intervention causes inefficiency or worse outcomes than markets would have produced, and regulatory capture describes how regulators may come to serve industry interests rather than the public. Partial equilibrium analyzes a single market in isolation, while general equilibrium considers the state in which all markets clear simultaneously, recognizing that interventions in one market spill over into others.