Optimal Income Distribution

Abstract

In the previous chapter, it was shown that there are many cases in which competitive markets fail to allocate resources optimally. Even if we disregard the existence of such difficulties, however, what competitive markets can do is only to achieve a Pareto optimal allocation, which may not be the optimal organization of an economy, since Pareto optimality is, though necessary, by no means sufficient for it. To choose the optimal organization of the economy from many Pareto optimal allocations is the problem of the optimal distribution of incomes, in view of the second half of the fundamental theorem of welfare economics, which insists that any Pareto optimal allocation can be achieved through perfect competition if incomes are properly distributed among consumers (Sect. 7.8). Since different individuals have different opinions on how should incomes be distributed, and the market mechanism cannot be relied on to solve it, the problem of optimal income distribution is a social choice which has to be made politically through voting in a democratic society.