The First Welfare Theorem explains how resources are allocated efficiently in perfectly competitive markets. It states that in these markets, competitive equilibrium leads to Pareto efficiency, meaning no one can be made better off without making someone else worse off.

Imagine two neighbors living in a rural area. One has a surplus of firewood, essential for heating during cold nights, while the other has access to clean water from a nearby spring. The first neighbor values water more, as it’s scarce for them, while the second neighbor values firewood due to its importance in their daily lives. Seeing the opportunity to benefit, they agree to trade. Initially, they exchange small amounts to see how much they benefit. Over time, they adjust the trade quantities to reflect their needs and preferences, continuing until both feel they’ve gained as much as possible without losing something they value more.

At this point, neither neighbor has an incentive to trade further, as doing so would make one worse off. This state is Pareto efficiency, where resources are distributed in a way that maximizes satisfaction for both without causing harm to either. This example illustrates how individuals can allocate resources efficiently through voluntary exchange, benefiting from cooperation in an ideal setting with no external factors or transaction costs.

However, real-world markets are rarely this straightforward. Problems like hidden costs, such as pollution caused by production, or lack of information, such as one person not knowing the true value of their trading, often disrupt this efficiency. Even small transaction costs, like fees or taxes, can change how resources are exchanged and distributed.