Problems of Second Best

Abstract

The discussion and analysis in the previous chapters was based on the assumption that all the Pareto optimum conditions were satisfied throughout the non-public-enterprise part of the economy. The problem discussed was thus one of first-best optimisation. Now casual observation is sufficient to demonstrate that, in the real world in which public enterprises have to price their products, this assumption is invalid. In the rest of the economy prices are not everywhere equal to marginal social costs, because of the existence of non-lump-sum taxes on both factors and products, of market imperfections, such as monopoly and administered prices, and of externalities. Furthermore, at any particular moment of time not all public enterprises will have their prices equal to marginal social costs. If the government, through actions such as anti-monopoly legislation and directives to public enterprises, is unable to bring about the satisfaction of the necessary first-order conditions, then the welfare-maximisation problem as discussed so far must be reformulated. Social welfare must now be maximised subject to constraints in addition to those of the community’s production function and available resources.