The Optimality of Regulated Pricing: A General Equilibrium Analysis
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Consider a world where consumers, with diminishing marginal rates of substitution, maximize utility subject to their budget constraints and firms, with constant or decreasing returns to scale technologies, maximize profits subject to the prevailing prices. Then every competitive allocation is Pareto optimal and every Pareto optimal allocation can, with lump sum redistribution of endowments and share holdings, be supported as a competitive equilibrium. These two propositions, the first and second welfare theorems, form the foundation of neoclassical welfare economics. Unfortunately, in a world where some firms with increasing returns to scale technologies are price-setting profit maximi-zers, both of these theorems fail to be true. In this case, there is a need for government intervention, which may take the form of regulated pricing of firms with increasing returns to scale technologies.
KeywordsGeneral Equilibrium Model Production Possibility Public Enterprise Production Possibility Frontier Pareto Optimal Allocation
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