A characterization of piecemeal second best policy
This paper derives conditions under which prices may be set proportional to margin cost in some sectors of the economy when fixed distortions exist in other sectors. Two simple neo-classical economies are considered -- one with fixed producer prices and one with variable producer prices. In the former case, necessary and sufficient conditions are derived for piecemeal policy in terms of properties of derivatives of the demand functions. These conditions are interpreted in terms of separability properties of utility functions. In the latter case, sufficient conditions are derived which involve both demand and supply derivatives. We use a dual formulation to the problem, where conditions in terms of demand and supply derivatives are observable, and explicitly take into consideration the budgetary constraint of the government. In general, complete laissez-faire is not optimal.
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