Lecture4 - Lecture Note 4 The General Theory of Second Best Part 2B Paper 1 Dr T.S Aidt University of Cambridge Michaelmas 2010 1 Introduction

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Lecture Note 4: The General Theory of Second Best Part 2B: Paper 1. & Dr. T.S. Aidt University of Cambridge Michaelmas 2010 1 Introduction Recall the distinction between the &rst and the second best. A &rst best world is one in which the government can insure by an appropriate policy choice that all the Pareto conditions are satis&ed. A second best world is one in which this is not possible and some distortions are irremovable and only a subset of the Pareto conditions can, by the very nature of the situation, be satis&ed through an appropriately chosen government intervention. The general theory of second best ±developed amongst others by the Cam- bridge economist James Meade ± provides us with useful insights into how a government should act in the presence of such irremovable distortions. It is useful &rst to consider some sources of "irremovable distortions". We can make a distinction along two dimensions: what is irremovable and for whom is it irremovable. Recall from Lecture 1 that we can divide distortions into those which are endogenous and those which are policy-imposed. Examples of the former include market imperfects, externalities and information asymmetries. Examples of the later include political restrictions on the set of policy instru- ments (e.g., an unwillingness to use a poll tax), international commitments to particular policies (e.g., membership of the European Union (EU) and thus par- ticipation in the Common Agriculture Policy (the CAP), or membership of the World Trade Organization and thus a commitment not to use tari/s), budget constraints for state owned &rms etc. All these can in principle be irremovable for some decision makers, but not necessarily for all. For example, the House of Commons could, in principle, remove the distortions associated with the CAP by deciding to leave the EU, but the HM Treasury or the Inland Revenue Ser- vices cannot escape the distortions created by this programme on their own & Disclaimer: This note may contain mistakes. If you spot any, please bring them to my attention. 1
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and must then take them as given when designing tax and expenditure policies. Likewise, distortions related to imperfect competition in particular sectors can, in principle, be removed by the government, but may have to be taken as given by individual departments within government. So, when thinking about what is irremovable, it is important to specify for whom the distortion must be taken as given. 2 The Principles The policy guidance provided by the general theory of second best can be sum- marized as follows: 1. Second best world with interdependencies between markets: If there ex- ist irremovable distortions, policy should be guided by the principle that distortions can o/set each other and by the principle that new distortions can counteract existing ones and not by an attempt to restore Pareto conditions is some markets (or sectors of the economy).
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This note was uploaded on 06/04/2011 for the course ECONOMICS paper 1 taught by Professor Aidt during the Spring '11 term at Cambridge.

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Lecture4 - Lecture Note 4 The General Theory of Second Best Part 2B Paper 1 Dr T.S Aidt University of Cambridge Michaelmas 2010 1 Introduction

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