lecture5 - Lecture Note 5: Production E ciency Part 2B:...

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Lecture Note 5: Production E¢ ciency Part 2B: Paper 1. & Dr. T.S. Aidt University of Cambridge Michaelmas 2010 1 Introduction The two main insights emerging from the theory of second best are that dis- tortions in one market may o/set distortions in other markets and that it is not, in general, optimal to aim policy interventions at the Pareto conditions in a subset of markets. This principle, however, assumes that markets are inter- dependent. If they are not, then it is optimal to design policy to restore the Pareto conditions in those independent markets. One can, of course, judge the issue of independence on a case by case basis, but it would be very useful if one could &nd conditions under which speci&c and important types of independencies hold. The Diamond-Mirrlees Production E¢ ciency Result is the leading example of this and one that provides insights into a wide range of policy design questions. The sorts of questions that the Production E¢ ciency Result can address include the following: 1. Should the public sector be productively e¢ cient in the sense that the marginal rate of technical substitution between any two inputs should be the same in all public enterprises? 2. Should the private sector be productively e¢ cient in the sense that the marginal rate of technical substitution between any two inputs should be the same in all private companies? 3. Should the economy as a whole be productively e¢ cient in the sense that the marginal rates of technical substitution are the same in the public and private sector? 4. Should one use trade taxes (export taxes and tari/s) to raise revenue? 5. Should one tax intermediate goods? & Disclaimer: This note may contain mistakes. If you spot any, please bring them to my attention. 1
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6. What is the correct value for the social discount factor? The answers are not so obvious as it may seem: remember the general the- ory of second best. If there are irremovable distortions or the government has redistributive objectives, then maybe it is optimal to distort production choices and to create (or not to eliminate all) production ine¢ ciencies. Nevertheless, in a Diamond-Mirrlees (DM) world, all these questions can be answered unam- biguously. Government policy should respect production e¢ ciency throughout the economy. 2 The Diamond-Mirrlees Production E¢ ciency Result The Diamond-Mirrlees world is build on seven key assumptions: 1. All markets are competitive (i.e., all consumers and producers take prices as given). 2. There is constant returns to scale in the production of all commodities. 3. The government has full &exibility in choosing the tax rate levied on all commodities and all factors of production in the economy. 4. The government needs to raise a certain amount of revenue R .
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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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lecture5 - Lecture Note 5: Production E ciency Part 2B:...

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