The implication of this theorem was that most of the simple and general guidelines for policy provided by welfare economics – for example, the ‘Paretian conditions’ stating that price should equal marginal cost – would not be relevant for real-world economies which are likely to be subject to constraints on policy. The Lipsey–Lancaster article seems to have come as a shock to economists in general and has since had a significant impact on the theory, and practice, of economic policy. Apparently, until the publication of this article, the conventional wisdom was that it was desirable to pursue a ‘piecemeal policy’, here and there fulfilling the ‘Paretian conditions’ – which, if applied everywhere, would lead to a Pareto optimum – regardless of whether these conditions actually were attained elsewhere.
The general theorem for the second best optimum states that if there is introduced into a general equilibrium system a constraint which prevents the attainment of one of the Paretian conditions, the other Paretian conditions, although still attainable, are, in general, no longer desirable.
KeywordsLagrange multipliers Marginal cost pricing Marginal rate of substitution Marginal rate of transformation Pareto efficiency Public finance Second best Trade creation Trade diversion
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