The theory of the second best, first formally presented by Lipsey and Lancaster [16], maintains that the abolition of an arbitrarily chosen distortion in an economy with multiple distortions may reduce the welfare of the economy. The main objective of the present paper is to formulate some piecemeal policy recommendations which would definitely result in a move towards efficiency. In particular, we will prove the following: (a) a policy which reduces all price distortions uniformly will improve the welfare of the economy, if it is stable in the Marshallian sense. (b) a policy which brings the highest distortion to the level of the next highest will improve the welfare of the economy, if the good with the highest distortion is substitutable for all the other goods and if the economy is stable in the Marshallian sense. Our results integrate the characterization of the second best solution by Green [9], the analysis of the uniform reduction of tariff and excise tax by Foster and Sonnenschein [8] and Bruno [4], and the demonstration by Kemp [15] that the welfare effect of the tariff reduction in the two commodity world is related to the stability of the economy. In the present paper, an extensive use of the compensated demand function enables us to reveal the underlying relationship among these seemingly unrelated works.' In Section 2, we will define the compensated demand function, and will present its properties used in this paper. The model will be presented in Section 3. In Section 4 we will establish that in an economy with constant-cost technology a uniform reduction in excise tax rates improves welfare provided that the aggregate of income terms weighted by marginal costs (AIM) is positive. We will also show that a reduction of the highest tax rate to the level of the next highest rate improves the welfare if the AIM is positive and if the good with the highest tax rate is substitutable for all other goods. In Section 5 the main theorems will be proved by establishing that the positivity of AIM in the propositions of Section 4 can be replaced by another condition if the economy is stable under the Marshallian adjustment mechanism (which is defined in the text). Section 6 will re-evaluate the theory of the second best from our framework. (This section can be read independently of Section 5.) Throughout this paper, a matrix will be denoted by an upper-case letter; a lower-case bold-faced letter will represent a column vector; its transpose will be shown by a prime; and the ith element of the vector is denoted by the same letter with subscript i, unless stated otherwise.

Journal Article The Paradox in Capital Theory and Complementarity of Inputs Get access Tatsuo Hatta Tatsuo Hatta Ohio State University and Saitama University Search for other works by this author on: Oxford Academic Google Scholar The Review of Economic Studies, Volume 43, Issue 1, February 1976, Pages 127–142, https://doi.org/10.2307/2296606 Published: 01 February 1976 Article history Received: 01 August 1973 Accepted: 01 November 1974 Published: 01 February 1976

[Consider a small country with a strictly convex production possibility set, where non-traded goods as well as traded goods are produced. Suppose that tariffs are the only causes of the distortions in this economy. In the present paper, we will prove that in this economy reduction of the highest tariff rate to the level of the second highest rate will improve welfare if (i) inferior goods do not exist, (ii) the good on which the highest tariff rate is imposed is substitutive to all the other goods both in consumption and in production, and (iii) the non-traded goods are substitutive to all the other goods both in consumption and in production.]

[This paper generalizes the Global Correspondence Principle by extending, in two major ways, Paul Samuelson's 1971 analysis of the exchange rate response to an international purchasing-power transfer. We analyze the price effect of a shift in any parameter, not necessarily a transfer. We then explore the resulting adjustments in any nonprice variable such as welfare. As our analysis shows, the direction of these adjustments depends neither on whether they are small or large nor on whether equilibrium is locally stable or unstable.]

This paper reconsiders the welfare effects of a transfer payment in a two-commodity world with two agents (countries), by taking the presence of exogenous and endogenous distortions into account. When there is an exogenous tax-cumsubsidy on production, consumption, or trade, the analysis demonstrates that a transfer may paradoxically enrich the donor and immiserize the recipient under certain specific conditions. These welfare paradoxes are also shown to be possible if the transfer endogenously induces “directly unproductive profit-seeking” activity of lobbyists. Concluding remarks emphasize the paper's relevance for policymakers.

This paper generalizes the Global Correspondence Principle by extending, in two major ways, Paul Samuelson's 1971 analysis of the exchange rate response to an international purchasing-power transfer. We analyze the price effect of a shift in any parameter, not necessarily a transfer. We then explore the resulting adjustments in any nonprice variable such as welfare. As our analysis shows, the direction of these adjustments depends neither on whether they are small or large nor on whether equilibrium is locally stable or unstable.