Factor-Market Distortions and Dynamic Optimal Intervention: Comment
Recently in this Review, Harvey Lapan developed a dynamic analysis of distortions in domestic labor markets. His primary contribution was to point out that the static solution to the problem of distortions is incompatible with optimal adjustment to long-run equilibrium. Lapan concluded that labor market distortions could be handled optimally by providing employment subsidies to firms in the depressed sector that are somewhat less than the employment subsidies implied by static analysis. Unemployment would exist and serve as a policy instrument to encourage labor migration from the depressed sector to the rest of the economy. In contrast, I will argue that optimal intervention should consist of two elements: a subsidy to employment in the depressed area exactly equal to the static optimal subsidy; and transfer payments to workers to cover the costs of migration from the declining sector of the economy. With this program there would be no unemployment in the depressed area in the short run. The fundamental point I wish to make is that in a dynamic setting, optimal intervention requires the use of two policy instruments, not one. The optimal solution entails both an offset to existing short-run distortions, and a replication of the dynamic path the economy would follow if markets were perfect.
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