Pricing and Trade Policy
1. Introduction
We want to investigate the economic and welfare implications of pricing and trade policies,
including price instruments as well as quantity instruments. The analysis is presented under transaction
costs. Transaction costs are those costs that arise whenever resources are used in the process of
exchanging goods among agents. The introduction of transaction costs in the analysis exhibits several
desirable characteristics. First, if transaction costs vary among agents (e.g., if they increase with the
distance between trading agents), then transaction costs can be expected to be higher in international trade
(when traders are in different countries) than in domestic markets (when market participants are from the
same country). Second, the analysis provides an endogenous treatment of what are the traded versus nontraded goods, depending on the magnitude of exchange costs. This can help explain the existence of “local
markets.” Third, in general equilibrium, the transaction costs are themselves endogenous and can be
affected by changes in economic policy. For example, market liberalization may contribute to reducing the
cost of resources used in exchange, which would further stimulate (beyond the effects of reducing
tariffs/quotas) the development of markets and increase the benefits from trade. This suggests significant
interactions between policy, transaction costs, market activities and welfare.
The analysis relies on the benefit function and its use in general equilibrium analysis. It considers
price and quantity distortions, by investigating the associated distorted market equilibrium, and by
studying the implications of domestic and trade policy for resource allocation and welfare under
transaction costs.
A significant problem in market liberalization is that it is often part of a second-best strategy. In
this context, the reduction or elimination of a subset of distortions in a competitive equilibrium may not be
welfare improving. While free trade is efficient under competitive markets, in the presence of trade
barriers, a partial move toward free trade may actually reduce welfare. This is of particular interest when
domestic policy affects the distortionary effects of trade policy. For example, there are situations where
domestic production quotas can help reduce the distortionary effects of export subsidies. This stresses the
importance of an integrated analysis of the effects of domestic and trade policy.
2. A Global Economy
Consider a global economy consisting of m commodities and n economic agents. We distinguish
between two mutually exclusive groups of agents: consumers and production units. Let Nc be the set of
consumers, and Ns the set of production units. The set of all agents is N = Nc  Ns = {1, 2, …, n}. The i-th
consumer chooses a consumption bundle xi = (xi1, …, xim)  Xi  Rm, i  Nc. We assume that the feasible
set Xi is closed, convex, has a lower bound and a non-empty interior, i  Nc. The i-th consumption unit
has a preference relation represented by the utility function ui(xi), i  Nc. The utility function ui(xi) is
assumed continuous, non-decreasing, and quasi-concave on Xi, i  N.
The allocation of m goods among the n agents also involves production and trading activities. For
the i-th production unit, the production activities yi = (yi1, …, yim) are netputs (positive for outputs, and
negative for inputs) chosen from the feasible set Yi  Rm representing the underlying technology, with yi
 Yi, i  Ns. The set Yi is assumed non-empty and closed, i  Ns.
Note: The feasible set Yi being defined separately for each firm implicitly assumes no externality across
firms. Introducing externalities would require appropriate modifications to the analysis presented
below.
Trade involves the vector t = {tijk: i, j  N; k = 1, …, m}  R
mn 2
. For outputs, tijk is the quantity
of the k-th commodity traded from agent i to agent j. When i  j, tijk is the quantity of the k-th commodity
“sold” or “exported” by agent i to agent j, or equivalently the quantity “purchased” or “imported” by the jth agent from the i-th agent. When i = j, this includes tiik, the quantity of the k-th commodity that the i-th
agent trades with itself. We consider the case where trade can be costly and involves the use of resources.
Let z = (z1, z2, …, zn), where zi = (zi1, …, zim)  Rm is the vector of commodities used by the i-th agent in
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trading activities, i  N. The trading activities (-z, t) are chosen from the transformation set Z 
2
Rmn R mn consisting of all feasible points involving trade t and the associated vector z. Thus, (-z, t)  Z,
where the notation “-z” is used to reflect that the z’s are inputs in the trading process. We assume that the
set Z is closed, and that (0, 0)  Z, i.e. that the absence of trade can take place without using any
resources. Below, we will interpret the cost of z as “transaction costs” associated with exchange among
the agents. Also, we make the following assumption.
Assumption A1: (free tiik distribution).
If (-z, t)  Z, then {(-z, t'): tijk' = tijk for i  j, tiik' = tiik + dik, k =1, …, m, i , j  N}  Z for all dik.
Assumption A1 states that the i-th agent can modify tiik, the quantity of commodity k not subject
to trade, without affecting the use of resources z, for all k = 1, …, m, i  N. This means that no resources z
are used when agents consume their own production. In other words, transaction costs are relevant only in
the presence of exchange between different agents.
Since trade can exist between any two agents, each being either a production unit or a consumer, it
will be convenient to treat all agents symmetrically. For that purpose, we let X i = {0}  Rm be the
consumption set of the i-th production unit, i  Ns, and Yi = {0}  Rm be the production set of the i-th
consumption unit, i  Nc. This means that the only feasible production for a consumption unit is yi = 0, i 
Nc, and that the only feasible consumption for a production unit is xi = 0, i  Ns. Note that, labor being one
of the m commodities, consumers can trade labor with production units, which allows for joint production
and consumption choices under a single decision-maker (e.g., the case of household production).
Let x = {xi, i  N}, y = {yi, i  N}, where x  X = X1X2…Xn, and y  Y = Y1Y2…Yn.
Definition 1: A feasible allocation is defined as a vector (x, y, z, t) satisfying
jN tij  yi - zi, i  N,
(1a)
and
xi  jN tji, i  N,
(1b)
where tij = (tij1, tij2, …, tijm), xi  Xi, yi  Yi, i  N, and (-z, t)  Z.
Equation (1a) states that the i-th agent cannot export more than its production yi net of resources used in
trade zi, i  N. And equation (1b) states that the i-th agent cannot consume more than it obtains either
from itself (tiik) or from others (ji tjik). Note that summing (1a) and (1b) over i yields
iN xi  jN iN tij  iN yi - iN zi,
which implies that aggregate consumption cannot exceed aggregate production, minus aggregate resources
used for trading purpose. Next, we incorporate various domestic and trade policy instruments in the model
and investigate their effects on market equilibrium and resource allocation.
3. Policy Distortions and Market Equilibrium
We consider a market equilibrium where the i-th agent can face two prices for commodity k: piks
when commodity k is treated as a production activity, and pikc when commodity k is treated as a
consumption activity. The corresponding price vectors are ps = {piks: k = 1, …, m, i  N}  R mn
  for
"producer prices," and pc = {pikc: k = 1, …, m, i  N}  R mn
  for "consumer prices." Although the case
s
c
where p = p can be seen as an important special case, the distinction between ps and pc will prove
important in policy analysis: ps and pc can differ in the presence of distortionary policy.
Consider policy distortions generated by domestic policy as well as trade policy. The policy
instruments involve price instruments (i.e., taxes, tariffs and subsidies) as well as quantity instruments
(i.e., production and trade quotas). Denote by rijk the unit tariff (unit subsidy if negative) imposed on tijk for
commodity k exchanged from agent i to agent j, k = 1, …, m, i, j  N. We denote the unit tariffs/subsidies
by the vectors rij = {rijk: k = 1, …, m}  Rm and r = {rij: i, j  N}  Rmn². Partition the set of agents into
mutually exclusive groups: N = {D1, D2, …}, where Ds is the set of domestic agents in the s-th country.
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When i  Ds and j  Ds, then rijk represents an import tariff imposed on the k-th commodity by the s-th
country. When i  Ds and j  Ds, then -rijk is an export subsidy imposed on the k-th commodity by the s-th
country. As such, r measures price instruments used in trade policy. Alternatively, if (i, j)  Ds with i  Ns
and j  Nc, then rijk represents a domestic tax (domestic subsidy if negative) on the k-th commodity, which
creates a price wedge between producer price piks and consumer price pikc. As such, r would reflect
domestic tax and pricing policy. Allowing for differences between domestic consumer and producer prices
and thus price distortions in domestic markets, this conceptual framework provides a fairly general model
of pricing policy. In general, taxes or tariffs (rijk > 0) tend to increase consumer prices, decrease producer
prices and generate budgetary revenue. Alternatively, subsidies (rijk < 0) tend to increase producer price
piks, decrease consumer price pikc and involve budgetary cost. The implications of these revenues/costs for
welfare analysis are analyzed below.
Denote by qijk the quantity trade quota imposed on the trade flow tijk of the k-th commodity
exchanged from agent i to agent j, k = 1, …, m, i, j  N. For simplicity, we focus the analysis on output
quotas, with qijk  0. The quota qijk imposes an upper bound on the quantity traded tijk. Letting qij = (qij1,
…., qijm), this gives
tij  qij, i, j  N.
(2a)
We also consider domestic production quotas qyi restricting the production of the i-th producer.
The introduction of domestic production quotas is relevant as they can affect the distortionary effects of
trade policy. Again, for simplicity, we focus the analysis on output quotas, with qyi  0 imposing an upper
bound on the quantity produced by the i-th producer:
yi  qyi, i  Ns.
(2b)
We expect the quotas q = {qij: i, j  N; qyi, i  Ns} to generate quota rents to market participants.
Denote by Qij the unit-quota rents associated with the quotas qij, and by Qyi the unit quota rents associated
with the production quotas qyi. Then, the vector of quota rents is Q = {Qij: i, j,  N; Qyi: i  Ns}. The
effects of quota rents on welfare will be discussed below. We are interested in evaluating the effects of the
policy instruments  = (r, q) on resource allocation and trade, on the market prices (ps, pc) and on the
quota rents Q.
We make the following additional assumption.
Assumption A2: (free g-distribution).
There exists a numeraire good that can be traded between any two agents without using any resource
z. Let this good be the m-th commodity, which we call “money”. Throughout the paper, we consider
monetary valuation that can be expressed in terms of units of the bundle g = (0, …, 0, 1)  R m
 . We
assume that:
a) if (-z, t)  Z, then {(-z', t): tijk' = tijk for all i, j  N, k = 1, …, m-1; tijm' = tijm + dijm for all i, j 
N}  Z for all dijm satisfying tijm + dijm  0,
b) rijm = 0, qijm = + for i, j  N, and qym = +, meaning that neither tariff nor quota exists for
the m-th commodity.
Note that condition a) in Assumption A2 states that money (i.e., commodity m) can be exchanged
among agents without incurring any transaction cost. And condition b) reflects the fact that the analysis
focuses on pricing and trade policy related to the first (m-1) commodities.
Next, consider the case where all agents are price-takers. We focus our analysis on the effects of
the policy instruments (r, q) on market equilibrium. We call the associated equilibrium distorted market
equilibrium. The objective is to investigate the nature of the distorted market equilibrium and the effects of
(r, q) on production decisions y, consumption decisions x, trade activities (z, t), market prices (p c, ps), and
quota rents Q.
Definition 2: An allocation (x*, y*, z*, t*) along with market prices ps* = {pis*: pis*  g = 1, pis*  R m , i 
*
N}, pc* = {pic*: pic*  g = 1, pic*  R m
 , i  N} and the quota rents Q  0 is a distorted market
equilibrium if
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a) (x*, y*, z*, t*) is a feasible allocation,
b) for each i  Nc and all xi  Xi,
pic*  xi  pic* xi* implies that ui(xi)  ui(xi*),
c) for each i  Ns and all yi  Yi,
(pis* - Qyi*)  yi*  (pis* - Qyi*)  yi,
d) for all (-z, t)  Z,
iN jN (pjc* - pis* - rij - Qij*)  tij* - iN pis*  zi*
 iN jN (pjc* - pis* - rij - Qij*)  tij - iN pis*  zi,
e) for each i  N, pis*  0, pic*  0, with pis*  [yi* - zi* - jN tij*] = 0, and pic*  [jN tji* - xi*] = 0,
f) for each i, j  N, tij*  qij, Qij*  0, Qij*  [qij - tij*] = 0, and for each i, yi*  qyi, Qyi*  0, and Qyi* 
[qyi - yi*] = 0.
Condition a) requires feasibility. Condition b) represents economic rationality for consumption
units. Condition c) is the profit maximization behavior for production units under production quotas. It
considers that firms behave as if they were facing prices (pis* - Qyi*), showing that quota rents Qyi*  0
reduce the incentive to produce. Condition d) states that trade activities maximize profit under trade policy
distortions. When i and j represent agents located in different countries, both the tariffs r and the quotas q
act as trade barriers that reduce the profitability of trade. Condition e) states the budget constraint for each
agent, whether it is treated as a producer (involving prices ps) or a consumer (involving prices pc). Finally,
condition f) imposes the quota constraints (2a) and (2b), with the requirement that the quota rent Q* can be
positive only if the corresponding quotas are binding.
Note 1: Condition d) has important implications for trade activities under policy distortions (r, q). To
illustrate, consider the trade cost function C(t, ) = minz {iN pis*  zi: (-z, t)  Z}. In the special
case where C(t, ) is differentiable in t and the k-th commodity is an output (tijk  0), the
maximization problem implied by condition d) yields the familiar Kuhn-Tucker conditions with
respect to tijk:
pjkc* - piks* - C/tijk - rijk - Qijk*  0 for tijk*  0,
(3a)
and
[pjkc* - piks* - C/tijk - rijk - Qijk*]  tijk* = 0.
(3b)
Equations (3) show how trade policy generates price distortions through the
tariffs/subsidies rijk and the quota rents Qijk*. In the context of a competitive market equilibrium,
equation (3a) implies that (pjkc* - piks*)  C/tijk + rijk + Qijk*, i.e. that the price difference for
commodity k between agents i and j, pjkc* - piks*, cannot exceed the marginal transaction cost,
C/tijk, plus the price distortion, rijk + Qijk*. And when exchange takes place from agent i to agent
j for the k-th commodity (tijk > 0), then (3a) and (3b) imply that (pjkc* - piks*) = C/tijk + rijk + Qijk*.
In this case, the price difference (pjkc* - piks*) must equal the marginal transaction cost C/tijk plus
the price distortion (rijk + Qijk*). This can be interpreted as the first-order condition for profit
maximizing trade under distortionary policy. For example, in the absence of transaction costs
where C/tijk = 0, then (pjkc* - piks*) = rijk + Qijk*, showing that (rijk + Qijk*) acts as a “price wedge”
between consumer price pjkc* and producer price piks*. Note that in the absence of price distortions
(where rijk = 0, Qijk* = 0), this would generate the law of one price: pjkc* = piks* for all i, j  N. This
shows that under competitive markets, the law of one price holds only in the absence of both
transaction costs and distortionary policy. Alternatively, when C/tijk > 0, transaction costs in (3)
create a price wedge between pjkc* and piks*. Thus either policy distortion (rijk  0 and/or Qijk* > 0)
or the presence of transaction costs (C/tijk > 0) is sufficient to imply that the law of one price
fails. Finally, when transaction costs and price distortions are “high enough” so that C/tijk + rijk +
Qijk* > (pjkc* - piks*) for some i and j satisfying (pjkc* - piks*)  0, then the incentive to trade
disappears as (3b) implies tijk* = 0. Then, the k-th commodity becomes non-traded between agents
i and j. If this happened for all agents, this would imply the absence of market for the k-th
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commodity. This illustrates that our general approach treats the presence and development of
markets as endogenous. It shows the adverse effects that transaction costs and policy distortions
can have on trade and market activities. Alternatively, it stresses the role of low transaction costs
and market liberalization policies in the creation and functioning of competitive markets.
Note 2: In the case where ps = pc = p, solving for the term (pi*  tij*) in condition e) gives
pi*  tij* = pi*  yi* - pi*  zi* - pi*  (ji tij*) = pi*  xi* - pi*  (ji tji*), i  N,
or
pi*  (ji tij*) - pi*  (ji tji*) = pi*  yi* - pi*  zi* - pi*  xi*, i  N.
This can be interpreted as a “balance of payment” constraint which states that, for any agent i  N,
the value of net exports must equal profit, minus the cost of trade, minus consumer expenditures.
4. The Utility Frontier in Distorted Market Equilibrium
To analyze the efficiency effects of distortionary policy, we rely on the concept of utility frontier.
Definition 3: Under policy  = (r, q), U(x*) = {ui(xi*), i  Nc} is on the utility frontier of the economy if x*
= {xi*: i  Nc} is feasible and if there does not exist another feasible x such that u(x)  u(x*), u(x)
 u(x*).
Since domestic and trade policy  = (r, q) generate distortions that can adversely affect the
efficiency of resource allocation, the utility frontier defined above is typically not the Pareto utility frontier
(especially since we have assumed no externality). Our objective here is to assess the quantitative and
qualitative effects of partial policy reforms (represented by changes in ) on this utility frontier. The
following function will prove important in our analysis.
Definition 4: Given the reference bundle g  R m satisfying g  0, define the i-th agent’s benefit function
as
bi(xi, Ui) = max{: (xi - g)  Xi, u(xi - g)  Ui} if (xi - g)  Xi and u(xi - g)  Ui for some ,
= - otherwise,
for i  Nc. The aggregate benefit function is then defined as
B(x, U) = iN bi(xi, Ui),
where x = {xi: i  Nc} and U = {Ui: i  Nc}.
The benefit function bi(xi, ui) measures individual consumer benefit (expressed in units of the
commodity bundle g) the i-th consumer would be willing to give up while facing xi to reach the utility
level ui. When the commodity bundle g has a unit price, the benefit function can be interpreted as an
individual willingness-to-pay measure. And B(x, U) provides a corresponding measure of aggregate
consumer benefit. Under the assumptions that the set Xi is convex for each i  N and the function ui(x) is
quasi-concave, the benefit function bi(xi, ui) is concave in xi for i  Nc. Then, the aggregate benefit
function B(x, U) is concave in x.
Definition 5: Define a maximal equilibrium under policy  = (r, q) as an allocation (x, y, z, t) satisfying
V(, U) = maxx,y,z,t {B(x, U) - iN jN rij  tij: equ. (1a), (1b), (2a), (2b);
(x, y, -z, t)  XYZ}.
(4a)
Let
W(, U) = V(, U) + iN jN rij  tij*,
(4b)
*
where t solves the optimization problem in (4a). If in addition to being a maximal equilibrium, U
is chosen such that W(, U) = 0, then the allocation is zero-maximal under the policy  = (r, q).
Note that equations (4a) and (4b) involve the term (iN jN rij  tij), the amount of money
associated with the tariffs/subsidies r. This term is subtracted from the aggregate benefit B in (4a). As
such, tariffs are treated as an additional cost to exchange commodities among agents (which reduces the
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incentive to trade). But, this term is also added in (4b) to reflect that the tariff revenues eventually benefit
the agents that capture them. Also, note that equations (2a)-(2b) impose the quota restrictions in (4a).
Next, we investigate the relationships between zero-maximality and the utility frontier. (The
proofs are similar to the ones presented earlier).
Proposition 1: Assume that ui(xi) is strictly increasing in the m-th commodity xim for at least one
consumer. Under policy  = (r, q), if the feasible allocation (x*, y*, z*, t*) is on the utility frontier,
then it is zero-maximal.
Proposition 2: Assume that the utility function ui(xi) is quasi-concave for each i  Nc, and that the sets Y
and Z are convex. Under policy  = (r, q), if the feasible allocation (x*, y*, z*, t*) is zero-maximal
and satisfies x*  int(X), then it is on the utility frontier.
Propositions 1 and 2 establish conditions under which W(, U) = 0 (in a zero-maximal
equilibrium) is the implicit equation for the utility frontier under policy  = (r, q). This has the following
intuitive interpretations. First, the set of utilities u satisfying W(, U)  0 identifies feasible distribution of
welfare among the consumers. Indeed, having W(, U) < 0 cannot be feasible: it corresponds to B(x*, U) <
0, i.e. to situations where u(xi*)  ui cannot hold for all i  Nc. Thus, the inequality W(, U)  0 can be
interpreted as the aggregate budget constraint for all agents under distortionary policy and transaction
costs. It simply states that aggregate net benefit cannot be negative, i.e. that all benefits obtained must be
feasibly generated within the economy. Second, as investigated earlier, finding W(, U) > 0 is necessarily
below the utility frontier. In this context, we can interpret W(, U) as the distributable monetary surplus.
This surplus, if positive, can always be redistributed costlessly (under assumption A2) to some nonsatiated agent and generate welfare improvements to at least one agent without making anyone else worse
off. It follows that the set of u satisfying W(, U) = 0 traces out the utility frontier under government
policy  and in the presence of transaction costs. This is a useful result for empirical analysis to the extent
that the surplus function W(, U) involves monetary measurements, yet it is obtained under general
ordinal preferences. Note that the move along the utility frontier can take place in several ways. It can
involve lump sum transfers (through the tijm) across agents. Or it can involve redistribution across agents
of profit from production and trade activities, of quota rents, and of revenue/cost generated by
tariffs/subsidies.
Next, to show the linkages between the utility frontier and distorted markets, we want to establish
the relationships between zero-maximality and distorted market equilibrium. This is done by considering
the Lagrangean associated with the constrained optimization in (4a). For x  X, y  Y, (-z, t)  Z, ps 
2
mn
n
c
R mn
 , p  R  and Q  R  , define the Lagrangean
L(x, y, z, t, U, ps, pc, Q, ) = B(x, U) - iN jN rij  tij + iN pis  [yi - zi - jN tij]
+ iN pic  [jN tji - xi] + iN jN Qij  [qij - tij] + iN Qyi  [qyj - yi],
(5)
s
where p , pc and Q are vectors of Lagrange multipliers associated with constraints (1a), (1b), (2a)
and (2b), respectively, and  = (r, q).
The variables (ps, pc, Q) in (5) are Lagrange multipliers associated with constraints (1a), (1b), (2a)
and (2b). When the commodity bundle g has a unit price, the benefit function B(x, U) has a monetary
interpretation, and the Lagrange multipliers (ps, pc, Q) have the standard interpretation of measuring the
shadow price of the corresponding constraints. In market economy, ps and pc are then market prices
reflecting resource scarcity for supply and demand facing each agent. And Q measures the quota rents
associated with quotas q.
We will be interested in studying the allocation (x*, y*, -z*, t*)  XYZ and a vector (ps*, pc*, Q*)
 0 which satisfy a saddle-point of the Lagrangean:
L(x, y, z, t, U, ps*, pc*, Q*, )
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 L(x*, y*, z*, t*, U, ps*, pc*, Q*, )  L(x*, y*, z*, t*, U, ps, pc, Q, ),
(6)
for all (x, y, -z, t)  XYZ and all (ps, pc, Q)  0, subject to the normalization rule pis*  g = pic*  g = 1, i
 N. Assume that there exists a feasible point where the constraints (1a), (1b), (2a) and (2b) are not
binding (Slater's condition). Then, if the sets X, Y and Z are convex, the saddle-point characterization (6)
is necessary and sufficient for the maximal allocation given in (4a). To obtain a zero-maximal allocation in
(4b), one simply needs to choose U to satisfy W(, U) ≡ V(, U) + iN jN rij  tij* = 0.
The saddle-point of the Lagrangean in (6) is closely related to the characterization of a distorted
market equilibrium given in Definition 2. To see that, first consider the first inequality in (6). Under the
normalization rule pis*  g = pic*  g = 1, i  N, it implies the following optimization problems
ei(pic, Ui) ≡ minx{pic  xi: ui(xi)  ui: xi  Xi} = - maxx{bi(xi, ui, g) - pic  xi: xi  Xi}, i  Nc, (7a)
yi(pis - Qyi) = maxy {(pis* - Qyi*)  yi: yi  Yi}, i  Ns,
(7b)
T(ps, pc, r, Q) = argmaxz,t {iN jN (pjc* - pis* - rij - Qij*)  tij - iN pis*  zi: (-z, t) .
(7c)
Equation (7a) corresponds to condition b) in definition 2 of a distorted market equilibrium.
Equation (7b) is condition c) in definition 2 of a distorted market equilibrium. Condition d) in definition 2
is obtained in a similar manner from (7c). Finally, from the saddle-point theorem, the saddle-point
problem (6) implies the complementary slackness conditions
pis*  [yi* - zi* - jN tij*] = 0,
(8a)
c*
*
*
pi  [jN tji - xi ] = 0,
(8b)
for i  N, and
Qij*  [qij - tij*] = 0, i, j  N,
(8c)
which satisfy conditions e) and f) in definition 2.
Note the role played by assumption (A2). Under assumption (A2), the first inequality in (6)
implies that pims* = pimc* = pm* for all i  N (otherwise, tijm* or tjim* and thus L(x*, y*, z*, t*, u, ps*, pc*, Q*, )
would be unbounded, a contradiction). Thus, the optimal choice for tijm means that the price of the m-th
commodity (money) is the same for all agents. Without a loss of generality, it can be normalized to be
equal to 1, with pm* = pis*  g = pic*  g = 1 for all i  N. This means that money is used as a basis for
evaluating all welfare measures.
Define the aggregate profit function as (ps, pc, Q, r) ≡ iNs yi(pis - Qyi) + T(ps, pc, r, Q),
whereyi(pis - Qyi) and T(ps, pc, r, Q) are given in (7b) and (7c), respectively. And define the aggregate
expenditure function as E(pc, U) = iNc ei(pc, Ui), where ei(pc, Ui) is given in (7a). The profit functions
(ps, pc, Q, r), yi(pc) and T(ps, pc, Q, r) are each convex in (ps, pc, Q, r). And the expenditure functions
E(pc, U) and ei(pc, Ui) are each concave in pc. Using this notation, the second inequality in the saddle-point
problem (6) implies that (ps*, pc*, Q*) satisfy
V(, U) = min ps ,p c ,Q {(ps, pc, Q, r) - E(pc, U) + iN jN Qij  qij + iN Qyi  qyi
: (ps, pc, Q)  0, pis*  g = pic*  g = 1, i  N},
where  = (r, q). Let
W(, U) = V(, U) + iN jN rij  tij*.
(9a)
(9b)
Equations (9a)-(9b) provide a dual characterization of the distributable surplus. As noted above, if
U is chosen to satisfy W(, U) = 0, then the corresponding allocation would be zero-maximal.
Equation (a)-(b) provide a formulation for equilibrium prices (ps*, pc*) and quota rents Q*. Under
the convexity of the sets X, Y and Z, these are the market prices and quota rents obtained in a distorted
market equilibrium under policy instruments  = (r, q). This gives the “dual approach” to market
equilibrium analysis now commonly used in the economic analysis of policy and trade distortions.
7
Note that (iN jN Qij  qij + iN Qyi  qyi) in (9a) is the aggregate quota rent involving both trade
and production activities. It is added in (9a) to reflect that the quota rents benefit the agents who capture
them. Similarly, the aggregate tariff revenue (iN jN rij  tij*) is added in (9b) to reflect that these
revenues benefit the agents that receive them.
5. Implications for welfare and resource allocation
The above results are now used to analyze the economic implications of government policy under
transaction costs. Clearly, the policy instruments  = (r, q) affect resource allocation. The associated
distortions are expected to influence adversely economic efficiency. Indeed, in the context where there is
no externality, the distorted economy is expected not to satisfy the Pareto efficiency criterion. This raises
two related questions: 1) how to represent the welfare implications for the distorted economy; and 2) how
to assess the nature and extent of economic inefficiency due to distortionary domestic and trade policy. To
answer these questions, we examine next the welfare measurements of government policy under
transaction costs.
5.1. Evaluation of a discrete change in policy
We analyze the general case of a discrete change in the policy instruments . Assuming that the
sets X, Y and Z are convex, it will be convenient to focus on the saddle-point of the Lagrangean in (6). For
a given U, let (x*(, U), y*(, U), z*(, U), t*(, U)) denote an allocation that satisfies the saddle-point
condition (6). And let V(, U) = [B(x*, U) - iN jN rij  tij*] denote the aggregate net benefit evaluated at
x*(, U), y*(, U), z*(, U) and t*(, U). Then, the following result applies.
Proposition 3: For a given U, assume that a saddle-point in (6) holds with saddle value V(, U) for all  =
(r, q)  A. Then, for any , ’  A,
iN jN rij’  [tij*(’, U) - tij*(, U)] + iN jN Qij*(’, U)  [qij’ - qij]
+ iN Qyi*(’, U)  [qyi’ - qyi]
 W(’, U) - W(, U)
iN jN rij  [tij*(’, U) - tij*(, U)] + iN jN Qij*(, U)  [qij’ - qij]
+ iN Qyi*(, U)  [qyi’ - qyi],
(10)
where W(, U) = V(, U) + iN jN rij  tij*(, U).
Proof : Letting w = (x, y, z, t) and  = (ps, pc, Q), the Lagrangean in (5) can then be written as L(w, , ,
) = f(w, , ) +   g(w, ) for w  W and   0. The first inequality in the saddle-point (6) then
gives L(w, *(), )  V(), for any w  W. Choosing w = w*(’), we obtain
L(w*(’), *(), )  V().
Note that
V(’) = f(w*(’), ’)
 f(w*(’), ’) + *()  g(w*(’), ’), since *()  0, and g(w*(’), ’)  0,
= L(w*(’), *(), ’).
Summing the two inequalities gives
V(’) - V()  L(w*(’), *(), ’) - L(w*(’), *(), ),
or, in the context of the Lagrangean (5),
V(’, U) - V(, U)
 -iN jN (rij’ - rij)  tij*(’, U) + iN jN (qij’ - qij)  Qij*(, U) + iN (qyi’ - qyi) 
Qyi*(, U).
Using the relationship W(, U) = V(, U) + iN jN rij  tij*(, U), this yields the second
inequality in equation (10).The first inequality is obtained by switching  and ’ and multiplying
by (-1).
8
Proposition 3 provides a lower bound and an upper bound on the change in the aggregate net
benefit [W(’, U) - W(, U)] evaluated at u. It is very general in the sense that it applies without
restrictions on the set A. It does not require the decision rules x*(, U), y*(, U), z*(, U) and t*(, U) to
be differentiable functions, nor single value mappings. And it applies to arbitrary discrete changes in the
policy instruments  = (r, q). Finally, it considers the joint effects of price and quantity policy instruments
used in both domestic and trade policy. This provides general results on the effects of policy reform. Also,
proposition 3 includes some important results as special cases. To see that, consider the following
corollary.
Corollary 1: For any , ’  A,
iN jN [rij’ - rij]  [tij*(’, U) - tij*(, U)]
+ iN jN [Qij*(’, U) - Qij*(, U)]  [qij’ - qij]
+ iN [Qyi*(’, U) - Qyi*(, U)  [qyi’ - qyi]  0.
(11)
Again, corollary 1 applies in general for any discrete change in . It has two useful implications.
First, consider the case where tariffs are changed but where quotas are unchanged (q = q’). Then, (11)
becomes
iN jN [rij’ - rij]  [tij*(’, U) - tij*(, U)]  0.
This means that t*(r, ) is non-increasing in r: ceteris paribus, an increase in tariffs r tends to
decrease the corresponding quantities traded. Note that this intuitive result is obtained without
differentiability assumptions. In the special case where the change in tariffs (r’ - r) is “small” and the
function t*(, U) is differentiable in r, this implies that [r’ - r]  [t*(, U)/r]  [r’ - r]  0, i.e. that the
matrix [t*(, U)/r] is symmetric, negative semi-definite. In addition, if (r’ - r)  0 is not in the null space
of [t*(, U)/r], then [r’ - r]  [t*(, U)/r]  [r’ - r] < 0.
Second, consider the case where tariffs are now unchanged (r = r’). Then (11) yields
iN jN [Qij*(’, U) - Qij*(, U)]  [qij’ - qij] + iN [Qyi*(’, U) - Qyi*(, U)  [qyi’ - qyi]  0.
This means that the quota rent Q*(, ) is non-increasing in q: ceteris paribus, imposing stricter
quotas (represented by a decrease from q to q’) tends to increase the corresponding quota rents. Again this
intuitive result holds without differentiability assumptions. In the special case where the change in quotas
(q’ - q) is “small” and the function Q*(, U) is differentiable in q, this implies that [q’ - q]  [Q*(, U)/q]
 [q’ - q]  0, i.e. that the matrix [Q*(, U)/q] is symmetric, negative semi-definite. In addition, if (q’ - q)
 0 is not in the null space of [Q*(, U)/q], then [q’ - q]  [Q*(, U)/q]  [q’ - q] < 0.
5.2. Impacts on the utility frontier
To evaluate the welfare implications of proposition 3, two attractive choices for U are possible.
First, consider the case where u is chosen such that aggregate net benefit is zero in situation : W(, U) =
0. Then, [W(’, U) - W(, U)] = W(’, U) measures the aggregate net income gain (or loss if negative)
associated with a move from  to ’. In other words, [W(’, U) - W(, U)] = W(’, U) is a simple
measure of aggregate efficiency gains (“compensating variation”) generated by a policy change from  to
’. And proposition 3 provides bounds on these efficiency gains under transaction costs. With this
particular choice of U, note that x*(, U), y*(, U), z*(, U) and t*(, U) correspond to an allocation on
the utility frontier under situation .
Second, consider the case where U is chosen such that aggregate net benefit is zero in situation ’:
W(’, U) = 0. Then, [W(’, U) - W(, U)] = -W(, U) measures the aggregate net income loss (or gain if
negative) associated with replacing ’ in favor of . It follows that [W(’, U) - W(, U)] = -W(, U) is a
simple aggregate efficiency measure (“equivalent variations”) generated by giving up the exchange
environment ’. With this choice of u, x*(’, U), y*(’, U), z*(’, U) and t*(’, U) is on the utility frontier
under situation ’. With either choice of u, the term [W(’, U) - W(, U)] can thus be used to evaluate
how the utility frontier shifts under a policy change from  to ’. As such, proposition 3 provides a basis
to investigate Pareto welfare improving moves.
9
Proposition 4: For any change from  to ’ in A,
a sufficient condition for [W(’, U) - W(, U)]  (>) 0 is
iN jN rij’  [tij*(’, U) - tij*(, U)] + iN jN Qij*(’, U)  [qij’ - qij]
+ iN [Qyi*(’, U)  [qyi’ - qyi]  (>) 0,
(12a)
and a necessary condition for [W(’, U) - W(, U)] (>) 0 is
iN jN rij  [tij*(’, U) - tij*(, U)] + iN jN Qij*(, U)  [qij’ - qij]
+ iN [Qyi*(, U)  [qyi’ - qyi]  (>) 0,
(12b)
where the weak (strict) inequalities correspond to a weak (strict) Pareto welfare improvement.
Proposition 4 states important results. They are simple and very general. Again, they apply under
both price instruments r and quantity instruments q; they consider jointly domestic and trade policy; they
allow for discrete change in the policy instruments  = (r, q); they allow for transaction costs that reduce
the incentive to trade; and they hold without differentiability assumptions. Interpreting [W(’, U) - W(,
U)] as measuring the shift in the utility frontier, proposition 4 establishes that (12a) is a sufficient
condition for a policy change from  to ’ to be Pareto improving. Expression (12a) states that the term
iN jN rij’  [tij*(’, U) - tij*(, U)], reflecting the change in the aggregate value of tariff revenues
evaluated at r’, plus the term iN jN Qij*(’, U)  [qij’ - qij] + iN [Qyi*(’, U)  [qyi’ - qyi], reflecting the
aggregate change in quota rents, is non-negative. Given Q*  0, a sufficient condition for the change in the
term involving quota rents to be non-negative is that q’  q, i.e. that trade and production quota restrictions
be relaxed. Here, we want to stress that this result applies under reform involving both price and quantity
policy instruments for domestic as well as trade policy. However, the effects of domestic and trade policy
reform on the term involving taxes/tariffs revenue are more complex. Indeed, reducing tariffs/subsidies
(where 0  rijk’  rijk if rijk > 0; and rijk  rijk’  0 if rijk < 0) and/or relaxing quotas (q’  q) is in general not
sufficient to imply that iN jN rij  [tij*(’, U) - tij*(, U)]  0. However, (12a) implies that a sufficient
condition for market liberalization satisfying q’  q to generate aggregate efficiency gains is that it
stimulates trade (tijk*(’, U)  tijk*(, U)) for commodities that are subject to tariff (rijk > 0) and reduces
trade (tijk*(’, U)  tijk*(, U)) for commodities that are subsidized (rijk < 0). This simple result is quite
powerful in the sense that it is intuitive and applies under very general conditions.
There are also situations where partial market liberalization is immiserizing. Proposition 4
provides additional information on this issue. It shows that expression (12b) is a necessary condition for a
policy change from  to ’ to be Pareto improving. Alternatively, it means that, whenever (12b) is not
satisfied, then a partial move toward free markets cannot be efficiency improving. Expression (12b) states
that the term iN jN rij  [tij*(’, U) - tij*(, U)], reflecting the change in the aggregate value of tariff
revenues evaluated at r, plus the term iN jN Qij*(, U)  [qij’ - qij] + iN [Qyi*(, U)  [qyi’ - qyi],
reflecting the aggregate change in quota rents, is non-negative. Again, given Q*  0, a sufficient condition
for the change in the term involving quota rents to be non-negative is that q’  q, i.e. that trade and
production quota restrictions be relaxed, a result that applies under both tariffs and quotas. As before, the
effects of domestic and trade policy reform on the term involving tariff revenue are more complex. Indeed,
reducing tariffs/subsidies (with 0  rijk’  rijk if rijk > 0; and rijk  rijk’  0 if rijk < 0) and/or relaxing quotas
(q’  q) is in general not sufficient to imply that iN jN rij  [tij*(’, U) - tij*(, U)]  0. When the lefthand side in (12b) becomes negative, then partial market liberalization necessarily reduces efficiency. This
is the situation where policy reform is immiserizing. This is an illustration of the theory of the second best
applied to policy analysis. More specifically, proposition 4 shows the conditions under which partial
market liberalization reduces efficiency: with q’  q, for policy reform to be immiserizing, (12b) must not
hold, implying that iN jN rij  [tij*(’, U) - tij*(, U)] must be negative and large. This simple result
appears quite useful. It warns us against domestic and trade policy reform (especially quota reform) that
exacerbates the distorting effects of pricing policy by stimulating exports that are subsidized and/or
reducing imports that are taxed.
10
5.3. Implications under differentiability
To explore further the usefulness of proposition 4, consider the special case where the change in
policy (’ - ) is “small” and the function t*(, U) is differentiable in . Then, proposition 4 implies the
following result.
Corollary 2: For any small change from  to ’, [W(’, U) - W(, U)]  (>) 0 if and only if
r  [t*(, U)/r]  [r’-r] + r  [t*(, U)/q]  [q’-q]
+ iN jN Qij*(, U)  [qij’ - qij] + iN [Qyi*(, U)  [qyi’ - qyi]  (>) 0,
(13)
where the weak (strict) inequality corresponds to weak (strict) Pareto welfare improvement
associated with a change from  to ’.
Note that the first term in (13) involves the matrix [t*(, U)/r], measuring the effects of tariffs
on trade. We have seen above that [t*(, U)/r] is a symmetric, negative semi-definite matrix. In the case
of a proportional decrease in tariffs/subsidies where r’ = k r, 0  k < 1, it follows that the first term in (13)
is always non-negative: r  [t*(, U)/r]  [r’ - r]  0. Then, there are two simple scenarios where equation
(13) is always satisfied. The first scenario concerns a proportional tariff/subsidy reduction in the absence
of quotas (where q = q’ = , Q* = 0). The first term in (13) is then non-negative, while the absence of
quotas implies that the second and third terms in (13) vanish. This generates the important result that, in
the absence of quotas, a proportional tariff reduction is always (at least weakly) welfare improving. The
second scenario concerns quota relaxation in the absence of tariffs (where r = r’ = 0). The absence of
tariffs means that the first and second terms in (13) vanish. And any quota relaxation (q’  q) always
implies that the third term in (13) is non-negative (since Q*(, U)  0). Thus, in the absence of tariffs,
relaxing any quota is always (at least weakly) welfare improving.
What happens to these local results in the more realistic situation where both tariffs and quotas are
present? Two important findings follow from (13). First, it remains true that any proportional tariff
reduction is (at least weakly) welfare improving in the presence of trade and production quotas, provided
that these quotas remain constant (with q = q’ < ). To see that, it suffices to note that the first term in (13)
is non-negative under proportional tariff reduction, while the second and third terms vanish when q = q’.
This applies to situations covering both domestic and trade policy. Second, in a second-best world, any
quota relaxation may not be welfare improving. This finding is obtained from corollary 2: in the presence
of tariffs or subsidies (r  0), the second term in (13), r  [t*(, U)/q]  [q’-q] (which involves crosscommodity effects of quotas on trade), cannot be signed in general. In this case, quota relaxation (q’ - q) 
0 can interact with tariffs r in such a way that the inequality in (13) may no longer hold. Note that this
indeterminacy remains even if tariffs/subsidies remain unchanged (with r = r’). Thus, in a second-best
world of partial market liberalization, relaxing production and/or trade quotas in the presence of tariffs
does not necessarily generate a Pareto improvement.
In the presence of tariffs, subsidies, and quotas, corollary 2 shows conditions under which relaxing
quotas are efficiency enhancing. It also shows that these conditions are not always satisfied under partial
market liberalization. In particular, it gives results that apply to the joint effects of domestic and trade
policy reform. Indeed, expression (13) is not always positive when r  0 as it depends on the effects of
quotas on trade: r  [t*(, U)/q]  [q’-q]. Since this includes the effects of production quotas on trade, it
suggests that domestic policy has to be taken into consideration in the analysis of policy reform. For
example, relaxing production quotas (q’  q) in the presence of subsidized exports (rijk < 0) can decrease
welfare if this has strong positive impacts on subsidized trade (with tijk*(, U)/q > 0). This would
identify second-best conditions under which partial market liberalization is immiserizing.
This shows that the welfare effects of market liberalization become more complex in the presence
of both tariffs/subsidies and quotas in domestic and trade policy. For example, in the presence of export
tariffs, the analysis points to the importance of the cross-commodity effects of changing domestic
11
production quotas on trade. Such effects can lead to decreased efficiency associated with partial market
liberalization. This illustrates the usefulness of the results stated in propositions 3-4.
In addition, under differentiability and for a small change in  = (r, q), note that proposition 3 implies that
dW = r  dt*(, U) + iN jN Qij*(, U)  dqij + iN Qyi*(, U)  dqyi.
(14)
First, consider the case where q = . For any discrete change from r to r’, the fundamental theorem of
calculus gives
W(r’, U) - W(r, U) =
=

r'
r

r'
(W/r) dr,
r
r  dt*(, U),
using (14).
When starting from r = 0 and facing a single tariff change from 0 to rij’, this reduces to

W(rij’, U) - W(0, U) =
r'
= [rij tij*] |0ij -
rij'
rij dtij*(rij, U)
0

rij'
0
= [rij’ tij*(rij’, )] -
tij*(rij, U) drij, (using integration by parts)

rij'
0
tij*(rij, ) drij  0.
(15)
This gives two important results. First, any imposition of tariff tends to be inefficient (as it reduces
aggregate welfare). Second, the aggregate welfare change can be measured easily from the general
equilibrium function tij*(rij, ). From (15), the welfare change is equal to the tariff revenue [rij’ tij*(rij’, )]
minus the area to the left of the general equilibrium function tij*(rij, ) and between rij = 0 and rij = rij’.
Second, consider the case where r = 0. For any discrete change from q to q’, the fundamental theorem of
calculus gives
W(q’, U) - W(q, U) =
=

q'
q

q'
(W/q) dq,
q
Q* dq,
using (14). When facing a single quota change fromq (where the quotaq is “large enough” not be
binding) to qij’, this reduces to
W(qij’, U) – W(q, U) =

q ij'
q
Qij*(qij, ) dqij  0.
This gives two important results. First, imposing any quota tends to be inefficient (as it reduces aggregate
welfare). Second, the aggregate welfare change can be measured easily from the general equilibrium quota
rent Qij*(qij, ). The welfare change is equal to the area below the general equilibrium quota rent Qij*(qij, )
and between qij =q and qij = qij’.
5.4. The welfare effects of market liberalization policies
The above results evaluate the welfare effects of economic and trade policy (as reflected by the
policy instruments  = (r, q)). In the presence of competitive markets, such policies are typically
inefficient (as they generate a decline in aggregate welfare). This is expected. Since competitive markets
generate Pareto efficient allocations (from the welfare theorems), any policy that “distorts” competitive
markets are necessarily inefficient. This argument is often used to support market liberalization policies.
But denying any role for non-market institutions appears extreme.
To evaluate the limitations of competitive markets, three factors play important roles: transaction
costs, externalities and non-convexity.
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5.4.1. The role of transaction costs
The above analysis was developed under transaction costs. Thus, the presence of transaction costs
does not invalidate the above arguments. We have seen that transaction costs have two effects: 1/ the “law
of one price” no longer holds; and 2/ they limit exchange. Thus, seeing the absence of exchange in general
(and markets in particular) can be consistent with Pareto efficiency (when such absence is due to high
transaction costs). In that sense, the absence of competitive markets (e.g., risk markets) is not sufficient to
motivate government policy. And the limitations of markets can be balanced by the use of contracts.
Which institutional form is more appropriate depends in part on the nature and magnitude of transaction
costs: attaining economic efficiency implies the minimization of transaction costs. This stresses the need
for an evaluation of transaction costs under alternative economic institutions at the firm and household
levels, at the regional level, at the national level, and at the international level.
5.4.2. The role of externalities
As we have seen, externalities have adverse affect on the ability to decentralize decisions. But
under convexity, they do not invalidate profit maximization (e.g., the Coase theorem supports the validity
of aggregate profit maximization in support of Pareto efficiency). The challenge is with the development of
a coordination scheme that can implement efficient allocation. This can be done by mergers, by private
contracts, or by public policy. Which solution is most appropriate is specific to the source and nature of
externalities. In addition, the relative efficiency of each scheme is likely to depend on the associated
transaction cost. This indicates the presence of significant interactions between externality management and
transaction costs.
5.4.3. The role of non-convexity
Non-convexity provides a fundamental challenge to competitive markets. The simplest example is
given by the presence of fixed costs. Fixed costs typically induce increasing returns to scale (IRTS) at least
in the region of “small scale” of operation. Under IRTS, firms cannot survive in standard competitive
markets. Indeed, with average cost being larger than marginal cost under IRTS, marginal cost pricing
implies negative profit, providing no incentive for competitive firms to produce. Trying to find solutions to
this problem include monopolies (e.g., patents in R&D), regulated monopolies (e.g., utilities), price
discrimination (private or publicly administered), subsidized industry (e.g., “infant industry” protection),
and government policy (e.g., research, infrastructure). Evaluating the relative efficiency of these alternative
schemes is a good area for further research (e.g., which price discrimination scheme can implement a
Pareto efficient allocation?).
Note that there are scenarios where globalization can help solve non-convexity issues. This occurs
in industries where technology exhibits both IRTS (for “small” firm sizes) and constant returns to scale
(CRTS) for firms of larger size. When the local market is smaller than a “scale-efficient firm” (defined as
the smallest firm size exhibiting CRTS), then a competitive firm would have no incentive to produce (being
in the region of IRTS where competitive profit is negative). However, globalization can be associated with
an increase in market size that is large enough to exceed a “scale-efficient” firm size and thus support a
competitive industry.
Example 1: Consider the case of utilities traditionally managed as regulated monopolies. Then
globalization means that local markets are turned into a global market that may become larger than a
“scale-efficient firm”. If this is the case, globalization can induce firms to produce in the CRTS region, with
competitive markets supporting an efficient allocation.
Example 2: Consider the case of a developing country trying to develop one of its industries. The
presence of fixed cost may mean that its “infant industry” is “small” and produces in the IRTS region
(meaning that a competitive industry cannot generate positive profit). One solution is a protectionist
economic policy (including domestic subsidy and/or restrictive trade policy) with a focus on the “small”
domestic market (e.g., as seen in “import substitution policies”). Another solution is an “export oriented
policy” where the focus is to produce for the larger world market, with the intent to “grow” the industry
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into the region of CRTS, where profit is non-negative and competitive markets can support an efficient
allocation.
5.4.4. Relative welfare effects of market liberalization
Our analysis suggests that competitive markets have the ability to support a Pareto efficient
allocation. Competitive markets have the additional advantage of allowing for decentralized decisionmaking in the absence of externalities. These are strong arguments in favor of competitive market
allocations. But how does that compare with non-market allocations? What are the relative gains from
competitive market allocations? The answer depends on the alternative non-market institutions being
evaluated. A partial answer to these questions is obtained by looking at the welfare gains obtained by
switching from some “distorted markets” to competitive markets. When considering the distortions
generated by traditional economic policy (e.g., domestic subsidies, import tariffs, production and trade
quotas), the answer is: the welfare gains from “market liberalization policy” tend to be less than 10 percent
(and often less than 2-3 percent). See homework #4 and #5. This seems “rather small.” Could that mean
that we are missing something important in traditional welfare analyses?
5.4.5. Need for a broader approach
How do the estimated gains from market liberalization policy compare to other estimates of
efficiency gains? Estimates of technical and allocative inefficiency can be large (see homework #1 and 3).
So are the estimates of productivity growth from technological progress (see homework #2). Over the last
century, technological progress has generated productivity growth of the order of 1-2 percent per year in
many industries (e.g., the case of agriculture in the U.S., Europe or Asia). This suggests that over decades,
the efficiency gains from productivity growth dwarf the estimated gains from market liberalization. This
also suggests that a large part of long-term economic growth comes from technological progress.
Does that mean that the benefits of market liberalization are “small”? Not necessarily. It may just
mean that economists have underestimated the benefits from market liberalization. This underestimation
may have three sources: 1/ Market liberalization studies have typically assumed that all firms are
technically and allocatively efficient; 2/ There is much evidence of heterogeneity in technical and
allocative efficiency among firms; and 3/ Market liberalization policies may help reduce the technical and
allocative inefficiency of firms (by forcing out inefficient firms and/or speeding up the adoption of new
technologies). There is empirical evidence supporting these arguments.
This suggests a need for a broader approach involving an integrated analysis of economic
efficiency, going from firm-level technical and allocative efficiency to aggregate-level efficiency, and
including the role of both markets and non-market institutions. This also indicates a need to focus on the
role of human capital in improving managerial abilities, in stimulating technological and institutional
innovations, and in supporting long-term economic growth and development.
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