The Optimality of Arbitrary Partial Equilibrium Welfare Analysis

Abstract

This paper characterizes the general equilibrium foundation of arbitrary partial equilibrium welfare analysis in second-best economies. While prior theory recognizes the importance of market distortions affected by relative price changes, it offers little guidance about the necessary scope of Marshallian partial equilibrium analysis. The paper determines necessary and sufficient conditions for optima of Marshallian total surplus functions to characterize second-best Pareto-optimal allocations. While these conditions confirm much of the traditional approach to applied welfare economics, they bring doubt about its reliability for public policy and concerns over its systematic use to build conventional economic wisdom. Copyright 2006 Blackwell Publishing Inc..