The Theory of Water and Utility Pricing - Global Drinking Water Management and Conservation - page 82

part of the research agenda of the New Public Economics, which started with the
publication of the work of Mirrlees ( 1971 ). Much of the new research in public
economics, inspired by Ramsey

that is Pareto-
wise improving, shows that policy makers and state tax authorities face asymmetric
informational constraints which means that the

' is idea of a “ second-best solution ”

redistribution envisaged
by the Second Theorem of Welfare Economics is just not possible. This is partly
because the framers of the Second Theorem, in their zeal for justifying a decen-
tralized free enterprise economy, ignored the fact that the Second Theorem was
incentive-incompatible, and therefore essentially vacuous. This has now led
researchers like Guesnerie ( 1994 ) and Boadway ( 1997 ) to conclude that society

“ optimal ”

' s

second-best ef ciency frontier lies everywhere inside the first-best frontier. This

result is important enough to be called a new ”

that should replace the Second Theorem of Welfare Economics; I shall call it the
Third Theorem of (Public) Welfare Economics, a theorem that is the logical result of
the whole new public economics originating with the work of Professor James
Mirrlees.
Given the Third Theorem, most policy rules applicable to

“ theorem of new public economics

first-best economies
no longer apply for real economies: social values (or shadow prices) differ from
market prices; the standard

first-best Samuelson rules (for public expenditures) are
generally no longer valid; and quantity controls may be ef cient policy instruments.

But there is more bad news: in a dynamic world, even this second-best frontier
becomes unattainable. An important property of second-best policies in dynamic
economies is that they are generally not time-consistent or sub-game perfect.
Adding the requirement of sub-game perfection along with incentive compatibility
restricts the economy to a ciency frontier, which is inside the sec-

ond-best one, wherever self-selection constraints bind. Not surprisingly, policies
that might not have been sensible in a second-best world now become justi

“ third-best ” ef

able in
a third-best one. These policies include many of the things that we observe in the
real world such as in-kind transfers, quotas, minimum wages, rules for taxation-
induced forced saving for retirement, various sorts of investment subsidies, and
redistributional measures, such as subsidized drinking water, and the provision of
free quasi-public goods such education and free medical care. In fact in the case of
drinking water, an essential good for consumption and health, a negative con-
sumption tax (i.e. a subsidy) is an obvious necessity. If any subsidy is at all
justi ed, it is likely to be for drinking water. However, in the present low-tax

climate it is unlikely to happen, although in some local jurisdictions in the US and
also in Australia, equity considerations do seem to affect water-pricing decisions, as
we shall see below in Sects. 5.7.1 and 5.7.3 .
Nevertheless, the dominant trend in water pricing is that the water utility
achieves at least complete cost recovery, including the recovery of capital costs, as
the capital will have to be replaced when the capital equipment is worn out. Hence
Ramsey pricing becomes of practical relevance. Below we continue the exposition
of Ramsey pricing.