SFB 303 Discussion Paper No. A - 47
Author: Peters, Wolfgang
Title: Cost Inefficiency and Second Best Pricing
Abstract: It is a well-known and widespread opinion that public production in reality is neither cost nor
production efficient, i.e. the commodities are not produced at minimum costs, and, additionally, that the realized
production plan will lie below the production possibility frontier. Such an initial situation is always perceived as
suboptimal, and therefore most politicians believe in the necessity of cost efficient public production for a
welfare optimum. But the reason for production efficiency is that welfare maximization contradicts any kind of
waste. As this paper will show, advising the management of public enterprises to produce at minimum costs,
leads to welfare losses.
We shall see that, in general, second best pricing requires cost inefficient public
prediction, and cost minimizing factor usage is guaranteed to be welfare optimal in special cases alone. This is a
counter-intuitive result and should therefore be extensively explained. But the question, how to run the public
sector, should not be answered under the aspect of cost inefficiency only. Hence, it is an important task to find
practicable rules to advise the management of a public enterprise which take care of the remarkable effects
presented in the paper.
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