Optimal regulation under fixed rules for income distribution (Q1099759)

It is by now well known that if arbitrary lump sum transfers are feasible, then the optimal regulation of firms involves marginal cost pricing. Here, we consider optimal regulation in an economy in which lump sum taxation is possible but the income distribution is, in some sense, fixed. We show that under certain conditions, production efficiency and marginal cost pricing are desirable. In general, however, this need not be the case. In an economy with increasing returns, it is possible that the second best utility possibility frontier is strictly dominated by the Pareto frontier and none of the marginal cost pricing equilibria lie on the second best frontier.