Quasi Optimality: The Price We Must Pay for a Price System

The paper argues that, in the absence of lump-sum payments, a Pareto optimum is achievable by marginal-cost pricing and/or competitive equilibrium only when the boundary of the social production set happens to be linearly homogeneous near that optimal solution. Thus, contrary to widespread belief, both diminishing and increasing returns can be incompatible with achievement of optimality via parametric prices. Generally, the best that any set of fixed prices can achieve is the Ramsey solution constrained by Walras's law. The resulting welfare loss is the price society must pay for using a price system to allocate resources.