Optimal policies in a three sector economy with open unemployment and surplus labor

This article analyzes a three-sector economy with a significant subsistence sector. Previous studies essentially derived first-best conditions based on an optimal subsidy system where technical efficiency is achieved. In our model, technical efficiency cannot exist from within our system. A unique feature of our model is the existence of an endogenous subsidy implying that a full-employment subsidy can only be non-uniform. Adjustment in the endogenous subsidy by the amount of wage differentials will equalize wage rates in the market economy. Full employment can be achieved if and only if the marginal products of the two modern sectors are equalized with the subsistence wage. That is, significant reduction of the subsistence sector is a necessary and sufficient condition for acquiring full employment in a three-sector economy