Policy Analysis in a Second-Best World

This paper first describes the new literature in environmental economics on the socalled "double dividend" and then explores its implications for a broad range of economic issues. The basic finding in this literature is that in a second-best, general equilibrium setting, environmental measures raise costs and prices and thereby reduce the real wage. This rise in the cost of living reduces slightly the quantity of labor supplied in an already highly distorted labor market, giving rise to losses in social welfare that can be large relative to the basic welfare gains from improved environmental policy. These losses may be offset to some extent by using revenues (if any) from the environmental programs to reduce existing taxes on labor. This same line of analysis applies to many programs and institutions in the economy that raise the cost of living: tariffs and quotas on imports, agricultural price-support programs, monopoly pricing, programs of occupational licensure that limit entry, and many others. The paper thus suggests that traditional, partial equilibrium benefit-cost analysis has, in many instances, unwittingly omitted a potentially quite significant class of social costs from the calculations.