12. A Theoretical Framework of Mixed Systems

The fundamental theorems of welfare economics prove under stringent conditions that the free market mechanism leads to the efficient allocation of economic resources. It is highly regarded as a theoretical underpinning of the “invisible hand” (Adam Smith), but generally inapplicable to the real economies in modern societies where externalities abound that cannot be addressed by the market mechanism. First, social needs for public goods are increasing in the face of rapid industrialization and urbanization. They call for construction and maintenance of stronger industrial infrastructure and further improvement of environmental and educational facilities. Second, governments are often required to employ taxes and subsidies to alleviate pollution, congestion, and depletion of natural resources stemming from Marshallian externalities interacted among a large number of citizens. The purpose of this chapter is to provide a comprehensive theoretical framework for mixed economies facing the problems of externalities and public goods.