Average-cost pricing, increasing returns, and optimal output in a model with home and market production

The analysis of economies of specialization at the individual level by Yang & Shi (1992) and Yang & Ng (1993) is combined with the Dixit & Stiglitz (1977) analysis of monopolistic-competitive firms to show that, ignoring administrative costs and indirect effects (such as rent-seeking), even if both the home and the market sectors are produced under conditions of increasing returns and there are no preexisting taxes, it is still efficient to tax the home sector to finance a subsidy on the market sector to offset the under-production of the latter due to the failure of pricetaking consumers to take account of the effects of higher consumption in reducing the average costs and hence prices, through increasing returns or the publicness nature of fixed costs. Within market production, it is efficient to subsidise more the sector with a higher fixed cost, a lower elasticity of substitution between goods, and a lower degree of importance in preference which all increases the degree of increasing returns.