Public Finance, 2nd Edition

Chapter 2 presents a baseline ``textbook'' version of the basic general

equilibrium model that is used to develop normative public sector decision

rules. The chapter emphasizes how the norms described in Chapter 1 are

incorporated into the formal model.

Chapter 3 concludes the introductory material with two methodological

points. The Wrst point is the distinction between Wrst-best and second-best

analysis. First-best analysis assumes that a government is free to pursue

whatever policies are necessary to reach society's economic goals. It is re-

stricted only by the two natural fundamentals inherent in any economy:

individuals' preferences over goods and factor supplies and the available

production technologies for turning inputs into outputs. Second-best theory

assumes, more realistically, that a government is constrained beyond the two

fundamentals in pursuing society's goals. For example, a government may

lack the information it needs about individuals' preferences or production

technologies to design Wrst-best policies, or it may be forced to use certain

kinds of taxes that distort economic decisions.

The second methodological point relates to the political content of the

baseline general equilibrium model developed in Chapter 2. The discussion

centers on the General Impossibility Theorem of Kenneth Arrow, another

Nobel laureate in economics. Arrow's theorem, which he published in 1951,

stands as one of the landmarks results of twentieth-century political philoso-

phy.

1

He proved that, in general, the political decisions needed to achieve any

social objective, economic or otherwise, cannot be made in a manner that

would be acceptable to a democratic society. This was a devastating blow to

the concept of a democratic or representative government. Any normative

economic theory of the public sector must acknowledge the huge political

shadow cast over it by Arrow's theorem.

THE FUNDAMENTAL NORMATIVE QUESTIONS

A normative economic theory of the public sector addresses four fundamen-

tal questions:

1. The primary normative question, upon which all others turn, is the

question of legitimacy: In what areas of economic activity can the govern-

ment legitimately become involved? The legitimacy question points to the

expenditure side of government budgets, asking what items we should expect

to Wnd there and why.

2. Once the appropriate sphere of government activity has been deter-

mined, the next question concerns how the government should proceed.

What decision rules should the government follow in each area?

1

K. Arrow, Social Choice and Individual Values, Wiley, New York, 1951.

1. INTRODUCTION TO NORMATIVE PUBLIC SECTOR THEORY 5