Public Finance, 2nd Edition

2

A GENERAL EQUILIBRIUM MODEL

FOR PUBLIC SECTOR ANALYSIS

A BASELINE GENERAL EQUILIBRIUM MODEL

Individual Preferences

Production Technologies

Market Clearance in the Aggregate

EFFICIENCY: THE PARETO-OPTIMAL CONDITIONS

EQUITY: THE SOCIAL WELFARE FUNCTION AND OPTIMAL

DISTRIBUTION OF INCOME

The Bergson-Samuelson Social Welfare Function

Limitations of the Social Welfare Function

MAXIMIZING SOCIAL WELFARE

Necessary Conditions for Social Welfare Maximization

The First-Best Efficiency-Equity Dichotomy

The Pareto-Optimal Conditions

Pareto Optimality and Perfect Competition

The Interpersonal Equity Conditions

POLICY IMPLICATIONS AND CONCLUSIONS

Chapter 2 develops a baseline analytical model of an economy, variations

of which have been used for almost all mainstream public sector analysis.

A model must possess four attributes to be useful as a framework for a

normative theory of the public sector. First, it must be a general equilibrium

model of the economy. All general equilibrium models describe the three

fundamental elements of any economy: (1) the preferences of every con-

sumer, (2) the production technologies and (3) market clearance for all

goods and services and factors of production. A particular model may

contain other features as well, but the three fundamentals must be present

to have a valid general equilibrium model. Second, the model must be Xexible

enough to consider a broad spectrum of public sector problems, particularly

those associated with externalities, decreasing cost production, asymmetric

information, the distribution of income, and various issues in the theory of

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