Public Finance, 2nd Edition

based taxes and transfers are lump sum. Therefore, the assumption that the

government can pursue an optimal lump-sum redistribution policy is heroic

in the extreme. Nonetheless, public sector economists have been quite willing

to employ the assumption of optimal lump-sum redistributions to analyze

allocational policy questions in a Wrst-best framework.

FIRST-BEST ANALYSIS

First-best analysis means that the government has a suYcient set of policy

tools for whatever problems may exist to restore the economy to the bliss

point on its Wrst-best utility-possibilities frontier. By the `Wrst-best' utility-

possibilities frontier, we mean the locus of pareto-optimal allocations con-

strained only by three fundamentals of any economy: individual preferences,

production technologies, and market clearance.

2

The required set of policy tools is broad indeed. If the analysis occurs

within the context of a market economy, it is understood either that all

markets are perfectly competitive or that the government can adjust behav-

ior in noncompetitive markets to generate the perfectly competitive results.

Faced with a breakdown in one of the technical assumptions discussed in

Chapter 1, the government must be able to respond with a policy that restores

Wrst-best pareto optimality. As we shall discover in Part II, the required

policy responses may be exceedingly complex, enough so that they have little

hope of practical application. Finally, the government must employ optimal

lump-sum redistributions to equalize social marginal utilities of consumption

(income) at the Wrst-best bliss point.

The Two Dichotomies in First-Best Models

What is the attraction of Wrst-best analysis, given its stringent and unrealistic

assumptions? The answer is that Wrst-best analysis is really the only way to

analyze the particular allocation problems caused by breakdowns in the

technical assumptions and market imperfections in and of themselves. Con-

sider, Wrst, the role of lump-sum redistributions in this regard.

If lump-sum redistributions are feasible, then the problem of social

welfare maximization dichotomizes into separate eYciency and distributional

Papers and Proceedings, May 1976. The Tax Reform Act of 1986 led to renewed interest in these

elasticities. See A. Auerbach and J. Slemrod, ``The Economic EVects of the Tax Reform Act of

1986,'' Journal of Economic Literature, June 1997.

2

If some factors or production are supplied in absolutely Wxed amounts, they, too, act as

constraints on the set of attainable utility possibilities. Recall that the general equilibrium model

of Chapter 2 assumes variable factor supplies so that, formally, consumers' disutility from

supplying factors enters as an argument of the social welfare objective function rather than as

a constraint.

3. FIRST-BEST AND SECOND-BEST ANALYSIS AND THE POLITICAL ECONOMY 67