Public Finance, 2nd Edition

distributional considerations and from all the other conditions within the

economy that are required for pareto optimality. This property justiWes the

use of very simple general equilibrium models that focus exclusively on one

source of market failure and describe the rest of the economy by means of a

single composite commodity that is assumed to be marketed competitively.

Assuming a Wrst-best policy environment is a tremendous analytical conveni-

ence.

SECOND-BEST ANALYSIS

Suppose, realistically, that lump-sum taxes and transfers are not available to

the government, at least not with suYcient Xexibility to generate the interper-

sonal equity conditions of the standard model. This changes the analysis

rather drastically. To see why, consider two government policy strategies in

the context of a market economy, one designed to produce distributive

equity, the other designed to restore Wrst-best pareto optimality.

Constrained Social Welfare Maximization

Suppose that the government chooses to redistribute income until social

marginal utilities are equalized by using taxes and transfers that are not

lump sum.

4

The redistribution necessarily introduces distortions into the

economy because some consumers and/or producers now face diVerent prices

for the same goods and/or factors. Since consumers and producers equate

relative prices to their marginal rates of substitution and transformation,

respectively, and since pareto optimality requires that the marginal rate of

substitution (MRS) equals the marginal rate of transformation (MRT), some

of the pareto-optimal conditions no longer hold. The redistribution forces the

economy beneath its Wrst-best utility-possibilities frontier.

Suppose instead that the government focuses only on allocational prob-

lems and chooses allocational policies designed to bring society to the Wrst-

best utility-possibilities frontier.

5

Without simultaneously employing lump-

sum redistributions, however, the economy would not be at the bliss point, in

general. The government may actually choose some policy mix designed to

move the economy somewhat closer to full pareto optimality, and somewhat

closer to distributive equity, but the point remains that removing the possi-

bility of feasible lump-sum redistributions restricts the set of solutions avail-

able to the government, for example, to the shaded portion in Fig. 3.1. The

viable allocations and distributions may or may not include points on the

4

Assume it is possible to equalize social marginal utilities without lump-sum redistribu-

tions. It may not be, given the available policy tools.

5

Again, assume this is possible.

3. FIRST-BEST AND SECOND-BEST ANALYSIS AND THE POLITICAL ECONOMY 71

1

U

2

U

B

2

W

FIGURE 3.1

Wrst-best utility-possibilities frontier, but, importantly, they deWnitely exclude

the bliss point, point B. The policy problem now becomes one of Wnding the

best policy option within this restricted set of opportunities. As such it is part

of second-best analysis,deWned as the analysis of optimal public sector policy

given that the bliss point on the Wrst-best utility possibilities frontier is

unattainable.

One immediate implication of second-best public expenditure analysis is

that government policy should not necessarily try to keep society on its Wrst-

best utility-possibility frontier. Points other than those on the Wrst-best

frontier may yield greater social welfare within the restricted set of policy

alternatives. To see this, refer to Fig. 3.2.

Suppose society is initially at point A in Fig. 3.2, possibly because one of

the technical assumptions of Chapter 1 has failed and the competitive market

is therefore generating the wrong allocation of resources. If lump-sum redistri-

butions were feasible and the world were otherwise Wrst best, the government

should design policies to restore full pareto optimality and redistribute lump

sum to achieve the bliss point, point D in the Wgure. In a second-best environ-

ment, without the ability to redistribute lump sum, the policy option that

brings society to point B on the Wrst-best frontier is dominated by another

option that keeps society below the frontier, point C. Society's goal is still the

maximization of social welfare, reaching the highest possible social welfare

indiVerence curve. Point C is the maximum attainable level of social

welfare given the restricted set of available options. Point B is pareto

72 SECOND-BEST ANALYSIS