Public Finance, 2nd Edition

To summarize, second-best public expenditure theory has oVered the

severest possible challenge to the long-standing Wrst-best orthodoxy in the

attempt to make public sector theory more realistic. The second-best rules

often bear no clear-cut relationship to their long-standing Wrst-best counter-

parts. These challenges notwithstanding, the Wrst-best results of public ex-

penditure theory have hardly disappeared. They still dominate undergraduate

textbooks on public sector economics and they instruct much actual policy

debate. The staying power of Wrst-best analysis is no doubt due to the intuition

it provides about allocational and distributional issues and its call for limited

government intervention. In contrast, second-best policy rules tend to be

resisted as normative policy prescriptions, since they contain the problematic

social welfare terms, they tend to call for broad intervention in the economy,

and the policy rules are so sensitive to the form and number of constraints. The

relative advantages of the Wrst-best results must always be weighed against

the blatant unrealism of the Wrst-best models in a policy context.

SIMILARITIES BETWEEN FIRST-BEST AND

SECOND-BEST ANALYSIS

The numerous diVerences between Wrst-best and second-best public sector

analysis should not obscure the fact that the two approaches are virtually

identical in method and philosophy. The challenge to Wrst-best orthodoxy is

contained in the Wrst-order conditions of the second-best models. One would

certainly not want to minimize the importance of this challenge, since the

Wrst-order conditions translate directly into normative policy rules. But

second-best analysis hardly represents a methodological or philosophical

departure from Wrst-best theory. All it does is attach some additional con-

straints to the basic Wrst-best neoclassical general equilibrium model in an

attempt to be more realistic. This is not revolutionary. For instance, second-

best analysis retains the fundamental notion that the government is interested

in social welfare maximization, with social welfare indexed by means of an

individualistic Bergson±Samuelson social welfare function. In principle,

then, second-best analysis honors consumer sovereignty to the same degree

as Wrst-best analysis, even though its results are less clear cut in this regard.

Furthermore, second-best research has generally remained closely allied with

the competitive market system, so much so that the following standard

competitive market assumptions are commonplace in second-best models:

1. Consumers maximize utility subject to a budget constraint and have

no control over any prices.

2. Private sector producers are decentralized price-taking proWt

maximizers such that goods prices equal marginal costs and factor

prices equal the values of marginal products.

3. FIRST-BEST AND SECOND-BEST ANALYSIS AND THE POLITICAL ECONOMY 79