Public Finance, 2nd Edition

12

INTRODUCTION TO SECOND-

BEST ANALYSIS

A BRIEF HISTORY OF SECOND-BEST THEORY

Second-Best Tax Theory

Second-Best Expenditure Theory

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PHILOSOPHICAL AND METHODOLOGICAL UNDERPINNINGS

PREVIEW OF PART III

First-best analysis oVers us a complete, internally consistent normative

theory of the public sector, yet the theory is far from satisfactory. It is often

quite unrealistic and therefore unresponsive to the needs of policymakers.

First-best models ignore a number of important real-world phenomena that

the policymaker cannot ignore.

The strengths and weaknesses of Wrst-best theory derive from a common

source, that the only restrictions on a Wrst-best policy environment are the

two sets of restrictions inherent in any economic system: the underlying

production relationships and market clearance for all goods and factors. In

particular, those sectors of the market economy not subject to government

intervention are assumed to be perfectly competitive, and the admissible set

of government policy tools includes anything necessary to achieve a social

welfare maximum. The government can redistribute any good or factor lump

sum; it can change the price of any good or factor to consumers or Wrms; it

can commandeer inputs and supply outputs at will, subject as always to given

production relationships and market clearance; and it has perfect informa-

tion about preferences, technologies, and markets. In short, the government

has suYcient degrees of freedom to achieve Bator's bliss point, the social

welfare maximum. It can design whatever policies are necessary to restore

387

pareto optimality and bring society to its Wrst-best utility-possibilities fron-

tier. Then it can move society along the frontier to the bliss point by means of

lump-sum redistributions that satisfy the interpersonal equity conditions.

Second-best analysis is a reaction to these heroic Wrst- best assumptions.

In an attempt to be more realistic, it posits at least one additional constraint

on the policy environment. The constraint(s) can be on the underlying market

environment, on the set of admissible government policy tools, or on the

information available to the government. An immediate implication is that

the search for the social welfare maximum covers a restricted set of alloca-

tions and distributions relative to Wrst-best theory, illustrated by the shaded

portion in Fig. 12.1. The deWning diVerence from Wrst-best analysis is that the

restricted set cannot include point B, Bator's bliss point, because adding

binding restrictions must reduce the maximum attainable level of social

welfare. Whether or not any points on the Wrst-best utility-possibilities fron-

tier are feasible depends on the nature of the additional constraints, but such

points might not be policy relevant anyway. As illustrated in Fig. 12.1, point

AonU

2

U

1

is dominated by any point within the shaded portion and

above the social welfare indiVerence curve W

1

.

The entire thrust of second-best analysis is toward increased realism. For

instance, second-best theory recognizes that governments cannot redistribute

income lump-sum. Taxes and transfers conditioned on income are almost

always distorting. Similarly, all market economies contain some monopoly or

monopsony elements that are unlikely to disappear in the foreseeable future.

1

U

2

U

B

3

W

1

W

A

FIGURE 12.1

388 12. INTRODUCTION TO SECOND-BEST ANALYSIS