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INTERMEDIATE PUBLIC ECONOMICS
second edition
INTERMEDIATE PUBLIC ECONOMICS
second edition

Jean Hindriks and Gareth D. Myles

The MIT Press

Cambridge, Massachusetts
London, England
© 2013 Massachusetts Institute of Technology

All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical
means (including photocopying, recording, or information storage and retrieval) without permission
in writing from the publisher.

MIT Press books may be purchased at special quantity discounts for business or sales promotional use.
For information, please email [email protected] or write to Special Sales Department,
The MIT Press, 55 Hayward Street, Cambridge, MA 02142.

This book was set in Times New Roman by Westchester Books group. Printed and bound in the United
States of America.

Library of Congress Cataloging-in-Publication Data

Hindriks, Jean.
Intermediate public economics / Jean Hindriks and Gareth D. Myles.–2nd ed.
p. cm.
Includes Index.
ISBN 978-0-262-01869-2 (hardcover : alk. paper)
1. Welfare economics 2. Finance, Public 3. Economic policy. I. Myles, Gareth D. II. Title.
HB846.5.H56 2013
336′ .001—dc23
2012029292

10 9 8 7 6 5 4 3 2 1
pour mon épouse Ewa et mes enfants (JH)
to the memory of my parents (GDM)
Contents

Preface to Second Edition xxi

Preface to First Edition xxiii
List of Figures xxv

I PUBLIC ECONOMICS AND ECONOMIC EFFICIENCY

1 An Introduction to Public Economics 3

1.1 Public Economics 3
1.2 Methods 3
1.3 Analyzing Policy 5
1.4 Preview 6
1.5 Scope 9
2 Equilibrium and Efficiency 13
2.1 Introduction 13
2.2 Economic Models 13
2.3 Competitive Economies 14
2.4 The Exchange Economy 15
2.5 Production and Exchange 22
2.6 Efficiency of Competition 26
2.6.1 Single Consumer 27
2.6.2 Pareto-Efficiency 31
2.6.3 Efficiency in an Exchange Economy 33
2.6.4 Extension to Production 37
2.7 Lump-Sum Taxation 39
2.8 Discussion of Assumptions 41
2.9 Summary 43
3 Behavioral Economics 51
3.1 Introduction 51
3.2 Behavioral Individuals 53
3.2.1 Simple Example: How Much to Save? 53
3.2.2 Present-Bias 54
3.2.3 The (β, δ) Model of Self-Control 55
3.2.4 Reference-Dependence Bias 57
3.2.5 The Gambler’s Fallacy 58
viii Contents

3.2.6 Confirmation Bias 59

3.2.7 Confidence Bias 60
3.2.8 Framing Bias 60
3.2.9 Conformism Bias 62
3.2.10 Identity and Social Norms 63
3.3 Behavioral Markets 64
3.3.1 Money Pump 65
3.3.2 Complementary Mistakes 65
3.3.3 Rationality Tug-of-War 67
3.4 Behavioral Policy 67
3.4.1 Internalities versus Externalities 68
3.4.2 Automatic Enrollment 69
3.4.3 The SMarT Plan 69
3.4.4 Complementarity 70
3.5 Behavioral Welfare 71
3.5.1 New Welfare Criterion 71
3.5.2 Choice-Based Welfare Analysis 72
3.5.3 Refinement and Structural Modeling 73
3.5.4 Application: Global Warming 74
3.6 Other-Regarding Preferences 76
3.6.1 Ultimatum Game 76
3.6.2 Social Preferences 77
3.6.3 Market Impact 78
3.7 Conclusions 80

II GOVERNMENT

4 Public Sector Statistics 89

4.1 Introduction 89
4.2 Historical Development 89
4.3 Composition of Expenditure 94
4.4 Revenue 97
4.5 Government Debt 107
4.6 Measuring the Government 112
4.7 Conclusions 114
ix Contents

5 Theories of the Public Sector 119

5.1 Introduction 119
5.2 Justification for the Public Sector 119
5.2.1 The Minimal State 119
5.2.2 Market versus Government 121
5.2.3 Equity 122
5.2.4 Efficiency and Equity 123
5.3 Public Sector Growth 123
5.3.1 Development Models 123
5.3.2 Wagner’s Law 124
5.3.3 Baumol’s Law 125
5.3.4 A Political Model 126
5.3.5 Ratchet Effect 128
5.4 Excessive Government 129
5.4.1 Bureaucracy 130
5.4.2 Budget-Setting 132
5.4.3 Monopoly Power 133
5.4.4 Corruption 134
5.4.5 Government Agency 135
5.4.6 Cost Diffusion 137
5.5 Conclusions 138

III DEPARTURES FROM EFFICIENCY

6 Public Goods 147

6.1 Introduction 147
6.2 Definitions 148
6.3 Private Provision 150
6.4 Efficient Provision 154
6.5 Voting 156
6.6 Personalized Prices 159
6.7 Mechanism Design 163
6.7.1 Examples of Preference Revelation 163
6.7.2 Clarke–Groves Mechanism 166
6.7.3 Clarke Tax 168
6.7.4 Further Comments 169
x Contents

6.8 More on Private Provision 170

6.8.1 Neutrality and Population Size 170
6.8.2 Experimental Evidence 174
6.8.3 Modifications 176
6.9 Fund-Raising Campaigns 178
6.9.1 The Contribution Campaign 179
6.9.2 The Subscription Campaign 181
6.10 Conclusions 182
7 Club Goods and Local Public Goods 191
7.1 Introduction 191
7.2 Definitions 192
7.3 Single-Product Clubs 193
7.3.1 Fixed Utilization 194
7.3.2 Variable Utilization 196
7.3.3 Two-Part Tariff 197
7.4 Clubs and the Economy 199
7.4.1 Small Clubs 200
7.4.2 Large Clubs 200
7.4.3 Conclusion 207
7.5 Local Public Goods 208
7.6 The Tiebout Hypothesis 212
7.7 Empirical Tests 214
7.8 Conclusions 216
8 Externalities 223
8.1 Introduction 223
8.2 Externalities Defined 224
8.3 Market Inefficiency 225
8.4 Externality Examples 228
8.4.1 River Pollution 228
8.4.2 Traffic Jams 229
8.4.3 Pecuniary Externality 230
8.4.4 The Rat Race Problem 232
8.4.5 The Tragedy of the Commons 233
8.4.6 Bandwagon Effect 235
8.5 Pigouvian Taxation 236
8.6 Licenses 239
xi Contents

8.7 Internalization 241

8.8 The Coase Theorem 242
8.9 Nonconvexity 247
8.10 Conclusions 248
9 Imperfect Competition 255
9.1 Introduction 255
9.2 Concepts of Competition 256
9.3 Market Structure 257
9.3.1 Defining the Market 257
9.3.2 Measuring Competition 258
9.4 Welfare 260
9.4.1 Inefficiency 260
9.4.2 Incomplete Information 263
9.4.3 Measures of Welfare Loss 264
9.5 Tax Incidence 268
9.6 Specific and Ad valorem Taxation 274
9.7 Regulation of Monopoly 277
9.8 Regulation of Oligopoly 282
9.8.1 Detecting Collusion 282
9.8.2 Merger Policy 283
9.9 Unions and Taxation 285
9.10 Monopsony 286
9.11 Conclusions 288
10 Asymmetric Information 297
10.1 Introduction 297
10.2 Hidden Knowledge and Hidden Action 300
10.3 Actions or Knowledge? 301
10.4 Market Unraveling 302
10.4.1 Hazard Insurance 302
10.4.2 Government Intervention 305
10.5 Screening 307
10.5.1 Perfect Information Equilibrium 308
10.5.2 Imperfect Information Equilibrium 310
10.5.3 Government Intervention 313
10.6 Signaling 314
10.6.1 Educational Signaling 316
10.6.2 Implications 321
xii Contents

10.7 Moral Hazard (Hidden Action) 323

10.7.1 Moral Hazard in Insurance 323
10.7.2 Effort Observable 325
10.7.3 Effort Unobservable 326
10.7.4 Second-Best Contract 327
10.7.5 Government Intervention 329
10.8 Public Provision of Health Care 330
10.8.1 Efficiency 330
10.8.2 Redistributive Politics 332
10.9 Evidence 334
10.10 Conclusions 336

IV POLITICAL ECONOMY

11 Voting 345
11.1 Introduction 345
11.2 Stability 345
11.3 Impossibility 347
11.4 Majority Rule 350
11.4.1 May’s Theorem 350
11.4.2 Condorcet Winner 351
11.4.3 Median Voter Theorems 351
11.4.4 Multidimensional Voting 356
11.4.5 Agenda Manipulation 358
11.5 Alternatives to Majority Rule 361
11.5.1 Borda Voting 361
11.5.2 Plurality Voting 363
11.5.3 Approval Voting 363
11.5.4 Runoff Voting 364
11.6 The Paradox of Voting 365
11.7 The “Alabama” Paradox 371
11.8 Political Competition 372
11.8.1 Downsian Model 372
11.8.2 Policy Divergence 373
11.8.3 Multidimensional Competition 376
11.8.4 “Swing Voter” Politics 377
11.8.5 Citizen-Candidate Model 379
11.9 Conclusions 381
xiii Contents

12 Rent-Seeking 387
12.1 Introduction 387
12.2 Definitions 388
12.3 Rent-Seeking Games 390
12.3.1 Deterministic Game 391
12.3.2 Probabilistic Game 394
12.3.3 Free-Entry 396
12.3.4 Risk Aversion 397
12.3.5 Conclusions 398
12.4 Social Cost of Monopoly 398
12.5 Equilibrium Effects 401
12.6 Government Policy 404
12.6.1 Lobbying 404
12.6.2 Rent Creation 406
12.6.3 Conclusions 408
12.7 Informative Lobbying 408
12.8 Controlling Rent-Seeking 413
12.9 Conclusions 414

V EQUITY AND DISTRIBUTION

13 Optimality and Comparability 423

13.1 Introduction 423
13.2 Social Optimality 424
13.3 Lump-Sum Taxes 427
13.4 Impossibility of Lump-Sum Taxes 430
13.5 Redistribution In-Kind 434
13.6 Aspects of Pareto-Efficiency 436
13.7 Social Welfare Functions 440
13.8 Arrow’s Theorem 441
13.9 Interpersonal Comparability 443
13.10 Comparability and Social Welfare 446
13.11 Conclusions 450
14 Inequality and Poverty 457
14.1 Introduction 457
14.2 Measuring Income 458
14.3 Equivalence Scales 460
xiv Contents

14.4 Inequality Measurement 466

14.4.1 The Setting 467
14.4.2 Statistical Measures 467
14.4.3 Inequality and Welfare 475
14.4.4 An Application 480
14.5 Poverty 481
14.5.1 Poverty and the Poverty Line 482
14.5.2 Poverty Measures 483
14.5.3 Two Applications 488
14.6 Unequal Opportunities 489
14.6.1 Defining Equality of Opportunity 490
14.6.2 Measuring Equality of Opportunity 491
14.6.3 Equal-Opportunity Policy 491
14.7 Intergenerational Inequality 492
14.7.1 Measuring Issues 492
14.7.2 Causal Mechanisms 493
14.8 Conclusions 496

VI TAXATION

15 Commodity Taxation 505

15.1 Introduction 505
15.2 Deadweight Loss 506
15.3 Optimal Taxation 509
15.4 Production Efficiency 513
15.5 Tax Rules 515
15.5.1 Inverse Elasticity Rule 516
15.5.2 Ramsey Rule 517
15.6 Equity Considerations 521
15.7 Applications 523
15.7.1 Reform 524
15.7.2 Optimality 526
15.8 Efficient Taxation 528
15.9 Public Sector Pricing 530
15.10 Conclusions 531
16 Income Taxation 537
16.1 Introduction 537
16.2 Equity and Efficiency 538
xv Contents

16.3 Taxation and Labor Supply 539

16.4 Empirical Evidence 544
16.5 Optimal Income Taxation 547
16.6 Two Specializations 555
16.6.1 Quasi-Linearity 555
16.6.2 Rawlsian Taxation 559
16.7 Numerical Results 561
16.8 Voting over a Flat Tax 563
16.9 Conclusions 565
17 Tax Evasion 573
17.1 Introduction 573
17.2 The Extent of Evasion 574
17.3 The Evasion Decision 576
17.4 Auditing and Punishment 583
17.5 Evidence on Evasion 586
17.6 Effect of Honesty 588
17.7 Tax Compliance Game 590
17.8 Behavioral Models 593
17.9 Compliance and Social Interaction 599
17.10 Conclusions 600
18 Limits to Redistribution 607
18.1 Introduction 607
18.2 Revelation Principle 609
18.3 The Tax Principle 614
18.4 Tax Mix: Separation Principle 620
18.5 Capital Income Tax 624
18.6 Non–Tax Redistribution 626
18.7 Conclusions 628

VII MULTIPLE JURISDICTIONS

19 Fiscal Federalism 635

19.1 Introduction 635
19.2 Arguments for Multi-level Government 636
19.2.1 Costs of Uniformity 637
19.2.2 Tiebout Hypothesis 639
19.2.3 Distributive Arguments 640
xvi Contents

19.3 Optimal Structure: Efficiency versus Stability 640

19.4 Accountability 643
19.5 Risk-Sharing 646
19.5.1 Voluntary Risk-Sharing 646
19.5.2 Insurance versus Redistribution 649
19.6 Hard and Soft Budgets 650
19.7 Evidence on Decentralization 653
19.7.1 Decentralization around the World 653
19.7.2 Decentralization by Functions 655
19.7.3 Determinants of Decentralization 656
19.8 Conclusions 657
20 Fiscal Competition 665
20.1 Introduction 665
20.2 Tax Competition 665
20.2.1 Competitive Behavior 666
20.2.2 Strategic Behavior 667
20.2.3 Size Matters 673
20.2.4 Public Input Provision 674
20.2.5 Tax Overlap 676
20.2.6 Tax Exporting 677
20.2.7 Efficient Tax Competition 679
20.3 Income Distribution 681
20.3.1 Perfect Mobility 681
20.3.2 Imperfect Mobility 682
20.3.3 Race to the Bottom 685
20.4 Intergovernmental Transfers 686
20.4.1 Efficiency 686
20.4.2 Redistribution 689
20.4.3 Flypaper Effect 690
20.5 Evidence 691
20.5.1 Race to the Bottom 691
20.5.2 Race to the Top 693
20.5.3 Tax Mimicking 693
20.6 Conclusions 694
21 Issues in International Taxation 703
21.1 Introduction 703
xvii Contents

21.2 International Efficiency 704

21.2.1 Efficient Allocations 705
21.2.2 Markets and Efficiency 706
21.2.3 Taxation and Efficiency 708
21.3 Capital and Corporations 709
21.3.1 Capital Taxes 709
21.3.2 Corporate Taxation 711
21.3.3 Formula Apportionment 715
21.3.4 Summary 717
21.4 Transfer Pricing 717
21.5 Location 720
21.5.1 Locational Choice 721
21.5.2 Agglomeration Rents 722
21.5.3 Evidence 723
21.6 Harmonization of Taxes 725
21.7 Tax Principles 729
21.8 Tariff Policy 732
21.8.1 Welfare Cost of Tariffs 733
21.9 Trade Agreements 736
21.10 Conclusions 741

VIII ISSUES OF TIME

22 Intertemporal Efficiency 751

22.1 Introduction 751
22.2 Overlapping Generations 753
22.2.1 Time and Generations 753
22.2.2 Consumers 754
22.2.3 Production 755
22.3 Equilibrium 758
22.3.1 Intertemporal Equilibrium 759
22.3.2 Steady State 759
22.4 Optimality and Efficiency 762
22.4.1 The Golden Rule 762
22.4.2 Pareto-Efficiency 765
22.5 Testing Efficiency 769
22.6 Conclusions 770
xviii Contents

23 Social Security 775

23.1 Introduction 775
23.2 Types of System 776
23.3 The Pensions Crisis 778
23.4 The Simplest Program 781
23.5 Social Security and Production 783
23.6 Population Growth 787
23.7 Sustaining a Program 790
23.8 Ricardian Equivalence 794
23.9 Social Security Reform 797
23.10 Conclusions 802
24 Economic Growth 809
24.1 Introduction 809
24.2 Exogenous Growth 810
24.2.1 Constant Savings Rate 810
24.2.2 Optimal Taxation 817
24.3 Endogenous Growth 823
24.3.1 Models of Endogenous Growth 824
24.3.2 Government Expenditure 826
24.4 Policy Reform 829
24.5 Empirical Evidence 833
24.6 Conclusions 837

IX APPLICATIONS

25 Cost–Benefit Analysis 847

25.1 Introduction 847
25.2 What Is Cost–Benefit Analysis? 848
25.2.1 Simple Example 849
25.2.2 Broader Approach 850
25.3 The Process of CBA 851
25.3.1 Discounting Future Values 853
25.4 Principles of CBA 856
25.4.1 Common Unit of Measurement 856
25.4.2 Revealed Preferences 857
25.4.3 Valuing Market Goods: Marshallian Surplus 858
xix Contents

25.4.4 Valuing Non-market Goods: Hedonic Prices 859

25.4.5 Impact Assessment 860
25.4.6 Decision Criteria 861
25.4.7 Difficulties for CBA 862
25.5 Valuing Life 865
25.6 Valuing the Future 869
25.6.1 Intertemporal Arbitrage 870
25.6.2 The UK Green Book 873
25.6.3 Adjustment for Risk 875
25.7 Theoretical Foundations of CBA 876
25.7.1 Social Welfare Evaluation 877
25.7.2 Distributive Weights 882
25.7.3 Market Prices and Shadow Prices 883
25.8 Conclusions 889
26 Economics of Climate Policy 895
26.1 Introduction 895
26.2 Special Features 897
26.3 The Science of Global Warming 900
26.3.1 Greenhouse Gases and Temperatures 900
26.3.2 Controversies 904
26.3.3 Predictions 907
26.4 Integrating Economics and Climate 910
26.4.1 Sources of Damage 911
26.4.2 Modeling Economic Damage 912
26.4.3 Effects of Policy 915
26.5 Competing Generations 917
26.6 Ecological Discounting 924
26.7 Climate Policy in Practice 929
26.7.1 Pricing and Policies 929
26.7.2 The EU Emissions Trading Scheme 931
26.7.3 International Agreements 934
26.7.4 Prices or Quantities 937
26.7.5 Further Policies 939
26.8 Conclusions 940

Index 947
Preface to Second Edition

We have been very pleased with the reception given to the first edition of Intermediate
Public Economics. We wish to thank all our colleagues in universities across the world
who have adopted the book to support their teaching. Their helpful comments and
encouragement have provided the motivation to undertake this substantive revision.
The second edition of Intermediate Public Economic reflects recent developments in
the academic literature and in policy debate. New chapters are included on behavioral
economics, cost–benefit analysis, economics of climate policy, and international taxa-
tion. A chapter has also been added on the limits to redistribution that complements the
existing chapters on commodity taxation and income taxation. The advice of numer-
ous users of the first edition has resulted in many other parts of the book having been
improved by the expansion of some arguments and the clarification of others.
The book is written with the intention that it should be accessible to anyone with
a background of intermediate microeconomics and macroeconomics. The level and
quantity of mathematics is kept as low as possible without sacrificing intellectual rigor,
but the book remains analytical rather than discursive. Some fairly abstract arguments
are included—particularly in the new chapter on redistribution—where it has been
judged that these make sufficiently important points that the extra burden imposed on
the reader will be amply rewarded.
Additional exercises have been added at the end of each chapter. Correspondingly, a
new Solutions Manual is available to accompany the book. Powerpoint slides for each
of the chapters are also available.
The list of people to whom we are indebted for directly or indirectly assisting with
the preparation of this book continues to grow. For assistance with the second edition
we wish to thank Nizar Allouch, Douglas Bernheim, Thierry Bréchet, James David-
son, Pascale Duran-Vigneron, Alessandro Ferrera, Christian Gollier, Roger Guesnerie,
Andreea Halunga, Nigar Hashimzade, Tatiana Kirsanova, Christos Kotsogiannis, Eti-
enne Lehmann, Cuong Le Van, Miguel-Angel Lopez-Garcia, Miltos Makris, François
Maniquet, Ross McKitrick, Sushama Murthy, Pierre Pestieau, Matthew Rablen, Em-
manuelle Taugourdeau, Henry Tulkens, Unal Zenginobuz, and the members of the
Mirrlees Review of the UK tax system.
We also want to thank again the people we thanked for the first edition, many of
whom have also contributed to this edition: Paul Belleflamme, Tim Besley, Chuck
Blackorby, Christopher Bliss, Craig Brett, John Conley, Richard Cornes, Philippe
De Donder, Sanjit Dhami, Peter Diamond, Jean Gabszewicz, Peter Hammond, Arye
xxii Preface to Second Edition

Hillman, Norman Ireland, Michael Keen, Jack Mintz, James Mirrlees, Frank Page Jr.,
Susana Peralta, Pierre Pestieau, Pierre M. Picard, Ian Preston, Maria Racionero,
Antonio Rangel, Les Reinhorn, Elena del Rey, Todd Sandler, Kim Scharf, Hyun
Shin, Michael Smart, Stephen Smith, Klaas Staal, Jacques Thisse, Harrie Verbon,
John Weymark, David Wildasin, and Myrna Wooders.
Jean notes that the chapter on behavioral economics has benefited from the inspiring
lectures given by Douglas Bernheim and Vincent Crawford at the 2011 ECORE Summer
School in Louvain-la-Neuve, Belgium. He also wishes to thank his Master’s degree
students at UCL who tested several of the chapters. Gareth wishes to thank ATAX
(University of New South Wales), ENS Cachan, NYU in London, and Universitat
Autònoma de Barcelona for generous hospitality while parts of the book were written
and tested. He also wishes to thank the Association of Public Economic Theory for
providing such excellent conferences that make it possible to keep in touch with the
book’s users.
We observed in the Preface to the first edition that Public Economics is about the
government and the economic effects of its policies. We should also observe that public
economics continually absorbs new ideas from other fields and uses these whenever
they can improve the understanding of policy. This book offers an extended insight into
what Public Economics says and what it can do. We hope that you enjoy it.

Jean Hindriks
Louvain La Neuve
Gareth Myles
Exeter
February 2012
Preface to First Edition

This book has been prepared as the basis for a final-year undergraduate or first-year
graduate course in Public Economics. It is based on lectures given by the authors at
several institutions over many years. It covers the traditional topics of efficiency and
equity but also emphasizes more recent developments in information, games, and,
especially, political economy.
The book should be accessible to anyone with a background of intermediate microe-
conomics and macroeconomics. We have deliberately kept the quantity of math as low
as we could without sacrificing intellectual rigor. Even so, the book remains analytical
rather than discursive.
To support the content, further reading is given for each chapter. This reading is
intended to offer a range of material from the classic papers in each area through recent
contributions to surveys and critiques. Exercises are included for each chapter. Most
of these should be possible for a good undergraduate but some may prove challenging.
There are many people who have contributed directly or indirectly to the prepara-
tion of this book. Nigar Hashimzade is entitled to special thanks for making incisive
comments on the entire text and for assisting with the analysis in chapters 11 and 24.
Thanks are also due to Paul Belleflamme, Tim Besley, Chuck Blackorby, Christopher
Bliss, Craig Brett, John Conley, Richard Cornes, Philippe De Donder, Sanjit Dhami,
Peter Diamond, Jean Gabszewicz, Peter Hammond, Arye Hillman, Norman Ireland,
Michael Keen, Francois Maniquet, Jack Mintz, James Mirrlees, Frank Page Jr., Su-
sana Peralta, Pierre Pestieau, Pierre M. Picard, Ian Preston, Maria Racionero, Antonio
Rangel, Les Reinhorn, Elena del Rey, Todd Sandler, Kim Scharf, Hyun Shin, Michael
Smart, Stephen Smith, Klaas Staal, Jacques Thisse, Harrie Verbon, John Weymark,
David Wildasin, and Myrna Wooders.
Public Economics is about the government and the economic effects of its policies.
This book offers an insight into what Public Economics says and what it can do. We
hope that you enjoy it.

Jean Hindriks
Louvain La Neuve
Gareth Myles
Exeter
February 2005
List of Figures

2.1 Typical Edgeworth box 17

2.2 Preferences and demand 18
2.3 Relative price change 19
2.4 Equilibrium 19
2.5 Equilibrium and excess demand 21
2.6 Typical production set 23
2.7 Profit maximization 24
2.8 Utility maximization 28
2.9 Efficient equilibrium 29
2.10 Constant returns to scale 31
2.11 Pareto-efficiency 33
2.12 The First Theorem 34
2.13 The Second Theorem 36
2.14 Proof of the Second Theorem 39
2.15 A lump-sum transfer 40

4.1 Total expenditure, 1870 to 2010 (% of GDP) 90

4.2 Total expenditure, 1970 to 2011 (% of GDP) 91
4.3 Individual expenditure items (% of GDP) 92
4.4 Government expenditure, 2010 (% of GDP) 94
4.5 Share of expenditure by levels of government, 2009 95
4.6 Composition of general spending, 2007 96
4.7 Composition of central spending 98
4.8 Composition of state spending 99
4.9 Composition of local spending 100
4.10 Tax revenues, 1965 to 2009 (% of GDP) 101
4.11 Tax revenue for category of taxation, 2009 101
4.12 Tax revenue by level of government, federal countries, 2009 102
4.13 Tax revenue by level of government, unitary countries, 2009 103
4.14 Tax shares at each level of government, United States, 2009 104
xxvi List of Figures

4.15 Tax shares at each level of government, Germany, 2009 105

4.16 Tax shares at each level of government, Japan, 2009 105
4.17 Tax shares at each level of government, United Kingdom, 2009 106
4.18 Budget deficit (% of GDP) 108
4.19 Corporate debt of nonfinancial corporations (% of GDP) 109
4.20 Government debt (% of GDP) 110
4.21 Household debt (% of GDP) 110
4.22 Aggregate debt of the 17 euro area countries (% of GDP) 111
4.23 Debt in euro area countries (% of GDP) 112

5.1 Excessive government 132

5.2 Government agency 136

6.1 Typology of goods 149

6.2 Preferences and choice 151
6.3 Best reaction for consumer 2 152
6.4 Nash equilibrium 153
6.5 Inefficiency of equilibrium 153
6.6 Allocation through voting 157
6.7 Lindahl equilibrium 161
6.8 Gaining by false announcement 162
6.9 Announcements and payoffs 164
6.10 Payoffs and overstatement 165
6.11 Clarke–Groves mechanism 167
6.12 Payoffs for player 1 167
6.13 Effect of a transfer 171
6.14 New equilibrium 172
6.15 Additional consumers 174
6.16 Public good experiment 175
6.17 Contribution campaign 180

7.1 Utility and club size 201

7.2 Optimum with unequally sized clubs 203
xxvii List of Figures

7.3 Optimum with equally sized clubs 205

7.4 Non-unique club size 206
7.5 Achieving efficiency 207
7.6 Stability of the symmetric equilibrium 210
7.7 Inefficient stable equilibrium 211

8.1 Deviation of private from social benefits 227

8.2 Equilibrium with river pollution 229
8.3 Choice of commuting mode 230
8.4 Job choice 231
8.5 Rat race 232
8.6 Tragedy of the commons 234
8.7 Equilibrium keyboard choice 235
8.8 Pigouvian taxation 237
8.9 Uncertain costs 241
8.10 Nonconvexity 247

9.1 Monopoly pricing 265

9.2 Deadweight loss with monopoly 266
9.3 Tax incidence with perfectly elastic supply 269
9.4 Tax incidence in the general case 269
9.5 Tax undershifting 270
9.6 Tax overshifting 271
9.7 Possibility of a profit increase 273
9.8 Contrasting taxes 276
9.9 Natural monopoly 279
9.10 Monopsony in the labor market 287

10.1 Equilibrium in the insurance market 304

10.2 Multiple equilibria 306
10.3 Perfect information equilibrium 309
10.4 Separating contracts 311
10.5 Separating and pooling contracts 312
xxviii List of Figures

10.6 Nonexistence of pooling equilibrium 313

10.7 Market intervention 314
10.8 Single-crossing property 317
10.9 Separating equilibrium 319
10.10 Unreasonable beliefs 322
10.11 First-best contract 326
10.12 Switching line 327
10.13 Second-best contract 328

11.1 Location of households 352

11.2 Single-peaked preferences 353
11.3 Single-crossing without single-peakedness 355
11.4 Single-peakedness in multi-dimensions 357
11.5 Binary agenda 359
11.6 Probabilities of election 367
11.7 Participation and the probability of being pivotal 368
11.8 Closeness and the probability of being pivotal 369

12.1 Monopoly deadweight loss 399

12.2 Competitive and monopoly equilibria 402
12.3 Monopoly and lobbying 402
12.4 Threat of lobbying 403

13.1 Utility possibility frontier 425

13.2 Social indifference curves 426
13.3 Social optimality 427
13.4 Optimal lump-sum taxes and incentive compatibility 433
13.5 Efficiency and inequity 438
13.6 Incompleteness of Pareto ranking 439

14.1 Construction of Engel scale 463

14.2 Adult good equivalence scale 464
14.3 General equivalence scale 465
xxix List of Figures

14.4 Construction of a Lorenz curve 472

14.5 Lorenz curves as an incomplete ranking 473
14.6 Relating Gini to Lorenz 474
14.7 Gini social welfare 477
14.8 Equally distributed equivalent income 479

15.1 Deadweight loss 506

15.2 Income and substitution effects 507
15.3 Absence of deadweight loss 508
15.4 Revenue and production possibilities 510
15.5 Consumer choice 511
15.6 Optimal commodity taxation 512
15.7 Production efficiency 514

16.1 Labor supply decision 540

16.2 Effect of a wage increase 541
16.3 Effect of a tax increase 542
16.4 A tax threshold 542
16.5 Several thresholds 543
16.6 Taxation and the participation decision 544
16.7 Taxation and the consumption function 548
16.8 Agent monotonicity 549
16.9 Income and skill 549
16.10 Upper limit on tax rate 550
16.11 Initial position and new tax function 551
16.12 Transfer of consumption 552
16.13 Allowing relocation 552
16.14 Zero marginal rate of tax 553
16.15 Allocations and the consumption function 556
16.16 Binding incentive compatibility 557

17.1 Interior choice: 0 < X∗ < Y 578

17.2 Corner solutions 578
xxx List of Figures

17.3 Increase in detection probability 581

17.4 Increase in the fine rate 581
17.5 Income increase 582
17.6 Tax rate increase 583
17.7 Audit game 591
17.8 Equilibrium compliance 600

18.1 Mechanism design 612

18.2 Direct and indirect mechanisms 613
18.3 Allocation with no redistribution 617
18.4 Maximal redistribution 618
18.5 Decentralization by taxation 619
18.6 Differential taxation and nonseparability 623

19.1 The costs of uniformity 638

19.2 Centralization and decentralization 641
19.3 Political accountability and voter welfare 645
19.4 Regional distribution of income 647

20.1 Allocation of capital 668

20.2 Symmetric Nash equilibrium 671
20.3 Advantage of smallness 674
20.4 Tax overlap 677
20.5 Matching versus lump-sum grant 688

21.1 Profits and effective corporate tax rates 712

21.2 Effect of a tariff on a small country 734
21.3 Effect of a tariff on a large country 735

22.1 Generational structure 754

22.2 Consumer choice 756
22.3 Consumption possibilities 761
22.4 Steady-state equilibrium 762
22.5 Golden Rule and competitive equilibrium 765
xxxi List of Figures

23.1 Annual income and cost forecast for OASI 780

23.2 Pareto improvement and social security 782
23.3 Population growth and consumption 788
23.4 Population growth and consumption 789
23.5 Population growth and social security 789
23.6 Social security game 792

24.1 Dynamics of the capital stock 812

24.2 Steady state 813
24.3 Golden Rule 815
24.4 Consumption and the saving rate 816
24.5 Taxation and consumption growth 829
24.6 Level and growth effects 830
24.7 Growth effects of tax reform 832
24.8 US tax and growth rates 833
24.9 UK tax and growth rates 834
24.10 Average and marginal tax rates 835

25.1 Increase in gross benefit 858

25.2 Official values for a road accident fatality 869
25.3 Intertemporal equilibrium 872
25.4 Scitovsky reversal 879

26.1 The warming process 901

26.2 Accumulation of greenhouse gases, CO2 e ppm 902
26.3 Global average temperature (annual average difference from normal) 903
26.4 Hockey stick plot 903
26.5 Global average temperature (monthly, difference from normal) 905
26.6 Estimates of climate sensitivity 908
26.7 Predicted changes in climate patterns 910
26.8 Industrial CO2 emissions: DICE and two IPCC scenarios 916
26.9 Discount rates 918
26.10 Ecological value 928
xxxii List of Figures

26.11 Coverage of the EU Emissions Trading Scheme 932

26.12 Allowance price evolution in the EU ETS, 2005 to 2008 933
26.13 Effect of a climate tax 934
26.14 CO2 emissions 2007, metric tons 936
26.15 CO2 per person 2007, metric tons 937
I PUBLIC ECONOMICS AND ECONOMIC EFFICIENCY
1 An Introduction to Public Economics

1.1 Public Economics

The study of public economics has a long tradition. It developed out of the original
political economy of John Stuart Mill and David Ricardo, through the public finance
tradition of tax analysis into public economics, and has now returned to its roots with
the development of the new political economy. From the inception of economics as a
scientific discipline, public economics has always been one of its core branches. The
explanation for why it has always been so central is the foundation that it provides for
practical policy analysis. This has always been the motivation of public economists,
even if the issues studied and the analytical methods employed have evolved over
time. We intend the theory described in this book to provide an organized and coherent
structure for addressing economic policy in a rigorous and coherent way.
In the broadest interpretation, public economics is the study of economic efficiency,
distribution, and government economic policy. The subject encompasses topics as
diverse as responses to market failure due to the existence of externalities, the motives
for tax evasion, and the explanation of bureaucratic decision-making. In order to reach
into all of these areas, public economics has developed from its initial narrow focus on
the collection and spending of government revenues to its present concern with every
aspect of government interaction with the economy.
Public economics attempts to understand both how the government makes decisions
and what decisions it should make. To understand how the government makes decisions,
it is necessary to investigate the motives of the decision makers within government,
how the decision makers are chosen, and how they are influenced by outside forces.
Determining what decisions should be made involves studying the effects of the al-
ternative policies that are available and evaluating the outcomes to which they lead.
These aspects are interwoven throughout the text. By pulling them together, this book
provides an accessible introduction to both of these aspects of public economics.

1.2 Methods

The feature that most characterizes modern public economics is the use made of eco-
nomic models. These models are employed as a tool to ensure that arguments are
conducted coherently with a rigorous logical basis. Models are used for analysis because
4 Part I: Public Economics and Economic Efficiency

the possibilities for experimentation are limited and past experience cannot always be
relied on to provide a guide to the consequences of new policies. Each model is in-
tended to be a simplified description of the part of the economy that is relevant for the
analysis. What distinguishes economic models from those in the natural sciences is the
incorporation of independent decision-making by the firms, consumers, and politicians
that populate the economy. These actors in the economy do not respond mechanically
but are motivated by personal objectives and are strategic in their behavior. Capturing
the implications of this complex behavior in a convincing manner is one of the key
skills of a successful economic modeler.
Once a model has been chosen, its implications have to be derived. These implications
are obtained by applying logical arguments that proceed from the assumptions of the
model to a set of formally correct conclusions. Those conclusions then need to be
given an interpretation in terms that can be related to the original question of interest.
Policy recommendations can subsequently be derived but always with a recognition
of the limitations of the model. A careful line has to be drawn between conclusions
that are justifiable given the model and conclusions that go beyond what the model can
support.
The institutional setting for the study of public economics is invariably the mixed
economy where individual decisions are respected but the government attempts to af-
fect these through the policies it implements. Within this environment many alternative
objectives can be assigned to the government. For instance, the government can be as-
sumed to care about the aggregate level of welfare in the economy and to act selflessly
in attempting to increase this. Such a viewpoint is the foundation of optimal policy
analysis that inquires how the government should behave. But there can be no pre-
sumption that actual governments act in this way. An alternative, and sometimes more
compelling view, is that the government is composed of a set of individuals pursuing
their own selfish agenda. Such a view provides a very different interpretation of the
actions of the government and often provides a foundation for understanding how gov-
ernments actually choose their policies. This perspective will also be considered in this
book.
The focus on the mixed economy makes the analysis applicable to most developed
and developing economies. It also permits the study of how the government behaves
and how it should behave. To provide a benchmark from which to judge the outcome
of the economy under alternative policies, the command economy with an omniscient
planner is often employed. This, of course, is just an analytical abstraction.
5 Chapter 1: An Introduction to Public Economics

1.3 Analyzing Policy

The method of policy analysis in public economics is to build a model of the economy
and to find its equilibrium. Policy analysis is undertaken by tracing the effects of a
policy through the ways in which it changes the equilibrium of the economy relative
to some status quo. Alternative policies are contrasted by comparing the equilibria to
which they lead.
In conducting the assessment of policy, it is often helpful to emphasize the distinc-
tion between positive and normative analysis. The positive analysis of government
investigates topics such as why there is a public sector, where government objectives
emerge, and how government policies are chosen. It is also about understanding what
effects policies have on the economy. In contrast, normative analysis investigates what
the best policies are, and aims to provide a guide to good government. These are not
entirely disjoint activities. To proceed with a normative analysis, it is first necessary to
conduct the positive analysis: it is not possible to say what is the best policy without
knowing the effects of alternative policies upon the economy. It could also be argued
that a positive analysis is of no value until used as part of a normative analysis of pol-
icy. Normative analysis is conducted under the assumption that the government has a
specified set of objectives and its action are chosen in the way that best achieves these.
Alternative policies (including the policy of laissez faire or, literally “leave to do”) are
compared by using the results of the positive analysis. The optimal policy is that which
best meets the government’s objective. Hence the equilibria for different policies are
determined and the government’s objective is evaluated for each equilibrium.
In every case restrictions are placed on the set of policies from which the government
may choose. These restrictions are usually intended to capture limits on the information
that the government has available. The information the government can obtain on the
consumers and firms in the economy restricts the degree of sophistication that policy
can have. For example, the extent to which taxes can be differentiated among different
taxpayers depends on the information the government can acquire about each individual.
Administrative and compliance costs are also relevant in generating restrictions on
possible policies.
When the government’s objective is taken to be some aggregate level of social welfare
in the economy, important questions are raised as to how welfare can be measured. This
issue is discussed in some detail in a later chapter, but it can be noted here that the answer
involves invoking some degree of comparability between the welfare levels of different
individuals. It has been the willingness to proceed on the basis that such comparisons
6 Part I: Public Economics and Economic Efficiency

can be made that has allowed the development of public economics. While differences
of opinion exist on the extent to which these comparisons are valid, it is still scientifically
justifiable to investigate what they would imply if they could be made. Furthermore
general principles can be established that apply to any degree of comparability.

1.4 Preview

Part I of the book, which includes this chapter, introduces public economics and pro-
vides a review of basic results that are used repeatedly in later chapters. The discussion
of the methodology of public economics has shown that a necessary starting point for
the development of the theory of policy analysis is an introduction to economic model-
ing. This represents the content of chapter 2 in which the basic model of a competitive
economy is introduced. The chapter describes the agents involved in the economy and
characterizes economic equilibrium. An emphasis is placed upon the assumptions on
which the analysis is based since much of the subject matter of public economics follows
from looking at how the government should respond if these are not satisfied. Having
established the basic model, the chapter then investigates the efficiency of the com-
petitive equilibrium. This leads into some fundamental results in welfare economics.
The analysis of competitive equilibrium is based on the standard assumption that in-
dividuals act rationally in their pursuit of narrow self-interest. This assumption has
been increasingly challenged by mounting evidence of observed behavior (so-called
anomalies) that is inconsistent with rationality and self-interest. The literature that ex-
plores these inconsistencies is typically called behavioral economics. The anomalies
raise important questions in many areas of economic policy, so a review of the most
relevant parts of behavioral economics is undertaken in chapter 3.
The analysis of government begins in part II. Chapter 4 provides an overview of
the public sector. It first charts the historical growth of public sector expenditure over
the previous century and then reviews statistics on the present size of the public sector
in several of the major developed economies. The division of expenditure and the
composition of income are then considered. The level of public debt has recently
become an issue of major policy importance, so data are given to demonstrate the
increase in debt over time and its allocation across countries. Finally, issues involved
in measuring the size of the public sector are addressed. The issues raised by the
statistics of chapter 4 are addressed by the discussion of theories of the public sector in
chapter 5. Reasons for the existence of the public sector are considered, as are theories
that attempt to explain its growth. A positive analysis of how the government may have
7 Chapter 1: An Introduction to Public Economics

its objectives and actions determined is undertaken. An emphasis is given to arguments

for why the observed size of government may be excessive.
The focus of part III is on the consequences of market failure. Chapter 6 introduces
public goods into the economy and contrasts the allocation that is achieved when
these are privately provided with the optimal allocation. Mechanisms for improving
the allocation are considered and methods of preference revelation are also addressed.
This is followed by an analysis of clubs and local public goods, which are special
cases of public goods in general, in chapter 7. The focus in this chapter returns to an
assessment of the success of market provision. The treatment of externalities in chapter
8 relaxes another of the assumptions. It is shown why market failure occurs when
externalities are present and reviews alternative policy schemes designed to improve
efficiency. Imperfect competition and its consequences for taxation is the subject of
chapter 9. The measurement of welfare loss is discussed and emphasis is given to the
incidence of taxation. A distinction is also drawn between the effects of specific and ad
valorem taxes. Symmetry of information between trading parties is required to sustain
efficiency. When it is absent, inefficiency can arise. The implications of informational
asymmetries and potential policy responses are considered in chapter 10.
Part IV provides an analysis of the public sector and its decision-making processes.
This can be seen as a dose of healthy scepticism before proceeding to the body of
normative analysis. An important practical method for making decisions and choosing
governments is voting. Chapter 11 analyzes the success of voting as a decision mech-
anism and the tactical and strategic issues it involves. The main results that emerge
are the Median Voter Theorem and the shortcomings of majority voting. These results
are then used to develop the analysis of political competition. The consequences of
rent-seeking are analyzed in chapter 12. The theory of rent-seeking provides an alter-
native perspective upon the policy-making process that is highly critical of the actions
of government.
Part III focuses on economic efficiency. Part V complements this by considering
issues of equity. Chapter 13 analyzes the policy implications of equity considerations
and addresses the important restrictions placed on government actions by limited in-
formation. Several other fundamental results in welfare economics are also developed
including the implications of alternative degrees of interpersonal comparability. Chap-
ter 14 considers the measurement of economic inequality and poverty. The economics
of these measures ultimately re-emphasizes the fundamental importance of utility the-
ory. The chapter also stresses the importance of the intergenerational transmission of
poverty.
8 Part I: Public Economics and Economic Efficiency

Part VI is concerned with taxation. It analyzes the basic tax instruments and the
economics of tax evasion. Chapters 15 and 16 consider commodity taxation and income
taxation, which are the two main taxes levied on consumers. In both of these chapters
the economic effects of the instruments are considered and rules for setting the taxes
optimally are derived. The results illustrate the resolution of the equity/efficiency trade-
off in the design of policy and the consequences of the limited information available
to the government. In addition to the theoretical analysis the results of application
of the methods to data are considered. The numerical results are useful, since the
theoretical analysis leads only to characterizations of optimal taxes rather than explicit
solutions. These chapters all assume that the taxes that are levied are paid honestly
and in full. This empirically doubtful assumption is corrected in chapter 17, which
looks at the extent of the hidden economy and analyzes the motives for tax evasion and
its consequences. The final chapter of this section, chapter 18, adopts a very abstract
approach to investigate the question of whether restricting attention to mixed economies
limits what can be achieved by policy intervention. It provides the comforting result
that there is no allocation mechanism that can out-perform competitive trade with tax
intervention.
Part VII studies public economics when there is more than one decision-making
body. Chapter 19 on fiscal federalism addresses why there should be multiple levels
of government and discusses the optimal division of responsibilities between different
levels. The concept of tax competition is studied in chapter 20. It is shown how tax
competition can limit the success of delegating tax-setting powers to independent ju-
risdictions. The globalization of the world economy and the closer integration of the
European economies has emphasized the importance of the international dimension of
taxation. A range of issues involved in the design of tax systems in a globalized world
are reviewed in chapter 21.
Part VIII concentrates on intertemporal issues in public economics. Chapter 22 de-
scribes the overlapping generations economy that is the main analytical tool of this part.
The concept of the Golden Rule is introduced for economies with production and cap-
ital accumulation, and the potential for economic inefficiency is discussed. Chapter 23
analyzes social security policy and relates this to the potential inefficiency of the com-
petitive equilibrium. Both the motivation for the existence of social security programs
and the determination of the level of benefits are addressed. Ricardian equivalence is
linked to the existence of gifts and bequests. This part is completed by chapter 24, which
considers the effects of taxation and public expenditure on economic growth. Alterna-
tive models of economic growth are introduced, and the evidence linking government
policy to the level of growth is discussed.
9 Chapter 1: An Introduction to Public Economics

The final part of the book, part IX, considers two applications of the theory. The
discussion of cost–benefit analysis in chapter 25 draws on many of the earlier results
to detail a methodology for evaluating when the implementation of a project—which
can be interpreted as any change in policy—will increase social welfare. Chapter 26
completes the book with a discussion of the economics of climate policy. The focus
in the chapter is on how the tools of public economics can be applied to policy in the
presence of pervasive uncertainty.

1.5 Scope

This book is essentially an introduction to the theory of public economics. It presents

a unified view of this theory and introduces the most significant results of the analysis.
As such, it provides a broad review of what constitutes the present state of public
economics.
What will not be found in the book are many details of actual institutions for the
collection of taxes or discussion of existing tax codes and other economic policies,
although relevant data are used to illuminate arguments. There are several reasons
for this. This book is much broader than a text focusing on taxation, and to extend the
coverage in this way, something else has to be lost. Primarily, however, the book is about
understanding the effects of public policy and how economists think about the analysis
of policy. This should give an understanding of the consequences of existing policies,
and to benefit from the discussion does not require detailed institutional knowledge.
Furthermore tax codes and tax law are country-specific, and pages spent discussing
in detail the rules of one particular country will have little value for those resident
elsewhere. In writing the book we wished it to appeal to as broad an audience as
possible. From this perspective, the method of reasoning and the analytical results
described here have value independent of country-specific detail. Finally there are
many alternative texts available that describe tax law and tax codes in detail. These are
usually written for accountants and lawyers and have a focus rather distinct from that
adopted by economists.

Further Reading

The history of political economy is described in the classic volume:

Blaug, M. 1996. Economic Theory in Retrospect. Cambridge: Cambridge University Press.
Two classic references on economic modeling are:
10 Part I: Public Economics and Economic Efficiency

Friedman, M. 1953. Essays on Positive Economics. Chicago: University of Chicago Press.

Koopmans, T. C. 1957. Three Essays on the State of Economic Science. New York: McGraw-Hill.
Two books that show how the tools of public economics can be applied to practical policy analysis
are:
Mirrlees, J. 2010. Dimensions of Tax Design. Oxford: Oxford University Press.
Mirrlees, J. 2011. Tax by Design. Oxford: Oxford University Press.
The issues involved in comparing individual welfare levels are explored in:
Robbins, L. 1935. An Essay on the Nature and Significance of Economic Science. London: Macmillan.

Exercises

1.1 Should an economic model be judged on the basis of its assumptions or its conclusions?
1.2 Explain the economic implications of the imposition of quality standards for drinking
water.
1.3 Can economics contribute to an understanding of how government decisions are made?
1.4 In the introduction to “The Economics of Welfare” (1928) Pigou states that:

When a man sets out upon any course of inquiry, the object of his search may be either light or
fruit—either knowledge for its own sake or knowledge for the sake of good things to which
it leads.
What should be the balance betweeen light and fruit in public economics?

1.5 What should guide the choice of economic policy?

1.6 Are bureaucrats motivated by different factors than entrepreneurs?
1.7 What restricts the policies that a government can choose? Are there any arguments for
imposing additional restrictions?
1.8 The UK government scheme Sure Start helps children in disadvantaged areas to have an
equal start in life with children from better-off backgrounds, by developing a “one-stop-
shop” approach to local family support services. A government minister commented “In
the years ahead, children who are healthier and more ready to learn, stronger families and
communities, less crime and fewer school-age pregnancies will benefit us all.” Examine the
efficiency and equity components of the minister’s comments.
1.9 “Physics is a simpler discipline than economics. This is because the objects of its study are
bound by physical laws.” Do you agree?
1.10 If individual welfare levels cannot be compared, how can it be possible to make social
judgments?
11 Chapter 1: An Introduction to Public Economics

1.11 “Poverty should be reduced to lessen the extent of malnutrition and raise economic growth.”
Distinguish the positive and normative components of this statement.
1.12 “It is economically efficient to maintain a pool of unemployed labor.” Is this claim based on
positive or normative reasoning?
1.13 “High-income earners should pay a high rate of tax because their labor supply is inelastic
and the revenue raised can be used to assist those on low incomes.” Distinguish between the
positive and normative components of this statement.
1.14 Bob Wailer was a talented singer from a very early age. With no training or practice he built
a successful career as the enigmatic frontman of a punk revivalist band. From the day she
could hold a bow Emma Libro was trained in classical violin. After many years of study and
practice she finally obtained lead violin for the Exeter Philharmonic and a lucrative recording
contract. Assume that Bob and Emma have the same income. Is it equitable for them to pay
the same amount of tax?
1.15 Consider two methods of dividing a cake between two people. Method 1 is to throw some of
the cake away, and share what is left equally. Method 2 is to give one person 75 percent of
the cake and the other 25 percent. Which method do you prefer, and why?
1.16 A cake has to be apportioned between two people. One is well-nourished, and the other is
not. If the well-nourished person receives a share x, 0 ≤ x ≤ 1, a share y = [1 − x]2 is left
for the other person (some is lost when the cake is divided). Plot the possible shares that the
two people can have. What allocation of shares would you choose? How would your answer
change if y = [1 − x]4 ?
1.17 A cake is to be divided between two people. Unfortunately, when the cake is sliced some
is lost. Specifically, if the sizes of the two portions are denoted x and y, then the size of
the slices satisfy the relation x 1/2 + y 1/2 = 1. Graph the possible divisions of the cake and
discuss how the balance between efficiency and equity will affect the choice of division.
1.18 Can an economic model be acceptable if it assumes that consumers solve computationally
complex maximization problems? Does your answer imply that Tiger Woods can derive the
law of motion for a golf ball?
1.19 To analyze the effect of a subsidy to rice production, would you employ a partial equilibrium
or a general equilibrium model?
1.20 If the European Union considered replacing the income tax with an increase in VAT, would
you model this using partial equilibrium?
1.21 What proportion of the world’s economies (by number, population, and wealth) can be
described as “mixed”?
1.22 What problems may arise in setting economic policy if consumers know the economic model?
1.23 Should firms maximize profit?
1.24 To what extent is it possible to view the government as having a single objective?
1.25 Are you happier than your neighbor? How many times happier or less happy?
12 Part I: Public Economics and Economic Efficiency

1.26 Assume that consumers are randomly allocated to either earn income Mℓ or income Mh ,
where Mh >Mℓ . The probability of being allocated to Mℓ is π . Prior to being allocated to an
income level, consumers wish to maximize their expected income level. If it is possible to
redistribute income costlessly, show that prior to allocation to income levels, no consumer
would object to a transfer scheme. Now assume that there is a cost  for each consumer of
income Mh from whom income is taken. Find the maximum value of π for which there is
still unanimous agreement that transfers should take place.
2 Equilibrium and Efficiency

2.1 Introduction

The link between competition and efficiency can be traced back, at least, to Adam
Smith’s eighteenth-century description of the working of the invisible hand. Smith’s
description of individually motivated decisions being coordinated to produce a socially
efficient outcome is a powerful one that has found resonance in policy circles ever
since. The expression of the efficiency argument in the language of formal economics,
and the deeper understanding that comes with it, is a more recent innovation.
The focus of this chapter is to review what is meant by competition and to describe
equilibrium in a competitive economy. The model of competition combines indepen-
dent decision-making of consumers and firms into a complete model of the economy.
Equilibrium is shown to be achieved in the economy by prices adjusting to equate
demand and supply. Most important, the chapter employs the competitive model to
demonstrate the efficiency theorems.
Surprisingly, equilibrium prices can always be found that simultaneously equate
demand and supply for all goods. What is even more remarkable is that the equilibrium
so obtained also has properties of efficiency. Why this is remarkable is that individual
households and firms pursue their independent objectives with no concern other than
their own welfare. Even so, the final state that emerges achieves efficiency solely
through the coordinating role played by prices.

2.2 Economic Models

Prior to starting the analysis, it is worth reflecting on why economists employ models
to make predictions about the effects of economic policies. Models are used essentially
because of problems of conducting experiments on economic systems and because the
system is too large and complex to analyze in its entirety. Moreover formal modeling
ensures that arguments are logically consistent with all the underlying assumptions
exposed.
The models used, while inevitably being simplifications of the real economy, are
designed to capture the essential aspects of the problem under study. Although many
different models will be studied in this book, there are important common features that
apply to all. Most models in public economics specify the objectives of the individual
14 Part I: Public Economics and Economic Efficiency

agents (e.g., firms and consumers) in the economy, and the constraints they face, and
then aggregate individual decisions to arrive at market demand and supply. The equi-
librium of the economy is next determined, and in a policy analysis the effects of
government choice variables on this are calculated. This is done with various degrees
of detail. Sometimes only a single market is studied—this is the case of partial equilib-
rium analysis. At other times general equilibrium analysis is used with many markets
analyzed simultaneously. Similarly the number of firms and consumers varies from one
or two to very many.
An essential consideration in the choice of the level of detail for a model is that
its equilibrium must demonstrate a dependence on policy that gives insight into the
functioning of the actual economy. On the one hand, if the model is too highly specified,
it may not be capable of capturing important forms of response. On the other hand, if it
is too general, it may not be able to provide any clear prediction. The theory described
in this book will show how this trade-off can be successfully resolved. Achieving a
successful compromise between these competing objectives is the “art” of economic
modeling.

2.3 Competitive Economies

The essential feature of competition is that the consumers and firms in the economy
do not consider their actions to have any effect on prices. Consequently, in making
decisions, they treat the prices they observe in the market place as fixed (or parametric).
This assumption can be justified when all consumers and firms are truly negligible in
size relative to the market. In such a case the quantity traded by an individual consumer
or firm is not sufficient to change the market price. But the assumption that the agents
view prices as parametric can also be imposed as a modeling tool, even in an economy
with a single consumer and a single firm.
This defining characteristic of competition places a focus on the role of prices, as
is maintained throughout the chapter. Prices measure values and are the signals that
guide the decisions of firms and consumers. It was the exploration of what determined
the relative values of different goods and services that led to the formulation of the
competitive model. The adjustment of prices equates supply and demand to ensure that
equilibrium is achieved. The role of prices in coordinating the decisions of independent
economic agents is also crucial for the attainment of economic efficiency.
The secondary feature of the economies in this chapter is that all agents have access
to the same information, or in formal terminology, that information is symmetric. This
15 Chapter 2: Equilibrium and Efficiency

does not imply that there cannot be uncertainty, but only that when there is uncertainty,
all agents are equally uninformed. Put differently, no agent is permitted to have an
informational advantage. For example, by this assumption, the future profit levels of
firms are allowed to be uncertain and shares in the firms to be traded on the basis of
individual assessments of future profits. What the assumption does not allow is for
the directors of the firms to be better informed than other shareholders about future
prospects and to trade profitably on the basis of this information advantage.
Two forms of the competitive model are introduced in this chapter. The first form is
an exchange economy in which there is no production. Initial stocks of goods are held
by consumers and economic activity occurs through the trade of these stocks to mutual
advantage. The second form of competitive economy introduces production. This is
undertaken by firms with given production technologies who use inputs to produce
outputs and distribute their profits as dividends to consumers.

2.4 The Exchange Economy

The exchange economy models the simplest form of economic activity: the trade of
commodities between two parties in order to obtain mutual advantage. Despite the
simplicity of this model, it is a surprisingly instructive tool for obtaining fundamental
insights about taxation and tax policy. This will become evident as we proceed. This
section presents a description of a two-consumer, two-good exchange economy. The
restriction on the number of goods and consumers does not alter any of the conclusions
that will be derived; they will all extend to larger numbers. What restricting the numbers
does is allow the economy to be displayed and analyzed in a simple diagram.
Each of the two consumers has an initial stock, or endowment, of the economy’s two
goods. The endowments can be interpreted literally as stocks of goods, or less literally
as human capital, and are the quantities that are available for trade. Given the absence
of production, these quantities remain constant. The consumers exchange quantities
of the two commodities in order to achieve consumption plans that are preferred to
their initial endowments. The rate at which one commodity can be exchanged for
the other is given by the market prices. Both consumers believe that their behavior
cannot affect these prices. This is the fundamental assumption of competitive price-
taking behavior. More will be said about the validity and interpretation of this in
section 2.6.
A consumer is described by their endowments and their preferences. The endowment
 
of consumer h is denoted by ωh = ω1h , ω2h , where ωih ≥ 0 is h’s initial stock of good i.
16 Part I: Public Economics and Economic Efficiency

 
When prices are p1 and p2 , a consumption plan for consumer h, x h = x1h , x2h , is
affordable if it satisfies the budget constraint

p1 x1h + p2 x2h = p1 ω1h + p2 ω2h . (2.1)

The preferences of each consumer are described by their utility function. This func-
tion should be seen as a representation of the consumer’s indifference curves and does
not imply any comparability of utility levels between consumers—the issue of com-
parability is taken up in chapter 13. The utility function for consumer h is denoted by
 
U h = U h x1h , x2h . (2.2)

It is assumed that the consumers enjoy the goods (so the marginal utility of consumption
is positive for both goods) and that the indifference curves have the standard convex
shape.
This economy can be pictured in a simple diagram that allows the role of prices in
achieving equilibrium to be explored. The diagram is constructed by noting that the
total consumption of the two consumers must equal the available stock of the goods,
where the stock is determined by the endowments. Any pair of consumption plans
that satisfies this requirement is called a feasible plan for the economy. A plan for the
economy is feasible if the consumption levels can be met from the endowments, so that

xi1 + xi2 = ωi1 + ωi2 , i = 1, 2. (2.3)

The consumption plans satisfying (2.3) can be represented as points in a rectangle with
sides of length ω11 + ω12 and ω21 + ω22 . In this rectangle the southwest corner can be
treated as the zero consumption point for consumer 1 and the northeast corner as the
zero consumption point for consumer 2. The consumption of good 1 for consumer 1 is
then measured horizontally from the southwest corner and for consumer 2 horizontally
from the northeast corner. Measurements for good 2 are made vertically.
The diagram constructed in this way is called an Edgeworth box and a typical box
is shown in figure 2.1. It should be noted that the method of construction results in the
endowment point, marked ω, being the initial endowment point for both consumers.
The Edgeworth box is completed by adding the preferences and budget constraints of
the consumers. The indifference curves of consumer 1 are drawn relative to the south-
west corner and those of consumer 2 relative to the northeast corner. From (2.1) it can
be seen that the budget constraint for both consumers must pass through the endowment
point, since consumers can always afford their endowment. The endowment point is
17 Chapter 2: Equilibrium and Efficiency

x12
2

1
x2 x 2
1
+ 2 x2
2 2

1 1
x1
1 2
1
+ 1

Figure 2.1
Typical Edgeworth box

common to both consumers, so a single budget line through the endowment point with
gradient − pp21 captures the market opportunities of the two consumers. Thus, viewed
from the southwest, it is the budget line of consumer 1, and viewed from the north-
east, the budget line of consumer 2. Given the budget line determined by the prices p1
and p2 , the utility-maximizing choices for the two consumers are characterized by the
standard tangency condition between the highest attainable indifference curve and the
budget line. This is illustrated in figure 2.2, where x 1 denotes the choice of consumer
1 and x 2 that of 2.
At an equilibrium of the economy, supply is equal to demand. This is assumed to be
achieved via the adjustment of prices. The prices at which supply is equal to demand
are called equilibrium prices. How such prices are arrived at will be discussed later. For
the present the focus will be placed on the nature of equilibrium and its properties. The
consumer choices shown in figure 2.2 do not constitute an equilibrium for the economy.
This can be seen by summing the demands and comparing these to the level of the
endowments. Doing this shows that the demand for good 1 exceeds the endowment
but the demand for good 2 falls short. To achieve an equilibrium position, the relative
prices of the goods must change. An increase in the relative price of good 1 raises
the absolute value of the gradient −p1 /p2 of the budget line, making the budget line
steeper. It becomes flatter if the relative price of good 1 falls. At all prices the budget
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and it feeds the several plasmodes which bathe the several tissues.
Passing into the capillaries, it becomes transformed as it passes
through their walls into the intercellular spaces, saturating the acid
products of the cell-activities with its alkalies, and furnishing the
protoplasms with their needed materials.
62. It will be understood that, although in appearance these
stages are sharply defined, in reality they are insensible. But from
the analytical point of view we may regard Nutrition as the office of
the plasmode, and Evolution as the office of the protoplasm.
Although evolution or genesis of form depends on assimilation, it is
not a necessary consequence: the plasmode or the protoplasm
might preserve such perfect equality in the waste and repair, such
complete equilibrium, as not to undergo any development. The ova,
for example, which exist in the ovaries at birth are not all
subsequently developed; and if with modern embryologists we
conclude that there is no replacement of these by proliferation we
shall in them have examples of organites remaining unchanged
21
through a period of fifty years. But such an equilibrium is perhaps
only possible in complete inactivity.
63. Again, although the office of the plasmode is primarily that of
forming protoplasm, I think there is evidence to suggest that it not
only does this, but that some of it is used in the direct development
of energy, especially heat and electricity. The various forms of starch
and sugar taken in with the food or formed in the liver, certainly do
not as such enter into protoplasm. The same with alcohol.
64. It is perhaps in forgetfulness of the artificial nature of
analytical distinctions that controversies rage respecting what are
called intercellular substances and cell-walls. Now that the wall is no
longer regarded as an essential constituent of the cell, but as a
secondary formation, two opinions are maintained: first, that it is
merely a concentration of the external layer of protoplasm; secondly,
that it is a product of secretion from the protoplasm. Both positions
may be correct. Certainly in some cases there is no other
appreciable difference between wall and protoplasm than that of a
greater consistence; whereas in many other cases there exists a
decided difference in their chemical reactions, showing a difference
of composition. Taking both orders of fact, we may conclude that the
cell-wall is sometimes part of the organite, and sometimes product:
a blood-cell and a cartilage-cell may be cited as examples of each.
And this argument applies to the intercellular substance also.
65. The terms plasmode and protoplasm are general, and include
many species. There are different plasmodes for the different
tissues, so that we find phosphates of soda in the blood-serum,
phosphates of potash in the nerve-plasma, phosphates of magnesia
in the muscle-plasma, and phosphates of lime in the bone-plasma;
having severally to form the specifically different protoplasms of
these tissues. Observe, moreover, the gradations of these in respect
of their physical state: the blood being the most liquid, the nerve a
degree more solid, the muscle still more solid, and the bone almost
entirely solid; and since solubility of material is a necessary condition
of the chemical changes, we can understand how the blood, the
nerve, the muscle, and the bone represent degrees of vital activity:
the greater the instability of organized substance, the more active its
molecular renovation. Many serious errors result from overlooking
the specific differences of protoplasms; among them may be
mentioned that very common one of asserting that the ovum of a
man is not distinguishable from the ovum of any other mammal, nor
the ovum of a mammal from that of a reptile; nay, we sometimes
see it stated that the protoplasm from which a mammal may be
developed is the same as that which is the germ of an oak. So long
as this simply asserts that we have at present no means of
distinguishing them by any chemical or physical tests, there can be
no objection raised; but it is a serious misconception, which any
embryological investigation ought to rectify, to suppose that the
ovum is not specific from the first.
66. Between the organites and their plasmodes there is the
necessary relation, which corresponds with the relation between
organisms and their mediums. Once formed, the organites are
arranged side by side, or end on end, into textures or tissues, and
these are grouped into organs, every organ being constituted by a
collection of tissues, as every apparatus is by a collection of organs,
and the organism by the federation of all the parts. We have more
than once insisted on the necessity of synthetic interpretation to
complete the indications of analysis: which means that no account of
vital phenomena is real unless it takes in all the co-operant factors,
both those of the organism and the medium. Neglect of this canon
vitiates Dr. Beale’s otherwise remarkable labors.

THE HYPOTHESIS OF GERMINAL MATTER.

67. It may help to elucidate certain important points if I here
examine the hypothesis which Dr. Beale has worked out with such
patient skill, but with what seem to me such unphysiological results.
He deserves, I think, more applause than has been awarded to him,
not only for the admirable patience with which he has pursued the
idea, but also for the striking definiteness of the idea itself—always a
great advantage in an hypothesis, since it gives precision to
research. If biologists have paid but little attention to it, this is no
doubt due to the theoretical, still more than to the observational
contradictions it presents. Histologists dispute his facts, or his
interpretations; while other biologists do not see their way in the
application of his hypothesis. Respecting all disputed points of
observation I shall be silent, for I have myself made no systematic
researches in this direction, such as would entitle me to form an
estimate of the evidence. But my dissent from the hypothesis is
founded on biological principles so fundamental that I should be
willing to take my stand entirely on the facts he himself puts
22
forward.
68. The hypothesis is that nothing in the organism has any claim
to vitality except the minute masses of protoplasm (by him called
bioplasm), which in the egg represent, he thinks, about the one-
thousandth part of the whole mass, the rest being lifeless matter,
namely, pabulum, and formed material. This bioplasm is the
germinal matter out of which, by a process of dying, arise the
tissues and humors constituting the formed material—these, with
the pabulum which feeds the germinal matter, being all dead
material. The germinal matter itself, though living, only lives because
there is temporarily associated with it that Vital Force of which we
have already spoken (§ 14). In virtue of this association, a particle of
matter not exceeding the one hundred-thousandth of an inch in
diameter is said to be alive; and, presumably, to contain within it all
those manifold powers which the term Life condenses. The pabulum
brought under the influence of this Vital Force is transformed into
germinal matter which, escaping from this mysterious influence, dies
into tissue. Muscle-fibres and nerve-fibres are thus not living parts,
nor are their actions vital. So that, to be consistent, we must not
speak of the organism as living, but as a dead structure produced by
the Vital Force, and set in action by the aid of scattered bits of
germinal matter. He has not, I think, stated whether each of these
bioplasms has its own Vital Force, so that the organism is the
theatre of millions of Vital Forces; or whether it is one Vital Force
which animates the whole organic world of plants and animals. But
nothing can be less equivocal than his position respecting the
lifelessness of every part of the organism except the germinal
matter.
69. The germinal matter may be selected as the primary stage of
the formed material, the initial point of growth, and thus stand for
the pre-eminently distinctive centre of Nutrition; but were we to limit
all Nutrition to the germinal matter, as defined by Dr. Beale, and
deny the co-operation of all the formed material, we should still not
be justified in restricting Life to simple Nutrition. We cannot exclude
such phenomena as those of Sensation and Motion, nor can we
23
assign these to the germinal matter. To suppose this, would be
equivalent to saying that the steam which issues from a teakettle is
capable of the actions of a locomotive engine. The steam from the
kettle is like the steam from the boiler, it has molecular energy, and
by this will co-operate in the production of mechanical work, if the
mechanism be adjusted to it. The molecular energy of the
protoplasm in muscular fibre may be indispensable to the
movements of the muscles, but these, and not the protoplasmic
movements alone, are muscular contractions. An hypothesis,
therefore, which is obliged to declare that muscle-fibre and nerve-
fibre are not living, even when active in the organism, seems to me
defective at its base. If we view these apart from the organism, they
may, like all the other formed materials, be regarded as dead; and
no one doubts that epidermis, nail, horn, hair, and bone are dead in
this sense, that they cannot live independently, and do not
reproduce themselves. But so long as even these form constituents
24
of the living organism, they also are living (§ 42). It is only by a
misconception of the analytical artifice that so simple a truth could
have been missed.
70. But this misconception meets us at many a turn. The Vitalist
hypothesis of an extra-organic agent of course refuses to regard Life
as the expression of all the co-operant conditions; and even
opponents of that hypothesis often fall into the same error of
principle, when they attempt to explain Life by localizing it in the
cells; which is simply a morphological substitution for the once
popular doctrine that only the vascular parts were organized, and
every part destitute of blood-vessels was dead. This idea seemed
supported by the facts of the most highly vascular parts being the
most vital, and of a parallelism existing between the vital activity of
those organs which when injected seemed almost entirely composed
of blood-vessels, as the liver and brain, and those which showed
scarcely a trace of vessels, as cartilage and bone; it seemed
supported also by the appearance of blood-vessels in all new
formations, and by the idea of the blood as the nutrient fluid. Then
came the cell-doctrine, and the belief that the cell was the really
ultimate morphological element—which may be true—and that “here
alone there is any manifestation of life to be found, so that we must
25
not transfer the seat of vital action anywhere beyond the cell,” —
which is very questionable.
 71. We have already seen that the cell is an anatomical element,
or organite; the organism is but an aggregate of organites and their
plasmodes. But Biology, which deals with the organism as a whole,
and with functions which are the resultants of all the vital properties,
must not be restricted to any single factor, however important. It
would assuredly be deemed absurd to say that diamond rings and
lead-pencils were the same, because the diamond and the
plumbago, which are the specific elements of each, are both the
same chemical element,—carbon. The substance is really different in
diamond and plumbago, is different in properties, and is, in rings
and pencils, united with different substances into objects having very
different properties. Whatever analysis may discover as to the
identities of organic structures, we cannot explain a single vital
phenomenon without taking into account the three terms, Structure,
Aliment, and Instrument; and whenever a cell is said to be the seat
of vital action, these three terms must be implied. In Dr. Beale’s
hypothesis the restriction is carried to its extreme; not content with
the cell, he withdraws vital action from the cell as a whole, assigning
it to the protoplasm and nucleus—cell-contents and cell-wall being,
in his view, dead. If it be true that the protoplasm is alone
concerned in Nutrition, yet Nutrition is not Life. Occupied mainly with
formative processes, it leaves other indispensable processes to other
parts. He instances the removal of all the tissues during the
metamorphoses of insects:—“new organs and textures are laid down
afresh and developed ab initio, instead of being built up upon those
first formed.” But to show how he restricts the idea of Life, he adds:
“Such complete change, however, necessitates a state of existence
26
during which action or function remains in complete abeyance.”
The muscles and nerves which are instrumental in this functional
life are said to be dead. It is true that the muscle-fibre does not
develop fresh fibres. But it is equally true that the protoplasm of
muscle does not alone execute muscular contraction. Each has its
special office. Hence I reject the idea that formed material is dead.
He further says “formed material may be changed, it cannot change
itself.” The antithesis is doubly inexact: 1°, nothing changes itself,
but only yields to pressure, or reacts on being stimulated; and 2°, all
the evidence at hand is against the notion that the formed material
is not the seat of incessant molecular change; it is wasted and
repaired molecule by molecule. Kölliker properly protests against the
growing tendency of histologists to deify protoplasm, and to make it
the sole seat of vital changes, the cell-wall and cell-products having
also, he says, their physiological importance. It is manifestly
erroneous to deny vital changes to the red blood-corpuscles on the
27
ground of their no longer containing germinal matter.
72. The analytical view may separate certain parts as active, and
other parts as passive, and thus regard the cells as the seats of vital
activity, the intercellular substance as merely accessory and
instrumental; but the real or synthetical view must recognize both
parts as equally indispensable, equally vital. Take cartilage, for
instance, with its enormous preponderance of intercellular substance
(formed material), and consider how absolutely impossible any of its
uses would be were it reduced to the germinal matter of its
corpuscles! And so of all the tissues.
73. If formed material is not to be excluded from the living parts
of the organism, neither is the plasmode, out of which the germinal
matter arises, since here we have the nutritive changes in their
highest activity; and because the property of Nutrition is here most
active, the other property of Development is in abeyance. Dr. Beale
holds that pabulum necessarily becomes germinal matter; but when
we come to treat of Nutrition it will appear that this is not more true
than that Food necessarily becomes Tissue: some of it does; but
much of it is used up for heat and other purposes.
74. What is true and important in the distinction between
germinal matter and formed material is, that from the former
onwards there is a gradual process of devitalization, the older parts
of every organite and tissue approaching more and more to the
state of inorganic matter. But to show how vain is the attempt to
restrict Vitality to any one out of a complex of co-operant factors, we
might set up a chemical hypothesis to the effect that Vitality
depends on phosphates, and with it explain the phenomena quite as
well as with the hypothesis of germinal matter. For not only is it
found that the productive quality of a soil depends on its richness in
phosphates, but, as Lehmann has shown, wherever cells and fibres
make their appearance phosphates are found, even in the lowest
organisms, which, however, contain but little. Phosphates abound in
seeds and ova, in muscles and ganglia, and are deficient in the
woody parts of plants and the elastic fibres of animals. The infant
absorbs phosphates in large quantities and excretes them in small
quantities. Nervous activity is accompanied by the consumption of a
third more phosphorus than accompanies muscular activity.
Phosphates are among the most energetic of organic stimulants. But
who would endow the phosphates with Vitality, on the ground of
their indispensable presence in all vital processes?
75. Life, as we saw, is the expression of the whole organism.
Many of the parts are incapable of manifesting any vital phenomena
except in connection with all the rest; and of those parts which may
be separated from the organism and continue to manifest some vital
phenomena, none are capable of manifesting all. When the
connexus of the parts is destroyed the organism is dead. Long after
that cessation which we call Death, there are still evidences of
Vitality in some of the parts: the heart will continue to beat, the
glands will secrete, the hair will grow, the temperature will still be
above that of the surrounding medium, the muscles will be
excitable; these vital properties are the activities of organized
substances, and so long as the state of organization is preserved
they are preserved; but the Life, which is the synthesis of all the
vital properties, vanishes with the destruction of that synthesis.
76. May we not generalize this, and say that every special form of
existence, organic or inorganic, is determined by the synthesis of its
elements? Atoms are grouped into molecules, molecules into
masses, masses into systems. Out of the textureless germinal
membrane and the yolk, with no additions from without except
oxygen and heat, are developed all the textures and organs of the
chick; and this chick weighs no more than the egg out of which it
was evolved. The development has been a succession of syntheses—
epigenesis upon epigenesis. We may, if we please, regard each
organite, as it appears, living its separate life, and each tissue its
separate life; but we must not confound under the same symbol
modes of existence so widely different as the activities of an
organite, and the activities of an organism constituted by millions of
organites.
77. If therefore we cannot restrict Life to the processes of
Nutrition, Dr. Beale’s hypothesis, whatever value it may have as
explaining histogenesis, is quite unacceptable. Neither Vital Force
nor Bioplasm covers the whole ground. For the former there is no
better evidence than our ignorance of the real synthesis; for the
latter the evidence is positive in its nature, but its interpretation is
questionable. Dr. Beale selects as the germinal matter those portions
of tissue which are susceptible of being deeply stained by the
carmine solution, the formed material being only stained in a faint
degree; the nucleus and nucleolus are the portions of germinal
matter which are most deeply stained; and hence he concludes that
the older the matter the fainter will be its coloration. There is no
dispute as to the value of the staining process, invented by Gerlach,
for the discrimination of chemically different parts of a tissue; and
28
Dr. Beale has made excellent use of it in his researches. But I
altogether dispute the conclusion that the staining process reveals
the parts which are exclusively vital; and for this reason: it depends
solely on the acid reaction of those parts; and we cannot divorce the
acid from the alkaline agencies, both being indispensable. Nay, it has
been proved that in the living animal no organized substance can be
stained. Lord Godolphin Osborne first discovered, in 1856, that the
29
protoplasm of growing wheat was susceptible of coloration; but
Gerlach, in 1858, found that this never took place in the animal
during life. He kept tadpoles and intestinal worms for weeks in
colored fluids, without a single spot becoming stained; although no
sooner did these animals die than the staining began. Nor even
when he injected the colored fluids under the skin and into the
30
stomach, was the slightest coloration produced.
To Gerlach’s testimony may be added that of Stein, who, in his
magnificent work on Infusoria, says that not only has no foreign
substance ever been found in the protoplasm of the Opalina, but in
the Acineta, and all the embryos of the higher Infusoria known to
31
him, he has been unable to color the living substance. This
resistance of the living protoplasm is surely a serious objection to
the hypothesis that only those parts of the dead organism which are
stained were the truly vital parts. Ranke sums up the results of his
experiments thus: “They all show that the living cell resists the
imbibition of every substance which it cannot assimilate. It is
precisely the impossibility of staining the cell that proves this
conclusively, since every particle of carmine absorbed would have
revealed its presence.”
It is not to be supposed that Dr. Beale was unacquainted with
Gerlach’s experiments. He has at any rate so far qualified the
statement of his hypothesis as to admit that it is only after death
that the germinal matter is stained. “The living matter” (he says,
How to Work with the Microscope, p. 107) “possesses an acid
reaction, or to speak more correctly, an acid reaction is always
developed immediately after its death.” Now, since this acid reaction
only presents itself after death, and it is this which is revealed by the
carmine, we have no right to conclude that the carmine singles out
the vital parts. Every one knows that the living muscle and nerve,
when in repose, present an alkaline or faintly neutral reaction, and
after excitation this is changed into an acid reaction, which increases
with the exhaustion of the tissue. In strict logic, therefore—if we
could logically apply such a test—it is the unstained parts that ought
to be called vital. But, in truth, alkalinity and acidity are equally
indispensable.
78. The main object of my bringing this question forward was to
illustrate the danger of being misled by analysis: a danger we shall
see to be very serious in psychological inquiries. The aid derived
from analysis need never be undervalued; all that we have to bear in
mind is that it is only a logical artifice, and that our real explanation
must always be synthetic. Because of the tendency to rely on
analysis there has been an imperfect discrimination of the profound
difference between

ORGANISMS AND MACHINES;

and while on the one hand the legitimate striving of the biologist to
display the mechanism of organic actions has been denounced by a
certain school as Materialism and a hateful attempt to “rob Life of its
mystery,” there has been on the other hand a misconception of this
mechanism, as if its dependent actions were of the nature of
machines, that is to say, as if organized mechanisms were strictly
comparable with machines constructed of inorganic parts. No doubt
the laws of Mechanics are the same in both, for these are abstract
laws which take no account of concrete differences. But when
elaborate parallels are drawn up between steam-engines and animal
organisms, the coal consumed in the one likened to the food in the
other, and the force evolved in the combustion in both being the
same, there is a complete obliteration of all that specially
distinguishes vital activity.
79. Between an organism and a machine there is the superficial
resemblance that both have a complex structure, and are
constructed of different and dependent parts. But underneath this
32
resemblance there is a radical diversity. The arrangement of parts
in the organism is more than a juxtaposition, it is a solidarity, arising
from the fact of their being all differentiations from a common
substance which is a special combination of the three classes of
proximate principles. Thus they are not parts which have been put
together, but which have been evolved, each out of a pre-existing
part, and each co-operating in the very existence of the other. The
machine is made of independent and primarily unrelated parts; its
integrity depends on the continued preservation of the substance of
each part; waste is here destruction. The organism is constituted by
interdependent and primarily related parts; its integrity depends on
the continued destruction and renovation of their substance; waste
is a condition of vitality. The actions of the machine are
subordinated; the actions of an organism are co-ordinated. The lever
moves a wheel, and the wheel in moving liberates a spring, each
transmitting a communicated impulse, but otherwise each acts
independently—no slight modification in the structure or movement
of the wheel will modify the structure or the movements of the lever,
no alteration in the tension of the spring will affect the structure of
the wheel. But in the organism all are parts of one sympathetic
whole; each reacts on each; each is altered by the other. Not a
nerve is stimulated, nor a muscle moved, but the entire organism is
affected. A condensation here is the cause of a greater imbibition
there. The injection of salt or sugar under the skin of the frog’s leg
will produce cataract in its eye. The activity of a secreting cell in the
ovary, or liver, alters the condition of the brain; the activity of the
brain will check the secretion of a gland, or relax the sphincters of
the bladder. When we observe the growth of horns, or the
appearance of the beard, concomitant with the secretion of
spermatic cells—and especially when we observe with these a
surprising change in the physical and moral capabilities and
tendencies of the organism—we understand how the remotest parts
of this mechanism are bound together by one subtle yet all-powerful
tie. Nothing of this is visible in a machine. In a machine the material
is so far of secondary importance that it may be replaced by
materials of various kinds: a pulley may be worked with a hempen
cord, a silken cord, or an iron chain; a wheel may be wood, iron,
copper, brass, or steel; the actions will in each case be similar. Not
so the organic mechanism: the slightest variation, either in
composition or intimate structure, will affect, and may frustrate the
organic activity. It is only in the skeleton that the specific character
of the materials may be changed; and here only in the substitution
33
of one phosphate for another in the solid masonry.
 80. Another marked characteristic of the organism is that it has a
connexus of actions, the simultaneous effect of a continuous
evolution, appearing in stages and ages. And in the animal organism
there is a consensus as well as a connexus, through which there is
evolution of Mind; and in the Social Organism an evolution of
Civilization. This consensus forms an intermediate stage through
which the animal actions are sensitive as well as nutritive, and the
nutritive are regulated by the sensitive. It is obvious that nothing like
this is to be found in a machine; and we conclude, therefore, that
any view of the organism which regards its mechanism without
taking in these cardinal characteristics must be radically defective.
We no more deny the existence of mechanical phenomena in
denying that the organism is like a machine, than we deny the
existence of chemical phenomena in denying that Vitality is
chemical.
 CHAPTER IV.

THE PROPERTIES AND FUNCTIONS.

81. The terms Property and Function are not always used with
desirable precision. There is, however, a marked distinction between
the property which characterizes a tissue in whatever organ the
tissue may be found, and the function which is exhibited by an
organ composed of several tissues. We ought never to speak of a
function unless we imply the existence of a correlative organ; and it
is therefore incorrect to speak of the function of Nutrition, since all
the tissues nourish themselves; but we may speak of certain organs
as special instruments in facilitating Nutrition. Thus also with
respiration, usually, but not accurately, spoken of as the function of
the lungs; the lungs being simply the most effective of the
instruments by which the interchange of gases (which also takes
place in every tissue) is facilitated. If by Respiration we mean
Breathing, then, indeed, Respiration is the function of the lungs; if
we mean the absorption of oxygen and the exhalation of carbonic
acid, Respiration is a general property of vital tissue. A fragment of
muscle removed from the body respires, so long as its organization
is intact; but it does not breathe—it has no accessory instruments,
nor does it need them. The co-operation of nerve centres,
diaphragm, ribs, circulating system, etc., necessary in the complex
organism to bring the due amount of oxygen to the tissues, and
convey away the carbonic acid, is here needless. In the ascending
animal series we find this necessity growing with the complexity of
the organism. The whole skin respires in the amphibia, and to some
extent in man also: a frog will live for ten or fourteen days after
extirpation of its lungs, the skin respiring sufficiently to keep up a
feeble vitality. But the skin does not suffice; and, very early, certain
portions are specialized into organs (at first in the shape of external
gills, and finally as internal lungs), for the more energetic, because
more specialized, performance of this office. In the simpler
organisms the blood is easily reached by the air; therefore no
instrument is needed. In primitive societies the transport of goods is
effected by men and women carrying them; in civilized societies by
the aid of horses and camels, and wagons drawn by oxen; till finally
these are insufficient, and railways are created, whose power of
transport transcends the earlier methods, as the breathing of a
mammal transcends the respiration of a mollusc. Breathing is the
special function of an organ—the lungs (or more strictly, the thoracic
apparatus)—as Railway Transport is a special social function.
Although each of the tissues forming this organ can, and does,
exhale carbonic acid and absorb oxygen—and each of the railway
servants can, and does, transport objects to and from the locomotive
—yet the main work is thrown upon the special apparatus.
82. What is meant by properties of tissue and functions of organs
may be thus illustrated. Let us suppose ourselves investigating the
structure of a ship. We find it composed of various materials—wood,
iron, copper, hemp, canvas, etc.; and these under various
configurations are formed into particular parts serving particular
purposes, such as deck, masts, anchor, windlass, chains, ropes, sails,
etc. In all these parts the materials preserve their properties; and
wherever wood or iron may be placed, whatever purpose the part
may serve, the properties of wood and iron are unaffected; and it is
through a combination of these properties that the part is effective;
while through the connection of one part with another the purpose
becomes realized. The purposes to which masts, ropes, or sails are
subservient may be called their functions; and these of course only
exist, as such, in the ship. It is the same with the organism. We find
it composed of various Tissues, and these are combined into various
34
Organs or Instruments. The properties of Tissues remain the
same, no matter into what Organs they may be combined; they
preserve and exert their physical, chemical, and vital properties, as
wood and iron preserve their properties. Each Tissue has its
characteristic quality; and the Organ which is constructed out of a
combination of several Tissues, more or less modified, is effective
35
solely in virtue of these properties, while the Function of that
organ comes into play through its combination with other organs.
For example, muscular tissue has a vital property which is
characteristic of it, Contractility; and muscles are organs constituted
36
by this tissue and several others; such organs have the general
function of Contraction, but whether this shall be specially
manifested in the beating of the heart, the winking of the eyelid, the
movement of the chest, or the varied movements of the limbs, will
depend on the anatomical connections. The reader unfamiliar with
Biology is requested to pay very particular attention to this point; he
will find many obscurities dissipated if he once lays hold of the
“principal connections.”
82a. Although Bichat’s conception was of great value, it was not
sufficiently disengaged from the metaphysical mode of viewing
biological phenomena. Both he and his disciples will be found
treating Properties as entities, and invoking them as causes of the
phenomena instead of recognizing them simply as abstract
expressions of the phenomena. Readers of my First Series will
remember how often I have had occasion to point out this common
error: men having baptized observed facts with a comprehensive
name, forget the process of baptism, and suppose the name to
represent a mysterious agency. The fact that gases combine is
expressed in the term affinity; and then Affinity is understood to be
the cause of the combinations. The fact that bodies tend towards
each other is called their gravitation, and Gravitation is then said to
cause the tendency. The doctrine of vital properties has been thus
misunderstood. While no one imagines that he can operate on
affinity otherwise than by operating on the known conditions under
which gases combine, many a biologist and physician speaks as if he
could operate on the Irritability of a tissue, or the Co-ordination of
muscles, by direct action on these abstractions.
Let it be therefore once for all expressly stated that by the
property of a tissue is simply meant the constant mode of reaction
of that tissue under definite conditions. The property is not a cause,
otherwise than the conditions it expresses are a cause. And these
conditions are first those of the organized structure itself, and
secondly those of the medium in which it lives. Oxygen unites with
Hydrogen to form water, but only under certain pressures; so
likewise muscles manifest Contractility on being stimulated (that is
their mode of reaction), but only under certain degrees of
temperature, humidity, and a certain chemical composition of the
plasmode. The property is so truly an expression of the co-operant
conditions, that it is found to vary with those conditions, and to
vanish when they vary beyond a certain limit.
An attempt has been made to restrict the notion of a property to
an ultimate fact. Whatever is not reducible to known conditions is to
be accepted as a property. Combustion, for example, is reducible to
the molecular combination of oxygen and some other gas; but this
combination itself is not reducible, and it is therefore christened
affinity. I cannot accept this view. Admitting our inability to say why
gases combine under certain conditions (and in this sense all facts
are inexplicable and ultimate, unless we take the how as ample
explanation of the why), I must still say that since affinity itself
depends on the co-operation of known conditions, it is not less
explicable than combustion. But the point is unimportant: what we
have here to settle is the meaning of a property of tissue,—and that
is the mode of reaction which that tissue manifests under constant
conditions, internal and external.
83. The evolution of Life is the evolution of special properties and
functions from general properties and functions. The organism rises
in power as it ramifies into variety. Out of a seemingly structureless
germinal membrane, by successive differentiations certain portions
are set apart for the dominant, or exclusive, performance of certain
processes; just as in the social organism there is a setting apart of
certain classes of men for the dominant or exclusive performance of
offices, which by their co-operation constitute Society. The soldier
fights, but ceases to build or reap, weave or teach; the mason
builds; the agriculturist sows and reaps; the priest and thinker teach;
the statesman governs. In simple societies each does all, or nearly
all; but the social life thus manifested is markedly inferior to the
energetic life of a complex society. So with organisms. An amœba
manifests the general properties of Nutrition, Reproduction,
Sensibility, and Movement. But it has no special organs,
consequently no special functions. The polype has a certain
rudimentary specialization of parts: it has a simple alimentary cavity,
and prehensile tentacles; and although by these it can seize and
digest its prey, it can only do so in a limited way—all the manifold
varieties and power of prehension and digestion observed in more
complex organisms are impossible with such organs as the polype
possesses.
84. Differences of structure and connection necessarily bring
about corresponding differences in Function, since Function is the
directed energy of the Properties of tissues. One organ will differ
from another in structure, as the liver from the pancreas, or the
kidney from the spleen; or one organ may closely resemble another
but differ from it only in connections, as a sensory and a motor
nerve, or an extensor and a flexor muscle. We must therefore always
bear both points in mind. Every modification, structural or
connectional, is translated by a corresponding modification in the
office. The hand and the foot show this well. The tissues are the
same in both, the properties are the same, and both have the same
general function of Prehension; but their morphological differences
carry corresponding differences in their uses.
Suppose we have a galvanic battery, we know that its electric
force may be variously applied. Two pieces of charcoal fixed to the
ends of its conducting wires give us the electric light; replacing the
charcoal by a telegraphic apparatus we can transmit a message from
one continent to the other; the wires dipped in a solution effect a
chemical decomposition, dipped into a mixture of gases they effect a
chemical composition. In these, and many other applications, the
property of the battery is constant; but the functions it subserves
have varied with the varying co-operants. So with the properties of
37
tissue. Not only have we to bear in mind the organic connections
of the tissues, but also the relation of the organs to their media.
Swimming and Walking, for example, are both functions of the
locomotive apparatus, but they are specially differenced by the
media in which the animal moves.
85. The properties of tissues are their peculiar modes of reaction,
and each tissue has its dominant characteristic, such as the
Contractility of the muscle, and the Neurility of the nerve. But there
has of late years sprung up a misleading conception, partly a
consequence of the cell-theory, and partly of the almost inevitable
tendency of analysis to disregard whatever elements it provisionally
sets aside; this conception is the removal of the property from its
tissue, and the localization of it in one of the organites—cell or fibre.
This has been conspicuously mischievous in the case of the nerve-
cell, which has been endowed with mysterious powers, and may be
said to have usurped the place of nerve-tissue. I shall have to speak
of this in the next problem. Here I only warn the student against the
common error. The properties of a tissue depend on the structure
and composition of that tissue, together with its plasmode and
products; they vary as these vary. To select any one element in this
complex, and ascribe the reaction of the tissue to that, is only
permissible as a shorthand expression.
86. What has just been expounded may be condensed in the
following biological law:—

Identity of tissue everywhere implies identity of property;

and similarity of tissue corresponding similarity of property.
Identity of organic connection everywhere implies identity of
function; and similarity of organic connection similarity of
function.
 87. This law, first formulated by me in 1859, and then applied to
the interpretation of nervous functions, was so little understood that
for the most part it met with either decided denial or silent neglect;
no doubt because of the general disinclination to admit that the
properties and functions of the spinal cord could be similar to those
of the brain, in correspondence with the similarity of their tissues
and organic connections. Even Professor Vulpian, who adopted it, as
well as my principal interpretations, hesitated, and relapsed into the
orthodox view in assigning three different properties to one and the
38
same tissue in cord, medulla oblongata, and cerebrum. In the
course of our inquiries we shall so frequently have to invoke this law
that I earnestly beg the reader to meditate upon it, and ask himself
upon what other grounds, save those of structure and connection,
the properties and functions can possibly rest? If on no other, then
similarity in structure and connection by logical necessity involves
similarity in property and function.

DOES THE FUNCTION DETERMINE THE

ORGAN?
88. Closely connected with this law, which simply formulates the
self-evident principle that every action is rigorously determined by
the nature of the agent, and the conditions under which the act
takes place, is the surprising question whether functions are
dependent upon organs, or organs dependent on functions?—a
question which sometimes takes this shape: Is Life the result of
organization, or is organization the result of Life?
The vitalist, who holds that Life is an extra-organic agent, is
39
logical in declaring organization to be the consequence of Life; but
there are many organicists who conclude from certain facts that
organs are developed by functions, and that organization is a result
of Life. There seems, however, to be some equivoque here. I cannot
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