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A Study of the Voluntary Exchange Or Price Theory of Public Finance A STUDY OF THE VOLUNTARY EXCHANGE OR PRICE THEORY OF PUBLIC FINANCE 1 I By DONALD RAY ESCARRAZ I\ Bachelor of Science University of Tampa Tampa, Florida 1960 Master of Business Administration University of Wisconsin Madison, Wisconsin 1961 Submitted to the Faculty of the Graduate School of the Oklahoma State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY August, 1964 OKLAHOMA STATE UNIVERSl1Y LIBRARY JAN 8 l9v5 A STUDY OF THE VOLUNTARY EXCHANGE OR PRICE THEORY OF PUBLIC FINANCE Thesis Approved: 570240 ii PREFACE The voluntary exchange or price theory of public finance has a his­ tory which is as long as the history of the price theory of private goods, if the number of years is the basis for the length of history. However, the price theory of public goods has not achieved the level of accepta­ bility which the price theory of private goods has achieved. The acceptance of the price theory of public finance by economists in the future will depend, to a large extent, upon its application to real world situations . However, the extent to which it is likely to be applied by economists in the future will probably depend upon the extent to which certain problems and criticisms of the theory are understood. This dissertation represents an attempt to evaluate the problems and criticisms of the price theory of public finance . All of the speci­ fic problems and criticisms could not be treated comprehensively in this paper but I believe that the ones which are most likely to act as barriers to the future application of the theory have been treated. The conclu­ sions derived from the analysis of probl ems and criticisms do not pro­ vide a basis for discussing the specific future applications of the theory . However, the conclusions from this type of analysis do provide a basis for making some general statements about broad areas of future application of the theory . Despite this recognition of the importance of future applications of the theory, the primary theme of the dissertation is the analysis of iii the problems and criticisms of the price theory of public finance. I believe that once these problems and criticisms are more fully under­ stood, specific applications of the theory will more or less naturally follow . The full scope of possible problems cannot be known until they arise from attempts to make specific applications of the theory. How- ever, the motivation to even attempt to apply the theory will not exist until the general criticisms of the theory have been thoroughly analyzed and understood . My indebtedness is acknowledged to Dr. Ansel M. Sharp who started me into the study of the price theory of public finance and who as my dissertation adviser guided me away from many of the side issues into which I would have otherwise undoubtedly strayed . The cooperation and help of Dr . Julian H. Bradsher i n the editing of. early drafts of the entire dissertation and of Dr . Richard H. Leftwich in evaluating some of the models developed in Chapters IV and V also deserves special acknowledgement . The editing of the final rough draft by Mrs. Ansel Sharp gave me greater confidence in the finished dissertation and is, therefore, acknowledged. Acknowledgement is also made of the cooperation of Dean Helmer E. Sorenson and Dr . Wilton T. Anderson who, as members of my cormnittee from outside the Department of Economics, kept their doors open to me and who promptly cooperated with Dr . Sharp, Dr. Bradsher and me . I also wish to acknowledge the work and loyalty of my family. Barbara, my wife, typed the many early drafts of the dissertation de­ spite the fact that she was expecting our third child in May, 1964 . Her iv work of typing, however, could not have been accomplished without the cooperation of our first two children, Pamela and Paul. Last, but not least, I wish to acknowledge the work of Mrs. Karen Konstas in typing the final draft of the dissertation. She took over the job of doing the final typing with a very limited time in which to complete the typing of material which was not familiar to her. V TABLE OF CONTENTS Chapter Page . I. INTRODUCTION 0 0 0 0 0 0 0 0 0 O a o o o o o o o o o o ·o o o 1 II. THE DEVELOPMENT OF THE VOLUNTARY EXCHANGE OR PRICE THEORY OF PUBLIC FINANCE: NONGRAPHICAL MODELS • • • • • • • • • • • • 6 Maffeo Pantaleoni • 0 $ 0 0 0 0 0 10 Ugo Mazzola • • • • • • • • • • • a•oo ooo 13 Emil Sax. • • • • • • • ooeoooo 16 Antonio DeViti DeMarco. • • • • • • o· o o o o o o o 19 ·Summary ·••• 0 0 C o 0 • • • • 0 oo•o•omot 24 IIL THE DEVELOPMENT OF THE VOLUNTARY EXCHANGE OR PRICE THEORY OF PUBLIC FINANCE: GRAPHICAL MODELS. • • • • • • • • • 27 Erik Lindahl and Knut Wicksell •• 0 0 0 0 0 0 0 27 Howard R. Bowen •• 40 Milton z. Kafoglis •• 0 0 0 Q • 0 Q O 0 51 Summary. 0 • • 0 . o•oooo 57 IV. A CRITIQUE OF CRITICISMS: REVEALED PREFERENCES •• . 60 Preferences will not be Revealed ••••••••• 61 A Large Number of Solutions Exist when Preferences are Revealed. • • • • • • • • • • • . 69 Summary ••••• 00000000000000000 . 77 V. THE PRICE THEORY OF. PUBLIC FINANCE: A. SUGGESTED APPROACH. • 80 A Modified Musgrave-Samuelson Model 0 0 0 0 0 0 0 Q 81 Important Assumptions in the Model. 0 •. 88 Summary • • • • • • • 0 0 0 0 0 91 VI. A CRITIQUE OF CRITICISMS: TAXES AND THE POLITICAL PROCESS • 94 Prices and Taxes. • • • • • • • • • • • • • • • • • 96 The Market Mechanism and the Political Mechanism. • • • 99 Summary e C O O O O O O O O O O O O O O O O O O O O 110 vi TABLE OF CONTENTS (Continued) Chapter Page VII. CONSTITUTIONAL RULES AND POLICY RULES OF GOVERNMENT: A SUGGESTED APPROACH • • • • • • • • • • • • • • . 113 The Representative Constitutional Form of Government •• 115 Public Goods Neutral as to the Optimum Allocation of Resources o o q o o o o o o o o o o o o o o o o • Q " 12 0 Pareto Optimum Allocation of Resources as a Standard of Reference. • • • • • • • • • • • • • • • • • • 124 Public Goods Neutral as to Prices of Private Goods. 126 Public Goods Neutral as to the Private Sector of the Economy • 0 0 0 0 0 0 0 0 129 Summary • • • • • • 0 0 O O O O O ~ 132 VIII. SUMMARY AND CONCLUSIONS. 0 0 • 0 • 0 0 • 0 0 0 0 0 ' . 135 Applicability and Limitations of the Theory.as an Explanation of the Real World •••••••••• 141 Applicability and Limitations of the Theory as a Framework for Policy Proposals •••••• 0 0 0 143 Applicability and Limitations of the Theory as a Framework for Discussing Concepts of Public Finance • 145 SELECTED BIBLIOGRAPHY • 0 0 o O 0 148 vii LIST OF FIGURES Figure Page 1. LindahlModel •• • • • • 0 • 0 OQOOOC, . 0 0 0 0 ~ Q 0 29 2. Wicksell Model •• • • • • 0 • 0 0 0 0 0 I . • • • • • • • 31 3. Bowen Model I •• 0 0 9 0 0 0 0 0 • 0 • • 0 0 0 0 0 ' 0 0 • 0 41 4. Bowen Model II • 0 • 0 0 0 0 0 • 0 • • . 0 • 0 0 0 44 Bowen Model III. • 0 0 0 0 0 0 0 O • 0 • 0 0 I G 0 0 • 0 0 0 46 6. Lindahl Model and Bowen Model I. • • • • • • . 0 • • 47 7 •.Kafoglis Model - Adjustment of Indifference Map. • 0 0 • 54 8. Kafoglis Model - Net Income Consumption Curves • • 0 0 0 0 • 56 9. Revealing of Preferences • 0 Q O O O O 0 63 10. Musgrave-Samuelson Model •••••• 0 • . • • 0 0 0 I 70 11. Utility Frontier with Social Goods • • 0 . 0 0 0 I I I 72 12. Musgrave-Samuelson Model with Private Goods •• 0 0 74 13 0 Utility Frontier with Private Goods ••••• 76 14 0 Modified Musgrave-Samuelson Model with Private Goods • . 82 15. Price Theory Under Various Market Situations •••• 0 0 0 0 84 16. Modified Musgrave-Samuelson Model with Social Goods. 86 17. Public Goods Neutral as to Optimum Allocation of Resources • 121 18. Public Goods Neutral as to Prices of Private Goods ••• 0 0 127 19. Public Goods Neutral as to Private Sector of the Economy • • 130 viii CHAPTER I INTRODUCTION +he voluntary exchange or price theory of public finance had its origin in the benefit approach to taxation but it never has had the widespread acceptance enjoyed by the benefit approach in the eighteenth and nineteenth centuries. The causes of this lack of acceptance of the voluntary exchange or price theory of public finance is the pri­ mary theme of this dissertation. More specificially, an attempt is made to show that the criticisms of the theory are not a sufficient reason to completely reject the theory. In the process of analyzing the major criticisms of the price theory of public finance, suggested approaches to the theory and to the application of the theory to the political process are made. There are many aspects to the voluntary exchange approach to public finance, but its essence can be understood by simply considering it to be the application of the whole body of price theory to the problem of the supply of goods and services by the govet'I\ment. This view of the theory of public finance requires that the revenues of the government (taxes) be considered together with the expenditures of the government. The expendi­ tures of government must be considered as costs of producing goods and services. The government is, thus, considered to be a producer or firm in the economy, similar to private firms.
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