A major part of our research effort is devoted to the development of an appropriate conceptual framework for the normative analysis of public goods provision when the value that any one person attaches to the public good is known only to that very person. Whereas most of the literature considers the problem of public-good provision with private information in a small economy, we focus on large economies, in which any one individual is too insignificant to affect the level of public-good provision aggregate outcome. We have several reasons for choosing this focus:

• Whereas the small-economy models studied in the literature are useful, e.g., for thinking about how the inhabitants of a village can co-ordinate on the installation of an irrigation system, we believe that it is not so useful for thinking about how a country with more than a million inhabitants should choose the level of resources that are devoted to national defense or to the legal system.
• Most models of taxation are models of large economies, as are most models of market equilibrium for private goods. If there is to be any hope of integrating public goods provision theory with the rest of welfare economics, we need to have a convincing account of public-good provision in a large economy.
• The differences between private and public goods, more precisely, between goods that exhibit rivalry in consumption and goods that do not, emerges most clearly when the number of participants is large. For small economies, standard results on incentive mechanisms show that for both private and public goods, efficiency of final outcomes may be altogether unattainable if information about the value that any one person attaches to the good is private and if participation in the system is voluntary. For private goods, the inefficiency is less important the more people there are; for public goods, the reverse is true.
• As yet, we do not have a good conceptual and formal apparatus for thinking about public-good provision in a large economy. If we assume independence of individual valuations and we treat the large economy as a limit of finite economies, a law of large numbers implies that the cross-section distribution of valuations and therefore the efficient level of public-good provision is common knowledge. Even to talk about an information problem involved in the determination of efficient public goods provision levels in large economies, one must have correlated values. For a variety of reasons however, our understanding of incentive mechanisms with correlated values is unsatisfactory.

Mention of the problem of how a country with millions of inhabitants should decide on spending levels for national defense or for the judicial system undoubtedly raises the question why we are studying this as a problem of normative economics rather than political science. We do so because we want to have a measuring rod by which to assess the strengths and weaknesses of decision procedures that are actually used. Over the past thirty or so years, normative economics has learnt that a simple efficiency standard that abstracts from issues of information and incentives is not very useful. The theory of mechanism design has taught us to take account of information and incentive constraints and to ask what measure of efficiency can be achieved when these constraints are taken into account. This is the very type of question that we are asking about the provision and financing of public goods in large economies.

The relevance of the question is easily seen if one goes back to the well-known critique of political decision-making that was raised by the economists Stigler and Peltzman in the Seventies. According to this critique, political decision-making, in particular majority voting, gives rise to inefficient outcomes because it fails to take account of intensities of preferences. Thus, a majority of people who care slightly about an issue can impose its will on a minority who care deeply about it. If the disparity between the two groups is sufficiently large, the result is inefficient in the sense that everybody would be better off if the minority was able to “bribe” the majority to vote differently.

In this “economist’s critique” of collective decision-making by voting, no account is taken of possible information asymmetries, e.g., concerning the intensities of the different groups’ likes and dislikes of the alternatives that are voted on. One result of our research shows that, once these information asymmetries are taken into account, it may not even be possible to rely on something other than a voting mechanism, i.e., the Stigler- Peltzman critique of relying on such mechanisms becomes moot.

The research covered by this report under the general heading of Public Goods and Welfare Economics falls into three broad areas:

• Development of an overarching conceptual and formal framework that can be used  to integrate the theory of public goods provision with the rest of normative economics, in particular the theories of public-sector pricing and of taxation.
• Development of a conceptual and formal framework that is suitable for dealing with issues concern the revelation, communication and use of private information in a large economy.
• Development of a conceptual and formal framework that is suitable to address issues concerning incentives and governance on the supply side of public-good provision and can also be used to integrate the analysis of such issues with the more conventional analyses of demand and funding.

Research in the first of these areas has mainly been done in the period 2003 – 2005 and has been reported on in the last Institute Report. Activities in 2006 – 2007 have mainly involved mopping-up operations such as polishing and revisions for journal publications. Research in the second area has been the major achievement of the period 2006 – 2007. Research in the third area will be a major task for the period 2008 – 2009. The following Sections C.I.2 – C.I.4 of this report will take up each of these areas in turn.