Compensation With Induced Factor Movements in a Simple General Equilibrium Model

Interjurisdictional compensation can provide an effective method of achieving an optimal provision of public goods in an independent system of local governments, only if all the major side effects of public goods are included in its computation. Previous studies have suggested compensation levels calculated solely on spillins and spillouts of public goods, but in this framework the provision of public goods may induce migration of productive inputs. To incorporate potential movement of factors of production, we recast the local government expenditures problem in a simple general equilibrium framework and estimate the impact of migration on the suggested compensation level. We show that, within reasonable ranges of parameter values of our model, compensation based entirely on output externalities substantially understates the level necessary to achieve an allocatively efficient provision of public goods.