Public Good Mix in a Federation with Incomplete Information

We analyze a model of resource allocation in a federal system in which the center transfers real resources between member states. The center is assumed to be unable to observe the precise value of the cost differences across jurisdictions that motivate the transfers. Moreover, the center cannot observe the output levels of the individual local public goods provided by the jurisdictions, but must condition its transfers on a coarse aggregate of expenditures on public goods. We find that when the jurisdiction with private information realizes a high unit cost, it is generally worthwhile for the center to allow it a level of expenditure on public goods that differs from the "first best" level. However, whether that level is higher or lower than its first best level depends on the magnitudes of demand parameters for the local public good.