ABSTRACT
In this section, we extend the Arrow-Lind framework by allowing the taxpayers to choose their levels of contribution to the public investment and by endogenizing the total tax such that the project is fully funded. The inclusion of decision making in the Arrow-Lind framework has a profound effect on the interpretation of limiting cases. Specifically, we show that perfect risk spreading (due to the population of taxpayers tending to infinity) does not imply that social risk is negligible. In other words, if the public investment is evaluated on the basis of expected benefit, then risk-averse taxpayers are unwilling to contribute. We first present the model and characterize the equilibrium for any finite number of taxpayers. We then discuss the limiting case. This model is in the spirit of the model used in Arrow and Lind (1970). It does not consider the free rider problem, that is, the revelation of truthful valuations for the taxpayers. Prices are uniform and the government’s budget is balanced. This model is used primarily to study the effect of risk aversion and risk sharing.
