Post on 31-Mar-2015
Chapter 7Public Goods
Jonathan GruberPublic Finance and Public Policy
Aaron S. Yelowitz - Copyright 2005 © Worth Publishers
Introduction
Some markets do not work very well because the good in question has public good characteristics to it.
For example, in Dhaka, Bangladesh, public trash collection is fairly inefficient, but attempts at privatization have not fared any better.
The key problem with private collection of garbage is the free rider problem–with a private, voluntary system, each resident could simply sneak his garbage into his neighbor’s garbage and avoid making payments.
Introduction
Eventually, everyone would figure this out, and no one would be willing to pay trash collection voluntarily.
In fact, most residents have figured out the incentive to “free ride.” Only 50 of 1,100 neighborhoods have private garbage collection, however.
Introduction
This lesson explores the role of government in providing goods like this, and shows that the private sector tends to underprovide them.
It also explores the notion of “crowd-out” where public provision simply substitutes for already existing private provision of a good.
Introduction
The role of public goods is important in economics. The subsequent lessons explore issues related to: Cost-benefit analysis Political economy State and local government Education
OPTIMAL PROVISION OF PUBLIC GOODS
Pure public goods have two traits: They are non-rival in consumption: The
marginal cost of another person consuming the good is zero, and does not affect your opportunity to consume the good.
They are non-excludable: There is no way to deny someone the opportunity to consume the good.
Table 1Table 1 gives some examples.
Table 1
Defining pure and impure public goods
Is the good rival in consumption?
Yes No
Is the good
excludable?
Yes Ice cream Cable tv
No Crowded city sidewalk National defense
This table shows examples of pure public goods, impure public goods,
and private goods.
If a good is both rival and excludable, it is a private good.
Ice cream is rival, because my consumption of it precludes you from consuming the same ice cream. The only way for you to consume it is to
make more ice cream.
Ice cream is also excludable, because I can simply not share my
ice cream with you.
Some goods are “impure” public goods because they are non-rival, but they are (to some extent) excludable.
Cable TV is non-rival, because my consumption of it in no way
diminishes your consumption.
It is excludable, since the cable company can simply refuse to hook
up the system.Other goods are “impure” public goods because they are rival, but not
excludable.
For example, a crowded sidewalk is rival because your enjoyment is
reduced as more pedestrians also use the same sidewalk.
Yet it is non-excludable because it is clearly very difficult to prohibit
pedestrians from using the sidewalk.
Finally, pure public goods are both non-rival and non-excludable.National defense is a classic
example. It is non-rival because my consumption of national defense protection does not diminish your
consumption of it.
It is also non-excludable, because once an area is protected, everyone
“consumes” that protection.
OPTIMAL PROVISION OF PUBLIC GOODS
It is helpful to think of public goods as goods with a large, positive externality.
Optimal Provision of Private Goods
Consider a private good, like ice cream. Figure 1Figure 1 shows the market for ice
cream cones, assuming that the alternative use of the money is buying cookies at $1 each. This makes cookies the numeraire
good.
Quantity of ice cream
Price of ice cream
0 QBEN
SMB =DBEN+JERRY
QTOTAL
$2
S=SMC
$3
DBENDJERRY
QJERRY
Adding up Ben’s and Jerry’s individual demands give society’s demand at $3.
Adding up Ben’s and Jerry’s individual demands give society’s demand at $2.
Adding up Ben’s and Jerry’s individual demands at each
price gives society’s demand.
Ben has an individual, downward-sloping demand
curve for ice cream.
At a price of $3, neither person demands much ice cream.Jerry also has an individual,
downward-sloping demand curve for ice cream.At a price of $2, both people
demand more ice cream.Leading to a competitive
equilibrium at $2. Ben & Jerry consume different quantities.There is a market supply curve
associated with producing ice cream.
Figure 1 Demand for a private good
Optimal Provision of Private Goods
In this figure, as price adjusted, each person changed his quantity consumed.
For a private good, consumers demand different quantities at the same market price.
Optimal Provision of Private Goods
We can also represent this relationship mathematically. Ben has preferences over cookies (C) and ice cream (IC):
As does Jerry:
U C ICB ,
U C ICJ ,
Optimal Provision of Private Goods
Utility maximization requires that each of their indifference curves is tangent to the budget constraint. For Ben, we have:
For Jerry we have:
MU
MUMRS
P
PICB
CB IC C
B IC
C
,
MU
MUMRS
P
PICJ
CJ IC C
J IC
C
,
Optimal Provision of Private Goods
Recall that in equilibrium, the price of ice cream is $2, and the price of cookies is $1 (because it is the numeraire good).
In equilibrium each person must be indifferent between trading two cookies to get one ice cream.
Optimal Provision of Private Goods
On the supply side, ice cream cones are produced until the marginal cost equals the marginal benefit, which equals the price in a competitive market.
Recall that PC=$1, meaning:
MC PIC IC
MRS MRS P MCIC CB
IC CJ
IC IC, ,
Optimal Provision of Private Goods
The private market equilibrium in this case is socially efficient.
The MRS for any quantity of ice cream equals the SMB of that quantity–the marginal value to society equals the marginal value to any individual in the perfectly competitive market.
Optimal Provision of Public Goods
Now consider the tradeoff between a public good, like missiles, and a private good like cookies.
Figure 2Figure 2 shows the market for missiles, assuming that the alternative use of the money is buying cookies at $1 each.
$2$2
Quantity of missiles
Price of missiles
0
SMB=DBEN+JERRY
$4 S=SMC
$6
DBEN
DJERRY
1
$3
$1
5
Adding up Ben’s and Jerry’s willingness to pay gives
society’s demand for 1 missile.
Adding up Ben’s and Jerry’s willingness to pay for each
quantity gives society’s demand.
There is a market supply curve associated with producing
missiles
Leading to a competitive equilibrium at 5 missiles. Ben &
Jerry consume the same Q.Ben has a downward sloping demand curve for missiles.
Adding up Ben’s and Jerry’s willingness to pay gives society’s
demand for the 5th missile.
As does Jerry.
Ben’s willingness to pay for the first missile is $2.
While Jerry’s willingness to pay for the first missile is $4.
While Jerry’s willingness to pay for the fifth missile is $2.
Ben’s willingness to pay for the fifth missile is $1.
Figure 2 Demand for a public good
Optimal Provision of Public Goods
Unlike the case of private goods, where aggregate demand is found by summing the individual demands horizontally, with public goods, aggregate demand is found by summing vertically.
That is, holding quantity fixed, what is each person’s willingness to pay?
Optimal Provision of Public Goods
We can also represent this relationship mathematically. Ben has preferences over cookies (C) and missiles (M):
As does Jerry:
U C MB ,
U C MJ ,
Optimal Provision of Public Goods
To Ben, the marginal missile is worth:
For Jerry, the marginal missile is worth:
MU
MUMRSM
B
CB M C
B ,
MU
MUMRSM
J
CJ M C
J ,
Optimal Provision of Public Goods
The social marginal benefit (SMB) of the next missile is the sum of Ben and Jerry’s marginal rates of substitution:
Where “i” represents each person in society.
MRS M Ci
i,
Optimal Provision of Public Goods
The social marginal cost (SMC) is the same as earlier: the marginal cost of producing a missile:
Efficiency therefore requires:
MC M
MRS MCM Ci
iM,
Optimal Provision of Public Goods
That is, social efficiency is maximized when the marginal costs are set equal to the sum of the marginal rates of substitution (rather than each individual’s MRS).
This is because the good is non-rival. Since a unit can be consumed by all consumers, society would like the producer to take into account all consumers’ preferences.
PRIVATE PROVISION OF PUBLIC GOODS:
Private-sector Underprovision In general, the private sector
underprovides public goods because of the free rider problem.
Consider two people, Ben and Jerry, and two consumption goods, ice cream and fireworks.
Set the prices of each good at $1, but fireworks are a public good. Assume that Ben and Jerry have identical preferences.
Private-sector Underprovision
Ben and Jerry benefit equally from a firework that is provided by either of them. What matters is the total amount of
fireworks. Each person chooses combinations of
ice cream and fireworks in which his own MRS equals the ratio of price.
Private-sector Underprovision
For both Ben and Jerry, they set:
Whereas optimal provision requires:
MRS MU MUF IC IC F, , 1
MRS F ICi
i, 1
Private-sector Underprovision
With identical preferences:
Recall that marginal utilities diminish with increasing consumption of a good.
In this example, optimal provision would require that fireworks are consumed until their utility equals half the marginal utility of ice cream.
Thus, each individually buys too much ice cream privately.
2 12
MU
MUMU
MUF
ICF
IC
,
The Free Rider Problem in PracticeThe Free Rider Problem in Practice
There are some interesting examples of the free-rider problem in practice. Only 7.5% of public radio listeners in New
York contribute to the stations–that is, there is a lot of free-riding. In the United Kingdom, the BBC charges an annual licensing fee for all television owners.
Many users of file sharing services never contribute uploaded files; they only download files. Some of these services, like Kazaa, give download priority to those who contribute.
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When Is Private Provision Likely to Overcome the Free Rider Problem?
While the free-rider problem clearly exists, there are also examples where the private market is able to overcome this problem to some extent.
But the private market may still fall short of the socially optimal amount.
Can Private Providers Overcome the Can Private Providers Overcome the Free Rider Problem?Free Rider Problem?
Examples of private provision of a public good: Privately financed fireworks displays. Privately owned British lighthouses until
1842.
Business Improvement DistrictsBusiness Improvement Districts
A final example concerns business improvement districts (BID). The quality of city streets is a public good. During the 1980s, New York City’s Times Square had
high crime and many social problems. The city had given up on cleaning up Times Square.
In 1992, local businessmen started a BID–a legal entity to provide security and sanitation, with fees collected from local businesses.
New York law makes participation of businesses compulsory if BID organizers can get 60% of local businesses to join, allowing the organizers to overcome the free-rider problem.
The BID was a clear success in New York City.
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Business Improvement DistrictsBusiness Improvement Districts
On the other hand, Massachusetts law allows businesses to “opt-out” of a BID within 30 days of the BID approval by the local government.
This deters formation of BIDs in the first place, because there are fixed costs of doing so.
As a consequence, only 2 BIDs have been formed in Massachusetts.
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When Is Private Provision Likely to Overcome the Free Rider Problem?
Under what circumstances are private market forces likely to solve the free rider problem? Intense preferences. Altruism. Utility from one’s own contribution to
the public good.
Some individuals care more than others
When some individuals have especially high demand for a public good, private provision may emerge (but not necessarily provide efficiently).
The key intuition is that the decision to provide a public good is a function of the enjoyment that the individual gets from the total amount of the public good, net of cost. If a person gets a lot of enjoyment, or has a
lot of money, he will choose to purchase more of the public good even though it benefits others.
Some individuals care more than others
Olson and Zeckhauser (1966) studied the financing of NATO, which was a voluntary organization at the time. Although countries had an incentive to free-
ride on the contributions of others, the largest nations (such as the United States) did contribute.
Higher incomes or stronger tastes can mitigate the free rider problem to some extent, but are unlikely to solve it completely. Thus, underprovision is still likely to occur.
Altruism
Another reason is that there is evidence that many individuals are altruistic, caring about the outcomes of others as well as themselves.
Altruism
Laboratory experiments are becoming more popular in the economics profession.
Some experiments examine the incentive for college students to contribute to a pool of money, where the dominant, self-interested strategy should be to not contribute.
The experiments suggest that between 30% and 70% of participants contribute to the public good. As the experiment is repeated in multiple
rounds, contributions fall, but rarely reach zero contributions.
Private Provision of Public Goods:When is private provision likely to overcome the free rider problem ?
Of course, these experiments may be of limited applicability to the real world: Individuals may behave differently in a
contrived laboratory setting. The stakes are often small, so the cost
of being altruistic is low. College undergraduates may not be
representative of the population more generally.
Private Provision of Public Goods:When is private provision likely to overcome the free rider problem?
On the other hand, some real-world evidence is consistent with altruism in private support of public goods. Brunner (1998) found that the number
of public radio listeners who contribute decreases only modestly as the total number of listeners increases.
Warm glow
A final reason is that that individuals may provide for a public good is due to warm glow. The warm glow model is a model of public
good provision in which individuals care about both the total amount of the public good and their particular contributions as well.
For example, they may get some psychological benefit from knowing they helped a worthy cause.
In this case, the public good becomes more like a private good, though it does not fully solve the underprovision problems.
PUBLIC PROVISION OF PUBLIC GOODS
In principle, the government could solve the optimal public goods provision problem and then either provide the good directly or mandate individuals to provide the amount.
In practice, three problems emerge: Crowd-out. Measuring costs and benefits. Determining the public’s preferences.
Private Responses to Public Provision:
The Problem of Crowd-Out In some cases, the private market may
already be providing a socially inefficient level of the private good.
In this case, public provision may crowd-out some of the private provision–as the government provides more of the public good, the private sector provides less.
Private Responses to Public Provision:
The Problem of Crowd-Out For example, in the fireworks example with
Ben and Jerry, if one assumes: Ben and Jerry care only about the total
number of fireworks provided. Government provision will be financed by
charging equal amounts to each of them. And the government provides no more
fireworks than were being provided privately beforehand.
Then each dollar of public provision will crowd out private provision one-for-one.
Private Responses to Public Provision:
The Problem of Crowd-Out The full crowd-out in the fireworks
example is rare, though partial crowd-out is much more common and can occur when: People who don’t contribute to the public
good are taxed to finance its provision. Or when individuals derive utility from
their individual contributions as well as the total amount of the public good provided.
Private Responses to Public Provision:
The Problem of Crowd-Out If noncontributors are forced to help
pay for the good (but it is still below the social optimum), then the contributors’ effective income levels are higher than before.
As a result of this income effect, contributors buy more if the public good is a normal good, offsetting the crowd-out to some extent.
Private Responses to Public Provision:
The Problem of Crowd-Out Alternatively, as discussed previously,
there may not be full crowd-out if an individual cares about his own contributions (the warm glow model).
In this case, an increase in government contributions will not fully crowd out giving.
Public Provision of Public Goods:Measuring the costs and benefits of
public goods Another problem for government
provision is measuring costs and benefits of the public good. This entails the field of cost-benefit analysis, discussed in the next lesson.
For example, improving a highway involves valuations of commuting time saved as well reduced traffic fatalities.
How Can We Measure Preferences for the Public Good?
Finally, our model of optimal public good provision assumes the government knows each person’s preferences over public and private goods.
In practice, this runs into problems with preference revelation, preference knowledge, and preference aggregation.
These issues are addressed in the field of political economy.
Recap of Public Goods
Optimal provision of public goods Private provision Public provision