CHAPTER 3 PUBLIC GOODS

CHAPTER PUBLIC GOODS Introduction    Some markets 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 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 gives some examples Table Defining pure and impure public goods Is the good rival in Yesconsumption? No Yes Is the good excludable No ? Ice cream Cable tv Crowded city sidewalk National defense • Examples of public goods: • national defense • fireworks • radio and television broadcast signals • clean air 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 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 Price of ice cream S=SMC $3 $2 DJERRY Figure QJERRY QBEN QTOTAL DBEN SMB =DBEN+JERRY Quantity of ice cream Demand for a private good 10 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 11 Optimal Provision of Private Goods  We can also represent this relationship mathematically Ben has preferences over cookies (C) and ice cream (IC): U B C, IC   As does Jerry: U J  C, IC  12 Optimal Provision of Private Goods  Utility maximization requires that each of their indifference curves is tangent to the budget constraint For Ben, we have: B MU IC PIC B  MRS IC ,C  MU CB PC  For Jerry we have: J MU IC PIC J  MRS IC ,C  MU CJ PC 13 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 14 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 MC IC  PIC  Recall that PC=$1, meaning: B J MRS IC ,C  MRS IC ,C  PIC  MC IC 15 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   16 Optimal Provision of Public Goods   Now consider the tradeoff between a public good, like missiles, and a private good like cookies Figure shows the market for missiles, assuming that the alternative use of the money is buying cookies at $1 each 17 Price of missiles $6 S=SMC DJERRY $4 $3 SMB=DBEN+JERRY $2 $2 DBEN $1 Figure Quantity of missiles Demand for a public good 18 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? 19 Optimal Provision of Public Goods  We can also represent this relationship mathematically Ben has preferences over cookies (C) and missiles (M): U B C, M   As does Jerry: U J  C, M  20 Optimal Provision of Public Goods  To Ben, the marginal missile is worth: MU MB  MRS MB ,C MU CB  For Jerry, the marginal missile is worth: MU MJ  MRS MJ ,C MU CJ 21 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:  MRS i M ,C i  Where “i” represents each person in society 22 Optimal Provision of Public Goods  The social marginal cost (SMC) is the same as earlier: the marginal cost of producing a missile: MC M  Efficiency therefore requires:  MRS i M ,C  MC M i 23 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 24 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 25 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 26 Private-sector Underprovision  For both Ben and Jerry, they set: MRS F , IC  1, MU IC  MU F  Whereas optimal provision requires:  MRS i F , IC 1 i 27 Private-sector Underprovision  With identical preferences:  MU F  MU IC 2   1, MU F   MU IC     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 28 ion tThe ica l p Ap  Free Rider Problem in Practice There are some interesting examples of the freerider problem in practice   Only 7.5% of public radio listeners in New York contribute to the stations–that is, there is a lot of freeriding 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 29 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 30 10 Can Private Providers Overcome the Free Rider Problem?  Examples of private provision of a public good:   Privately financed fireworks displays Privately owned British lighthouses until 1842 31 n t io ica l p Ap  Business 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 32 ion cat pli p A    Business 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 BIDs have been formed in Massachusetts 33 11 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 34 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 35 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 36 12 Altruism  Another reason is that there is evidence that many individuals are altruistic, caring about the outcomes of others as well as themselves 37 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 38 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 39 13 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 40 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 41 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 42 14 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 43 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 44 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 45 15 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 46 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 47 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 For example, improving a highway involves valuations of commuting time saved as well reduced traffic fatalities 48 16 Fireworks in South Town Quantity Julia’s MB Seita’s MB Leah’s MB ΣMB MC Total Benefit Total Cost Net Benefits 10 $8 $5 $9 $22 $10 $22 $10 $12 20 $7 $4 $8 $19 $10 $41 $20 $21 30 $6 $3 $6 $15 $10 $56 $30 $26 40 $5 $2 $4 $11 $10 $67 $40 $27 50 $4 $1 $2 $7 $10 $74 $50 $24 60 $3 $0 $1 $4 $10 $78 $60 $18 49 The table below shows the marginal benefit from firework for the only two citizens of a country Firework are a public good If fireworks cost $175 a piece to produce, what is the efficient quantity of fireworks? Kathy a) b) c) d) e) f) Bobby Marginal benefit Quantity Marginal benefit (dollars per firework) (dollars per firework) 100 150 75 100 50 50 25 10 0% 0% 0% 0% 0% 0% 50 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 51 17 Recap of Public Goods    Optimal provision of public goods Private provision Public provision 52 Which of the following is public good? a) b) c) A Motorbike A ball A bridge d) A fish 0% a) 0% 0% b) c) 0% d) 53 Which of the following is not a private good? a) b) c) d) Pencil Laptop Table Water 0% a) 0% 0% b) c) 0% d) 54 18 NEXT CHAPTER…  ASYMMETRIC INFORMATION 55 19 ... • clean air 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,... out giving 47 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... field of political economy 51 17 Recap of Public Goods    Optimal provision of public goods Private provision Public provision 52 Which of the following is public good? a) b) c) A Motorbike A ball