Title: Public Goods and Government intervention
1Lecture 3
- Public Goods and Government intervention
- Suggested Readings Connolly Munro, The
economics of the public sector, chapter 4
2Market failures
- Market failures occur when prices do not fully
reflect either the marginal social benefits or
costs - such failures provide scope for political
interaction - how does this happen?
- Potential sources of market failure
- Public Goods
3Public Goods
- Introduction
- In market economies, private suppliers provide
the majority of goods and services to consumers.
However, certain goods are publicly provided.
These include for example defense, education, and
health. Why does the government instead of the
market provide these goods? Which
characteristics differentiate goods that are
privately provided from goods that are publicly
provided? How do we define public goods? - The terminology might induce the conclusion that
public goods are good that are publicly provided
as opposed to private goods. This conclusion is
simply WRONG! The public or private nature of the
good is an intrinsic characteristic of goods that
is not related to the provider of the good - Hence, it may well be that the state provides a
private good or that the market provides a public
good.
4Public Goods
- When is a good public?
- Definition
- A pure public good is a good that has two
characteristics - NON-EXCLUDABLE
- NON-DEPLETABLE (NON-RIVAL, NO-CONGESTION)
- Non excludability once the good is provided, it
is not possible to prevent any individual (even
individuals that eventually have not paid to
access the good!) from using the good. The reason
for non-excludability could be for example that
is technically impossible to check who is using
the good or that the cost of monitoring the use
of the good is so high that de facto monitoring
does not take place - Non-depletability (non rivalness) the fact that
some people are using the good doesnt not
prevent other people from using the same good. In
other words, the consumption by one person
doesnt reduce the quantity available for the
consumption of other individuals - When a good has these two characteristics, i.e.
is non-excludable and non-depletable, then it is
a pure public good. On the other hand, if a good
is excludable and depletable, then the good is a
private good. Finally, you have some good that
possess just one of these properties.
5Public Goods
6Public Goods
- Pure public goods
- street light
- defense
- air
- radio emissions
7Public Goods
- What are the implications of non-excludability
and non-rivalness? - Lets compare a pure private good (X) and a pure
public good (G) - Suppose that X1 and G1
- Suppose there are two consumers Anne and Bill
- Who consumes X?
- Who consumes G?
8Public goods versus Private Goods
- Since X is excludable and rival, either Anne or
Bill will consume it (it cannot be consumed by
both!). Hence, the consumer that values the good
the most (i.e. the consumer who is willing to pay
the highest price) will consume X. - With the public good this is not the case
9OPTIMAL PUBLIC GOOD PROVISION
- To provide optimally G, we need to take into
account that G is simultaneously consumed by Anne
and Bill, i.e. we need to take into account that
each unit of G is going to increase the utility
of both agents! - Social Marginal Benefit as opposed to Private
Marginal Benefit!
10Market Failure
- Can the market provide efficiently public goods?
- Private provision through voluntary contributions
- examples charity, private security
- naively following own demand curves can lead to
over or under provision
11Marginal benefit and demand curve for public goods
Marginal Cost
Marginal cost
15
Optimal provision of Public good
10
10
No provision of public good
5
5
Individual marginal benefit
Social marginal benefit
10
7.5
7.5
10
12Strategic contributions
- contributors are not naïve they observe and
react to others behavior so act strategically - Suppose that the student union decides to buy a
new big TV screen (lets say to watch soccer or
cricket!) and every member of the student union
declares that he will really enjoy a new big
screen!. To purchase the TV screen the union
relies on the voluntary contributions of each
member of the student union. Once the TV screen
is bought, each member of the student union has
access to the TV independently on the fact that
he has contributed or not to the purchase of the
TV.
13Strategic contributions
- The TV screen is in other words a public good for
the members of the student union since it is - non-excludable (no member can be prevented from
watching the TV) - non-rival (the fact that one member watches the
TV does not prevent other members from watching
it) - Question assuming that you care about watching
the next World Cup (or something better!) will
you contribute to buy the TV screen?
14Strategic contributions
- Lets give some numerical values
- Suppose that the cost of the TV is 100. Suppose
that if two people contribute they will each pay
50. On the other hand if just one person
contributes while the other refuses to pay, then
she will pay the entire cost of 100. If nobody
contributes, the TV is not bought. Lets assume
that the benefit for each individual from
watching the TV in monetary terms is 75, on the
other hand if the TV is not bought their payoff
is just zero. - Lets write down the payoffs of the contribution
game
15Payoffs
16The free-rider problem
- This is an example of prisoner dilemma. The two
individuals would clearly be better off
contributing but they end up not contributing! - Why do we obtain this result?
- This result is related to the public nature of
the good. Because the good is non-excludable and
non-rival, there is a strategic interdependence
in the contribution decision of the two players. - Loosely speaking, consider what individual 1 is
thinking when he has to decide whether or not to
buy the TV - if he buys the TV, he cannot prevent individual 2
from using the TV - if individual 2 buys the TV, he can use it for
free - and similarly for individual 2!
- Hence, although each individuals enjoys having
the TV, since each would enjoy it much more to
use it for free, then they end up having no TV! - This is known as the free-rider problem
17The free-rider problem
- The essence of the free-rider problem is that the
contribution by one player is an exact substitute
for the contribution of the other player.
Therefore, each player tries to exploit the
contribution from the other in order to obtain
the good for free. As each player is reasoning in
the same way, the result is that none of the
players will voluntary contribute! - In this example, where the quantity of the good
is discrete (either the good is provided or it is
not provided), if we rely on voluntary provision
the good is not provided. In general, if we
consider a continuos case, then the outcome will
be that a sub-optimal quantity of public good is
provided. It can also be shown that the
free-riding problem becomes more severe as the
number of players increases
18The free-rider problem
- To overcome the free rider problem, co-operation
or co-ordination of society is required. - Obstacle one enforcement is needed to implement
this behavior - repeated interaction with tit-for-tat punishments
- government activity or centralized decision
making such as compulsory taxation or regulation
19Welfare
- We have learned that when a good is public,
because of strategic interdependence, the
quantity of the public good provided by voluntary
contributions is not Pareto-efficient. - This is equivalent to say that if we rely on the
market to provide the good, then the outcome is
not efficient. - This is an example of market failure
- Is there a way to solve the market failure?
20Government Intervention
- The government considers the utility of all the
individuals in the society jointly, chooses the
level of public goods that maximises the social
surplus and introduces a tax to finance the
public good. - Therefore, if the government knows the
preferences of each individual, he can provide
efficiently the public good - This is not particularly difficult if all
individuals have the same preferences (for
example, if you all enjoy in the same way
watching the TV at the student union)
21Government Intervention
- However, individuals typically are heterogeneous
in their preferences for goods - How should the government choose the quantity of
public good if individuals have different tastes? - Suppose that g is the public good and c(g) is the
cost of providing the public good. Lets denote
U1(g) the benefit for individual 1 from using g
and U2(g) the benefit for of individual 2.
22The Samueson Rule
- The social surplus is the sum of the utilities of
the two individuals, minus the cost of provision
of the good. The government has to decide the
optimal level of g, that is the level of g that
maximises the social surplus - Social surplus U1(g)U2(g)-C(g)
- the optimal g is reached when the marginal
benefit is equal to the marginal cost. Note that,
since we are not considering one individuals, but
several, then the optimal g is reached when the
sum of the marginal benefit of the individuals is
equal to the marginal cost (Samuelson rule) - U1(g)U2(g)C(g)
- Samuelson rule the optimal quantity of g is such
that the sum of the marginal evaluation of the
goods for the two individuals is equal to the
marginal cost of the good.
23Samuelson Rule and Pareto frontier
- The social surplus maximising outcomes can be
represented graphically using the Pareto-frontier
(remember the frontier of UPS from last lecture). - We can represent all the levels of net utilities
that can be achieved choosing different levels of
g. - Every point on the frontier satisfies the
Samuelson rule. Therefore, the Samuelson rule
does not determine a precise outcome (doesnt
pick a specific point on the frontier).
24Utility possibility frontier (UPF)
UB
A
45
B
M
UA
25Mechanism of collective decision making
- How is a point on the frontier actually chosen?
- To choose a precise point we need to specify some
type of collective choice rule - Ex1 the government has some welfare function
(i.e. a function that gives a precise weight to
each individual in the society) and he chooses a
point according to this welfare function. Then
depending on the weight he gives to each
individual, he can choose a different point - Ex2 there is some political mechanism, like
majority voting to decide
26Local public goods and the Tiebout Mechanism
- Individuals vote with their feet
- If there are as many communities as there are
types, then efficiency will result - Argument is related to club solutions to public
goods - This mechanism relaxes assumption somewhat on
excludability
27Aggregation of preferences
- If there are not as many communities as types,
individuals with different preferences have to
find a way to undertake decisions affecting the
entire group - Group preferences and group choice
28Questions (prepare and answer all questions
before next week seminar)
- Which one of the following goods is a pure public
good? - Health care
- Roads
- Education
- Radio emission
- Wireless
- Suppose that Anne and Bill have agreed to buy a
new dishwasher for their house. Bill values the
dishwasher more than Anne and he would be willing
to pay up to 300 pounds for a new dishwasher,
while Anne is willing to spend up to 150. They
finally agree to buy a dishwasher whose cost is
250. If both of them contribute, they will share
equally equally the cost of 250. If one of them
refuses to contribute, the other will pay the
entire cost. If none of them contributes they
will not buy the dishwasher. Will Anne
contribute? Does your answer change if we assume
that Anne and Bill both are willing to pay up to
160 for the dishwasher? Explain whether the Nash
equilibrium in both cases is Pareto-efficient and
discuss whether a compulsory contribution scheme
would be welfare improving.