Running head: VALUING PUBLIC GOODS

Valuing Publics Goods and its Importance Rafael Uribe Writing 7/ CIEP University of Northern Iowa July 20, 2012

VALUING PUBLIC GOODS

Introduction What most people think of public goods is something that the government must provide. However, public goods are more than just what the government does. Also, most people do not really know what is a public good. The public goods are defined by only two characteristics: non-excludability and non-rivalry in consumption. Non-excludability means that when the good is produced, everyone can have access to it without paying, creating a free-rider problem that will lead the good to be unproduced (Holcombe, 2000; Graves, 2003). The non-rival condition means that after the good is produced, someones consumptions does not restricts others consumptions, i.e., both have access to the same amount of the good; this generates a good allocation problem because its optimal prize is zero (Holcombe, 2000; Graves, 2003). To explain both characteristics better, people can think of air as a public good. Someones consumption of air does not prevent others to breathe and also the quantity of air consumed is the same. It is very hard to actually find goods that fully satisfy both conditions, so there are grades of public goods. Moreover, there is an optimum of provision of public good, but knowing it implies knowing the preferences of all the citizens. The provision of public good is a demand revelation problem to know the willingness to pay for the good (Graves, 2003). The problem is how to measure its value if the incentives of the individuals are to lie about their willingness to pay, that is, to be a free rider -one person who uses the good but does not pay for it and have no incentive to do so. There are some methods that can be used to approximately measure the value of public goods, such as hedonic prices, contingent valuation and auction methods. Optimal provision of public good and crowding out Governments exist to regulate peoples life and also to provide goods that otherwise will not be produced. The main reason for the government to act is for the imperfection of markets.

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Most markets have externalities, failures, and do not assure that the distribution of resources satisfy the social preferences. One of the failures directly affects the provision of public good, i.e., free riders. In addition to market failures, there are natural monopolies where it is useless to have more than one supplier. Also, there are some goods that for the private sector there is no reason to produce because their cost is smaller than the benefit due to externalities. Trying to solve all these unclear situations of markets, the government comes to action. This intervention is not better nor worse than what the market can do (Graves, 2003). Both the government and the private sector can provide public goods. Even if some times the private sector has no incentives to produce these goods, there are ways and goods wherein they are willing to pay or participate. Individuals can directly donate to charity or the public good. Moreover, there is an indirect way of providing public goods by the private sector that is through taxes. Taxes have a big impact on what people do about this kind of good. When someone is donating money to charity and the government imposes taxes over him, his donations will decrease because that persons taxes will be used to provide public goods. This effect is called the crowding out effect of taxes on private provision. The crowding out of private provision is one of the effects researchers have to consider in order to provide the optimal amount of public good that is the reason of the increasing interest of researchers. The usual approach, developed by Bergstrom, Blume, and Varian (as cited in Coates, 1998), says that the crowding out should be complete, that is to say one dollar for one dollar, but the evidence prove this wrong. As Andreoni (1993) found in his experiment the crowding out was less than 100%, which proves that the earlier theory lacked predictive power. The complete crowding out in theory is due to the pure altruism, but can be fixed if the model considers the giving as a good itself (Andreoni, 1990). Considering the giving as a good itself,

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the crowding out is only 100% with taxes or redistribution if the people are similar, if not the provision will be more, that is, imperfect crowding out (Andreoni, 1990). Further investigations realized that even with a pure altruism model the incomplete crowding out could be found if the difference in cost provision is considered (Coates, 1998). Both the public and private sector have administrative costs that affect the provision of public goods. Andreoni (1990) assumed in his model that the cost was equal between them and that it was zero, arguing that his finding would change considering this cost. Coates (1998) redefined his model considering the costs and the findings differ in almost every case because now the model depends on the relation between the cost in private and public sectors. Thus, the optimal provision is not an easy issue to settle. Through taxes the government receives the money to provide the public good, but of those taxes not all the money goes to the provision of the good. Moreover, the government has to consider that its intervention will crowd out the private provision. It is important, then, for both to know the relation between their costs of production. In addition to this problem, the biggest problem is to know how much of the good must be provided, that is, how can government or the private sector know how much of the good they want. If this value is not known, the optimal provision is more a game with no real base. How to value the public goods To value public goods the willingness to pay researchers could use two main methods. Hedonic prices and contingent valuation, surveys, are the two methodological approaches that researchers can use to try to infer the valuation of the good. The Hedonic prices method is an indirect technique that uses regressions to indirectly value the willingness to pay, considering a non-linear model. The idea behind this is that even if investigators cannot value the public good itself, they can indirectly use the housing values or wages to understand the

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difference that the good makes in them, and thus their value (Brookshire, Thayer, Schulze, & DArge, 1982). The Hedonic Price method is commonly used considering the houses value. For the results not to be biased, considerations are needed. Thus, not only characteristics of the house are important, but also characteristics of the neighborhood and intangible goods like air quality and school quality (Brookshire et al., 1982; Brasington, 2002). Brasington (2002) used hedonic price method to measure the value people gives to the quality of the education. Despite the problem to understand quality in education, the model that Brasington used considered all the house and neighborhood characteristics, including an estimation of quality of education. In addition to these variables, some assumptions must be done to make conclusions; these assumptions vary depending on the nature of the good to be measured. One important effect must be considered when the goods are tangible, that is the Tiebout bias. The Tiebout hypothesis says that people choose where to live on the community that matches the tax rate and the public goods availability they desire (Brasington, 2002). Another problem that emerges with hedonic prices using housing values is that people pay indirectly by taxes and that generates correlation between variables and the error; thus, if nothing is done, the estimators are biased (Gyourko & Tracy, 1991). To solve this, Gyourko & Tracy (1991) used the salary in the regression and then they obtained unbiased estimators. Another way of using hedonic prices is estimating the demand for the public good. However, when using this approach some problems emerged due to the fact that some variables are correlated and that leads to bias and errors in the estimations. To solve this problem, some instrumental variables are used to indirectly estimate the demand (Bishop & Timmins, 2011). Besides instrumental variables, Bishop and Timmins (2011) proposed a different way to solve

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the correlation between variables. Their solution is finding parameters, which maximize the function of marginal willingness to pay. Usually the authors change the order of variables and use an econometric model that allows better estimators. The problem of this is the assumptions they made, but sometimes these assumptions are not strong, so they do not bias the results. On the other hand, we have the Contingent Valuation method that has its base in surveys. This method is based on some questions and its core is the development of a valuation and allocation procedure to the good (Brookshire & Coursey, 1987). Even if there is a common concern about the validation of using surveys because the people can change their mind, give a different answer every time, or lie in order to finish fast, this method can be very useful if it is used correctly. Brookshire et al. (1982) compared the survey method with the hedonic method. In this study, Brookshire et al. asked directly to householders their willingness to pay for an improvement in their air quality. Their study considers the Los Angeles metropolitan area, which is very polluted and the people have common knowledge about it. They categorized the air quality as poor, fair, and good, using the nitrogen dioxide and the total suspended particular matter levels. The researchers show pictures of the air to the people and ask how much they would pay for an improvement in their air quality. On the other hand, they also use hedonic prices to calculate the value of the air quality using the same places, but not always the same houses. According to Brookshire et al. (1982) the question used is very important to eliminate strategic bias. In their study, they used a question that eliminates all the bias that the survey approach can have. They showed that in their study no biases were found. They found that the willingness to pay is smaller than the estimation of the value of the air quality, but the difference

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was not significant, that is to say, the survey approach gave the same results as the hedonic price method. Thus, the survey method is a valid option to value public goods. To summarize, the survey method goes like this: first, the public good is explained to the subject; then the individual is explained with the situation in which the provision of public good increases or decreases; lastly, the person asked will reveal his/her willingness to pay for that good (Brookshire & Coursey, 1987). There is a common belief that the contingent valuation method works better with environmental goods and the hedonic price method works better with better defined public goods, such as a park or a subway, and with intangible goods, such as school quality. To value public goods, researches have other methods that can be useful.1 One of these methods is the action procedure that can be very similar to the survey method. Researchers can arrange an auction process in order to reveal the true willingness to pay of the individuals, using induced values (Brookshire & Coursey, 1987). As it is said recurrently in literature, the process becomes more precise when people learn the procedure, and the same happens with the auction method, that is, it becomes more assertive when the individuals understand perfectly the elicitation method (Brookshire & Coursey, 1987). The difference with the survey approach is that the researchers need to give more information to the people they asked. As in Brookshire and Coursey (1987) the method goes like this: first, the researchers define the framework, where there is a current provision of the good and the idea is to value an increase (decrease) of the amount provided, so they define how much will be the increment; next, they explain the situation to the individual, that is, the outcomes that can arise based on their contribution. A valuation of

Even though there are more methods, the auction is the last one it would be explained. For another method revised Kling, C. (1997).

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the increment is given and the individual is asked how much he/she will pay for the increment (diminish) of the public good, knowing that other neighbors will also contribute. Three situations can occur: first, the amount needed for the increase (decrease) it is not reached (greater), then the provision of the good stays the same and the individuals do not pay (individuals do not receive compensation); second, the amount is equal to the amount needed, thus the increment (reduction) will occur and the individuals will pay their willingness to pay (willingness to accept); lastly, if the amount is larger (smaller), the good is increase (reduced) and the individuals pay (receive) incompletely their willingness to pay (accept is bigger) because the costs are divided (Brookshire & Coursey, 1987). This process is face to face but can also be done in a laboratory. This procedure gives the individuals the correct incentives to reveal their true willingness to pay or accept in order to increase or reduce the provision of a public good (Brookshire & Coursey, 1987). Even if the models are not perfect, their frameworks are very important for the reason that will be explain in the next section. Implications and conclusions One of the main expenses of the government goes to the provision of public goods. For that reason it is very important to know how much people value these goods. If the government were able to know the real willingness to pay for public goods of the individuals, the optimal provision would be optimal and the expenses of the government would be better directed. It is very hard to find someone that wants more taxes. Knowing this situation, it is reasonable to think that people expect the most efficient use of this money. Whereas is true that the government has to distribute the taxes in operational costs, public goods, and in redistribution policies, it is also true that they should be as efficient and effective as possible. For that reason the knowledge of the valuation of public goods can be a good

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determinant of public expenditure. The main reason of this is that the expenditures of the government, the tax money, would be better distributed and then there will not be over-provision or under-provision, just the optimal amount that the individuals want. Knowing the valuation of the individuals it becomes easier to make a joint provision of the public good between the private and public sector. If the government has certainty that the crowding out is incomplete, using the private sector to optimally provide public goods becomes a real option. In conclusion, the public goods investigation is still new and there is not very applicable knowledge about it. Despite this situation, the actual knowledge of the field is quite big and is getting more accurate every year. It is not easy to understand a good that cannot be valued on markets and that need of elicitation and implicit methods to be valued. Nevertheless, the actual methods are very accurate if we analyze them. If people analyze the methods based on the econometric knowledge, the information we are getting of these goods is getting more accurate and close to reality. The econometric field is also growing and we cannot know its real dimension, so every advance that it is done here help researchers to get closer to value public goods. By accomplishing an accurate or exact valuation of public goods the government expenditure will be more controlled and clear and the people would be happier with their taxes.

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References Andreoni, J. (1990). Impure altruism and donations to public goods: A theory of warm- glow giving. Economic Journal, 100(401), 464-477. Retrieved from http://www.jstor.org/stable/2234133 Andreoni, J. (1993) An experimental test of the public-goods crowding-out hypothesis. American Economic Review, 83(5-6), 1317-1327. Retrieved from http://www.jstor.org/stable/2117563

Brasington, D. (2002). The demand for local public goods: The case of public school quality. Public Finance Review, 30(3), 163-187. doi: 10.1177/109114210203000301 Brookshire, D., Thayer, M., Schulze, W., & D'Arge, R. (1982). Valuing public goods: A comparison of survey and hedonic approach. American Economic Review, 72, 165-177. Retrieved from http://www.jstor.org/stable/1808583 Brookshire, D. , & Coursey, D. (1987). Measuring the value of a public good: An empirical comparison of elicitation procedures. American Economic Review, 77(4), 554566. Retrieved from http://www.jstor.org/stable/1814530 Bishop, K., Timmins, C (2011). Hedonic Prices and Implicit Markets: Estimating Marginal Willingness to Pay for Differentiated Products Without Instrumental Variables. Journal of Economic Literature. Retrieved from www.nber.org/papers/w17611.pdf Coates, D. (1998). Public good sector crowding out of private provision of Public goods: The influence of differences is production costs. Public Finance Review, 26(5), 460-479. doi: 10.1177/109114219802600503

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Graves, P. (2003). Valuing public goods. Challenge, 46(5), 100-112. Retrieved from http://search.ebscohost.com.proxy.lib.uni.edu/login.aspx?direct=true&db=crh& AN=11072970&site=ehost-live Gyourko, J., & Tracy, J. (1991). The structure of local public finance and the quality of life. Journal of Political Economy, 99(4), 774-806. Retrieved from http://www.jstor.org/stable/2937780 Holcombe, R. (2000). Public goods theory and public policy. Journal of Value Inquiry, 34(2-3), 273-286. Retrieved from http://search.proquest.com.proxy.lib.uni.edu/ docview/203920765?accountid=14 691 Kling, C. (1997). The gains from combining travel cost and contingent valuation data to value nonmarket goods. Land Economics, 73(3), 428-439. Retrieved from http://search.ebscohost.com.proxy.lib.uni.edu/ login.aspx?direct=true&db=bsh&AN=9709304277&site=ehost-live