Public Economics

Lecture 4: Public Goods

Noelia Bernal

Contact: n.bernall@up.edu.pe; Of.I-610

August 25, 2022

Public Economics Public Goods

Example (1)

The city of Lima has a garbage management problem.

The residents take out their garbage daily and the municipal
employees must collect it.
Problem: The employees don’t do it, leaving garbage on the
streets.
Solution: eliminate the public garbage collecting system and
hire a private company.

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Example (2)

Private garbage management (a voluntary fee is paid) faces a

free-rider problem:
any resident can keep getting out trash and does not need to
pay the fee
know their neighbors will pay for him
if neighbors pay, free rider gets all the benefits without paying
others will follow this behavior and the number of free riders
will increase
others will feel exploited and will not pay
there will be so many free riders that garbage will not be
collected.

Public Economics Public Goods

Public goods

Goods that suffer a free-rider problem are known as public

goods.
Definition and determination of their optimal production level.
We will ask: must the Government be involved in the
provision of public goods?
Private sector tends to provide the public good on a
sub-optimal level. However, under certain conditions, it does
it successfully sometimes.
Theoretically: Government can calculate the optimal amount
of the public good and provide it directly.
In practice: several problems
public provision can crowd out private provision
measuring costs and benefits is difficult
determination and aggregation of preferences is complicated.

Public Economics Public Goods

Definition

Pure public goods are:

Non-rivals in consumption: my consumption does not affect
other’s possibility to consume.
Non-excluding: there is no way to deny another person the
possibility to consume the good.
There are only a few pure public goods.
Most goods are impure public goods: satisfying both
conditions up to a certain point.

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Examples

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Optimal provision of private goods (1)

Model:
2 individuals: Ben and Jerry
Must decide how much consumption of ice cream and cookies
Assumption: price of cookies is US$ 1

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Optimal provision of private goods (2)

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Optimal provision of private goods (3)

In a market without failures:

Demand curve (horizontal sum) = SMB
Supply curve (marginal cost of producing x units of good) =
SMC
Equilibrium: SMB=SMC
Note that, at the same price, consumers demand different
quantities of the same good. They have different preferences
about ice cream relative to cookies.

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Optimal provision of private goods (4)

Mathematically:
MUicB B J Pic
= MRSic,c = MRSic,c =
MUcB Pc
Optimal choice of consumer happens when the marginal rate
of substitution between ice cream and cookies (MRS) is equal
to the price ratio of ice cream and cookies. MU is the
marginal utility.
In equilibrium: Pic = $2 and Pc = $1. Thus, each person will
be indifferent between trading 2 cookies and 1 ice cream.

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Optimal provision of private goods (5)
On the supply side: ice creams are produced until the
marginal cost (MC) of doing so is equal to the marginal
benefit (Pic , competitive market)

MCic = Pic

Since Pc = $1 and MCic = Pic , then MRS = MC .

Private equilibrium also reaches maximum social efficiency.
No failures.
For every amount of ice cream:
MSR=SMB; society values equal to the individual.
MC=SMC; cost for society equals the cost of producer.
In private equilibrium: SMB=SMC; social efficiency condition
is satisfied.
Marginal benefit of consuming the next unit equals the
marginal cost of producing it.
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Optimal provision of public goods (1)

Model:
2 individuals: Ben and Jerry
They have to decide how many cookies and missiles to
consume.
Assumption: price of cookies is US$ 1
There is no missile consumption for each individual, the
provided amount must be consumed equally for both.

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Optimal provision of public goods (2)

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Optimal provision of public goods (3)

Ben and Jerry have different preferences for cookies and

missiles, so they pay different prices for the same amount of
missiles.
The individual demands are added vertically: the prices that
each individual is willing to pay for the chosen quantity of
missiles is added.
On the supply side, supply is equal to it’s production cost.
Equilibrium: supply = demand, the optimal social production
level is achieved (5 missiles), since every amount of missiles
protects Ben and Jerry, the producer adds up each valuation
(desire to pay) to his production decision.

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Optimal provision of public goods (4)

Mathematically :
B J
SMB = MRSm,c + MRSm,c

Social marginal benefit (SMB) equals the sum of marginal

rates of substitution of Ben and Jerry, which represent their
valuation (of the next missile)
Social marginal cost (SMC) is the marginal cost (MC) of
producing one missile.
Hence, the maximizing efficiency condition is:
B J
MRSm,c + MRSm,c = MC

It is optimal to produce until MC equals the sum of benefits

for all consumers. Since it is non-rival and it can be consumed
by everyone simultaneously, society would prefer if the
producer takes this into account.

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Private provision (1)

Does the private sector provides the optimal amount of the

public good?
If so, there is no market failure; there is no place for
Government intervention and efficiency improvement.

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Private provision (2)

Under-provision due to the free-rider problem

Model:
2 individuals: Ben and Jerry
2 goods: ice cream and fireworks
Price of both goods is US$ 1 (for each firework bought one ice
cream is left out)
Fireworks are the public good, what matters is the total
amount
Ben and Jerry have the same preferences.

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Private provision (3)

Ben and Jerry will choose to consume at the point where the
indifference curve is tangent to their budget restriction (RP)
Slope of the RP is 1 (prices = $1) and slope of the curve is
the MRS, hence:
MUF
= MRSF ,c = 1
MUic

MUF = MUic

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Private provision (4)

But fireworks are a public good, so the social efficiency

maximizing condition is:
MRSFB,c + MRSFJ ,c = MC = 1

MUF
2x =1
MUic
1
MUF = MUic
2

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Private provision (5)

Remember that MU decrease with the consumption of a

good, so:
On private market equilibrium: fireworks are consumed until
MU equals the one from ice creams;
Social efficiency maximizing condition: fireworks are consumed
until their MU equals half of the ice cream’s.
More fireworks must be consumed.
Similar result to the free rider problem: investment has a cost
but the benefit is shared; individuals have incentives to invest
on a sub-optimal level.
Positive externality: fireworks provision of Ben or Jerry
benefits the other.
Space for Government intervention.

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Private provision (6)

Is it possible to solve the free-rider problem?

Yes, when:
Individuals are differentiated by their public good demand
There are altruistic individuals: our model assumes that
individuals are selfish, but here are individuals that worry about
others. They are willing to contribute for the public good even
under the presence of free riders (on the example: Ben
assumes the cost of the entire amount)
Contributing to the public good generates utility: for example
they get public acknowledgment. The public good approaches
a private good (“warm glow model”)

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Public provision

Theoretically, Government intervention can solve the

sub-provision problem.
It can calculate the optimal amount of the public good and
provide it or get the private sector to produce it.
In practice, several problems
Public provision can affect private provision (crowding out)
measuring costs and benefits is difficult
determination and aggregation of preferences is complicated

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Crowding out

Private sector already provides the public good before

Government intervention; reacts to the intervention
Public provision affects (crowding out) private provision: the
more Government provides, the less the private sector does.
Counters the gains of public provision.
Full crowding out is rare, partial crowding out is more
common.
Example: Bernal, Carpio and Klein (2017) SIS does not
generate crowding out of Essalud

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Measurement of cost and benefit

Example: a highway improvement

Government must give green light to the project if the sum of
benefits of all drivers exceeds the cost of doing so.
How to measure all costs and benefits?
Costs: labor, materials
Benefits: time saving, value of lives saved
Read chapter 8

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Public good preferences

Does the Government know individual preferences? Can it

calculate the marginal benefit (MRS) or the marginal cost?
3 problems
Revelation of preferences: individuals may not want to reveal
their true valuation; Government could charge more.
Knowledge of preferences: individuals may not know their own
valuation because they have little experience with public goods
Preference aggregation: how to aggregate the preferences of
all individuals?
Reading chapter 9.

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References

Chapter 7 of Gruber, Jonathan. Public Finance and Public

Policy, Fourth edition, Worth Publishers, 2013.
Mandatory reading: Chapters 7 y 8.

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