Chapter ? Public Goods After learning this chapter you will understand : Examples of Public Goods. Reservation Price. Conditions for Providing Public Good. Provision of Public Good and Distribution of Wealth. Free Riding. The Optimal Amount of Public Good. Quasi-Linear Preferences and Provision of Public Good. Pareto Efficient Provision of Public Good. VVVVVVVV For Full Course Video Lectures of All Subjects of Economics (Hons), B Com (H), BBE, MA Economics, NTA UGC NET Economics, Indian Economic Service (IES) Register yourself at www.primeacademy.in Dheeraj Suri Classes Prime Academy 9899192027Prime Academy, www.primeacademy.in Basic Concepts 1. Examples of Public Goods : Public goods are goods or services that are non- excludable and non-rivalrous in consumption, meaning that individuals cannot be effectively excluded from using them, and one individual's use of the good does not reduce its availability to others. Here are some examples: (i) Street lighting: Once installed, street lights provide illumination to all members of the community without excluding anyone, and one person's use of the light doesn't diminish its availability to others. (ii) National defense: The defense provided by a country's military is typically considered a public good because it protects all citizens within the country’s borders and cannot be provided selectively to only those who contribute to its funding. (iii) Public parks: Parks and recreational areas are typically open to all members of the public and can be used by multiple people simultaneously without diminishing the experience for others. (iv) Fire departments: If a city has a fire department to fight fires, it will almost surely try as hard to put out a fire on person i’s property as on Person j’s property. It would be impractical to provide fire fighting services to one person in the city without providing the same services to others. (v)__ Clean air: Air quality is a public good because one individual's enjoyment of clean air does not diminish its availability to others. However, this can be subject to the tragedy of the commons if not regulated properly. (vi) Basic research: Scientific research that leads to general knowledge and discoveries is often considered a public good because once the knowledge is discovered, it can be used by anyone without diminishing its availability. (vii) Public broadcasting: Television and radio broadcasts funded by the government or public contributions are available to all members of society and cannot be excluded based on payment. (viii) Flood control systems: Infrastructure such as dams, levees, and drainage systems that protect against flooding provide benefits to all residents in the affected area and are difficult to exclude individuals from using. (ix) Law enforcement: Police services and the justice system are often considered public goods because they protect all members of society and cannot be selectively provided to only those who contribute to their funding. (x) Public education: Education provided by government-funded schools is accessible to all children within a community regardless of their ability to pay, making it a public good. 2. Reservation Price : Let’s use w; and 12 to denote each person’s initial wealth, g1 and g» to denote each person’s contribution to the public good, and x1 and x2 to denote each person’s money left over to spend on private consumption. The budget constraints are given by m+gi=wi and x2 + g2=w2. Micro Economics 7. By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in We also assume that the cost of public good is “c° dollars, so that in order to purchase it, the sum of the two contributions must be at least ¢, Le., g1 + £22 ¢. The utility function of person 1 will depend on his or her private consumption, x1, and the availability of the public good. We'll write person 1’s utility fanction as u,(x,, G), where G will either be 0, indicating public good is not provided, or 1, indicating that public good is provided. Person 2 will have utility function ux(x2, G). Each person’s private consumption has a subscript to indicate that the good is consumed by person 1 or person 2, but the public good has no subscript. It is consumed by both people. Of course, it isn’t really consumed in the sense of being used up; rather, it is the services of the public good that are consumed by the two persons. The reservation price of'person 1 is the maximum amount that person 1 would be willing to pay to have the public good. That is, it is that price, r1, such that person 1 is just indifferent between paying r; and having the public good available, and not having the public good at all. If person 1 pays the reservation price and gets the public good, he will have w: — ri available for private consumption. If he doesn’t get the public good, he will have w; available for private consumption. If he is to be just indifferent between these two alternatives, we must have m(wi — ni, 1) = un(wi, 0) 3. Conditions for Providing Public Good : Let us consider two kinds of allocations, first is an allocation where the public good is not provided. This allocation takes the simple form (1, 2, 0); that is, each person spends his wealth only on his private consumption. The other kind of allocation is the one where the public good is provided. This will be an allocation of the form (x1, x2, 1), where 2 and 2% =W2—-g> (i) Necessary Condition : It will be a Pareto improvement to provide the allocation (x1, 22, 1) if both people would be better off having the public good provided than not having it provided. This means ui(w1, 0) < wm, 1) and —u2(w2, 0) < uaa, 1). Now using the definition of the reservation prices r; and r; we can conclude that wir gi and 72> g> This is a necessary condition for provision of the public good to be a Pareto improvement. This is a condition that must be satisfied if an allocation (w1, w2, 0) is Pareto inefficient, i.e., it must be that the contribution that each person is making to the public good is less than his willingness to pay for the public good. If a consumer can acquire the good for less than the maximum that he would be willing to pay, then the acquisition would be to his benefit. Thus the condition that the reservation price exceeds the cost share simply says that a Pareto improvement will result when each person can acquire the services of the public good for less than the maximum that he would be willing to pay for it. Micro Economics 73 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in (ii) Sufficient Condition : If each persons willingness to pay exceeds his cost share, then the sum of the willingnesses to pay must be greater than the cost of the public good, i-e., nitr> git g=c This condition is a sufficient condition for it to be a Pareto improvement to provide the public good. If the condition is satisfied, then there will be some payment plan such that both people will be made better off by providing the public good. If nr, +r , then the total amount that the roommates will be willing to pay is at least as large as the cost of purchase, so they can easily find a payment plan (g1, g2) such that r; > gi, > go, and gi+g2=c. 4. Provision of Public Good and Distribution of Wealth : Whether or not it is Pareto efficient to provide the public good will, in general, depend on the initial distribution of wealth (v1, 2). This is true because, in general, the reservation prices ri and r2 will depend on the distribution of wealth. It is perfectly possible that for some distributions of wealth r; + r > c, and for other distributions of wealth r+ r2 winritvi(1) = wi + x00) ux(v2 — ra, 1) = ua(ov2, 0) > we-rn + v1) = wr + vX0) which implies that the reservation prices are given by n= ni(l)- v0) and 72 = va(1) ~ v2(0) Thus the reservation prices are independent of the amount of wealth, and hence the optimal provision of the public good will be independent of wealth, at least over some range of wealths. 5. Quasi-Linear Preferences and Public Goods : In general, the optimal amount of the public good will be different at different allocations of the private good. But if the consumers have quasi-linear preferences it turns out that there will be a unique amount of the public good supplied at every efficient allocation. Quasi-linear preferences have a utility representation of the form : u(x, G) = 2 + v(G). This means that the marginal utility of the private good is always 1, and thus the marginal rate of substitution between the private and the public good—the ratio of the marginal utilities—will depend only on G. Thus, In the case of quasi-linear Micro Economics 14 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in preferences, all Pareto efficient allocations are found by just redistributing the private good. The amount of the public good stays fixed at the efficient level. 6. A Simple Model of an Economy with a Public Good : We assume that there are only two goods— a public good and a private good. The quantity of the public good is x. Let the price of the public good is $1 per unit. We assume that whatever quantity of the public good is available, is available to all. Therefore, x will enter every consumer’s utility function, although different consumers will value it differently. Generally, the consumers like the public good, but some may be indifferent to it and some may actually dislike it. We will let y; represent person i's consumption of the private good. Person i’s private good consumption enters i’s utility function, but no other utility function. We will measure the private good in dollar units also, so the price of the private good is also $1 per unit Production in this simple model involves transforming a private good into a public good, or vice versa. We will assume for simplicity that a unit of private good can be transformed by firms into a unit of public good, or vice versa. So, the marginal cost of public good is $1 We assume that there are n people. Person i’s income is M, and his utility function is u(x, y). To make our analysis simpler, we will assume that our consumers’ utility functions satisfy the special property of quasi linearity. We say our consumers have quasilinear preferences if their utility functions can be written as iQ, Yi) = Vile) + Yi The function v,(x) is called i’s benefit from the public good, and its derivative is his marginal benefit from the public good, abbreviated MB(x). We assume that v,(x) is an increasing and concave function, Because we are assuming that both goods are measured in dollar units, if person i is buying x units of the public good, and if he is consuming y; units of private good, then his budget constraint is x + y; = M,, In short, we are now assuming that person i solves the following problem: max u, (x, yi) = v(x) + y; Subject tox + y= My. To maximize his utility subject to his budget constraint, our consumer finds the point on his budget line at which the marginal rate of substitution of the private good for the public good equals the price ratio, which is 1 given our definitions of the units. That is MRS = vi'(x) = 1 We now let (x}4,y/") represent the market quantities of the public good and the private good that consumer i buys when he maximizes his utility subject to his budget constraint. We let x” = x! + xi! +--+ x} represent the total amount of public good, bought by all the consumers, when each consumer is paying the full cost of each unit of public good he or she is buying. That is, (x™, yM, yM, ..., yM) is a market equilibrium. Micro Economics 75 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in 7. The Optimal Amount of Public Good : Let y; and y. measure the private consumption of each person and x; and x2 be their contributions to the public good. Let x now measure the quantity of the public good they buy, and let the cost function for quantity be given by C(x). This means that if the two persons want to purchase a public good of quantity x, they have to spend C(x) dollars to do so. ‘The constraint being faced by the two persons is that the total amount that they spend on their public and private consumption has to add up to how much money they have, ie., yi + yo + CQ) = wi + We A Pareto efficient allocation is one where consumer 1 is as well-off as possible given consumer 2s level of utility. If we fix the utility of consumer 2 at i, we can write this problem as max ty (J1,X) ada such that 1(y2, x) =u yit yn + C(x) = wi + wr It turns out that the appropriate optimality condition for this problem is that the sum of the absolute values of the marginal rates of substitution between the private good and the public good for the two consumers equals the marginal cost of providing an extra unit of the public good, ie, [MRS] + [MRS3| = MC(G) The public good efficiency condition has been illustrated in the adjoining figure. We simply draw each person's MRS curve and then add them vertically to get the sum of the MRS curves. The efficient allocation of the public good will occur where the sum of the MRS’s equals the marginal cost. 8. Inefficient Market Equilibrium : We claim that the market equilibrium cannot be efficient. Let us assume that there are only two consumers, with identical tastes and identical income levels. Assume that consumer 1 gets his optimum bundle (xi, yi). Now consumer 2 is getting x!" units of the public good free of charge and since he has same preferences as of consumer | so he also want x! units of public good. So, he spends his entire income on private good and gets y units of private good. Now, at equilibrium the marginal benefits of both the individuals are same and are equal to 1, i.e., MB, = MB, = 1. Which means the sum of marginal benefits is 2 while the marginal cost of public good is 1. Thus, the market equilibrium is inefficient. Micro Economics 1.6 By :D eray Suri, 9899-192027Prime Academy, www.primeacademy.in a The Samuelson Optimality Condition for Public Goods : The Samuelson optimality condition, named after economist Paul Samuelson, relates to the provision of public goods in an optimal manner. It states that the total marginal benefits (MB) of a public good should equal the total marginal cost (MC) of providing it. Mathematically, it can be expressed as: YMBi= MC Where: MB; represents the marginal benefit derived by each individual from consuming the public good. MC represents the marginal cost of producing the public good. In simpler terms, the Samuelson optimality condition suggests that for efficiency in the provision of public goods, society should allocate resources in such a way that the total benefit derived from the provision of the public good equals the cost of producing it. This ensures that resources are allocated efficiently and that the maximum possible benefit is obtained from the resources available for producing public goods. Exercise 1 Theory Questions QI. Differentiate between non-exclusion and non-rivalry in consumption of public goods using a suitable example. [Eco. (H) 2011] Q2. Would you say “knowledge” is a public good? [Eco. (H) 2010] Q3. Why is the market provision of public goods unlikely to result in a Pareto efficient provision of these goods? [Eco. (H) 2011] Q4. Suppose a firm ‘C produces a positive amount of ‘good A’ and some pollution level “p’ which adversely affect production of another commodity ‘F”. What is the (Privately optimal level of pollution? (ii) Socially optimal level of pollution? (iii) Socially optimal level of pollution? Give the equilibrium conditions in each case. [Eco. (H) 2007] Q5. How will quasi-linear preferences affect Pareto efficient allocations of a public good? Discuss. [Eco. (H) 2007] Q6. Explain, using an example, what you understand by the Free-rider problem. [Eco. (H) IV Sem. 2016] Numerical Problems QI. Suppose that 10 people live on a street and that each of them is willing to pay Rs. 2 for each extra streetlight, regardless of the number of streetlights provided. If the cost of providing x streetlights is given by C(x) = 2°, what is the Pareto efficient number of streetlights to provide? [Ans. 10) Q2. Vimla has the utility function U(X, G) = (4 + G).X, where X is the number of rupees she spends on private consumption and G is a public good that takes a value 1 if it is provided and zero if it is not. If her income Rs. 1,000, what is her reservation price for the public good? [Eco. (H) 2010] Micro Economics 7 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in Qa. Q@. Q6. In an economy there is one private good x2 one public good x. All the citizens 100 . =, The prices of x2 and x are have the same utility function 4044, Re. 1 and Rs. 10 respectively. Everyone gets an income of Rs. 1000 per year. (i) Find the marginal rate of substitution between x; and x2. (ii) What is the marginal cost of one more unit of x1? (iii) There are 1000 people in the economy. Write an equation stating that the sum of MRS equals MC. (iv) A citizen’s budget constraint is Ait pg=}o00 and MRS of all citizens equals the marginal cost. Solve the combination of x; and x2. (v) If the cost of x is paid by every citizen of economy (equal share) then how much income would be left for x2? (vi) If the supply of x, equals demand for x: then will the units be equal/larger/smaller than Pareto efficient units? (vii) If the government promotes a subsidy option. If 50% of the cost of providing x1 is paid by the Government and is compensated by raising taxes. Find how many units of x; will be consumed? [Ans.:() “2, Gi) Rs.10, Gi) = 100, Gv) x1 = 100,.x = 999, () 1000-5, (vi) equal, (vil) x, = 100¥2 ] Ten students have opted for classes from a private institution and the fees would be divided equally (a) What is the additional fee if one of the student takes an additional class worth Rs. 20? (b)__ Is it an efficient system? Comment. [Ans.:Rs.2, (ii) No] In an economy, 100 citizens celebrate the eco day every year. They care about two things food and entertainment. Entertainment cost Re. | per unit. All the citizens have the same utility function w(f,e) = e +32. (a) Find the absolute value of marginal rate of substitution between food and entrainment. (b) What is the Pareto optimal amount of entertainment for the economy? | MU; 4 (Ans. : MRS =s7 = Zl A and B are friends and they want to buy good x and would share them. A’s utility function is U,(x,M,)=(1+x)M, and B’s utility function is Up(x, Mp) = (2 + x)Mp, where My and Mp are income spent on other goods by A and B respectively. If they buy good x then x = 1, if they don’t then x = 0. Wa and Wp are the income of A and B respectively. (a) Find the reservation price for A and B? (b) If Wa = 100 and Wa = 75 then under what condition they would buy good x? {Ans. : (i) _A’s reservation price = Wa/2, B’s reservation price = Wa/ Micro Economics 78 By :D eray Suri, 9899-192027Prime Academy, www.primeacademy.in (ii) Price of x <75] Q7. A and B share a room. They spend money on public good and private good. A’s utility function is Us(Xa, G) = 2X, + G and B’s utility function is Un(Xe, G) = XuG, where X represents private consumption and G is a public good. The cost function of public good is C(G) = G. They have a total of Rs. 8000 to spend on public good and private consumption. (a) Whatis the absolute value of marginal rate of substitution for A and B? (b) Write an equation that expresses the provision of the Pareto efficient public good? (c) If A and B each spend Rs. 2000 on private good and Rs. 4000 on public good. It this a Pareto efficient Outcome? (@)__ Give an example for the following conditions, provided it must be a Pareto optimal allocation. (i) B spends more than Rs. 2000 and A spends less than Rs. 2000 on private consumption. (ii) A spends more than 2000 on private consumption. (©) Comment on the set of Pareto optimal allocation. [Ans.:(@) MRS,=%, MRSB=XwG, (b) 3+*2=1, ©) Yes) Q8. In an economy there are two goods x, and x3, where x) is a private good and x) isa public. good. All the citizens have Cobb-Douglas utility _ function U(&,.4)) = x17x!. There are two income groups rich and poor. Rich group gets and income of Rs. 100 and poor gets an income of Rs. 50. Price of x) and x; are Re. 1 and Rs. 2 respectively. The cost of providing x1 is paid for by collecting tax, ie. Rs, 2 per unit of x. The amount of x; supplied is decided by vote. There are 1 lakh rich people and 2 lakhs poor people. (a) Ifall the citizens have to pay an equal amount of taxes and x; supplied is 20 units. (i) _ What would be the total government expenditure? (ii) How much tax will each citizen pay? (iii) How much income would be left for x2 for rich and poor? (b) If @ units of public are supplied, then find the total expenditure of the government? Find tax paid by each citizen. (©) _ If everyone has to consume same units of the public good then people will have a choice problem explain. (d) Find the optimal quantities of x; and x2 for rich and poor. [Ans. : (a)(i)Rs. 1,20,00,000, (ii) Rs. 40, (iii) Rich Rs. 60, Poor Rs. 10 (b) — 6,00,000a and 2a, (d) for rich x1 = 25, x2 = 50, and for poor x1 = 12.5, x2 = 25) Q9. Suppose the banana-chips industry is perfectly competitive and the market price is Rs. 100 per kg. One firm (firm i) finds a new process which leads to the following cost function for its output (Q;) Total Cost = 0.5Q? Social marginal cost (SMC) = 1.25Q; Micro Economics 19 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in This firm is still a price-taker. Find the per unit production tax which will lead to the socially optimum level of output by the firm. [Eco. (H) IV Sem. 2014] QI0. Derive the demand curve for a public good from the following individual 1 and 2 demand curves for the good. state your reasoning. q:= 180—p, gz = 120 — 2p [Eco. (H) IV Sem. 2014] QI1. Let X be a public good and Y be a private good. An economy has two individuals A and B who start with an initial endowment of Y as Y“* and Y®* respectively. X=/(¥!, Y!) where subscript ‘s” stands for subscription (contribution). Show the allocational failure of a competitive market mechanism. [Eeo. (H) IV Sem. 2014] QI2. Rohan (A) and Rahim (B), two university students, share an apartment. They consider buying a sofa (S) which they can share; ‘S* can take a value 1 or 0 depending on whether the sofa is bought or not. Rohan’s utility function is represented by ua(S, Ma) = (1 + S)Ma and that of Rahim is represented by ug(S, Mg) = (2 + S)Mp. Let Ma, Wa, Ms and We stand for their ‘residual’ expenditure (expenditure on all goods except *S’) and total income of A and B respectively (What is Rohan’s reservation price for ‘S”? What is Rahim’s reservation price for ‘S”? (ii) If Wa = 100 and Wy = 75, what must be the maximum cost of *S” so that it is Pareto improving for the two students to buy the sofa? (iii) _In a more general setting, let the utility functions of the agents be defined by uaQxa, G) and up(xp, G), where G can take only two values, 0 or 1, Let “c” be the cost of one unit of G and gs and gs be A’s and B’s contribution to the public good. If rs and rp represent A’s and B’s reservation prices for G, derive the necessary and sufficient conditions for the provision of G to be Pareto improving. Would it still be Pareto superior to provide Gif ra < ga? [Eco. (H) IV Sem. 2015] QI3. For two room mates, an air conditioner (AC) for their room is a public good. Their utility functions are given by : [Eco. (H) IV Sem. 2016] U:=(8+A)Miand U2 =(5 + A)Mp Where Mi and Mp are their private expenditures and A is 1 and 0 according as the AC is bought or not. If both roommates have a wealth of Rs. 5000 each and AC costs Rs. 3000. (i) Find their reservation prices for the AC. (ii) Find whether or not it is a Pareto improvement for them to acquire the AC. QI4. Consider two consumers both having a money income of Rs. 100 and with utility functions. [Eco. (A) IV Sem. 2016] U; = 101InG + Mi, Uz = 20 InG + Mz Where G is their expenditure on the public good and M), Mp are their expenditures respectively on their private good. Find the Pareto optimal amount of the public good. How would this change if their income increased to Rs. 150 each? Micro Economics 7.10 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in Questions from Recent Eco (H) Examination Ql. There are two agents and each agent has utility U(G, X,) where X; is private consumption and G is the size of public good. [Eco. (H) IV Sem. 2017] Gegite Where g, is agent i’s contribution on the public good. The price of private consumption is P, and the price of public good is Pg. Each agent has an income M; and thus has an individual budget constraint Py Xi+ Po .gi=M, Let the utility function of two agents be, U, = 300In G + X; and U2 = 200In G + X2 The incomes of the two agents M1 and M2 is given as 1000 each. Pg is given as I: (i) Write an equation that expresses the condition for the provision of the Pareto efficient level of the public good and find the value of G. (ii) Find the amount each person spends on private good, if each person shares the cost of the public good equally? (iii) Do you think as increase in income of both persons will increase the amount of public good provided? Give reason for your answer. Q2. Ann (A) and Bobby (B) share an apartment. They spend some of their income on private goods separately and some of their incomes on public good like TV. A's utility function is : Ug(XsG) = G/4X2/4and B's utility function is Ug(Xp,G) = G4/2Xq/?,where X, and Xp are the quantities consumed of private goods by Ann and Bobby and G is the size of the public good, where, G = ga + gp, the contribution of A and B for buying TV. Both Ann and Bobby have income of (W, and Ws respectively) Rs. 2000 each per month. Price of public good is given as, P;, = 100 and price of private good is given as, Py = 1.P; reflects the marginal cost of public good. (i) | Write the conditions for the provision of the Pareto efficient amount of public good assuming both Ann and Bobby can pool their resources. (i) Find the optimum size of G for the provision of the public good assuming X, =% [Eco. (H) IV Sem. 2018] Q3. Ina town of 20,000 residents ‘security’ is a public good. It costs Rs. 500 to provide a unit of ‘security’. The marginal benefit (MB) of a unit of ‘security’ to each resident is given by MB = 1/(1 + G) when a units of ‘security’ are provided. What is the Pareto efficient amount of ‘security’ for this town? [Eco. (H) IV Sem. 2019] Q4. Arun and Barun are deciding whether or not to buy a TV for a room they share (if bought, it would be a public good for them). Arun's utility function is given by Ua = (1 + G)Ma, and Barun's by Ug = (13 + G)Mp . where Ma, and Mg are the amounts they spend on their private consumption respectively. G = | if the TV is bought, and G = 0 if it is not bought. Both of them have Rs.60,000 each to spend on the public good and their private consumption and the TV costs Rs. 50,000. Is it Pareto efficient for them to buy the TV ? Explain. [Eco. (H) IV Sem. 2019] Micro Economics 71 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in Q5. Suppose two individuals A and B have the following preferences over private good (2) and public good (g): [Eco. (H) IV Sem. 2021] Ug = xq + J@ and Ug = xp + J and the cost of providing public good is C(g) = 0.5g. Show that a unique amount of the public good will be supplied at every efficient allocation. Q6. An individual’s inverse demand function for commodity X is given by Px = 10 — Qx, where the per unit market price Px captures his marginal willingness to pay for commodity X. Assume there are 10 individuals with the same demand curve, [Eco. (H) IV Sem. 2022] (i) Find and plot the market demand curve for X if it is a private good. (i) Find and plot the market demand curve for X if it is a public good. If the marginal cost of providing the public good X is Rs. 10 find the efficient quantity of public good provided. (iii) State the condition for Pareto efficient allocation of (a) _ two private goods (X and Y) between two individuals (A and B), and (b) one public good (G) and one private good (Y) between A and B. Compare the two conditions For Full Course Video Lectures of All Subjects of Economics (Hons), B Com (H), BBE, MA Economics, NTA UGC NET Economics, Indian Economic Service (IES) Register yourself at www.primeacademy.in Dheeraj Suri Classes Prime Academy 9899192027 Micro Economics 7.12 By Dheeraj Suri, 9899-192027