ECO 4554

Economics of State and Local Government

Lecture Notes

MICROECONOMIC ANALYSIS OF THE PUBLIC SECTOR:

MARKET EFFICIENCY AND MARKET FAILURE

Key Points

1. The quantity of a good or service is efficient if there is no other quantity that makes at least one
person better off without also making someone else worse off. At the efficient quantity, marginal
benefit equals marginal cost and the social surplus is maximized.

2. The equilibrium quantity in a competitive market is economically efficient provided there are no
increasing returns to scale, no externalities, and no “public” (collective consumption) goods.

3. When there are increasing returns to scale, externalities, or collective consumption goods, the
equilibrium allocation of resources in a competitive market is not efficient.

4. The quantity of a collective consumption good is likely to be inefficient no matter how the good
is supplied, whether the good or service is provided using the market model or the voluntary
contributions model or the government model. Using the market model, the supplier excludes
individuals who do not pay from consuming the good even though the marginal cost of serving
them is zero. Using the voluntary contributions model, individuals lack incentives to voluntarily
pay an amount equal to their marginal benefit. Using the government model, voting and taxes are
both sources of inefficiency.

Synopsis

First, we define the basic concepts used in microeconomic analysis: marginal benefit (also called
marginal utility or marginal value), marginal social benefit, marginal cost, and marginal social cost. A
demand function, schedule, or curve shows consumers’ marginal benefit for a good or service. A
supply function, schedule, or curve shows the marginal cost of providing a good or service.

Next, we define the concepts of consumer surplus, producer surplus, and social surplus, which is the
sum of consumer and producer surplus. We show that the social surplus is greatest when marginal
social benefit equals marginal social cost.

We then introduce the concept of economic efficiency. Efficiency is defined as a quantity such that no
other quantity would make one individual better off without harming someone else. Economic
efficiency is the most fundamental concept in the course. We show that the quantity of a good or
service that maximizes the social surplus is the efficient quantity.

We show that the competitive market equilibrium quantity is efficient if there are no increasing
returns to scale, no externalities, and no “public” (that is, collective consumption) goods. But when
there are increasing returns to scale or externalities or public goods, the equilibrium quantity is not
efficient. This is called “market failure”. We then define increasing returns to scale, externalities, and
“public” goods and show why each one causes market failure.

With “public” goods, if suppliers charge a price, they exclude some individuals whose marginal
benefit is positive but less than the price even though the marginal cost of supplying them is zero. On
 ECO 4554: Economics of State and Local Government
Microeconomic Analysis of the Public Sector:
Market Efficiency and Market Failure

the other hand, if suppliers do not charge a price but rely on voluntary payment by consumers,
consumers lack incentives to pay an amount equal to their true marginal benefit. In either case, the
quantity of the “public” good supplied is less than the efficient quantity. Finally, we argue that
government provision of a “public” good is also likely to be inefficient because it relies on voting and
taxes both of which are sources of inefficiency. Therefore, no matter what model of provision is
adopted, the supply of “public” goods is likely to be inefficient.

Lecture Notes

I. Marginal social benefit and marginal social cost

A. Marginal benefit (or marginal utility or marginal value): The change in benefit (or
utility or value) obtained by an individual or community from a small (that is, a
marginal) change in the quantity of a good or service:

MB=ΔTB÷ΔQ

where Δ means “change in”. See PowerPoint Slides Figure 1-1.

1. The vertical distance at each quantity up to the individual or community

demand curve represents the marginal benefit at that quantity.

2. Marginal benefit is not total benefit. The marginal benefit is the additional
value obtained from a small increase in the quantity, or the additional value
lost from a small decrease in the quantity. The total benefit is the sum of the
marginal benefits obtained from all units of the good from zero up to that
quantity.

3. Law of (eventually) diminishing marginal benefit or utility: As consumption

of any good or service increases, the marginal benefit or utility obtained from
additional units of the good or service (eventually) decreases.

a. The additional benefit gained when quantity increases from 19 to 20

(or benefit lost when quantity decreases from 20 to 19) is smaller
than the additional benefit gained when quantity increases from 9 to
10 (or lost when quantity decreases from 10 to 9).

b. Alternative interpretation: As consumption increases, total benefit or

utility increases but the rate of increase gets smaller and smaller.

c. The law of diminishing marginal benefit is the basis for “the law of
demand”, which says that when price increases, quantity demanded
decreases, and when price decreases, quantity demanded increases.
Demand curves are negatively sloped because of diminishing
marginal benefit.

4. Example: In a monetary economy, an individual’s marginal benefit for a

particular unit of a good or service is measured by the maximum price that
the individual is willing to pay for that unit. Suppose Huey typically
purchases 5 new CD’s each month at a price of $12 each, but he is willing to

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Microeconomic Analysis of the Public Sector:
Market Efficiency and Market Failure

pay no more than $11 for a sixth CD. Therefore, his marginal benefit from a
sixth CD is $11. Huey places a positive value on the sixth CD; it provides
him with additional satisfaction or pleasure, but not as much as the previous
5 CD’s.

B. Marginal social benefit

1. The marginal benefit obtained by all members of the community from a

given quantity of the good or service is the marginal social benefit of that
quantity of the good or service.

2. Marginal social benefit (MSB) includes both the marginal private benefit
(MB) or utility obtained by the direct consumers or users of the good or
service and any external benefits (MEB) received by other individuals who
are not direct consumers or users: MSB=MB+MEB.

3. Example: No one other than Huey benefits from Huey’s CD’s. Therefore,
Huey’s marginal benefit from the sixth CD is also the marginal social benefit
of the sixth CD ($11=$11+$0).

C. Marginal cost: The change in opportunity cost resulting from a small change in the
quantity of a good or service. The opportunity cost of a good or service is the value
of the best alternative good or service that could be supplied using the same
resources:

MB=ΔTB÷ΔQ

See PowerPoint Slides Figure 1-2.

1. The vertical distance at each quantity up to the individual or community

supply curve represents the marginal cost of that quantity.

2. Marginal cost is not total cost; the marginal cost is the additional cost of a
small increase in quantity or the cost saved from a small decrease in quantity.
The total cost of any quantity is the sum of the marginal costs from
producing all units of the good from zero up to that quantity.

3. Increasing marginal cost: As production of any good or service increases, the

marginal cost of the resources used to produce the good will typically
increase.

a. Successive increments in the quantity of any good cost more than

previous units; one more unit of the good costs more if you are
already supplying 20 units of the good than if you are only supplying
10 units.

b. Alternative interpretation: As quantity supplied increases, total cost

increases at an increasing rate.

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Microeconomic Analysis of the Public Sector:
Market Efficiency and Market Failure

c. There is no “law of increasing cost” and we will see many examples

of constant cost and decreasing cost. However, we can state that it is
not possible to increase the supply of a good or service indefinitely
without eventually encountering increasing cost; therefore, we can
refer to “the law of eventually increasing cost”.

4. Example: Suppose the total cost to produce 5 CD’s for Huey is $15 but
producing a sixth CD would increase the total cost to $21. Then, the marginal
cost of the sixth CD is $6 ($21-$15). If the marginal cost of the fifth CD was
$5, then marginal cost is increasing.

D. Marginal social cost

1. The marginal cost to all members of the community from a given quantity of
the good or service is the marginal social cost of that quantity of the good or
service.

2. Marginal social cost (MSC) includes both the marginal private cost to the
supplier of the good or service (MC) and any external costs imposed on other
individuals (MEC): MSC=MC+MEC.

3. If there are no external costs, the marginal social cost is the same as the
marginal cost to the supplier.

4. Example: No one other than the producer bears any of the costs of producing
CD’s for Huey. Therefore, the marginal cost of Huey’s sixth CD is also the
marginal social cost of that CD ($6=$6+$0).

II. Consumer and producer surplus

A. Consumer surplus: The difference between the marginal benefit or utility of a good to
consumers and the price paid (marginal consumer surplus) or the difference between
consumers’ total benefit or utility or willingness-to-pay and their total expenditure on
the good (aggregate consumer surplus). See PowerPoint Slides Figure 1-3.

Price
$50
$45 a
$40 Consumer
$35 Consumers'
Surplus
'Surplus b
$30
$25 c
$20 D (=MB)
$15
$10
$5
$0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Quantity
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Microeconomic Analysis of the Public Sector:
Market Efficiency and Market Failure

1. Diagrammatically, the distance between the demand curve and the price at
any quantity shows the marginal consumer surplus of that quantity: CS=MB-
P. The area below the demand curve and above the price and between zero
and any quantity shows the aggregate consumer surplus of that quantity.

2. Example: Suppose the price is $30. The marginal benefit or willingness to

pay for the tenth unit, shown by the demand curve, is $35. Therefore, the
marginal consumer surplus of the tenth unit is $5. The marginal benefit or
willingness to pay for the fifteenth unit is $30, exactly equal to the price, so
the marginal consumer surplus of the fifteenth unit is $0. But total consumer
surplus for all fifteen units is $112.50. (You can find total consumer surplus
at any quantity by calculating the area between the demand curve and the
price from zero up to that quantity.)

3. When marginal benefit or willingness to pay at a particular quantity is greater

than the price, an increase in the quantity increases consumer surplus. When
marginal benefit or willingness to pay at a particular quantity is less than the
price, a decrease in the quantity increases consumer surplus. And when
marginal benefit or willingness to pay at a particular quantity is equal to the
price, consumer surplus reaches a maximum at that quantity; either an
increase or a decrease from that quantity decreases consumer surplus.

4. Consumer surplus at a particular quantity represents the net gain to

consumers from having that quantity of this particular good or service instead
of the most valuable alternative good or service.

B. Producer surplus: The difference between the marginal cost of a good to suppliers
and the price (marginal producer surplus) or the difference between total cost and
total revenue received for the good (aggregate producer surplus). See PowerPoint
Slides Figure 1-4.

Price
$60 S(=MC)
$50
$40
$30
$20 Producer
Surplus
$10
$0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Quantity

1. Diagrammatically, the distance between the supply curve and the price at any
quantity shows the marginal producer surplus at that quantity: PS=P-MC.

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Market Efficiency and Market Failure

The area between the supply curve and the price and between zero and that
quantity shows the aggregate producer surplus of that quantity.

2. Example: Suppose the price is $30. The marginal cost of the tenth unit,
shown by the supply curve, is $20. Therefore, the marginal producer surplus
of the tenth unit is $10. The marginal cost of the fifteenth unit is $30, exactly
equal to the price, so the marginal producer surplus of the fifteenth unit is $0.
But total producer surplus for all fifteen units is $225.00. (You can find total
producer surplus at any quantity by calculating the area between the supply
curve and the price from zero up to that quantity.)

3. When marginal cost at a particular quantity is less than the price, an increase
in the quantity increases producer surplus. When marginal cost at a particular
quantity is greater than the price, a decrease in the quantity increases
producer surplus. And when marginal cost at a particular quantity is equal to
the price, producer surplus reaches a maximum at that quantity; either an
increase or a decrease from that quantity decreases producer surplus.

4. Producer surplus represents the net gain to suppliers from producing that
quantity of this particular good or service instead of using their resources to
produce the most valuable alternative good or service.

C. Social surplus

1. Social surplus is equal to consumer surplus plus producer surplus. It

represents the net gain to both consumers and suppliers from having a given
quantity of this particular good or service instead of the most valuable
alternative. It is the net gain to the entire community, the benefit from this
quantity of the particular good or service net of the costs. The costs are
opportunity costs, which means the value of other goods and services not
available to the community because the resources are being used to supply
this good. See PowerPoint Slides Figure 1-5.

Price
$60 S (=MC)
$50
$40
$30 Social
Surplus
$20 D (=MB)

$10
$0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Quantity

2. Social surplus is independent of price, and depends only on consumers’ MB

and suppliers’ MC. Price determines the distribution of the social surplus

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Market Efficiency and Market Failure

between consumers (consumer surplus) and suppliers (producer surplus) but

not the total amount of the surplus.

III. Economic efficiency and competitive markets See Example 1-1

A. This is the most basic concept. We show that the competitive market equilibrium
quantity is economically efficient. The argument is divided into steps:

1. first, we define the competitive market equilibrium quantity;

2. then, we define the concept of economic efficiency;

3. finally, we explain why the competitive market equilibrium quantity is also

the socially or economically efficient quantity provided that there are no
increasing returns to scale, no externalities, and no “public” or collective
consumption goods.

B. Competitive market equilibrium

1. Equilibrium means a “state of rest”. At the competitive market equilibrium,

neither buyers nor sellers have any incentive to change their behavior. If
neither buyers’ demand nor sellers’ supply changes, then neither the price
and quantity nor quantity changes.

2. The characteristic that identifies the competitive equilibrium is

QD=QS

The price and quantity at which this occurs are the equilibrium price and the
equilibrium quantity.

C. Define “economic efficiency” (or Pareto optimality): A quantity, Q*, is efficient if

there is no other quantity that makes at least one person better off without also
making someone else worse off.

1. The economically efficient quantity has three characteristics. If one of these

is true, then so are the other two.

a. Definition: No other quantity would increase any one person’s

benefit without decreasing someone else’s.

b. Surplus: No other quantity or allocation has a higher social

(consumer plus producer) surplus.

c. MSB=MSC (or MB=MC if MEB=MEC=0, that is, no externalities)

2. Intuitive explanation

a. Suppose the current allocation of resources is Q1, which includes a

particular quantity of oranges and a particular quantity of lemons.

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Market Efficiency and Market Failure

Suppose at this quantity of oranges, MSBoranges>MSCoranges. This

means the value to some consumer of one more orange (its MSB) is
greater than the value of the additional resources needed to produce
another orange (its MSC). This consumer is willing to give up more
than enough lemons (or give up purchasing power over more than
enough lemons) to free up the resources needed to produce the
additional orange. This consumer is better off with an alternative
allocation of resources, Q2, which includes one more orange than Q1
but a smaller number of lemons. Furthermore, reallocating the
resources from Q1 to Q2 doesn’t make any other individual worse off.
We do not have to take goods or resources away from anyone else to
produce another orange for our orange consumer. Allocation Q1 is
not economically efficient because there is an alternative allocation,
Q2, that makes our orange consumer better off without making
anyone else worse off.

b. Now, consider allocation Q3. In allocation Q3, MSBoranges<MSCoranges.

This means our orange consumer is unwilling to give up enough
lemons to free up the resources needed to produce one more orange.
In fact, our consumer would actually prefer more lemons and fewer
oranges. One less orange would free up enough resources to produce
more than enough lemons to satisfy our consumer. Our consumer
would be better off with fewer oranges and more lemons, and no one
else would be worse off. Therefore, Q3 is inefficient; there is an
allocation involving fewer oranges and more lemons that makes our
orange consumer better off without making anyone else worse off.

c. Any allocation in which MSB>MSC for any good is inefficient

because there is another allocation with more of this good that would
make at least one consumer better off and no one else worse off. Any
allocation with MSB<MSC for any good is also inefficient because
there is another allocation with less of this good and more of some
other good that would make this consumer better off and no one else
worse off. Therefore, the only efficient allocation is one with
MSB=MSC for every good.

D. Proof that the competitive market equilibrium quantity is also the efficient quantity

1. Consumer equilibrium: When MB(QD)>P, there is a net gain to having more

of a good or service. When MB(QD)<P, there is a net loss to having more.
Therefore, if there are no public goods so that consumers are unable to free
ride (see the discussion below), each consumer reaches equilibrium by
choosing the quantity of each good at which MB(QD)=P.

2. Producer equilibrium: When MC(QS)<P, there is a net gain to selling more of

a good or service. When MC(QS)>P, there is a net loss to selling more.
Therefore, if there are no increasing returns to scale so that no sellers incur
losses (see the discussion below), each seller reaches equilibrium by
choosing the quantity of each good at which MC(QS)=P.

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Market Efficiency and Market Failure

3. In equilibrium in a competitive market, both consumers and producers face

the same price. The price adjusts up or down to bring quantity demanded in
line with quantity supplied. This is the equilibrium condition: QD=QS=Q’,
where Q’ designates the equilibrium quantity. When both buyers and sellers
are in equilibrium, each buyer’s marginal benefit for each good, service, or
activity equals the suppliers’ marginal cost: MB(Q’)=P=MC(Q’).

4. If there are no externalities, MB(Q’)=MSB(Q’) and MC(Q’)=MSC(Q’) so

that in competitive equilibrium MSB(Q’)=MSC(Q’). Therefore, Q’, satisfies
both the competitive equilibrium condition, QD=QS, and the efficiency
condition, MSB=MSC. So the competitive equilibrium quantity, Q’, is also
the efficient quantity, Q*.

E. Market failure: If there are increasing returns to scale or externalities (positive or

negative) or “public” goods, the equilibrium allocation of resources in a competitive
market is not economically efficient. Competitive markets fail to provide an efficient
allocation of resources. Therefore, increasing returns to scale, externalities, and
“public” goods are sources of “market failure”. We now show why each one causes
the equilibrium allocation in a competitive market to be inefficient.

IV. Increasing returns to scale

A. Increasing returns to scale (“economies of scale”): As quantity increases with all

inputs variable (that is, as the scale of production expands), output increases
proportionally more than the inputs. See PowerPoint Slides Figure 1-6.

1. For example, if all inputs double, output increases by more than double.
When you double the inputs, your costs also double, but if your output more
than doubles, your cost per unit, or average total cost, goes down.

2. This means that when production is characterized by increasing returns to

scale, long-run average total cost (LRATC) decreases.

a. Mathematically, whenever the average value of a variable is

decreasing, the marginal value of the same variable must be less than
the average (not necessarily decreasing, just less than the average).

b. With increasing returns to scale, because LRATC is decreasing,

MC<LRATC at each quantity.

c. Diagrammatically, the LRATC curve is negatively sloped and the

MC curve lies below it (but is not necessarily negatively sloped).

3. Decreasing LRATC means a single large supplier can satisfy the entire
market demand at lower average cost than several smaller competing
suppliers. There are “economies of scale” to larger scale production.

4. Recall that (a) consumers choose the quantity at which MB=P, and (b) the
efficient quantity is the quantity at which MB=MC. This requires that
P=MC. But with increasing returns to scale, P=MC means P<LRATC.

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Market Efficiency and Market Failure

P<LRATC means losses for suppliers. Any supplier who produces the
efficient quantity where MB=P=MC suffers losses and in the long run leaves
the market. The best that sellers can do is to set a higher price equal to
LRATC to avoid losses. At a higher price, however, the quantity demanded
by consumers is less than the efficient quantity.

5. In summary, a seller who produces the efficient quantity by setting P=MC

suffers losses and leaves the market. A seller who avoids losses by producing
the quantity where P=LRATC produces less than the efficient quantity.

B. Applications of increasing returns in the economics of state and local government

1. Example 1 (Metropolitan consolidation): If production of a local government

good or service is subject to increasing returns to scale, a single large
community can supply the good or service at lower average cost than several
smaller communities. This is often used as a justification for metropolitan
consolidation where smaller communities in a metropolitan area join to form
a single larger jurisdiction.

2. Example 2 (Natural monopolies): Where fixed costs are high relative to

variable (marginal) costs, as with public utilities, increasing returns to scale
and decreasing LRATC characterize the entire range of feasible quantities.
Because the efficient quantity involves losses, government may assume
responsibility for providing the service at a loss or government may subsidize
a private supplier’s losses when the private supplier produces the efficient
quantity. (Note, however, that the taxes required to cover the government’s
loss or to pay the subsidy to the private supplier create inefficiency elsewhere
in the economy as we shall later see.)

V. Externalities

A. External benefits or positive externalities: Occur when an individual’s decision about

consumption or production provides benefits to other individuals who are not party to
the decision. See PowerPoint Slides Figure 1-7.

1. Individuals choose the quantity of each activity that makes their marginal
private benefit (MB) equal to their marginal cost. They ignore or may even
be unaware of the marginal external benefit (MEB) received by other
individuals.

2. Marginal private benefit does not include any benefits received by other
individuals. When individuals other than the direct consumer or producer
benefit from an activity, the marginal social benefit is greater than the
marginal private benefit: MSB=MB+MEB.

3. Because the benefit to the direct consumer or producer (marginal private

benefit) is less than the benefit to society (marginal social benefit), the
quantity chosen by the individual (where MB=MC) is less than the efficient
quantity (where MSB=MC).

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Microeconomic Analysis of the Public Sector:
Market Efficiency and Market Failure

B. External costs or negative externalities: Occur when an individual’s decision about

consumption or production imposes costs on other individuals who are not party to
the decision. See PowerPoint Slides Figure 1-8.

1. Individuals choose the quantity of each activity that makes their marginal
benefit equal to their marginal private cost (MC). They ignore or may even
be unaware of the marginal external cost (MEC) they impose on others.

2. Marginal private cost does not include the costs imposed on other
individuals. When individuals other than the direct consumer or producer
bear some of the costs of the activity, the marginal social cost is greater than
the marginal private cost: MSC=MC+MEC.

3. Because the cost to the direct consumer or producer (marginal private cost) is
less than the cost to society (marginal social cost), the quantity chosen by the
individual (where MB=MPC) is greater than the efficient quantity (where
MB=MSC).

C. Internalizing an externality: Actions taken to correct the inefficiency caused by an

externality are called “internalizing the externality”. Actions to internalize
externalities may include, among others, subsidies, taxes, redefining property rights,
or consolidation of smaller communities into larger communities.

D. Applications of externalities in the economics of state and local government

1. Some externalities arise within a single community. Some government

activities are justified as necessary to internalize these intrajurisdictional
externalities.

a. Example 1 (Subsidies): Public education confers direct benefits on

the students and their parents but it also may confer external benefits
on the community as a whole. For example, all members of the
community may benefit from living in a better-educated community.

(1). If the students or their parents must pay the full costs of their
education, they choose to spend less on education than is
economically efficient. A subsidy (“free” public schooling or
a voucher for private schooling) equal to the marginal
external benefit creates incentives for the students or their
parents to increase their consumption of education to the
economically efficient level.

(2). Even without the subsidy, the students and their parents
would choose some level of education. The externality is
only relevant and a subsidy is only appropriate if the
externality is marginal. A marginal externality means that
additional education beyond the amount the students or their
parents would choose on their own confers external benefits.
If, for example, only the first eight years of education confer
external benefits, but students and their parents would

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Market Efficiency and Market Failure

choose twelve years even without a subsidy, then there is no

externality at the margin. In this case, the externality is
inframarginal and the subsidy is unnecessary to provide
incentives for students and their parents to choose the
efficient quantity of education.

(3). However, if students and their parents would choose eight

years of education on their own, but other members of the
community would receive external benefits for up to 12
years of education, then the externality is marginal. A
subsidy may be appropriate to provide incentives for the
students and their parents to choose the economically
efficient quantity of education (12 years instead of 8).

b. Example 2 (User fees): At certain times of the day, a public facility

is crowded; each additional person using the facility imposes an
external cost on other users. A “peak load price” or user fee equal to
the marginal external cost of the congestion provides incentives for
individuals to reduce their use of the facility to the economically
efficient level.

2. Some externalities occur between different communities. Activities in one

community confer benefits or impose costs on members of other
communities. Some government activities are justified as necessary to
internalize these interjurisdictional externalities, also called
“interjurisdictional spillovers”.

a. Example 1 (Intergovernmental grants): Education supplied to

students in one community may confer external benefits on residents
of an adjoining community. For example, some students may
eventually relocate to the second community. If the first community
must pay the full costs of educating its students, it chooses to spend
less on education than is economically efficient. State government
can encourage the first community to increase its education
expenditures to the efficient level by supplementing local education
resources with a grant, the intergovernmental equivalent of a
subsidy.

b. Example 2 (Consumption taxes): Public services in communities

with major tourist attractions benefit not only residents but also
tourists most of whom are residents of other communities. If only
residents of the community bear the costs of the public services, they
choose a quantity that is less than the efficient quantity. If the
community imposes excise taxes on items consumed by tourists such
as hotel accommodations and rental cars, a share of the costs of
public services in the taxing community is exported to tourists.
Exporting some of the costs of public services to tourists creates
incentives for the residents of the taxing community to increase their
expenditure on public services to the efficient level.

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Market Efficiency and Market Failure

VI. “Public” (or more appropriately, collective consumption) goods See Example 1-2

A. “Private” (or individual consumption) good: A good or service such that each
individual consumes separate and identifiable units of the good; a unit of the good
consumed by one individual cannot be consumed by any other individual.

1. There is an element of “rivalry” among individuals in consumption of a

private good. A unit consumed by one individual is unavailable for
consumption by any other individual.

2. For private goods, each individual consumer’s MB for any one unit is also
the MSB for that unit of the good.

3. Total community demand for the good equals the horizontal sum of the
individual demands because separate units of the good must be supplied to
each consumer. At each price, we add the quantity that makes one
individual’s marginal benefit equal to the price to the quantities that make
every other individual’s marginal benefit equal to the price. The result is the
total quantity required to make each individual’s marginal benefit equal to
the price. See PowerPoint Slides Figure 1-9.

4. Efficiency conditions: At a fixed level of MB, we add the individual

quantities demanded to find the total amount necessary so that each
individual’s chosen quantity yields that amount of MB.

a. Each individual consumes an amount of the good where marginal

private benefit (which is the same in this case as marginal social
benefit) equals price, which in turn equals marginal social cost.

MB1=MB2=MB3=...=MSB=MSC

b. The total quantity provided must equal the sum of the amounts
required to satisfy each individual.

Q1+Q2+Q3+...=Qtotal

B. “Public” (or collective consumption) good: A good or service such that the same unit
of the good or service can simultaneously be consumed by more than one individual.
Individuals do not consume separate and identifiable units of a public good; instead,
they all jointly consume the same units of the good.

1. Public goods are “non-rivalrous”; consumption by one individual does not

reduce the amount available for other individuals. Individuals can share in
consumption of, or jointly consume, all units of the good.

2. Community demand for a public good is the vertical sum of the individual
demands. Each unit is being simultaneously consumed by all individuals in
the group. The marginal social benefit of that unit of the good equals the sum
of the marginal benefits of each of the individuals in the group. See
PowerPoint Slides Figure 1-10.

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Market Efficiency and Market Failure

3. Efficiency conditions (Samuelson condition for efficiency in the allocation of

resources with a public good): At a given quantity, we add across the
individual marginal benefits to find the marginal social benefit provided by
that quantity of the good.

a. All individuals in the group can simultaneously consume each unit of

a public. The marginal social benefit of each quantity is therefore the
sum of the marginal benefits of all individuals in the group. The
efficient quantity is the quantity at which the marginal social benefit
equals marginal social cost.

MB1+MB2+MB3+...=MSB=MSC

b. Because all individuals simultaneously consume each unit of the

good or service, each individual’s consumption equals the total
quantity provided.

Q1=Q2=Q3=...=Qtotal

C. Public goods are not the same as government goods or publicly-provided goods

1. Although commonly used, the terms “public” good and “private” good are
unfortunate and misleading. More appropriate terms are “collective
consumption good” and “individual consumption good”.

2. The distinction between "private" (or “individual consumption”) and "public"

(or “collective consumption”) goods depends on the technical properties of
the good; that is, it depends on whether or not it is possible for individuals to
jointly or collectively consume each unit of the good. The distinction does
not depend on whether the good is supplied in the private market or by
government.

3. Examples of public (collective consumption) goods:

• national defense
• crime prevention
• television programming
• roads (provided they are uncrowded)
• parks (provided they are uncrowded)
• golf courses (provided they are uncrowded)
• movie theaters (provided they are uncrowded)

4. Many goods supplied by government do not necessarily fit the technical

definition of public goods:

• education
• tennis courts and similar recreational facilities
• fire protection.

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 ECO 4554: Economics of State and Local Government
Microeconomic Analysis of the Public Sector:
Market Efficiency and Market Failure

Many goods supplied in the market by the private sector do fit the technical
meaning of public goods, at least over some geographic range or for some set
of consumers:

• private security services

• television programming
• golf courses (uncrowded).

D. Public goods and market failure

1. Consider two different models for providing a public good.

a. In the market model, the supplier sets a price and excludes from
consumption any individual who does not pay the price. We refer to
this as “exclusion”.

b. In the voluntary contributions model, the supplier does not set a price
but allows anyone to consume the good whether or not they pay for
it. We refer to this as “nonexclusion”.

c. We will show that in neither model is the quantity of a public good

likely to be efficient.

2. Market model (exclusion)

a. Suppliers set a price for the good. Individuals whose MB>P pay the
price and share in consumption of the good. Individuals whose
MB<P do not pay the price and are excluded from sharing in
consumption of the good.

b. Because it is a collective consumption good, the excluded

individuals could technically share in consumption of the good. No
additional units of the good would have to be provided. Their
consumption of the good imposes no costs on other consumers, and
so the marginal cost of allowing them to consume the good is zero.
They would be better off if they were not excluded from consuming
the good and no one else would be worse off. Therefore, it is
inefficient to exclude them.

c. Suppliers provide the quantity of the public good demanded by those

whose MB≥P and who are therefore willing to pay the price. The
suppliers’ equilibrium quantity is the quantity at which the sum of
the prices paid equals MC. But the marginal social benefit is the sum
of the MB’s of all individuals, non-payers as well as payers.
Therefore, MSB>MC, and the equilibrium quantity supplied is less
than the efficient quantity.

d. Lindahl equilibrium: There is one case in which the market model

can result in provision of the efficient quantity of a public good.

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 ECO 4554: Economics of State and Local Government
Microeconomic Analysis of the Public Sector:
Market Efficiency and Market Failure

(1). Suppose the supplier charges each individual a unique

individualized price that is just equal to individual marginal
benefit. Suppose also that the sum of these individualized
prices equals marginal (social) cost. Since Pi=MBi for each
individual and ΣPi=MSC, therefore, ΣMBi=MSB=MSC and
the equilibrium quantity of the good is the economically
efficient quantity.

(2). Individualized prices equal to individual marginal benefits

are referred to as Lindahl prices. The allocation resulting
from charging Lindahl prices is a Lindahl equilibrium. A
Lindahl equilibrium is efficient. Rarely do suppliers have
enough information about the preferences of their consumers
to perfectly price discriminate in this way. But there is a
lesson to be learned: the closer prices for public goods or
taxes are to individual (marginal) benefits, the closer is the
equilibrium quantity to the efficient quantity.

3. Voluntary contributions model (nonexclusion)

a. Suppose no effort is made to exclude individuals from consumption

of a public good even if they do not pay for it. The supplier expects
each consumer to voluntarily pay a price equal to marginal benefit.

b. Free rider: An individual who receives benefits from a good or

service without contributing to the costs is called a “free rider”.

c. With nonexclusion in the market for a public good, individuals can

consume the good even if they do not pay. Therefore, they have an
incentive to “free ride”, to voluntarily contribute an amount that is
less than their true marginal benefit or, in the extreme, to contribute
nothing to the cost of the public good.

d. The free-rider problem causes the quantity of the public good to be

less than the efficient quantity. If individuals free ride, their
voluntary payments are less than the amount needed to pay for the
efficient quantity. The quantity provided is less than the efficient
quantity, and in the extreme case of complete free riding, none of the
good is provided.

4. In conclusion, neither the market model nor the voluntary contributions

model can be relied upon to provide the efficient quantity of a public good.
With or without exclusion, the competitive market equilibrium quantity is not
likely to be the efficient quantity when there are public goods.

E. Government model (nonexclusion)

1. Government typically supplies a public good at no charge (nonexclusion) but

attempts to overcome the free rider problem by financing the good with
mandatory (involuntary) taxes. This is the government model.

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 ECO 4554: Economics of State and Local Government
Microeconomic Analysis of the Public Sector:
Market Efficiency and Market Failure

2. An advantage of the government model is that all potential beneficiaries can

consume the good; no one whose MB>0 is excluded.

3. Disadvantages of the government model: The government model does not

necessarily supply the efficient quantity of a public good for three reasons.

a. Since there is no direct cost to an individual for consuming the good

(that is, no price is charged), crowding may emerge as individuals
overconsume the good.

b. Without knowing consumers’ marginal benefits, it is difficult or

impossible to determine the efficient quantity of the good, but such
information is typically not available to the government.

c. The taxes required to finance the good create offsetting inefficiencies

in the markets for the taxed activities, as we shall see.

F. Efficient supply of a public good: Comparison of the market and voluntary

contributions models with the government model

1. None of the three models is likely to supply the efficient quantity of a public
good.

a. The market and voluntary contributions models fail either because of

exclusion or because of the free rider problem. The government
model fails because of crowding, insufficient information about
individual MB’s, and the inefficiency of taxes.

b. The choice of how to supply a public good is not a choice between

an inefficient quantity and an efficient quantity of the public good. It
is, instead, a choice among alternative models all of which are
inefficient.

c. The choice depends on weighing the relative inefficiencies

associated with each model on a case-by-case basis. For some goods,
the market model is more efficient (or less inefficient). For other
goods, the voluntary contributions model is more efficient (or less
inefficient). For yet other goods, the government model is more
efficient (or less inefficient). And for many goods, two or even all
three models may be used simultaneously to provide the good.

2. Typically, there is a correspondence between the model used and the

institution that provides the good. Private for-profit businesses most often use
the market model. Non-profit organizations most often use the voluntary
contributions model. Government most often uses the government model.
But the correspondence is not complete. Sometimes private for-profit
businesses use the government model (most notably in broadcasting and
newspaper and magazine publishing). Sometimes government uses the
market model. But the “bottom line” lesson is this: where public goods are

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 ECO 4554: Economics of State and Local Government
Microeconomic Analysis of the Public Sector:
Market Efficiency and Market Failure

involved, there is no presumption that either the market or government is

more efficient. The quantity provided is likely to be inefficient no matter
which model is used and no matter which institution provides the good.

3. Very important point: Even when some government action could, at least
conceptually, improve efficiency, that does not mean that government itself
must supply the good. This is an important point that is too often overlooked
or ignored. For example, the argument that government can improve
efficiency in the supply of education does not require that government
operate the schools. Subsidies to private schools may be just as effective as
“free” public education at creating incentives for students and their parents to
choose the efficient quantity of education.

3. Government can intervene in the market for a good in several ways only one
of which involves government as the supplier of the good.

a. Regulation: Government requires individuals to purchase the good in

the market from private suppliers and imposes a fine (tax) for
noncompliance (example: automobile airbags).

b. Subsidization: Government provides incentives for individuals to

purchase greater quantities of the good by subsidizing either the
buyer or the private market supplier (example: low income rental
housing).

c. Private production with public distribution: Government purchases

the good from private suppliers and distributes it to eligible
consumers, usually at no direct charge (example: vaccinations at
public health clinics).

d. Public production: Government hires the necessary resources in the

private market and produces the good or operates the facility
(example: public education).

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