Public Choice

Chapter 6
Market Failures and Government
Intervention

 How do governments and state

bureaucrats actually behave?

 Efficiency of providing the public goods

 Government failures leading to an

inefficient level of government
expenditure
Efficient Provision of Public Goods
 A trade-off between private and public goods is just like a
tradeoff between two private goods

 The indifference curves for the public goods are also

downward-sloping (more of one good must be obtained to
compensate for a reduction in the availability of the other good
for the consumer to remain indifferent)

 Indifference curves are also strictly convex to the origin (as

more private goods are consumed, the household is willing to
give up fewer and fewer units of the public good to obtain
successive additional units of the private good)

 The further away from the origin the indifference curve is

located, the higher overall utility it represents
 Existence Value

 An individual may derive satisfaction from the

provision of a public good even if he or she
himself or herself does not consume the
good

 Examples include charity, contributions for

preserving wild nature

 Some people attribute value just to the fact

that something exists: the existence value
 Compensating Variation
 Suppose the household is only consuming the private good: in
the space of the private and public goods the price of the
public good is zero so that the budget line is a horizontal line

 Suppose the government provides a certain amount of public

good

 What is the most the household is willing to pay for the

opportunity to consume that amount of public good?

 The reduction in quantity of the previously consumed private

good that leaves the household on the same indifference curve
is called compensating variation
 Compensating
Private good
Variation

A Initial budget line

C

CV
B

Public good
 Marginal Willingness to Pay
Private good

Marginal willingness to pay

for the public good

CV
Public good
Adding MWTP Curves for Public Goods

 Re-cap: one individual’s consumption

of a public good does not reduce the
other person’s ability to consume the
public good

 Therefore, we add MWTP-s for a public

good vertically rather than horizontally,
to obtain the aggregate MWTP
$ Aggregate MWTP

MWTP2

Aggregate MWTP

MWTP1

Public good
 How Large Should the Provision
of the Public Good Be?
 Re-cap: one individual’s consumption of a public good does not
reduce the other person’s ability to consume the public good

 Therefore, we add MWTP-s for a public good vertically rather than

horizontally

 Suppose the marginal cost curve (MC) of producing an extra unit of a

public good is increasing upwards

 The optimal supply is obtained when the sum of the marginal

willingness to pay over all households is equal to the marginal cost of
provision

 Since both households can consume the unit simultaneously, we just

add up the households’ marginal willingness to pay for the public good
in order to obtain total (aggregate) MWTP
 Adding MWTP for Public Goods
$

Hshld 2

Aggregate MWTP

MWTP
Hshld 1 household 1

Public
good
Adding up MWTP for Public Goods

 For a supply less than the equilibrium amount, the

sum of the marginal willingness to pay over all
households is greater than the marginal cost of
producing an extra unit of a public good

 For levels above the equilibrium amount households

are not willing to give up a sufficient amount of
consumption of other goods (or their income) to
cover the cost of producing the final unit of the
public good, so that reduction in supply adds to
social welfare
 Provision of Public Goods and
Pareto Efficiency
 A pure public good is efficiently supplied when the
sum of each individual’s marginal willingness to pay
is equal to the marginal cost of supplying the good

 Pareto efficiency in private markets requires that an

individual’s MWTP is equal to the marginal cost
(p=MC)

 The difference arises because public goods can be

consumed simultaneously by many individuals
 Public Goods Provision and
Pareto Efficiency

 Private goods:
MRS1=MRS2=p1/p2=MRT

 Public goods: MRS1+MRS2=MRT

How can Pareto Efficient Provision of
Public Goods can be Attained?
 Assume the voter is paying a tax price to cover the provision of
public goods (the individual’s share of a dollar of government
expenditure)

 With uniform taxation of H individuals the uniform tax price is

$1/H

 The tax paid by the individual is p*z, where z is the amount of

the public good

 In this case the budget constraint for a particular individual is

given by y=qx+pz, where qx is price times quantity of the
private good, y is income and pz is price times quantity of the
public good
 Deriving the Demand Curve for
Public Goods
 By varying the tax price for the public good provision we can
derive the demand curve for a public good

 If the public good is normal as opposed to inferior an increase

in the voter’s income shifts the demand curve to the northeast

 Therefore, individuals with different incomes will vote for

different levels of public goods (lower income people will vote
for a smaller amount of public goods)

 If taxation is proportional, the tax price is an increasing function

of income so that in this case we cannot be sure whether higher
incomes will lead to an increase of decrease of the demand for
a public good
Deriving the Demand Curve for a
Public Good

A
B

Budget Line with a

Smaller Tax Price

Budget Line with a

Higher Tax Price
Income and Demand for
a Public Good
 An increase in income shifts demand
curve for a public good rightwards
 Various income groups will vote for
different levels of public good
 Higher income does not necessarily
mean higher demand for a public good!
 It does under uniform taxation
 It does not necessarily under progressive
taxation
 Lindahl Equilibrium

 Assume there are only two individuals in the economy

 Let those individuals pay for the public goods

according to their respective demand curves

 Obtain equality between the sum of their tax prices

and the marginal cost of producing the public good

 In the Lindahl equilibrium P1+P2=MC, and the two

individuals are consuming the same amount of the
public good
 Lindahl Equilibrium and Pareto
Efficiency
 Lindahl equilibrium is Pareto efficient in the sense that price
(i.e. the sum of individual tax prices) is equal to the marginal
cost

 However, because individuals realize their tax prices depend on

their willingness to pay for the public goods provision may try to
cheat by under- or over-stating their true willingness to pay for
the public good

 This problem may be seen as a special case of the free rider

problem illustrated by means of the prisoners’ dilemma

 In general, it is necessary to reveal individual preferences in

order to arrive at Lindahl equilibrium, but it is not clear how to
do that
 Revealing Preferences for
Optimal Taxation
 In general, it is necessary to reveal individual preferences in
order to arrive at Lindahl equilibrium, but it is not clear how to do
that

 In the case of private goods, individuals reveal their preferences

in market place

 In the case of public goods there is no similar market

mechanism so we need to reveal preferences

 Possibilities
 Ask people about their willingness to pay for public goods
 Hypothetical payment experiments (contingent valuation
methodology)
 Use some voting mechanism
 The Majority Voting Rule

 Majority voting rule: the alternative (among two

alternatives) that receives the majority of votes wins

 Does the majority voting rule produce a Pareto-

efficient allocation?

 Each level of the public good provision results in

different levels of utility so we can plot utility
schedules against the various levels of public good
provision
Classes of Individuals according
to their Most Preferred Level of
Public Good Provision
Utility

The Rich

Middle Class

The Poor
Public Good
 The Median Voter
 The median voter is the one for whom the number of individuals
preferring more expenditure is exactly equal to the number of
individuals preferring less expenditure

 In the example before, the median voter’s most preferred level of public
good provision gets adopted according to the majority voting rule

 Under uniform taxation, majority voting results in the Pareto efficient

level of public good provision since the median voter prefers an
expenditure level such that his MWTP is equal to the marginal costs

 If taxation is proportional and the median voter’s income is smaller than

the average income in the society, his tax price will be small and he will
vote for a greater amount of public good compared to the one where
price is equal to marginal costs
 Proportional Taxation
 Suppose taxation is proportional to income
 Let median voter’s income fall short of the
average income
 Median voter’s tax price is relatively low
 Median voter will vote for too much of a
public good
 Expenditure on public goods will be
excessive
 Majority Voting and Pareto
Efficiency

 Majority-voting can, but need not be

Pareto efficient

 Sometimes majority-voting equilibrium

will not exist
 Majority Voting
 Majority-voting equilibrium can be, but
is not necessarily, Pareto-efficient
 Paradox of voting: the order is
important
 Multiple-peaked preferences
 Why do Voters Vote?

 With millions of voters in the society, each

individual’s impact on the voting outcome is
negligible

 Why do people continue to vote?

 Interdependent utilities (e.g. some people may
care about the poor or clean environment)
 In democratic societies, children are taught that
voting is a duty
 Bureaucrats and Voters
 Bureaucrats seek to maximize the size of their agencies so they choose
the level of public good provision that is too high compared to the
efficient one

 Bureaucrats might choose the level of public good provision for which
the society is willing to pay a positive price

 This maximum level of public good provision will be given by the

intersection of the aggregate demand curve for the public good and
the horizontal axis

 Such excessive provision of a public good will be incurring social

welfare loss
Excessive Provision
of Public Goods

Public good amount that

maximizes the size of the
bureaucracy

Socially efficient
level of public
good provision
 Avoiding Being Detected
 Lack of competition among
bureaucratic agencies

 Must be difficult to ascertain costs and

benefits of public good provision

 Another possibility: voted budgets

 Voted Budgets
 Forcing the voters to choose between too little and too much of the
public good, the bureaucrats have a good chance of getting the
permission to produce too much of the public good (e.g. police force
in a criminal city)

 The economic policy may reflect interests of those in power

 Size of agricultural sector is way too large in most industrialized powers

 In short, government intervention into public goods provision does not

necessarily move the economy closer to the Pareto efficient allocation
 Reversion Level
 Public good provision maximizing utility
of the median voter is disadvantageous
to the bureaucrat
 Design a voting scheme that has two
options:
 A little public good at the reversion level
(utility U1 for the median voter)
 A lot of public good (utility U2 a little more
than U1)
 Reversion Level Voting

The voting scheme (scam?) will result

in the size of the budget that maximizes
the bureaucrats’ utility

A utility a little bit

higher than the
one obtained at
the reversion level

Median voter
prefererence

Same utility with

Reversion
reversion level
Level
 Political Business Cycle
 Nordhaus (1975)
 Politicians increase probability of
reelection
 Voters dislike inflation and
unemployment
 Let’s manipulate business cycles to make sure
the minima of both are at the time of election!
 Reinforcing the size of troughs may be then
an objective
 Market Failures
 Sometimes governments can correct for
them
 Externalities
 Monopolies

 Often government intervention produces

Pareto inefficiency
 Voting paradoxes
 Public good provision