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Chapter 7

Public Goods

Jonathan Gruber
Public Finance and Public Policy

Aaron S. Yelowitz - Copyright 2005 © Worth Publishers


Introduction
 Some markets do not work very well because the
good in question has public good characteristics to
it.
 For example, in Dhaka, Bangladesh, public trash
collection is fairly inefficient, but attempts at
privatization have not fared any better.
 The key problem with private collection of
garbage is the free rider problem–with a private,
voluntary system, each resident could simply
sneak his garbage into his neighbor’s garbage and
avoid making payments.
Introduction
 Eventually, everyone would figure this out, and no
one would be willing to pay trash collection
voluntarily.
 In fact, most residents have figured out the
incentive to “free ride.” Only 50 of 1,100
neighborhoods have private garbage collection,
however.
Introduction
 This lesson explores the role of government in
providing goods like this, and shows that the
private sector tends to underprovide them.
 It also explores the notion of “crowd-out” where
public provision simply substitutes for already
existing private provision of a good.
Introduction
 The role of public goods is important in
economics. The subsequent lessons explore issues
related to:
 Cost-benefit analysis
 Political economy
 State and local government
 Education
OPTIMAL PROVISION OF PUBLIC
GOODS
 Pure public goods have two traits:
 They are non-rival in consumption: The marginal
cost of another person consuming the good is zero,
and does not affect your opportunity to consume
the good.
 They are non-excludable: There is no way to deny
someone the opportunity to consume the good.
 Table 1 gives some examples.
If a Ice
good
Icecream
cream
is both isisrival,
rival
also and
because
excludable, This
excludable,
my
Cable
Some
It is table shows
excludable,
TV
goods examples
is non-rival,
are since
“impure”theof
because pure
public
cable
my
Table
consumption
because 1 it Iiscan
aofprivate
simply
it precludes
good.
not share
you public
goods
company
from goods,
myconsumption canimpure
because simply
they itpublic
of arerefuse goods,
innon-rival,
no way
to hook
but
Yet
ForOther
itexample,
consuming is non-excludable
goods
ice the asame
cream are
crowded
“impure”
with because
sidewalk
iceyou. public
cream. Finally,
It The
they itis
National
is
isalsopure
and
diminishes
are non-excludable,
(toup defense
public
private
some
the
your goods
is a excludable.
goods.
system.
extent) classic
because
are both
consumption.
goods
rival
onlyclearly
wayDefining
because
because
very
for you difficult
they
your pure
are
enjoyment
torival,
to consume and
prohibit
but
itexample.
once
isisnot impure
non-rival
to an area
It is
and public
isnon-rival
protected, goods
non-excludable.
because
everyone
my
pedestrians
reduced make asfrom
excludable.
moreusingpedestrians
the sidewalk.
ice cream. also
consumption
“consumes”ofthat national
protection.
defense
Is the good
use the same sidewalk. protection does not diminish your
rival in consumption?
Yesconsumption of it. No
Yes Ice cream Cable tv
Is the good
excludable? No Crowded city sidewalk National defense
OPTIMAL PROVISION OF PUBLIC
GOODS
 It is helpful to think of public goods as goods with
a large, positive externality.
Optimal Provision of Private Goods
 Consider a private good, like ice cream.
 Figure 1 shows the market for ice cream cones,
assuming that the alternative use of the money is
buying cookies at $1 each.
 This makes cookies the numeraire good.
Price At a Adding
price
Ben
Adding up
ofhas
$3,Ben’s
an
up neither and Jerry’s
individual,
Ben’s person
and Jerry’s
individual demands at each S=SMC
of ice demands
downward-sloping
Jerry alsomuch
individual
has an ice cream.
demand
demands give
individual,
price givesforsociety’s
curve
society’s ice cream.
demand demand.
at $3.
cream downward-sloping demand
curve for ice
At a price cream.
of Adding
$2,
Leading
bothuppeople
to
Ben’s
a competitive
and Jerry’s
$3 demand more equilibrium
individual
ice cream.
atdemands
$2. Ben give
& Jerry
consume
society’s different
demand quantities.
at $2.
There is a market supply curve
associated with producing ice
$2 cream.

DJERRY DBEN SMB =DBEN+JERRY

0 QJERRY QBEN QTOTAL Quantity


of ice
cream
Figure 1 Demand for a private good
Optimal Provision of Private Goods
 In this figure, as price adjusted, each person
changed his quantity consumed.
 For a private good, consumers demand different
quantities at the same market price.
Optimal Provision of Private Goods
 We can also represent this relationship
mathematically. Ben has preferences over cookies
(C) and ice cream (IC):

U B C , IC 
 As does Jerry:

U J C , IC 
Optimal Provision of Private Goods
 Utility maximization requires that each of their
indifference curves is tangent to the budget
constraint. For Ben, we have:
M U ICB PIC
 M R S B
IC , C 
M U CB PC

 For Jerry we have:


M U ICJ PIC
J
 M R S IC , C 
J

MU C PC
Optimal Provision of Private Goods
 Recall that in equilibrium, the price of ice cream is
$2, and the price of cookies is $1 (because it is the
numeraire good).
 In equilibrium each person must be indifferent
between trading two cookies to get one ice cream.
Optimal Provision of Private Goods
 On the supply side, ice cream cones are produced
until the marginal cost equals the marginal benefit,
which equals the price in a competitive market.

M C IC  PIC
 Recall that PC=$1, meaning:

M RS B
IC , C  M RS J
IC , C  PIC  M C IC
Optimal Provision of Private Goods
 The private market equilibrium in this case is
socially efficient.
 The MRS for any quantity of ice cream equals the
SMB of that quantity–the marginal value to society
equals the marginal value to any individual in the
perfectly competitive market.
Optimal Provision of Public Goods
 Now consider the tradeoff between a public good,
like missiles, and a private good like cookies.
 Figure 2 shows the market for missiles, assuming
that the alternative use of the money is buying
cookies at $1 each.
Price of Adding
Adding up Ben’s
up Ben’s andand
Jerry’s
Jerry’s
missiles willingness
willingnesstotopay paygives
for each
society’s
quantitydemand
gives society’s
for 1 missile.
demand.
As does Jerry.
$6 There is a market supply curve
Leading to a competitive associated
Adding with and
up Ben’s producing
Jerry’s
equilibrium at 5 missiles. Ben & tomissiles
willingness pay gives society’s
Ben hasJerry
a downward
consumesloping
the same Q.
While
Ben’s Jerry’s
willingness
willingness
to pay demand
for
to pay
the for the 5th missile.
S=SMC
$4 demand Dcurve for missiles.
for the
firstfirst
JERRY
missile
missile
is $2.
is $4.
While
Ben’s Jerry’s
willingnesswillingness
to pay for
to pay
the
$3 for the
fifthfifth
missile
missile
is $1.
is $2.
$2
$2 SMB=DBEN+JERRY
DBEN
$1

0 1 5 Quantity of
missiles

Figure 2 Demand for a public good


Optimal Provision of Public Goods
 Unlike the case of private goods, where aggregate
demand is found by summing the individual
demands horizontally, with public goods,
aggregate demand is found by summing vertically.
 That is, holding quantity fixed, what is each
person’s willingness to pay?
Optimal Provision of Public Goods
 We can also represent this relationship
mathematically. Ben has preferences over cookies
(C) and missiles (M):

U B C , M 
 As does Jerry:

U J C , M 
Optimal Provision of Public Goods
 To Ben, the marginal missile is worth:

M U MB
 M R S B
M ,C
M U CB

 For Jerry, the marginal missile is worth:

M U MJ
 M R S J
M ,C
M U CJ
Optimal Provision of Public Goods
 The social marginal benefit (SMB) of the next
missile is the sum of Ben and Jerry’s marginal
rates of substitution:
 M RS
i
i
M ,C

 Where “i” represents each person in society.


Optimal Provision of Public Goods
 The social marginal cost (SMC) is the same as
earlier: the marginal cost of producing a missile:

MCM
 Efficiency therefore requires:

 M RS
i
i
M ,C  MCM
Optimal Provision of Public Goods
 That is, social efficiency is maximized when the
marginal costs are set equal to the sum of the
marginal rates of substitution (rather than each
individual’s MRS).
 This is because the good is non-rival. Since a unit
can be consumed by all consumers, society would
like the producer to take into account all
consumers’ preferences.
PRIVATE PROVISION OF PUBLIC
GOODS:
Private-sector Underprovision
 In general, the private sector underprovides public
goods because of the free rider problem.
 Consider two people, Ben and Jerry, and two
consumption goods, ice cream and fireworks.
 Set the prices of each good at $1, but fireworks are
a public good. Assume that Ben and Jerry have
identical preferences.
Private-sector Underprovision
 Ben and Jerry benefit equally from a firework that
is provided by either of them.
 What matters is the total amount of fireworks.
 Each person chooses combinations of ice cream
and fireworks in which his own MRS equals the
ratio of price.
Private-sector Underprovision
 For both Ben and Jerry, they set:

M R S F , IC  1, M U IC  M U F
 Whereas optimal provision requires:

 M RS
i
i
F , IC 1
Private-sector Underprovision
 With identical preferences:

 MU F  M U IC
2   1, M U F 
 M U IC  2

 Recall that marginal utilities diminish with


increasing consumption of a good.
 In this example, optimal provision would require
that fireworks are consumed until their utility equals
half the marginal utility of ice cream.
 Thus, each individually buys too much ice cream
privately.
i on
a t
p l i c The Free Rider Problem in Practice
Ap
 There are some interesting examples of the free-
rider problem in practice.
 Only 7.5% of public radio listeners in New York
contribute to the stations–that is, there is a lot of
free-riding. In the United Kingdom, the BBC
charges an annual licensing fee for all television
owners.
 Many users of file sharing services never
contribute uploaded files; they only download files.
Some of these services, like Kazaa, give download
priority to those who contribute.
When Is Private Provision Likely to Overcome
the Free Rider Problem?

 While the free-rider problem clearly exists, there


are also examples where the private market is able
to overcome this problem to some extent.
 But the private market may still fall short of the
socially optimal amount.
Can Private Providers Overcome the Free Rider
Problem?

 Examples of private provision of a public good:


 Privately financed fireworks displays.
 Privately owned British lighthouses until 1842.
i on
c a t Business Improvement Districts
p pli
A
 A final example concerns business improvement districts
(BID).
 The quality of city streets is a public good.
 During the 1980s, New York City’s Times Square had high
crime and many social problems. The city had given up on
cleaning up Times Square.
 In 1992, local businessmen started a BID–a legal entity to
provide security and sanitation, with fees collected from local
businesses.
 New York law makes participation of businesses compulsory if

BID organizers can get 60% of local businesses to join,


allowing the organizers to overcome the free-rider problem.
 The BID was a clear success in New York City.
i on
c a t Business Improvement Districts
p pli
A

 On the other hand, Massachusetts law allows


businesses to “opt-out” of a BID within 30 days of
the BID approval by the local government.
 This deters formation of BIDs in the first place,
because there are fixed costs of doing so.
 As a consequence, only 2 BIDs have been formed
in Massachusetts.
When Is Private Provision Likely to Overcome
the Free Rider Problem?

 Under what circumstances are private market


forces likely to solve the free rider problem?
 Intense preferences.
 Altruism.
 Utility from one’s own contribution to the public
good.
Some individuals care more than others

 When some individuals have especially high


demand for a public good, private provision may
emerge (but not necessarily provide efficiently).
 The key intuition is that the decision to provide a
public good is a function of the enjoyment that the
individual gets from the total amount of the public
good, net of cost.
 If a person gets a lot of enjoyment, or has a lot of
money, he will choose to purchase more of the
public good even though it benefits others.
Some individuals care more than others

 Olson and Zeckhauser (1966) studied the


financing of NATO, which was a voluntary
organization at the time.
 Although countries had an incentive to free-ride on
the contributions of others, the largest nations (such
as the United States) did contribute.
 Higher incomes or stronger tastes can mitigate the
free rider problem to some extent, but are unlikely
to solve it completely. Thus, underprovision is
still likely to occur.
Altruism

 Another reason is that there is evidence that many


individuals are altruistic, caring about the
outcomes of others as well as themselves.
Altruism

 Laboratory experiments are becoming more popular


in the economics profession.
 Some experiments examine the incentive for college
students to contribute to a pool of money, where the
dominant, self-interested strategy should be to not
contribute.
 The experiments suggest that between 30% and
70% of participants contribute to the public good.
 As the experiment is repeated in multiple rounds,
contributions fall, but rarely reach zero contributions.
Private Provision of Public Goods:
When is private provision likely to overcome the
free rider problem ?
 Of course, these experiments may be of limited
applicability to the real world:
 Individuals may behave differently in a contrived
laboratory setting.
 The stakes are often small, so the cost of being
altruistic is low.
 College undergraduates may not be representative
of the population more generally.
Private Provision of Public Goods:
When is private provision likely to overcome the
free rider problem?
 On the other hand, some real-world evidence is
consistent with altruism in private support of
public goods.
 Brunner (1998) found that the number of public
radio listeners who contribute decreases only
modestly as the total number of listeners increases.
Warm glow

 A final reason is that that individuals may provide


for a public good is due to warm glow.
 The warm glow model is a model of public good
provision in which individuals care about both the
total amount of the public good and their particular
contributions as well.
 For example, they may get some psychological
benefit from knowing they helped a worthy cause.
 In this case, the public good becomes more like a
private good, though it does not fully solve the
underprovision problems.
PUBLIC PROVISION OF PUBLIC
GOODS
 In principle, the government could solve the
optimal public goods provision problem and then
either provide the good directly or mandate
individuals to provide the amount.
 In practice, three problems emerge:
 Crowd-out.
 Measuring costs and benefits.
 Determining the public’s preferences.
Private Responses to Public Provision:
The Problem of Crowd-Out

 In some cases, the private market may already be


providing a socially inefficient level of the private
good.
 In this case, public provision may crowd-out some
of the private provision–as the government
provides more of the public good, the private
sector provides less.
Private Responses to Public Provision:
The Problem of Crowd-Out

 For example, in the fireworks example with Ben


and Jerry, if one assumes:
 Ben and Jerry care only about the total number of
fireworks provided.
 Government provision will be financed by
charging equal amounts to each of them.
 And the government provides no more fireworks
than were being provided privately beforehand.
 Then each dollar of public provision will crowd
out private provision one-for-one.
Private Responses to Public Provision:
The Problem of Crowd-Out

 The full crowd-out in the fireworks example is


rare, though partial crowd-out is much more
common and can occur when:
 People who don’t contribute to the public good are
taxed to finance its provision.
 Or when individuals derive utility from their
individual contributions as well as the total amount
of the public good provided.
Private Responses to Public Provision:
The Problem of Crowd-Out

 If noncontributors are forced to help pay for the


good (but it is still below the social optimum),
then the contributors’ effective income levels are
higher than before.
 As a result of this income effect, contributors buy
more if the public good is a normal good,
offsetting the crowd-out to some extent.
Private Responses to Public Provision:
The Problem of Crowd-Out

 Alternatively, as discussed previously, there may


not be full crowd-out if an individual cares about
his own contributions (the warm glow model).
 In this case, an increase in government
contributions will not fully crowd out giving.
Public Provision of Public Goods:
Measuring the costs and benefits of public goods

 Another problem for government provision is


measuring costs and benefits of the public good.
This entails the field of cost-benefit analysis,
discussed in the next lesson.
 For example, improving a highway involves
valuations of commuting time saved as well
reduced traffic fatalities.
How Can We Measure Preferences for the
Public Good?
 Finally, our model of optimal public good
provision assumes the government knows each
person’s preferences over public and private
goods.
 In practice, this runs into problems with
preference revelation, preference knowledge, and
preference aggregation.
 These issues are addressed in the field of political
economy.
Recap of Public Goods
 Optimal provision of public goods
 Private provision
 Public provision

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