Principles of Microeconomics 11. Public Goods and Common Resources*

1. Principles of Microeconomics11. Public Goods and Common Resources* Juan Pablo Chauvin August 10, 2011 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

2. Contents • Review of previous lecture • An Investment proposition • Classifying different types of goods • Public Goods • Common Pool resources • Introduction to Production Costs

3. 1. Review

4. Externalities • The uncompensated impact of one person’s actions on the well-being of a bystander. • Can be negative • Making social costs higher than private costs • Leads to an over-production of the good (with respect to the optimal quantity) • … or positive • Making social value greater than private value • Leads to an under-production of the good (with respect to the optimal quantity)

5. Policy responses to externalities • Command-and-control policies (regulation) • Market-based policies • Corrective taxes (pigouvian taxes) or subsidies • Taxes that induce private decision makers to take into account the social costs generated by a negative externality • Subsidies that induce private decision makers to take into account the social benefits generated by a positive externality • Tradable pollution permits • Firms with lower costs of reducing pollution can sell their permits to firms with higher costs of reducing pollution. • Market-based policies (theoretically) can achieve the same goals as regulations, but more efficiently

6. Refer to the figure below. The socially optimal level of output is • Q1. • Q2. • Q3. • Q4.

7. Refer to the figure below. Which of the following would improve economic efficiency in the market? • a tax equal to P1 - P3 • a tax equal to P0 - P4 • a subsidy equal to P1 - P3 • a subsidy equal to P0 - P4

8. 2. An investment proposition

9. An investment proposal:THE CCU • Welcome to the CCU! (“Class Credit Union”) – your place to invest! • All the students of the class collectively own the CCU. • This is your lucky day! We bring you an investment opportunity!

10. An investment proposal:THE CCU • You currently own 800 “brownie points” (BP) • You can invest any amount from 100 to 800 BP (in increments of 100) with the CCU • You can also decide not to invest at all and keep your 800 BP • Your individual investment will go to a common class investment pool • The CCU will pay a return of 10% (one extra BP for every 10 BP that the class invest) at the end of this exercise • Then, the full amount (capital plus interests) will be redistributed equally to all the students in this class. • Note that everybody will receive an equal share from the investment fund final balance, regardless of whether they invested or not!

11. A - Nothing B – 100 dollars C – 200 dollars D – 300 dollars E – 400 dollars F – 500 dollars G – 600 dollars H – 700 dollars I – 800 dollars How much will you deposit to the Class Credit Union?

12. A - Nothing B – 100 dollars C – 200 dollars D – 300 dollars E – 400 dollars F – 500 dollars G – 600 dollars H – 700 dollars I – 800 dollars Given your recent experience, How much will you now deposit to the Class Credit Union?

13. 3. Classifying different types of goods

14. Important Characteristics of Goods • A good is excludable if a person can be prevented from using it. • Excludable: fish tacos, wireless internet access • Not excludable: FM radio signals, national defense • A good is rival in consumption if one person’s use of it diminishes others’ use. • Rival: fish tacos • Not rival: An MP3 file of Ben Harper’s latest single

15. The Different Kinds of Goods

16. STUDENTS’ TURNCategorizing roads • A road is which of the four kinds of goods? • Hint: The answer depends on whether the road is congested or not, and whether it’s a toll road or not. Consider the 4 different cases that arise from this observation.

17. Answers • Rival in consumption? Only if congested. • Excludable? Only if a toll road. Four possibilities: Uncongested non-toll road: public good Uncongested toll road: natural monopoly Congested non-toll road: common resource Congested toll road: private good

18. 4. Public Goods

19. Public Goods • Are goods that are non-excludable and non-rival • Some important public goods are: • National defense • Knowledge created through basic research • Fighting poverty • Public goods are difficult for private markets to provide because of the free-rider problem.

20. The free-riding problem • Free rider: a person who receives the benefit of a good but avoids paying for it • If good is not excludable, people have incentive to be free riders, because firms cannot prevent non-payers from consuming the good. • Result: The good is not produced, even if buyers collectively value the good higher than the cost of providing it.

21. Cost-benefit analysis • If the benefit of a public good exceeds the cost of providing it, government should provide the good and pay for it with a tax. • Problem: Measuring the benefit is usually difficult. • Cost-benefit analysis: a study that compares the costs and benefits of providing a public good • Cost-benefit analyses are imprecise, so the efficient provision of public goods is more difficult than that of private goods.

22. 5. Common Pool Resources

23. Common Resources • Like public goods, common resources are not excludable. • Cannot prevent free riders from using • Little incentive for firms to provide • Role for government: seeing that they are provided • Additional problem with common resources:rival in consumption • Each person’s use reduces others’ ability to use • Role for government: ensuring they are not overused • Some important Common Resources are: • Clean air and water • Congested roads • Fish, whales, and other wildlife

24. The Tragedy of the Commons • A parable that illustrates why common resources get used more than is socially desirable. • Setting: a medieval town where sheep graze on common land. • As the population grows, the number of sheep grows. • The amount of land is fixed, the grass begins to disappear from overgrazing. • The private incentives (using the land for free) outweigh the social incentives (using it carefully). • Result: People can no longer raise sheep.

25. The Tragedy of the Commons and externalities • The tragedy is due to an externality: Allowing one’s flock to graze on the common land reduces its quality for other families. • People neglect this external cost, resulting in overuse of the land.

26. STUDENT’S TURNPolicy options for common resources • With your knowledge about externalities, you can help the people of this town! • What could the townspeople (or their government) have done to prevent the tragedy? • Try to think of two or three options.

27. Answers • Impose a corrective tax on the use of the land to “internalize the externality.” • Regulate use of the land (the “command-and-control” approach). • Auction off permits allowing use of the land. • Divide the land, sell lots to individual families; each family will have incentive not to overgraze its own land.

28. 6. Introduction to Production Costs

29. Let’s take a step back… • We have started discussing situations in which the market outcomes may not be the most efficient for society as a whole • Externalities • Public Goods • Common Pool Resources • Another very important case is that of Monopolies. • In order to analyze Monopolies, we need to have a deeper understanding of how firms make decisions. • Let’s take a step back to explore what is behind the Supply Curve!

30. the amount a firm receives from the sale of its output the market value of the inputs a firm uses in production Total Revenue, Total Cost, Profit 0 • We assume that the firm’s goal is to maximize profit. Profit = Total revenue – Total cost

31. Costs: Explicit vs. Implicit 0 • Explicit costs require an outlay of money,e.g., paying wages to workers. • Implicit costs do not require a cash outlay,e.g., the opportunity cost of the owner’s time. • Remember one of the Principles of Economics:The cost of something is what you give up to get it. • This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.

32. Explicit vs. Implicit Costs: An Example 0 You need $100,000 to start your business. The interest rate is 5%. • Case 1: borrow $100,000 • explicit cost = $5000 interest on loan • Case 2: use $40,000 of your savings, borrow the other $60,000 • explicit cost = $3000 (5%) interest on the loan • implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000. In both cases, total (exp+ imp) costs are $5000

33. Economic Profit vs. Accounting Profit 0 • Accounting profit = total revenue minus total explicit costs • Economic profit = total revenue minus total costs (including explicit and implicit costs) • Accounting profit ignores implicit costs, so it’s higher than economic profit.

34. The Production Function 0 • A production function shows the relationship between the quantity of inputs used to produce a good and the quantity of output of that good. • It can be represented by a table, equation, or graph. • Example: • Farmer Golib grows Cotton. • He has 5 acres of land. • He can hire as many workers as he wants. • To build Golib’s Production Function we need to determine how many additional bags of cotton he would produce each time he hires one additional worker for his farm.

35. EXAMPLE: Farmer Golib’sProduction Function L(no. of workers) Q (bags of cotton) 3,000 2,500 0 0 2,000 1 1000 1,500 Quantity of output 2 1800 1,000 3 2400 500 4 2800 0 0 1 2 3 4 5 5 3000 No. of workers 0

36. ∆Q ∆L Marginal Product 0 • If Golib hires one more worker, his output rises by the marginal product of labor. • The marginal productof any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. • Notation: ∆ (delta) = “change in…” Examples: ∆Q = change in output, ∆L = change in labor • Marginal product of labor (MPL) =

37. EXAMPLE: Farmer Golib’s Total & Marginal Product L(no. of workers) Q(bags of cotton) 0 0 ∆Q = 1000 ∆L = 1 1 1000 ∆Q = 800 ∆L = 1 2 1800 ∆L = 1 ∆Q = 600 3 2400 ∆Q = 400 ∆L = 1 4 2800 ∆L = 1 ∆Q = 200 5 3000 0 MPL 1000 800 600 400 200

38. MPL = Slope of Prod Function 3,000 2,500 2,000 Quantity of output 1,500 1,000 500 0 0 1 2 3 4 5 No. of workers 0 L(no. of workers) Q(bags of cotton) MPL MPL equals the slope of the production function. Notice that MPL diminishes as L increases. This explains why the production function gets flatter as L increases. 0 0 1000 1 1000 800 2 1800 600 3 2400 400 4 2800 200 5 3000

39. Why MPL Is Important • Recall one of the Principles of Economics:Rational people think at the margin. • When Farmer Golibhires an extra worker, • his costs rise by the wage he pays the worker • his output rises by MPL • Comparing them helps Golibdecide whether he would benefit from hiring the worker.