Updated: 8 Feb 2012 E CON 635: PUBLIC FINANCE Lecture 5

1. Updated: 8 Feb 2012ECON 635: PUBLIC FINANCELecture 5 Topics to be covered: Externalities Public Goods & Other Sources of Market Failure Individual Consumers imposing Costs on Others A Competitive Market with Externalities Policy Corrections to Control Externalities Reducing Marginal External Cost with Regulation Coase Theorem Rival vs. Non-rival Consumption Methodologies to Analyze Private & Public Goods Markets Market Demand for Private & Public Goods Free Rider Problem in Public Goods Allocative Efficiency between Public & Private Goods Voting Paradox Transaction Costs Imperfect or Asymmetric Information Failure to Correct Mal-Distribution of Income Stabilization Merit Goods

2. ECONOMIC PRINCIPLES: EXTERNALITIES, PUBLIC GOODS AND OTHER SOURCES OF MARKET FAILURE • The market economy is able to serve to secure an efficient use of resources efficiently for private goods when certain conditions are met. • Consumers must bid for what they wish to buy and must thus reveal their preferences to producers. • Producers in trying to maximize their profits, will produce what consumers want to buy with the least cost of production. • In short, competition will ensure the mix of goods produced matches to consumers’ preferences. • This view is of course what is idealized. 1

3. ECONOMIC PRINCIPLES: EXTERNALITIES, PUBLIC GOODS AND OTHER SOURCES OF MARKET FAILURE (CONT’D) • However in reality difficulties arise and cause market failure. They are: a) externalities -- (external costs/benefits not considered by producers/ consumers), b) public goods -- (goods which are non rival in consumption and where exclusion from consumption of individuals who do not pay is either prohibitively costly or is not feasible), c) small number of producers/consumers (There is the possibility of one or a few larger produces providing the good or service a lower cost than many producers could)-- (monopoly, oligopoly, monopsony), d) High transaction costs, imperfect/asymmetric information (The consumer can not judge its quality)- (fertilizer, medicine, insurance policies, cost of obtaining information) e) Failure of markets to correct income distribution. Problems in allocating resources efficient and sufficiently. 2

4. EXTERNALITIES • Externalities occur when a producer or a consumer imposes costs or confers benefits on other persons who are not directly involved in the market transaction. • In other words cost and benefits that are not reflected in the price of a good or a service. • Positive externality occurs • Negative externality occurs • These external costs/benefits are not taken into account by parties involved in the market exchange while taking consumption/production decisions. • Thus these are not private costs/benefits, rather they are external to the producers/consumers and are imposed on the rest of the society without their wish or consent. 3

5. NEGATIVE EXTERNALITIES • Negative externalities are said to occur when costs are imposed on persons that do not participate in the market transaction of a good or service. • Thus the individuals participating in the market exchange do not incur the cost of the activity as it will be borne by other members of the society. • When production decisions do not take into account the external costs imposed on society, these decisions are likely to lead to inefficient outcomes. • Some mechanism is needed in order to correct this type of market failure. • Some examples of negative externalities are air pollution caused by automobiles, factories, thermal power plants, or cigarette smoking; water pollution due to sewerage or factory waste; and high noise caused by automobiles, airplanes and other vehicles. • In all these cases, the external costs are not taken into account by those who impose the costs on other members of society. To compute the true cost of production incurred by the society, the external cost should be added to the private cost. Social Cost = Private Cost of Production + External Cost Imposed 4

6. An Individual Consumer Imposing Costs on Others • MPC: Marginal private cost of consumption. • MEC: Marginal external cost of consumption. • MSC: Marginal social cost of consumption. • MSC = MPC + MEC Qpvt > Qsoc Ppvt < Psoc 5

7. A Competitive Market with Externalities Dead Weight is Triangle XYZ MPB = MSB Qsoc < Qpvt MSC = MPC + MEC Psoc > Ppvt 6

8. Policy Corrections to Control Externalities a) Impose a tax and thereby shift the private supply curve up. b) Regulate the production of the pollutant and thereby shift supply curve (MSC) down. c) Adopt both (a) and (b) above. 7

9. Shift Supply Curve Up Imposing Tax and Shift Private Supply Curve Up • Ps (= Psoc – tax) • This is called "internalizing" the external cost. • It means that with the help of the tax, the private producers are being made to bear the external costs imposed by them on the society. 8

10. Shift Supply Curve Up (Cont’d) Tax Adjustment Needed to Offset Shift in Demand from D to D’ • When demand D shifts outward to D' due to change in any of the caused by non-price determinants of demand. 9

11. Shift Supply Curve Up (Cont’d) Tax Adjustment due to Increase in MPC • When the private marginal cost of production increases. • Q1soc > Q’soc P1soc < P’soc 10

12. Reducing Marginal External Cost with Regulation • The marginal external cost can also be reduced by regulating the level of pollution r by issuing tradable permits or fixing production quotas. This gives the firm an incentive to spend real resources to control pollution. • However any additional investment and operating costs needed to reduce pollutants will increase the marginal private costs of production. MPC shifts upward to MPC`. This lowers the marginal external cost but increases the marginal private cost. 11

13. POSITIVE EXTERNALITIES External Benefits • Some benefits are conferred on other persons who do not consume the good or service directly. i.e. benefits of innovations that are available to everyone, immunization against contagious diseases, planting of anti-soil erosion trees by a farmer. • Apple orchard and honey production MSB = MPB + MEB Dead Weight Loss is Triangle XYZ 12

14. POSITIVE EXTERNALITIES (CONT’D) • The inefficiency in this market is given by the triangular area XYZ. • Therefore, to increase the consumption of this good, a) subsidy could be given to the producers causing them to lower their supply price as shown by a lowering of the supply curve. • The producers get a price of Ps plus subsidy while the consumers pay a price of Pd (equal to Ps). The government intervention has increased consumption to Qsoc and the amount of subsidy is represented by the area of the rectangle AXZD(=Qsoc×(Psoc-Ps)). (w/subsidy) Quantity (Output) 13

15. POSITIVE EXTERNALITIES (CONT’D) Subsidy to Consumers Quantity (Output) • The quantity consumed can also be increased by subsidizing the consumers causing them to increase the quantity they demand. • When the subsidy is given to the consumers, it has the effect of reducing the price they have to pay for the good as compared to the price received by the producers. The MPB curve which is the private demand, shifts up by the subsidy equal to MPB'. This increases consumption to Qsoc because the private price net of subsidy falls to P’pvt. The marginal benefit to society is MBsoc and the government pays a subsidy equal to the area represented by the rectangle AXLD (equal to Qsoc × (Psoc - Ps). 14

16. Coase Theorem • "The Problem of Social Cost" suggested a method of internalizing the externalities. He developed his analysis by taking the example of a farmer and a rancher who had adjoining properties. • The rancher's animals used to stray in the farmer's field and destroy some of his crops. • The cattle of the rancher imposed an external cost on the farmer defined with respect to cattle straying, the rancher would continue to impose external costs on the farmer. • Initial property rights are well defined about this cattle straying, the external costs can be internalized. • The external cost, which was not taken into account by the rancher before the property rights were defined, will now become a direct cost to him. The cost has been internalized. 15

17. Coase Theorem (Cont’d) • Coase further suggested that an efficient outcome would still result if the rancher were to be given the rights to allow his cattle to stray in the farmer's property. • The farmer will be willing to pay an amount to the rancher in order to avoid damage from cattle to his crops. • An agreement would again be reached between the farmer and the rancher which would result in an efficient level of production of crops and straying of the cattle in the farmer's property. • The same efficient outcome could be attained through mutual bargaining between the two parties. 16

18. Elements of Coase Theorem • The basic point of Coase theorem is that if the transactions are costless and the property rights are well defined and enforced, the market will produce the efficient outcome even in the presence of externalities. The prerequisites for the Coase Theorem to hold are: • i) There are two parties to the bargain and the property rights are well defined; • ii) There are no transaction costs and no obstructions in bargaining; • iii) The bargaining agents find it advantageous to bargain and do not persist in strategic behavior which could breakdown bargains in the absence of transaction costs; and • iv) There are no income effects which change the demand or supply functions (relative to pre-payment bargains). 17

19. Elements of Coase Theorem (Cont’d) The Coase Theorem is likely to break-down under the following circumstances: i) When the number of bargainers (consumers and producers involved) is very large it may be difficult to involve all of the them. ii) The transaction costs where a large number of persons/parties are involved with such bargaining could be high. (effects of large thermal plants, acid rains, or noise in the vicinity of an airport). iii) When the good involved in negotiation is a public good, the problem of 'free rider' will arise. iv) When one or both sides to the bargain have an incentive to act as a monopolist instead of a participant in a free market transaction. v) It is not definite whether courts can enforce such bargaining agreements. There may be some elements of the agreement which courts do not approve. vi) Many issues of public importance like defense and police protection have external effects on large groups. In such cases, private markets will not function effectively without some form of government intervention. 18

20. Public GoodsExclusion vs. Non-Exclusion • One of the essential characteristics of a private good or service (hamburger, bus ride) is that it is possible to exclude the consumption of those persons who do not pay for it. • Non-exclusion with reference to a public good is either prohibitively costly or it is not feasible to confine the benefits of that good to a selected few. • For example, national defense of a country or from fire protection services in a community. 19

21. Rival vs. Non-Rival Consumption • A good or service is said to be rival in consumption when, if a person consumes it, another person cannot consume the same unit of the good or service. • On the contrary, if the consumption of a good or service by one person does not diminish the quantity that another person can consume, then the good or service is non-rival in consumption. • Examples, television, radio broadcasting, national defense, flood protection measures. 20

22. Rival vs. Non-Rival Consumption (Cont’d) • Category 1: Examples, goods and services produced in the private market, like hamburgers, coffee, pizza and the kind. • Category 2: Examples, deep sea fishing is rival in consumption but exclusion would be very costly. • Category 3: Examples, cable television where any number of persons can get the benefits by getting a decoder at the same time. It is possible to exclude persons from getting the benefits by levying a fee for the decoder. • In some cases, exclusion is feasible but it may not be desirable. For example, a bridge during non-rush hours. The marginal cost of one more person or one more car using the bridge is close to zero. Exclusion of those who do not pay, is quite feasible but it is not economically efficient or desirable. • Category 4: Some examples are national defense, fire works, flood protection works whether they pay for it. It is not feasible to exclude those who do not pay for this service. Similar is the case of flood protection. Any number of persons can enjoy the benefits and exclusion is neither feasible nor efficient. 21

23. Rival vs. Non-Rival Consumption (Cont’d) • The goods covered in category 1 are provided by private markets. • In category 4 cannot be provided by private markets. • Those goods which are wholly non-rival in consumption and also where the exclusion is impossible or prohibitively costly, are called pure public goods or social goods. • The private market can produce these goods but it cannot collect the payment. • Therefore, a provision has to be made in the government budget for these goods. • Goods in categories 2 and 3, that is, goods that are non-rival in consumption or where the exclusion is impossible are quasi-public goods. 22

24. Free Rider Problem in Public Goods • People can consume a public good without paying for it and, hence, the market will understate the benefits the community will derive from it. • This gives rise to the "free rider" problem. • For example, consider the development of a park in the city, built for recreation of the residents. • Some individuals would realize that they could still receive the benefits regardless of whether they contribute towards its construction. • As the size of free riders increases, it is more likely that every one would behave like a free rider and the public good can not be provided. 23

25. Methodologies to Analyze Private Goods and Public Goods Markets • Private Goods Markets: • Thus the market demand curve is obtained by a horizontal summation of the quantities demanded by all individual of the society who constitute the market. • From the market demand curve, it is possible to find out the market price and the quantity of X demanded. • Two goods X and Y, the price ratio of X to Y (MRSxy=PX/PY) • For consumer, Px=3, Py = 1  MRSxy=3/1 meaning, the consumers will be in equilibrium at point where these substituting 3 units of Y for 1 more unit of X. • During production of X and Y. • For producer, MRT = PX/PY MRT = 3/1 meaning, producer will produce goods X and Y to the point where resources used to produce X were three times that of product Y. • The free market equilibrium will take place when MRSAX&Y = MRSBX&Y = MRTX&Y = PX/PY . 24

26. Market Demand for Private Goods 25

27. Price E`` S MBA+MBB Price Price E` S S F`` E MBB F F` D=MBA D=MBB DA+B=MB G G G O H ’’ K’’ O H K0 K’’ O H’ K0’K’’ Quantity of H Quantity of H Quantity of H Ind. A Ind. B Market Demand for Public Goods Ind. A+B Item For A alone For B alone Combined 1 Gross Benefit for H Area EFKO Area E`F`K`O Area E``F``K``O 2 Net benefitsArea EFG Area E`F`G Area E``F``G • Area E’’F’’K’’O = Area of EFKO + Area E’F’K’O (Sum of benefits received across individual) • Area E’’F’’G>Area EFG + Area E’F’G because, cost of supply has to be borne only once • If the entire market is efficient, the individual A and B would consume K’’ instead of K0 and K0’, respectively. • Finally, for efficient consumption and production; the conditions are: 26

28. ALLOCATIVE EFFICIENCY BETWEEN PUBLIC AND PRIVATE GOODS (ALGEBRAIC TREATMENT) 27

29. There are two goods and two consumers: Good X: Private Good Good H: Public Good Individual A and B consume Xa units and Xb units of good X (private good) and H is the consumption of public good by both individual A and B. Utility of Person A: Utility of Person B:

30. PPF

31. Social Welfare Function is then represented as maximizing Limited availability of resources result in limited amount of production between good X and Y. Therefore, maximization of social welfare is subject to:

32. Lagrangian Equation Maximize: Subject to: Setting up Langrangian

33. First order conditions for interior solution become: In equation (2) and (3)

34. Therefore from equations (2), (3) and (4), we get: The left hand side and right hand side of equation (5) tells the change in total welfare for a change in consumption of good X for consumers A and B respectively. For consumer A, W/UA tells us the change in total welfare for small change in utility of person A, and UA/XA gives the change in utility of person A for small change in consumption of X.

35. Rewriting equation (1), we get the following equation:

36. From equations (6), (4) and (5)

37. Note that!!! Marginal ratio of substitution of good X for good H of person A Marginal ratio of substitution of good X for good H of person B Marginal rate of transformation of goods X for H

38. Therefore equation (7) gives us: Hence, for efficient level of production of public good H: The sum of the marginal rate of substitution (MRS) should be equal to marginal rate of transformation (MRT) X for Y.

39. Voting Paradox • Or "Arrow Paradox" after Kenneth J. Arrow (1951) won Nobel Prize in 1972. • Generally, simple macroeconomic models are based on the assumption that all decision are made by individuals and not by groups. • As rational individuals have different preference ordering, group decisions can be reached through negotiations or bargaining within the group. • In modern world, voting has been used to express social needs and to elect governments. • The common voting format followed is "one person one vote" and decisions are arrived at on the basis of simple majority. • Example: • Consider a town where there are three groups of persons who have identical preference ordering. • The town has funds to provide for only one of the three public goods, namely library, park or swimming pool, and suppose the town decides to have preference ordering through voting. • If the voting pattern is as follows, no decision can be reached through voting. 38

40. Voting Pattern of Groups A, B, C • If the residents vote in following order, then Pool vs. Park , Pool wins Pool vs. Library, Library wins In this agenda, the library is the winner. • If the residents vote in a different order, then Pool vs. Library, Library wins Library vs. Park, Park wins The park wins even with the same set of preference ordering of the residents. • If the park is set against the library, then Park vs. Library, Park wins Park vs. Pool, Pool wins Thus, the pool wins in this case. 39

41. Voting Paradox (Cont’d) • In this pattern of voting, which ever item is not taken up in the first round of voting, becomes the final choice of the residents. • Voting paradox shows that the residents as a group are not able to form a consistent preference ordering over alternative public goods, though each individual resident has a certain set of preferences. 40

42. Small Number of Producers/Buyers • When there is only one producer in the market, he will exercise a great deal of control over the market. • This supplier will also have the power to set the price in the market. • A monopolist produces a quantity that is lower than the social optimum and sets a higher price. • There is a failure of the private market. • There can be more than one producer but still there can be a great deal of control one. This market is oligopoly. • If there are many producers but one buyer. It is called monopsony. 41

43. Transaction Cost • It is the cost of obtaining information. • When these costs are high, the operation of the market will be affected. • If all consumers and producers had full access to information about preferences, prices and costs, the equilibrium price and quantity will be readily determined. 42

44. Imperfect or Asymmetric Information • Efficient market systems require that all available information be shared among producers and consumers without any cost. • Consumers may buy a product and discover that the good does not satisfy their needs completely. • Imperfect information frequently causes distortions in resource allocation. • Competitive market models assume that all factors of production such as labor and capital, are used where they are valued the most, and therefore earn the highest return. • Imperfect information can result in under-employment or inefficient use of labor. • A similar situation may arise in the use of capital and proper technologies of production. • Another case of imperfect information would be when the seller and the buyer of a good may have different information about a commodity. • Where one party has more information than the other, the market exchange will not be efficient. • Competitive markets fail to perform efficiently in these situations. 43

45. Failure to Correct Mal-Distribution of Income • Competitive markets enhance beneficial exchange. • But the extent of this exchange is limited by the amount of resources that individuals bring to the markets. • Individuals who have no resources for exchange, gain nothing from such exchanges in competitive markets. • The initial endowments of individuals differ and this may give some individuals an unfair advantage in market exchanges. • Eliminating all the differences in endowments is almost impossible. • In addition to unequal initial endowments, every person does not get equal opportunities to earn and participate in market exchanges. • This unequal opportunity in developing and utilizing one’s innate abilities becomes a source of unequal distribution of income. • The efficient market outcomes could leave some persons poor and others rich. 44

46. Merit Goods • These are goods the provision of which the society or the government wishes to encourage. • Goods such as housing security, basic education are held to be desirable. Similarly goods like liquor and cigarette are held to be undesirable - demerit goods. • In case of merit goods, again the society or government has to intervene and correct for the market outcomes. 45

47. Costs of Providing Public Goods and Correcting Market Failures • Governments often are unable to function efficiently in the correction of these private market failures. • The waste of resources and misguided outcomes imposed on communities in many instances by governments is difficult to exaggerate. • Governments themselves often suffer from many of the same defects as we see in the private sector. • Government Departments and Ministries that are set up to provide or regulate certain goods or services operate like monopolies. • Often officials must be bribed or consumers are forced to remain in queues because there are no competitive forces to promote services. • Public sector labor become political organizations and use their influence to obtain legal rights which allow them to impose extraordinary costs on the citizens they are supposed to serve. • The recent efforts at privatization of government functions is in reality a process of experimentation to see if alternative forms of government-commercial organizations can be developed in order to provide possible services with a lower cost and a higher quality. 46