Public Goods

1. Public Goods Rosen, Chapter 4 Copyright 2005, The McGraw Hill Companies. All rights reserved

2. Course Related Midterm Exam will be Jun 11th (rather than the 4th) Some more info on the paper: I will not be grading any papers until after the midterm is graded. I will however look over rough drafts before then, and let you know how the paper is progressing. If you plan on writing a paper, you should be thinking about possible topics. Remember, it is a good idea to talk to me before you start writing.

3. Last time We use the Edgeworth box to show how agents interact in an economy. First Welfare Theorem- If all agents act in a perfectly competitive fashion, and markets exist for all goods, then a competitive equilibrium (an equilibrium resulting from free exchange) will be Pareto efficient.

4. Second Welfare Theorem Under the same assumptions as the FWT, the second welfare theorem states that ANY Pareto Efficient point can be reached through lump-sum redistribution and free-trade. Combined with the FWT, there seems to be very little role for government at all.

5. In reality, we see government doing much more than lump-sum redistribution. Why? Imperfect Competition Monopolists and Oligopolists aren�t price takers Market failures Asymmetric information Externalities Public Goods

6. Let�s start with Public goods What is a public good? A pure public good possesses two qualities: Consumption is non-rivalrous. Person A�s consumption of a public good does not prevent person B from also enjoying the good. Consumption is non-excludable. It is not possible (or very expensive) to prevent people from consuming the good.

7. Examples of Public and Private Goods PUBLIC National Defense Fireworks Displays In a house with many roommates, a living area is a public good. Others? PRIVATE Candy Bars Pizza Beer

8. Valuation of Public Goods Everyone consumes same quantity of public good Marginal benefit of public good varies by person In a housecleaning example, different roommates value the clean apartment differently.

9. Classifications of Public and Private Goods Not all goods are purely public or purely private goods. Some goods are non-rivalrous in consumption, but exclusion is possible. Night-clubs, movie theaters are like public goods when they�re not too crowded, but as more and more people come, consumption becomes rival.

10. A Simple Table of Goods

11. Efficient Provision of Private Goods Derivation of aggregate demand: Each person�s demand curve represents the willingness-to-pay for an additional unit of a good. Private good: for any given price, add up the quantity demanded Graphically, this is a Horizontal summation of demand curves

12. So let�s go back to Adam and Eve�s fig leaves�Figure 4.1

13. Equilibrium in private goods market Equilibrium where supply curve intersects aggregate demand curve. Everyone pays the same price, P. Individuals consume different quantities, Q. The equilibrium is Pareto efficient.

14. Efficient provision of public goods Consider a fireworks display as a public good � it is nonrival and nonexcludable. Bigger displays give higher benefit. Public good: At any given quantity of public good, what is the willingness-to-pay (price)? Vertical summation of the demand curves.

15. Figure 4.4

16. Efficiency in public goods market Everyone consumes the same quantity, Q Individual�s marginal benefit varies. Efficiency requires that the sum of individual marginal benefits equals the marginal cost.

17. Numerical example Consider 2 individuals, Adam and Eve who have the following inverse demand curves, and face a marginal cost curve below.

18. Numerical example, private good If the good was a private good, then the aggregate demand curve is:

19. Numerical example, private good In a competitive market, P=MC

20. Numerical example, public good Efficient provision would require: P=MC

21. What is each person�s willingness to pay? Adam 100 � � * 138.46 = 30.76 Eve 200 � 138.46 = 61.54 So we have the conditions for efficient provision of the public good. Private market may not arrive at this allocation, however.

22. Efficient allocations of public goods: Problems Although a competitive market will provide private goods efficiently, will the same be true for public goods? People may have incentives to hide their true preferences for a public good. If Adam can get Eve to pay for the public good, he can use his income for other purposes and still enjoy the public good.

23. Problems, continued This incentive to let others pay for the public good while still enjoying the benefits is known as the �free rider problem.� The private market may therefore fall short of providing the efficient amount of the public good.

24. Problems, continued This incentive to free ride occurs because the public good is nonrival and nonexcludable. A person gets to consume the good even if he does not pay for it.

25. Problems, continued Return to the public goods numerical example. Suppose Adam chooses to free ride, and Eve therefore provides her optimal amount. Eve chooses:

26. Preference Revelation Mechanisms Say gov�t approaches Eve and says �Taxes will work like this: your bill will equal for another unit of public good will equal the total cost of the unit minus everyone else�s valuation.� Intuitively, Eve has no reason to lie about her own valuation of the good: her bill will depend on everyone else�s stated valuations. This is an example of a Groves mechanism. The government can use mechanisms like this to achieve efficiency.

27. Privatization debate Privatization means taking services that are supplied by the government and turning them over to the private sector for provision and/or production. Examples with competing public/private provision include policing, parks, and even the judicial system.

28. Private provision Mix of private and public provision depends on: Relative wage and materials costs: Which sector is less expensive? Administrative costs: Can these fixed costs be spread over a large group of people? Diversity of tastes. Private provision is more efficient with diverse tastes because people can tailor their consumption to their own tastes. Distributional issues. Notions of fairness may require that some commodities are available to everyone � such as education or health care.

29. Private production Even if there is agreement that the public sector should provide a good, it is not clear whether the public sector should produce it. Airport security workers are a timely example. Public sector managers may not have a strong incentive to control costs because of the lack of profit motive or fears of takeovers or bankruptcy. Quality of public services may be higher, however. This is more relevant when contracts are incomplete. The more contingencies that can arise, the harder it is to come up with complete contracts. (Consider contracting-out the armed forces.

30. Education provision Government spends approximately $400 billion on education annually. Why such extensive intervention? Education primarily a private good. Some efficiency concerns � socialization, political stability. Equity concerns � access to education increases social mobility. Elementary and secondary education is subsidized, compulsory, and produced by the government. This cannot be rationalized on efficiency grounds alone.

31. What do expenditures for public education accomplish? Educational inputs include teacher/pupil ratio, teacher education, experience, and salary, and expenditures per pupil. Educational outputs include test scores, attendance records, dropout rates, and labor market outcomes. Hanushek (2002) finds virtually no correspondence between inputs and outputs, though this conclusion is controversial. One especially noteworthy result is that over wide ranges, class size does not affect educational outcomes. Teaching to 30 students no less effective than teaching to 20. Hoxby (2002) claims that decreasing class sizes by 10% costs $615 per student. If this cost doesn�t gain anything, why pay it?

32. Still� We note that even though a class of 20 students doesn�t perform better than one of 30 students, a class of three or fewer students does generate better outcomes than one with 30 students. This result is especially pronounced in students initially performing at below-average levels.

33. Recap of public goods Public good definition Derivation of aggregate demand curves Inefficient provision of public goods Free rider problem Public versus private provision Education