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Chapter 25

Chapter 25. Public Goods, the Consequences of Strategic Voting Behavior, and the Role of Government. Market failure. Chapter 21 shows that trade between individuals results in a Pareto efficient allocation of goods In General, competitive markets are efficient

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Chapter 25

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  1. Chapter 25 Public Goods, the Consequences of Strategic Voting Behavior, and the Role of Government

  2. Market failure • Chapter 21 shows that trade between individuals results in a Pareto efficient allocation of goods • In General, competitive markets are efficient • Goods cannot be reallocated to make one person better off without making another worse off • The right amount of goods will be produced • However, under certain situations competitive markets do not achieve efficiency • Externalities • Information asymmetry • Public goods

  3. Public Goods • The nature of public goods implies that competitive markets do not provide the socially optimal amounts • The market fails

  4. Public Goods • Private goods • Excludable • Consumption is restricted to people who arewilling to pay • Rival • Consumption - by one person decreases availability to others • Public goods • Nonexcludability • Nonrival consumption

  5. The Free-Rider Problem • Free-rider problem • Members of society have an incentive to take advantage of public good without paying

  6. Pareto-optimal conditions for a public goods economy A (b) Price Price (a) Demand for public good Demand for private good D (consumer 2) D2 12 D (consumer 1) Societal demand (vertical sum of D1 +D2) D1 13 5 MC MC 21 9 Quantity of Private good Quantity of Public good 0 0 x2* q* 1 x1* The marginal benefit received by each person from consumption of the private good equals the marginal cost of providing the private good The sum of the marginal benefits received by all people from consumption of the public good equals the marginal cost of providing the public good.

  7. Pareto-Optimal Conditions -Economy with Public Goods • Pareto-optimal allocation, private goods • Same MRS (goods) • Same MRTS (inputs) • MRS=MRT • Public goods • Once produced • All consume – same amount

  8. Pareto-Optimal Conditions -Economy with Public Goods • Pareto-optimal allocation, public goods • Private goods - allocate until • MRS=price ratio • Same MRTS (inputs) • MRS private for public goods=MRT private for public goods

  9. Lindahl Solution to Public Goods Problem • Assumption • People – truthful • Preferences for public goods • Private goods market • No intervention • Public goods market • Government – market aid • Cost shares (prices)

  10. Lindahl Solution to Public Goods Problem • Maximize utility - Equilibrium • No change in demand • Private goods prices • Public goods cost shares • Private goods: Supply = Demand • Same price, different quantity • Public goods – same amount demanded • Nonexcludable • Different price, same quantity

  11. Figure 25.2 Private Good (b) D (a) 1-h h Person 2 • The Lindahl Solution Private Consumption path δ γ Cost Share to Person 1 A’ B’ A’ h’ x’ Cost Share to Person 2 A A B2 B1 β α B 0 0 g” g’ g* x* Public Good Person 1 Public good Private good At the Lindahl equilibrium, point D, both agents demand the level of the public good provided (g units), given their assigned cost shares (h for person 1 and 1-h for person 2)

  12. Lindahl Solution to Public Goods Problem • Lindahl equilibrium • Competitive equilibrium • Market: private & public goods • Pareto-optimal allocation for society • Weakness • Incentive – people lie • Free rider • Truth-telling – not Nash equilibrium • Amount provided < Pareto-optimal amount

  13. Figure 25.3 0 O* b a h c • The Lindahl equilibrium is not a Nash equilibrium By claiming a false demand curve, CC’, instead of her true demand curve, AA’, person 1 can reach a point 0* that is better for her than the Lindahl equilibrium point (the intersection of AA’ and BB’). B’ Person 2 Cost Share to Person 1 A C hb h0* ha hc B Cost Share to Person 2 0 gh ga g0* Person 1 A’ C’ I2 I3 Public good I1

  14. Theoretical Solutions to the Free-Rider Problem • Free riding • Real problem – to be addressed • Optimal sharing - costs of public goods • Allocating costs • People – incentive • Truth - public goods preferences

  15. The Demand-Revealing Mechanism • Demand-revealing mechanism • Creates incentive • People – reveal public goods preferences • Truthful manner • Optimal plan • Maximize difference • Willing to pay • Cost • Weakness: subsidies

  16. Table 25.1 • A demand-revealing mechanism based on a true willingness to pay for streetlights

  17. The Auction Election Mechanism • N people • Vi(X) – value of X units public good • Vi(0)=0 • Each person – bid (bi, Xi) • Cost share (q-Bi)X; Bi=Σj≠ibj; X=Σ Xk/N • Each person – reject or agree cost share • If all agree: X, cost share (q-Bi)X • If no agreement, X=0, payoff Vi(0)

  18. Table 25.2 • Subject valuations of three public goods projects in Smith’s experiments

  19. The Auction Election Mechanism • Telling the truth • Not dominant strategy • Nash equilibrium strategy • Auction election mechanism • Group level – satisfactory • Individual level – less well

  20. Figure 25.4 • Smith’s auction election experiments

  21. Figure 25.4 • Smith’s auction election experiments (cont’d) The auction election experiments usually result in the rational group choice, but they do not always induce truth-telling.

  22. The Role of Government • Function of government • Create institutions – mediate conflicts • Government mediation • People – private bargaining • Prerequisites for private bargaining • Reduce transaction costs • Zero-sum game • Aggregate: individuals’ preferences • Socially desirable outcome

  23. Figure 25.5 (a) • Average percentage of endowment contributed to public good due to the negative frame contributions

  24. Figure 25.5 (b) • Percentage free riding: the positive frame has fewer people free riding

  25. The Problem of Preference Aggregation:Arrow’s Impossibility Theorem • Government • Aggregate - preferences of individuals • Decision – affect welfare • Rational social choices • Reflect true preferences • Complete • Transitive

  26. The Voting Paradox • Voting institution • Majority voting rule • Voting paradox • If all people in society • Transitive preferences • Preference of society as a whole • Not transitive • Problem for society

  27. Table 25.3 • A preference matrix for a three-person society

  28. Conditions for Ideal Voting Mechanism • Group Rationality • Social preferences • Complete and transitive ordering • Set of alternatives • Unrestricted Domain • Every ordering - individual preferences • Complete and transitive (rational) • Allowed

  29. Conditions for Ideal Voting Mechanism • Pareto Optimality • If x preferred to y • Then, x - referred to y in social ranking • Independence • Social ranking of x and y • Individuals’ preferences between x and y • Nondictatorship • Not allowed: One powerful individual • Voting mechanism - own preferences

  30. Voting Mechanisms & Ideal Conditions • Arrow’s impossibility theorem • Voting mechanism • Determines transitive social preferences • Satisfies five conditions • Desirable voting mechanism • Doesn’t exist • Transitive social preferences – attained • Abandon desire for democracy

  31. Voting Mechanisms & Ideal Conditions • Simple majority voting rule • Transitive social preferences • Restrictions on preferences (condition 2) • Single-peaked preferences • Voting: one-dimensional issues • Preferences - single peaked • Uniquely best alternative preferred • Preferences decline • Increasing distance: best alternative

  32. Figure 25.6 Utility • Single-peaked preferences Person 2 Person 3 Person 1 Person 4 $B 0 Spending For each person, alternatives become steadily worse as they get further and further away, in either direction, from the preferred alternative

  33. The Problem of Vote Manipulation • Agenda manipulation • Individual – controls committee’s agenda • Manipulates: order - pairs of alternatives • Influence the outcome • Levine-Plott experiment • Majority voting rule • Intransitive • Used – by leader • To skew voting

  34. Table 25.4 • A preference matrix for a three-person committee

  35. Figure 25.7 • Agenda: Levine-Plott agenda manipulation experiment

  36. The Problem of Vote Manipulation • Strategic voting • Doesn’t reflect true preferences • Affect vote’s outcome • Strategy: tell truth • Not Nash equilibrium strategy

  37. Figure 25.8 • Decision tree: player who engages in strategic voting By lying in the first round of voting, person 1 can ensure that y, his second choice, is elected over z, his third choice, in the second round of voting.

  38. The Problem of Vote Manipulation • Borda count method • Choose: k alternatives • Allocation of votes • First alternative: k votes • Second alternative: k-1 votes • Alternative chosen - number total votes • Strategy: lie - Nash equilibrium • Borda count method • Can be manipulated

  39. Table 25.5 • A preference matrix for a five-person committee

  40. The Problem of Vote Manipulation • Gibbard-Satterthwaite theorem • Single outcome • Chosen from > two alternatives • Only voting rule - cannot be manipulated • Dictatorial voting rule

  41. The Government: Institutional Architect • Gibbard-Satterthwaite theorem • Problem – government • Any mechanism • Manipulated • Undesirable outcomes • Solution • Mechanisms with Nash equilibria • Satisfactory outcomes

  42. Figure 25.9 Because the government does not have full knowledge of the environment, it cannot construct the performance correspondence indicating which outcomes are desirable for that environment. Instead, the government attempts to specify a voting mechanism such that the citizens will choose the same outcomes that the government would if it had full knowledge of the environment. • The design of institutions

  43. The Government: Institutional Architect • Environment • Complete description • Economy • Voting body • Preferences - each member • Performance correspondence • Relationship: environment & set of desired outcomes • Which outcomes – satisfy performance criteria

  44. Rent Seeking - The Economicsof Interest Groups • Rent-seeking behavior • Behavior of interest groups • Attempt - extract rents • From government • From other authorities • Regulated monopoly • Profit – economic rent • Lobby – against deregulation

  45. Figure 25.10 Price • Rent-seeking behavior A firm would be willing to pay an amount equal to the potential monopoly profit, Rm = area pmbcpc , for a government franchise permitting it to operate as a monopolist b pm Rm c e pc Demand Marginal Revenue 0 Quantity qm

  46. Rent Seeking - The Economicsof Interest Groups • Competitive rent-seeking • Seek monopoly franchise • Rent-seeking • Wasteful • Increased cost to society • Deadweight loss • Lobbying costs

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