What is a Public Good? Efficient Provision of Public Goods

The Efficiency Conditions Private Provision of Public Goods Free-Riders Privatization

A PURE PUBLIC GOOD has two features:

1) Nonrival – once provided, another person can consume it at no additional cost

2) Nonexcludable (nonexclusive) – once provided, it is impossible or highly expensive to prevent anyone from consuming it

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National Defense is a good example of a pure public good:

1) Nonrival – all Canadians benefit2) Nonexcludable – it’s impossible to prevent a

Canadian from benefitting

Other examples: Conventional Radio, A Beautiful View, A Canada-Wide Sunglass dome designed to block harmful sun rays (Canadome)

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A PRIVATE GOOD has two features:1) Rival – once consumed, another person

cannot consume it2) Excludable (exclusive) – others can be

prevented from consuming it

Food (ie: pizza or sushi) is a good example of a private good. Once I eat it, it’s gone. (YUM!)

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6 Issues arise out of Pure Public Goods:6 Issues arise out of Pure Public Goods:1)1)Different ValuesDifferent Values2)2)Public Goods Aren’t AbsolutePublic Goods Aren’t Absolute3)NONRIVAL ≠ NONEXCLUDABLE4)Unconventional Public Good5)Private Provision6)Private Production

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-National defense protects everyone equally. Paranoid people love it and peace activists hate it.

-The Canadome is popular among people concerned with cancer and unpopular with people wanting tans. It affects everyone, however

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-technology and the market can affect a public good. A free TV station becomes private if you need a decoder. A beautiful view becomes rival if there is a crowd.

-An IMPURE PUBLIC GOOD is to some extent rival or to some extent excludable

-most public goods are impure, but analysis of pure public goods still gives valuable results for impure public goods

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-National parks are excludable if they have gates, but practically nonrival as they are so big

-My office hours are nonexcludable, as everyone is welcome, but rival if too many people are waiting in line

-Therefore many public goods are impure public goods

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-Inspiration can be nonrival and nonexcludable (such as coming from a sunset)

-Fear is nonrival, as one person being afraid doesn’t prevent others. Fear is also nonexcludable, as its hard to prevent.

-Income distribution or honesty are public goods as everyone benefits

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-Medical services, housing, licenses, and utilities can all be provided by the government and/or private sector

-The label public or private doesn’t indicate what sector provides the item

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-Some public services are contracted out to private contractors

-For example, the City of Edmonton contracts out much of its snow removal business-it provides the public service through private contractors

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-To cover efficient provision of public goods, we first look at efficient provision of private goods

-Consider Maka and Susan’s individual demands for video games

-At a market price, we add up Maka and Susan’s quantity demanded for video games to find market demand

-This results in a HORIZONTAL SUMMATION

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13

2

Maka Susan Market demand

40

100

Q Q Q

P P P

@ P=$40, QM+QS=QD

2+5=7

5 7

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2

Maka Susan Market

40

100

Q Q Q

P P P

When market supply intersects market demand, we find equilibrium price and individual demand.

5 7

S

Q*=51.5

3.5

@ P*=$65, QM+QS=Q*

1.5+3.5=5

65

-From microeconomic theory, we know that a consumer maximizes utility where MRSxy=Px/Py

-If we normalize Py to $1, this simplifies to MRSxy=Px

-Since price is found on the demand curve, Maka’s (Susan’s) demand expresses Maka’s (Susan’s) MRS at each level of consumption

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-From microeconomic theory, the supply curve comes from MC

-MRTxy=MCx/MCy, but since Py=MCy and Py=$1, MRTxy=MCx

-therefore the supply curve represents MRTxy

Then, at equilibrium, Supply=Demand, and

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PersonBxy

PersonAxyxy MRSMRSMRT

Pareto Efficiency Condition

-Consider Maka and Susan’s individual demands for a public good: youtube cooking shows

-youtube is nonrival and nonexcludable; one person’s consumption doesn’t affect the other

-The key difference in a public good is that BOTH can consume a purchased good; it is not used up

-This results in a VERTICAL SUMMATION to calculate willingness to pay

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18

2

Maka Susan

Market demand

4

10

Q Q Q

P P P

Maka is willing to pay $4 each for 2 youtube shows, and Susan is willing to pay $7 each,

therefore the market is willing to pay $11 each

7

2

11

2

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2

Maka Susan

Market demand

4

10

Q Q Q

P P P

The market Supply gives an equilibrium quantity of 3. Here price paid in the market ($6) is the sum of Maka’s payment ($2) and Susan’s payment ($4).

7

32

11

33

S

64

2

-Once again, if we normalize our other good to $1, demand (willingness to pay) represents MRS for each person.

-The sum of both people’s willingness to pay (market demand), is therefore the sum of individual MRS.

-The supply curve still represents MC and therefore MRT, so we have:

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PersonBxy

PersonAxyxy MRSMRSMRT

-Furthermore, again since Py=$1,

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PersonBPersonA MBMBMC -Intuitively, public goods should therefore be

provided until the point where the marginal cost of the good is equal to the sum of marginal benefits

-The private good equation can also be rewritten as

PersonBPersonA MBMBMC

In short, public goods are always best provided where

Total Marginal Benefit = Marginal Cost

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1) Solve each demand for P2) Find where P=0 to find cut-off points.3) Add together applicable demand curves

between cut-off points.

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A) Equate S=D in multiple pieces of demand function-When solved Q* value lies in the appropriate range, it is valid

B) Use individual demand to calculate each person’s price (negatives are zero)

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Rick and Shane decide to buy some fireworks to cheer up the survivors of the Zombie apocalypse. Their demand curves and firework supply are:

20

4200

100

PQ

PQ

PQ

S

DS

DR

26

4/50

4200

100

100)1

QP

PQ

QP

PQ

DS

DS

DR

DR

200

)0(4200

100

0100)2

DS

DS

DR

DR

Q

Q

Q

Q

QP

QQP

PPP

D

D

DS

DR

D

4

5150

4/50100

100Q 3)If

4/50

100Q 3)If

QP

PPD

DS

D

27

100Q if 4

5150

100Q if 4

150

3)

Q

Q

DP

28

ValidQ

Q

Q

QQ

PP SD

8.574

9130

4

9130

204

5150

100Q If

InvalidQ

Q

QQ

PP SD

244

530

204

150

100Q If

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2.42

8.57100

*100)2

*

*

*

R

R

R

P

P

QP

6.35

4/8.5750

4/*50)2

*

*

*

S

S

S

P

P

QP

Rick will pay $42.20 and Shane will pay $35.60 for 57.8 fireworks….

Which attracts the zombies, who eat everyone…

Which is good for the zombies?

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Shane Rick

Market demand

Q Q Q

P P P

Shane and Rick both put money towards the public good, which everyone enjoys (until they’re eaten).

57.857.857.8

S77.8

42.2035.6

If a public good is provided privately, its efficiency depend on how people represent their willingness to pay

-For private goods, people have no incentive to misrepresent their willingness to pay-if the price is $10, and that lies in their willingness to pay, they will pay the $10, consume the good and be happy

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-For public goods, people have an incentive to misrepresent their willingness to pay -if the price is $10, a person could hope someone else pays the price, then they get to enjoy it (they are a FREE RIDER)

-for example, at an alligator reserve, people can pay money to throw meat into the water and watch the alligators go, and often wait for someone else to buy and throw the meat

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-If the public good can be made excludable (ie: entrance fee), it is still provided inefficiently, as the MC of an additional consumer is zero, therefore P>MC

-The one way to avoid the free rider problem is through PERFECT PRICE DISCRIMINATION – everyone pays their willingness to pay-this requires full information, therefore private provision is often doomed to be inefficient

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THE FREE RIDER PROBLEM comes from the incentive to let others pay while you enjoy the benefits

-Yet empirically, people do band together to raise funds for public goods such as libraries

-This typically only happens when the number of contributors are small and everyone can see their impact

-Therefore government intervention is often needed for public goods

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The argument about who should PRODUCE public goods (government or private) often hinges on two concepts:

Cost vs. Quality

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-private companies often have lower costs due to a focus on profit and lack of unions

-private companies often produce inferior products (as in US health insurance refusing coverage or charging high premiums)

Some argue that quality can be maintained through good contracts-Some contracts are straightforward: cut the park lawn once a week-Some contracts are near impossible: treat this yet-to-be-discovered disease with the following yet-to-be-discovered drugs

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Market structure also needs to be considered:-If the government has a monopoly, is lack of

competition causing inefficiency?-If privatization creates a monopoly or oligopoly,

will market power cause inefficiency?

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West (1997) studied the 1993 privatization of Alberta liquor stores and learned the following:

-the number of liquor stores rose from 258 to 604, and although selection and individual stores fell, overall selection increased

-liquor prices rose between 8.5% and 10% (compared to 5% inflation)

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-Liquor store employment tripled as wages fell by up to 50% (the union was replaced)

-There was no evidence of increased alcohol consumption or alcohol-related crimes

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Was privatization good?More stores vs. poorer selection

Liquor Price IncreasesMore employment vs. Lower wages

If this privatization is so complex, what does that say about privatizing healthcare, utilities or schools?

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Externalities occur when one agents actions affect another outside market mechanisms

Externalities cause P≠SMC, causing inefficiency

Externalities can be dealt with privately through:

1) Assigning property rights (Coase Theorem)2) Mergers3) Social Conventions

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The government can deal with externalities through:

1) Pigouvian Taxes2) Pigouvian Subsidies3) Permits and a market4) Regulation

Taxes and Permits are generally most efficient and effective

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All public methods to address negative externalities suffer from:1) the difficulty in measuring externalities 2) possible redistribution issues

Positive externalities can be dealt with through subsidies

These can be hard to measure Financing subsidies can be distortionary This may effect equitable distribution

Public goods are nonrival and nonexcludable Public Goods are efficiently provided

where ∑MRS=MRT or ∑MB=MC (Private goods are efficiently provided

where MRSA = MRSB = MRT) Efficient provision occurs where

Total Benefit = Total cost It is unlikely that markets would provide

public goods efficiently, even if they are excludable

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Free-riding limits private provision of public goods

Two issues with production of public goods are efficiency and quality

Econ 384 had great students. Your professor had a lot of fun teaching this course.

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