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Public goods and an introduction to externalities
Today: Determining what a public good is; Efficient provision; Public versus private provision; Defining externalities
Beginning Unit 2
Last time We concluded our “tools” chapters End of Unit 1
Today Begin Unit 2
Public goods (Chapter 4) What is a public good? Efficient provision Public versus private provision
An introduction to externalities (Chapter 5)
Public goods
Public goods are goods that have some degree of two characteristics Nonrival Nonexcludable
These two characteristics lead to suboptimal consumption when public goods are privately purchased Externalities involved, to be defined later
Definitions
Nonrival good (R/G p. 52) “Once it is provided, the
additional resource cost of another person consuming the good is zero”
Nonexcludable good (R/G p. 52) “To prevent anyone from
consuming the good is either very expensive or impossible”
Pure public good (R/G p. 52) “A commodity that
is nonrival and nonexcludable in consumption”
Categories of goods
Low High
High Commons good
(oxygen that you breathe)
Public good
(lighthouses)
Low Private good
(pens)
Collective good
(copyrighted books)Nonexcl
udab
le
Nonrival
Categories of goods
Low High
High Commons good
(oxygen that you breathe)
Public good
(lighthouses)
Low Private good
(pens)
Collective good
(copyrighted books)Nonexcl
udab
le
Nonrival
Covered in Econ 1; uses basic supply/demand theory
Categories of goods
Low High
High Commons good
(oxygen that you breathe)
Public good
(lighthouses)
Low Private good
(pens)
Collective good
(copyrighted books)Nonexcl
udab
le
Nonrival
Often covered in Econ 1 or Econ 100B
Categories of goods
Low High
High Commons good
(oxygen that you breathe)
Public good
(lighthouses)
Low Private good
(pens)
Collective good
(copyrighted books)Nonexcl
udab
le
Nonrival
Goods with copyright or patent protection have some level of market power
Other examples of public goods Basic research Programs to fight poverty Uncongested nontoll roads Fireworks display
Noteworthy aspects of public goods Even though everyone consumes the same
quantity of the good, it need not be valued equally by all Surfers generally value ocean quality more than
people living in Utah Classification as a public good is not
absolute; it depends on market conditions and the state of technology Impure public goods are “rival and/or excludable
to some extent” (R/G p. 53)
Noteworthy aspects of public goods Some things that are not conventionally
thought of as commodities have public good characteristics Restaurant ratings
Consistent within a city Often different standards between cities Example: It appears harder to get an “A” rating in Los
Angeles County restaurants than in San Diego County
Noteworthy aspects of public goods Private goods are not necessarily provided
exclusively by the private sector Publicly provided private goods
Example: Government-provided food for the poor
Public provision of a good does not necessarily mean that it is also produced by the public sector Many publicly-provided services are contracted to
private firms Example: Defense-related goods
Demand of private goods
Demand of private goods are summed horizontally Add the quantity demanded for each person at a
given price
Efficient Provision of Private Goods
Price Adam (Df
A)Eve (Df
A)Market (Df
A+E)
$11 5 1 6
$9 7 3 10
$7 9 5 14
$5 11 7 18
$3 13 9 22
$1 15 11 26
0
1
2
3
4
5
6
7
8
9
10
11
12
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
DfADfE
DfA+E
Sf
$
Quantity of Pizza
Equilibrium and efficiency, private goods Privately-provided goods have optimal levels
produced if the following conditions are met: The goods are private
Rival and excludable Competitive markets
No market power exists Price and quantity are where demand and supply curves
meet
Recall First Welfare Theorem MRSfa
Adam = MRSfaEve = MRTfa
Public goods
We will examine pure public goods Highly nonrival Highly nonexcludable
Marginal analysis is used to find the optimal quantity Optimal quantity is where PUBLIC MB equals MC
An example: Fireworks
Units of Fireworks
1 2 3 4
Adam (DfA) $300 $250 $200 $150
Eve (DfE) 250 200 150 100
Market(Df
A+E)$550 $450 $350 $250
050
100
150200250300350400
450500550600650
700750800
1 2 3 4
DfA
DfE
DfA+E
Sf
Quantity of Fireworks
$
Pareto efficiency: Public goods case MRSfa = Pf / Pa
Set Pa = $1 MRSfa = Pf / 1 MRSfa = Pf
DfA shows MRSfa for Adam
DfE shows MRSfa for Eve
Sf shows MRTfa
Necessary condition for Pareto efficiency: MRSfa
Adam + MRSfaEve = MRTfa
Another example
Fireworks show off of a tiny coastal community 25 people live here Each person has the same private demand for fireworks
P = 2 – 0.08 Q MC for fireworks is 10
Notice that if fireworks were privately purchased, nobody would buy them (10 > 2)
Fireworks show as a public good Since one person’s enjoyment of fireworks
does not take away from the enjoyment from others, PUBLIC MB is the sum of PRIVATE MBs
PUBLIC MB is the vertical summation of all 25 PRIVATE MBs P = 25 (2 – 0.08 Q) = 50 – 2Q
Vertical summation
Vertical summation of 25 PRIVATE MB lines produces PUBLIC MB line Vertical
intercept is 50MC
PUBLIC MB
PRIVATE MB
Marginal analysis
To find efficient level of fireworks, set PUBLIC MB = MC 50 – 2Q = 10 Q = 20
Free rider problem
When public goods are provided privately, some people let others buy the good for their own enjoyment These people are known as free riders
Perfect price discrimination can solve the free rider problem Usually cannot be done, since it requires
knowledge of each person’s demand curve for the public good
Do people free ride?
Public goods games Inefficient results predicted
Experimental economics tests free rider theories
A public goods game
You can decide whether or not you want to contribute to a new flower garden at a local park If you decide Yes, you will lose $200, but every
person in the city you live in will gain $10 in benefits from the park
If you decide No, you will cause no change to the outcome of you or other people
A public goods game
What is each person’s best response, given the decision of others?
We need to look at each person’s marginal gain and loss (if any) Choose yes Gain $10, lose $200 Choose no Gain $0, lose $0
A public goods game
Which is the better choice? Choose no (Gain nothing vs. net loss of $190)
Nash equilibrium has everybody choosing no Efficient outcome has everybody choosing
yes Why the difference?
Each person does not account for others’ benefits when making their own decision
Experimental economics
Experiments are conducted approximately as follows A group of people meet in a classroom Each person is offered money (or the equivalent
of money) Each person has the opportunity to donate money
to a fund There is a “money multiplier” Money (after multiplied) gets distributed equally to
everyone in the classroom
Public goods experiments
Typical results of public goods experiments People contribute about 50% of resources to provision of
public good Contributions fall the more often the game is repeated More cooperation with prior communication Contribution rates decline when opportunity cost of giving
goes up “Warm-glow” giving
Some people may feel good by improving social welfare
Public versus private provision of a good Although public goods are often publicly
financed, there is often debate as to whether or not the public sector should also provide the good
There are a few criteria that help to determine provision Relative wage and materials costs Administrative costs Diversity of tastes Commodity egalitarianism
Provision criteria
Relative wage and materials costs Public sector workers are often unionized more,
leading to higher costs in the private sector Administrative costs
Often lower if service provided by public sector
Provision criteria
Diversity of tastes Private provision often means more options to the
consumer Distributional issues
Is there a minimum amount of schooling and health care that should be provided to everyone? Up to personal preference and debate
Public/private provision debate Change of provision between public and
private sectors Heavily debated in some cases Some issues
Uncertainty Responsibility of fulfilling services Quality of good or service Incomplete contracts in some private sector services
Example: All contingencies for security Consumer satisfaction within a market
Private provision of national defense Example: Substantial amounts of money are
spent on national defense 9.3% of GDP in 1962 (Cold War era) 3.4% of GDP in 1997
Many goods and services related to national defense are privately provided
The type of contract could lead to substantial changes in cost to government
Private provision of national defense Big private contracts to provide national
defense involve substantial risk Cost of cutting-edge technology is very uncertain Fixed price contracts leave all the risk on the firm
Winner’s curse Cost-plus contracts often lead to substantial cost
overruns No incentives to keep costs down
What else can be used? Incentive contracts
Incentive contracts
Incentive contracts incorporate aspects of fixed price and cost-plus contracts
Department of Defense pays a fixed fee plus a fraction of production costs TC = F + λ C When 0 < λ < 1…
There is an economic incentive to the firm to prevent cost overruns
The firm bears less risk than with fixed price contracts Special cases
λ = 0 Fixed price contract λ = 1 and F = 0 Cost-plus contract
Who decides how much to provide? Somebody in government must make
decisions about public goods More on decision making in Chapter 6
Political economy
Summary: Public goods
Public goods are nonrival and nonexcludable in consumption
Demand of public goods uses vertical summation
Free rider problem predicts suboptimal quantities purchased Mixed evidence from experimental economics
Ongoing debate between public and private provision of public goods
An introduction to externalities Markets are well functioning for most private
goods Many buyers and sellers Little or no market power by anybody Example: When demand shifts right for a good,
new equilibrium will have higher price and quantity Some markets do not have good
mechanisms to account for everything in a market Example: Talking on a cell phone in an airplane
Externalities
Externalities are effects that are not incorporated into market quantities and prices R/G (p.71) define an externality as “an activity of
one entity that affects the welfare of another entity in a way that is outside the market mechanism”
When markets have externalities, they are typically not efficient This is the topic of Chapter 5
Public good versus externality Although public goods are often looked at as
goods with externalities, we study the two topics separately Know which analysis applies when you solve a
problem
Negative externalities
Some examples of negative externalities Air pollution Water pollution
Sometimes you do not even think about polluting the water: Washing a car in your driveway
Noise pollution Highway congestion Standing at a concert or sporting event
Positive externalities
Some externalities are benefits Planting flowers in your front lawn Scientific research Vaccination
Prevents others from getting a disease from you Exercise?
Yes, if it leads to lower health care insurance premiums for others
More on the private health care market in Chapter 9
More externalities: Benefit or cost? Christmas decorations
Enjoyment or nuisance? A fan blowing in a warm office building
Cooling breeze or blowing your important papers? Use of perfume or cologne
Nice smell or allergen?
A simple example with externalities Suppose private MC equals quantity
MPC = Q Let demand be denoted by P = 100 – Q Let marginal damage be $10 per unit
A simple example with externalities
Translate equations and external cost to our graphical example
marginal damage per unit of $10
P = 100 – Q
MPC = Q
MSC = Q + 10
A simple example: Private equilibrium
Inefficient equilibrium w/o controls:
Set Q = 100 – Q Q = 50 (quantity F)
MPC = Q
P = 100 – Q
A simple example: Optimal equilibrium
Socially optimal quantity Q + 10 = 100 – Q Q = 45 (quantity E)
P = 100 – Q
MSC = Q + 10
An algebraic example: Price
Inefficient equilibrium, P = Q P = 50 Socially optimal quantity, P = Q + 10 P = 55
marginal damage per unit of $10
P = 100 – Q
MPC = Q
MSC = Q + 10
Price C = 50
Price B = 55
Recall E = 45 and F = 50
Summary: An introduction to externalities Externalities can be positive or negative
Sometimes, an action could lead to positive externalities for some people and negative externalities for others
With external damages, an equilibrium occurs that has too much produced and price too low (relative to the optimal quantity)
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