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)