Public goods. Public Economics. Carlo Fiorio Bocconi University

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Gregory Kelley
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1 Public Economics Bocconi University Academic Year 2006/2006

2 Today s questions What is a public good? Why does the state produce public goods? Is a public good necessarily produced by the state? Are public goods affecting efficiency conditions, hence the results of the FTWE?

3 What is a public good? are goods that present two key characteristics: they are non-rival; they are non-excludable. A good or service is non-excludable when once the good is provided for one person it is either logistically impossible or extremely expensive to exclude people from consuming the good (lighthouse, flowers in a garden, etc.). A good or service is non-rival if the consumption of one person does not affect the quantity available for consumption by others. Equivalently we could say that the marginal cost of supplying to an additional user is zero, MC = 0 (street lighting, national defence, etc.)

4 NOT goods by the state Note: public goods are NOT goods and services which are provided by the state. only part of the goods and services that the state produces are public goods; also the private sector can produce some public goods.

5 vs. private goods Pure public goods are fully non-rival and fully non-excludable. Pure private goods have neither of previous two characteristics Pure public goods are rather rare: more common to find goods that have different degrees of rivalry and excludability. Sometimes excludability is dependent upon technology.

6 Public and private goods 0% Cinema National park Pure public good Degree of rivalry Icecream Italian beach in August 100% Pure private good Degree of excludability 0%

7 Aggregate value of a private good Private goods are rival in consumption: as more of the good is demanded, more needs to be produced. The value that consumers place on private goods is given by their marginal benefit (MB) curves. The overall value of a private goods is given by the horizontal sum of individual MB curves.

8 Aggregate value of a private good MB MB MB MB A 1 MB B 1 MB A + MB B q A q B q A + q B

9 Optimal provision of public goods are non-rival: whatever is produced can be consumed. If the public good is prodived, both Ann and Bill benefit Hence, in the case of public goods, the aggregate value of the good is given by the vertical sum of individual marginal benefit curves.

10 Aggregate value of a public good MB of public good MB A MB B MB A + MB B Quantity of public good Quantity of public good

11 Efficiency conditions of a public good In a partial equilibrium model, the efficient level of production of a private good is where the MB to the consumer equals the MC to the producer. However, a public good is non-rival in consumption: then aggregate value to society must equal the marginal cost. The aggregate value to society of the overall willingness to pay is the vertical sum of the individual marginal benefits. Optimal level of provision of a public good N MB i = MC (1) i

12 Efficiency condition for a public good MB MC MB X

13 Why does the market fail? Given the nature of public goods, the cost of provision is often extremely high and individual consumers do not place enough value on it. Consider the case of Ann and Bill who place a value on a public good which is not enough for producing it. However, the sum of the benefit they would get if the public good was produced is higher than its cost. That s a clear inefficiency!

14 Why does the market fail? MC public good CMa MB A + MB B q Quantity of public good

15 The non-excludability problem If more than one person is interested in the consumption of a public good, each person has an incentive not to contribute to the production of the public good, i.e. to free ride. For instance, consider two individuals, Ann and Bill, who have to decide whether to contribute (C) or not (N). the benefit to each of the public good is 8 and the total cost is 10 Ann C N Bill C (3,3) (8,-2) N (-2,8) (0,0) Which is the dominant strategy? What is the consequence of it?

16 The non-rivalry problem According to I FTWE if the good to be produced is private, a competitive firm can supply the good at a price P > 0, and the price will be such that efficiency is reached, i.e. P = MC What happens if a private firm wants to produce a public good? Can a firm exclude consumption of the public good it produces? Assume that the private firm can charge a price, excluding consumers who do not want to pay to consume the good: is it efficient?

17 The non-rivalry problem P Demand for public good P > MC MC = 0 # of users Lost C.S.

18 Is gov t intervention always necessary? We saw market fails to deliver public goods, completely or at the desired level. Hence? Do we really always need a gov t?

19 Is gov t intervention always necessary? Private collective provision could be possible in small communities: it is less easy to free ride. Economic experiments show that social responsibility, fairness, altruism and belief in the collective seem do belong to human beings

20 Other possible market solutions Whenever the good is excludable in some ways efficient level of production can happen (and it can prevent overcrowding). Typical example: sport club Private firms can provide complementary goods Private firms can provide public goods if that is good for employees motivation, marketing, etc.

21 Gov t provision of public goods In some cases the gov t production of public goods is necessary. E.g. law and order. How does the state define the amount of contribution to be paid? How is price fixed? How is the efficient level (social evaluation) of production determined?

22 is designed to make revelation of true preferences the dominant strategy Each consumer is treated as a possible pivotal agent : her decision will influence the decision whether to produce the good or not. Assume each individual i, i = 1, 2,..., N is asked to state her gross value from the provision of a public good, s i. The good is produced if N i s i > x, where x is the cost of producing it. It is not produced if N i s i x The tax is designed to impose the full social cost of each one s decision upon that consumer herself. The for each agent i is t i = x j i s j, with j i.

23 The is a possible device to oblige individuals to reveal their preference correctly but has a number of limitations: the larger is society the more complicated the implementation of the tax; it is a penalty on false revelations, hence a loss in consumption; if coalition is possible the does not work, the pivotal agent will declare false preferences. does not work if valuations of the public good depend on income It does not allow the government to collect revenues equal to the total cost of the good.

24 References C&M, Ch. 4

MICROECONOMIC FOUNDATIONS OF COST-BENEFIT ANALYSIS. Townley, Chapter 4

MICROECONOMIC FOUNDATIONS OF COST-BENEFIT ANALYSIS Townley, Chapter 4 Review of Basic Microeconomics Slides cover the following topics from textbook: Input markets. Decision making on the margin. Pricing