ECON 2100 Principles of Microeconomics (Fall 2018) Public Goods and Common Resources

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1 ECON 2100 Principles of Microeconomics (Fall 2018) Public Goods and Common Resources Relevant readings from the textbook: Mankiw, Ch. 11 Public Goods and Common Resources Suggested problems from the textbook: Chapter 11 Quick Quiz Multiple Choice (Page 223): 1, 2, 3, 4, 5, and 6 Chapter 11 Questions for Review (Page 224): 1, 2, 3, and 4 Chapter 11 Problems and Applications (Pages ): 1, 2, 3, 5, 6, 7, 8, and 10 Definitions and Concepts: Excludable Good a good for which it is easy to prevent consumption by those who do not pay Non-Excludable Good a good for which it is difficult (or very costly) to prevent consumption by those who do not pay Rival Good a good for which consumption by one person does diminish the quantity or quality of consumption by others Non-Rival Good a good for which consumption by one person does not diminish the quantity or quality of consumption by others Private Good a good that is excludable and rival in consumption. Example: a Big Mac from McDonald s. Market provision of Private Goods is generally efficient. For goods that are NOT Private Goods, market provision will often be inefficient (i.e., Non-Private Good => Market Failure) Public Good a good that is non-excludable and non-rival in consumption Example: National Defense or a Fireworks Display Market provision of Public Goods is generally inefficient (due to the Free Rider Problem ). Common Good a good that is non-excludable but rival in consumption Example: fish in the ocean Collective Good a good that is excludable but non-rival in consumption Example: boxing match on PPV TV Tragedy of the Commons a parable which illustrates why a common good will be used/consumed by members of society at a level which is more than socially desirable Free Rider Problem if a public good were supplied in the marketplace, the amount provided would be less than the efficient quantity (since many people would attempt to enjoy the benefits of units purchased by others, while not purchasing any units themselves) i.e., many self interested people would rationally try to free ride on units purchased by others

2 we might still expect a positive amount to be provided (e.g., maybe Bill Gates and Warren Buffett might buy a few FA-22 s ), but the amount purchased would be less than the efficient amount Public Goods and Common Goods actually share much with goods that generate external effects Non-Excludable/Non-Rival nature of Public Good o if Person A purchases a unit of the public good, then Person B gets a benefit from this purchase o in many respects it s a big, positive externality o recall, free markets under-provide goods with positive external effects Non-Excludable/Rival nature of Common Good o nobody can stop Person A from using the Common Good o further, when Person A uses the Common Good he imposes a cost on Person B o in many respects it s a big, negative externality o recall, free markets over-provide goods with positive external effects Possible corrections for market failures from Public Goods and Common Goods Public Goods: have the government decide upon the quantity to be provided (presumably, a best guess of the optimal quantity ), and then tax people to cover the costs of providing the good Common Goods: (i) use regulation or impose taxes in an attempt to reduce consumption/use or (ii) attempt to transform the common good into a private good (by defining/enforcing property rights in order to make it excludable ) Collective Good (PPV TV) Degree of Excludability 1 Private Good (Big Mac) Public Good (National Defense) Degree of Rivalness Common Good (fish in the ocean)

3 Problem: 1. Consider a society consisting of five individuals (Amy, Ben, Claude, Dennis, and Emily), deciding upon how many units to consume of a good that is non-rival in consumption and non-excludable. Suppose throughout that it costs $500 to produce each unit of this good. No person has a positive benefit for any unit beyond the 4 th unit of the good. The marginal benefit for each person for each of the first three units is summarized in the table below. Amy s Ben s Claude s Dennis Emily s 1 st Unit nd Unit rd Unit A. What is the efficient quantity of the good? 1B. If this good were supplied in a free market by a profit maximizing firm, how many units would you expect to be traded? [Hint: How many units could a firm sell if they charged $500 per unit (the lowest price they could charge and cover their production costs)? ] Explain. 1C. Suppose that the government chose to provide two units of the good, and imposed a tax of $200 on each member of society (which would generate tax revenue to exactly cover the costs of providing the good ). Comparing this proposal to the free market outcome which was determined in part (1B), in which situation is Total Social Welfare larger? Explain. 1D. Again comparing the free market outcome which was determined in part (1B) to the situation in which the government provides two units of the good and imposes a tax of $200 on each person, which individuals are better off and which individuals are worse off under the proposal of government provision? Explain. Multiple Choice Questions: 1. If a good is such that it is easy to prevent consumption by those who do not pay for the good, then the good in question is A. an Excludable Good B. a Non-Excludable Good C. Rival in consumption D. Non-Rival in consumption 2. A Collective Good is A. Rival in consumption and Excludable B. Rival in consumption and Non-Excludable C. Non-Rival in consumption and Excludable D. Non-Rival in consumption and Non-Excludable

4 3. MARTA (the Metropolitan Atlanta Rapid Transit Authority ) provides consumers with rail and bus transportation. A one-way fare for a single ride on this public transportation system is sold at a price of $1.75. This good (i.e., a rail or bus ride on a MARTA train or bus) is a A. public good. B. private good. C. common good. D. More than one of the above answers is correct. 4. The refers to the recognition that if a public good were supplied in the marketplace, the amount provided would be less than the efficient quantity (since many people would attempt to enjoy the benefits of units purchased by others, while not purchasing any units themselves). A. Tragedy of the Commons B. Free Rider Problem C. Collective Good Dilemma D. St. Petersburg Paradox 5. One way to potentially correct for the market failure which would result if a public good were provided in a free market is to: A. impose a tax on the purchase of the item, so that fewer units are traded. B. completely ban the production/consumption of the item, so that no trade takes place. C. have the government decide upon the quantity to be provided (presumably, a best guess of the optimal quantity ), and then tax people to cover the costs of providing the good. D. None of the above answers are correct, since this is a trick question because there will typically not be a market failure if a public good were provided in a free market. 6. Which of the following goods would likely fit the definition of a Public Good? A. A Big Mac from McDonald s. B. A FA-22 Raptor fighter jet. C. Elementary education provided at a public school. D. Books available to be borrowed from a public library. 7. William is living in the United States illegally and does not pay any Federal Income Taxes. The U.S. Federal Government provides national defense by using some of the money that it receives form this tax. As a result, William is able to enjoy the benefits of national defense provided by the government without making any contribution whatsoever to the costs of its provision. This implies that William is A. a cheapskate. B. a free rider. C. a tragedy of the commons. D. irrational.

5 Answer to Problem: 1A. Recall that for a Public Good (i.e., a good that is non-excludable and non-rival in consumption) the Marginal Social Benefit of each unit is equal to the sum of s over all people in society (since, when a unit is provided, all people in society get to enjoy the benefits of the unit). From here it follows that the Marginal Social Benefit of the 1 st unit is $1,050 (= ), the Marginal Social Benefit of the 2 nd unit is $550 (= ), and the Marginal Social Benefit of the 3 rd unit if $150 (=100+50). Since the cost of producing each unit is $500, Social Welfare is maximized by producing two units (i.e., those units and only those units for which Total Social Benefits are greater than Costs of Production). 1B. If this good were supplied in a free market, we should expect zero units to be traded. To see this, recognize that if a firm were to charge less than $500, they would not be able to generate revenues which would cover production costs. Additionally, at any price at or above $500, no individual consumer would be willing to purchase a unit (since each consumer has a private marginal benefit of $400 or less for the first unit). Thus, in a free market, no units would be traded. 1C. Under the proposed plan, Total Social Benefits would be the sum of Marginal Social Benefits on the 1 st Unit and Marginal Social Benefits on the 2 nd Unit: $1,050+$550 = $1,600. Total Social Welfare could be obtained by subtracting Production costs (of $1,000 for two units of output) from this amount. Thus, Total Social Welfare under this proposal is: $1,600 $1,000 = $600. In comparison, at the free market outcome, zero units are traded, resulting in Total Social Welfare of $0. Therefore, Total Social Welfare is $600 greater under the proposal of government provision. 1D. However, individually some members of society are better off and some are worse off under the proposal of government provision. Note that under the free market outcome, each person has a Surplus of $0 (since no units are provided/consumed and no payments are made). Under the proposal of government provision the welfare of each individual is as follows: (Amy) = $( ) = $450 (Ben) = $( ) = $200 (Claude) = $( ) = $100 (Dennis) = $( ) = $( 75) (Emily) = $( ) = $( 75) Thus, Amy, Ben, and Claude would be better off under government provision, while Dennis and Emily would be worse off. Answers to Multiple Choice Questions: 1. A 2. C 3. B 4. B 5. C 6. B 7. B