Chapter 4. Public Goods. Copyright 2002 Thomson Learning, Inc. Thomson Learning is a trademark used herein under license.

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1 Chapter 4 Public Goods Copyright 2002 by Thomson Learning, Inc. Copyright 2002 Thomson Learning, Inc. Thomson Learning is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems without the written permission of the publisher. Printed in the United States of America ISBN X

2 Public Goods Public Goods are goods for which exclusion is impossible. One example is National Defense: A military that defends its citizenry from invasion does so for the entire public.

3 Characteristics of Public Goods Nonexclusion: The inability of a seller to prevent people from consuming a good when they do not pay for it. Nonrivalry: The characteristic that if one person consumes a good, another person s pleasure is not diminished nor is another person prevented from consuming it.

4 Pure Public Goods and Pure Private Goods Pure Public Good: There is no ability to exclude and there is no rivalry for the benefits. Pure Private Good: There is a clear ability to exclude and there is rivalry for the benefits.

5 Marginal Costs for Provision of Public Goods The marginal cost of allowing another person to benefit from a pure public good is zero while the marginal cost of a greater level of public good is positive.

6 Cost (Dollars) Copyright 2002 by Thomson Learning, Inc. Figure 4.1 Marginal Costs of Consuming and Producing a Pure Public Good-Figure A 200 Marginal Cost of Allowing an Additional Person to Consume a Given Quantity of Pure Public Good 0 1 Number of Consumers

7 Cost (Dollars) Copyright 2002 by Thomson Learning, Inc. Figure 4.1 Marginal Costs of Consuming and Producing a Pure Public Good--Figure B 200 Marginal Cost of Producing a Pure Public Good MC = AC 0 Units of a Pure Public Good per Year

8 Example Bread versus Heat Bread Clearly a pure private good because there is the ability to exclude and there is rivalry. Heat Clearly a pure public good because there is no ability to exclude and there is no rivalry.

9 Provision of Private Good and Public Goods: Markets and Government Price Excludable Public Goods vs Congestible Public Goods

10 Price Excludable Public Goods Excludability but no rivalry Another type of good is a priceexcludable public good: no rivalry but exclusion is easy. Examples: Country Clubs, Cable TV

11 Congestible Public Goods Rivalry but no excludability There are public goods where, after a point, the enjoyment received by the consumer is diminished by crowding or congestion. These are called Congestible Public Goods. Examples: roads and parks

12 Marginal Cost Copyright 2002 by Thomson Learning, Inc. Figure 4.2 A Congestible Public Good Marginal Cost per User 0 1 Number of Consumers per Hour

13 Table 4.1a Alternate Means of Producing, Distributing, and Financing Goods and Services CHARACTERISTICS OF THE GOOD OR SERVICE Pure Private Goods No ext ernalit y; low-cost exclusion Price-Excludable Public Goods Ext ernal benefit s when produced or consumed; lowcost exclusion MEANS OF PRODUCTION Privat e firms; government Government ; privat e firms under cont ract wit h government Privat e firms; government Government ; privat e firms under cont ract wit h government MEANS OF DISTRIBUTION Market s; direct unit charge No direct unit charge; eligibilit y t o consume various amount s det ermined polit ically Market s; direct unit charge (may be subsidized) No direct unit charge; consumpt ion available or required only at collect ively chosen quant it y and qualit y METHODS OF FINANCE Revenue from sales Taxes Revenue from sales; t axes Taxes PUBLIC EXAMPLE Food; clot hing; cars Schools; hospit als; t ransport a t ion PRIVATE EXAMPLE Government liquor st ores; government t obacco monopoly Government dist ribut ion of medical services and food t o low income cit izens Transit f acilit ies; public hospit als Public schools; public sanit at ion; inoculat ions

14 Table 4.1b Alternate Means of Producing, Distributing, and Financing Goods and Services CHARACTERISTICS OF THE GOOD OR SERVICE Congest ible Public Goods Collect ively consumed benef it s subject t o crowding; possibilit y of exclusion Pure Public Goods Collect ively consumed benef it s not subject t o crowding; highcost exclusion MEANS OF PRODUCTION Privat e firms; government Government ; privat e firms under cont ract wit h government 1. Privat e firms; government 2. Government ; privat e firms under cont ract wit h government MEANS OF DISTRIBUTION Fees for t he right t o use t he facilit y sold in market s No direct user charge (or part ial charge) No direct unit charge; quant it y dependent on amount collect ed No direct unit charge; quant it y and qualit y of service collect ively chosen METHODS OF FINANCE Revenue from sales Taxes; revenue f rom sales Fees; cont ribut ions Taxes PUBLIC EXAMPLE Clubs; t heat ers; amusement parks; sport ing event s Privat e charit y PRIVATE EXAMPLE Public golf courses; roads Public parks; public recreat ion; roads, bridges Public t elevision and radio Nat ional def ense; environment al prot ect ion

15 Figure 4.3 Classifying Goods According to the Degree of Rivalry and Excludability of Benefits from Their Use 1 C A H 0 B Rivalry 1

16 Demand For a Pure Public Good Demand for a Pure Private Good is derived by adding quantities at each price. Demand for a Pure Public Good is derived by adding how much people will be willing to pay at each quantity.

17 Price per Loaf of Bread (Dollars) Copyright 2002 by Thomson Learning, Inc. Figure 4.4 Demand For a Private Good E D C = MB C D B = MB A D A = MB A S = MC = AC D = Q D Loaves of Bread Purchased per Week

18 Marginal Benefit (Dollars) Figure 4.5 Demand For A Pure Public Good Z Z Z Copyright 2002 by Thomson Learning, Inc. Z 4 D A = MB A D A = MB A D B = MB B D C = MB C Security Guards per Week

19 Marginal Benefit (Dollars) Figure 4.6 Efficient Output for a Pure Public Good E MC = AC = MSB D A = MB A = MSB Copyright 2002 by Thomson Learning, Inc. MB A MB B MB C Security Guards per Week

20 Efficient Output of a Pure Public Good The socially optimal level of the public good requires that we set the Marginal Social Benefit of that good equal to its Marginal Social Cost. MSB = MSC Lindahl Pricing: Everyone in a group cooperates and pays their marginal benefit. We can demonstrate this issue mathematically, numerically (using a table), and graphically.

21 Mathematically Recall from Figure 4.5 that the marginal social benefit for a pure public good is the sum of the individual marginal benefits. That is: MSB = MB. Efficient output is therefore: MSB = MB = MSC.

22 Numerically Suppose we have three people who are discussing the issue of hiring security guards. Note that each person places a different value on the levels of security.

23 A Numerical Example Number of Security Guards per Week MB A $300 $250 $200 $150 MB B $250 $200 $150 $100 MB C $200 $150 $100 $50 MB $750 $600 $450 $300 If the cost of security guards is $450 per week, then no individual will hire even one guard, even though to group one is worth $750. The group should hire three. If they pay their marginal benefit, then three guards are hired. Person A pays $600 ($200 per guard), person B pays $450 ($150 per guard) and person C pay $300 ($100 per guard).

24 The Peace Dividend National Defense is the classic pure public good. Defense spending as a percentage of GDP Fell from above 8 percent during the Vietnam era to just above 5 percent in the late 1970s; Grew during the Reagan defense buildup of the 1980s; Fell below 5 percent with the demise of the Soviet Union.

25 Percentage of GDP Copyright 2002 by Thomson Learning, Inc. Public Policy Perspective: Defense Purchases as a Percentage of GDP, Year

26 Lindahl Equilibrium The amount each person contributes, t i, depends on their individual desires for the public good. The sum of the contributions equals the total cost of the public good. t i Q* = MC(Q*) = AC(Q*) t i = MC = AC All individuals agree to pay their share.

27 Freeriding Freeriding occurs when people are not honest in stating their Marginal Benefit because if they understate it, they can get a slightly reduced level of the public good while paying nothing for it.

28 Freeriding is easier with Anonymity: If everyone knows who contributes, there can be powerful social stigmas applied to shirkers. Large numbers of people: It s easier to determine the shirkers in a small group and the punishment is more profound when people close to you shun you.

29 Illustrating Voluntary Contributions to a Public Good: The Gulf War Under the premise that defeating Iraq in the Gulf War was a public good to be consumed by the industrialized economies and Arab nations, each nation was expected to contribute. The U.S. and UK contributed the bulk of the fighting forces. Saudi Arabia, Kuwait, the UAE, Japan, and Germany voluntarily paid $54 billion of the estimated $61 billion cost.