Public Goods

Public Finance Dr. Katie Sauer

Optimal Provision of Private Goods A numeraire good is a good for which the price is set to $1. - choice between goods depends on relative price not absolute price (The numeraire good is placed on the vertical axis when considering a budget constraint.)

Ben and Jerry are deciding their consumption of cookies and ice cream. - let cookies be the numeraire - look at choice of ice cream Each will have individual demand for ice cream. - as price falls, Qd rises - different Qd for each individual

The Market Outcome

Ben

Jerry

Market Demand is found by horizontally summing the individual demand curves. At $2, what is market demand? 2+1=3

Price

The market demand is the SMB of ice cream consumption. The market supply is the SMC of ice cream production.

$2

S = SMC

DB + DJ = D = SMB 3 Q cones

The market outcome is found where SMB = SMC. Consumers demand different quantities at the same price.

Optimal Consumer Choice using the tangency condition A consumers optimal choice is found at the tangency of - budget constraint - indifference curve That is, when: MRS = slope of budget constraint MRS = - MUx MUy BC slope = - px py

MRS is the rate you are willing to give up good y to get one additional unit of good x.

Ben: MUBic = MRSBic,c MUBc Jerry: MUJic = MRSJic,c MUJc = Pic Pc = Pic Pc

In market equilibrium: MRSBic,c = MRSJic,c

Pic Pc

An individual will adjust consumption until their MRS equals the market price ratio. If the price of an ice cream cone is $2 and the price of cookies is $1, then the price ratio is 2. This means: In equilibrium, each individual is indifferent between trading 2 cookies to get one ice cream cone. Individual marginal utility levels for each good can still differ.

Suppose Ben is consuming 1 cone and 1 cookie and his marginal utilities are as follows: MUic = 7 MUc 3 MRSic, c = 2.33 2.33 > 2 Ben would consume another ice cream cone. - reduce MU ice cream

Suppose Jerry is consuming 2 cones and 1 cookie and his marginal utilities are as follows: MUic = 3 MUc 2 MRSic, c = 1.5 1.5 < 2 Jerry would consume fewer ice cream cones. - raise MU ice cream

Market Supply On the supply side, equilibrium in competitive markets requires that Pic = MCic Since we know that in equilibrium on the demand side Pic must equal MRSic,c, we have: MCic = MRSic,c

The private market outcome is also the social-efficiencymaximizing outcome. With no market failures, MRS at any quantity = SMB of that quantity marginal value to individual = marginal value to society

MC at any quantity = SMC of that quantity marginal cost to producers = marginal cost to society

SMB = SMC

Optimal Provision of Public Goods Suppose Ben and Jerry are choosing between cookies (numeraire) and missiles. **individuals cannot choose their own specific consumption of a public good** - whatever amount is provided is consumed equally by all The choice therefore is over willingness to pay for a given quantity.

Ben

Jerry

For the 1st missile, Ben would be willing to pay $2 and Jerry would be willing to pay $4. - total willingness to pay is $6

Market Demand is found by vertically summing the individual demand curves. - market demand is SMB as well
Price

Supply = MC = SMC Optimal level: SMB = SMC

S = SMC

$6

$3 DB,J = SMB 1 5 Q missiles

Mathematically: The SMB is the sum of each individuals valuation: MRSBm,c + MRSJm,c = SMB The SMC is the marginal cost of production. Social-efficiency-maximizing level: MRSBm,c + MRSJm,c = MC

Example: Suppose Ben and Jerry live far from others. It is the 4th of July and they want to celebrate. They care about the consumption of ice cream and fireworks. - ice cream is a private good $1 per unit - fireworks are a public good $1 per unit - ice cream is the numeraire Suppose they have identical preferences.

Each individual will face MUF = 1 MUic 1 or MUF = MUic

to determine how many ice cream cones and fireworks each will buy.

The socially optimal level of fireworks is: MRSBF,ic + MRSJF,ic = 1 MUBF + MUJF MUBic MUJic = 1

since preferences are identical, rewrite as: = 1 2MUF MUic or MUF = (1/2) MUic

Each will privately choose the level where MUF = MUic Even though the socially optimal level is MUF = (1/2) MUic - fireworks should be consumed until their MU is half that of ice cream - more fireworks consumption in socially optimal outcome (to decrease the MU, consume more of the good) - private market outcome is less fireworks because of the free-rider problem

Underlying Mathematics Ben and Jerry live by themselves and far away from others. - each has income of $100 They each choose consumption over a private good, fried chicken and a public good, fireworks. - each are priced at $1 per unit Both Ben and Jerrys preferences can be expressed as U = 2ln(C) + ln(F) where F = FB + FJ

Ben will maximize U = 2ln(CB) + ln(FB + FJ) subject to (1)CB + (1)FB = 100 Can rewrite as a lagrangian:
L ! 2 ln(C B )  ln( FB  FJ )  P (100  C B  FB )

Jerry will do the same.

Private Provision of a Public Good How will each behave, given that the other will also provide some of the fireworks? Nash Bargaining = solve for own optimal strategy, given the others behavior

Ben:

xL 1 ! P ! 0 xFB ( FB  FJ ) xL 2 ! P ! 0 xC B C B xL ! 100  C B  FB ! 0 xPB

Bens reaction function: Jerrys reaction function:

100  2 FJ FB ! 3 100  2 FB FJ ! 3

Combine the two reaction functions:

100  2 FB 100  2 3 FB ! 3

And solve:
200  4 FB 3FB ! 100  3 9 FB ! 300  200  4 FB

FB ! 20
FJ ! 20

Total firework provision will be FB + FJ = 20 + 20 = 40

How does this compare to the socially optimal amount? - need to sum MRS - MRS is ratio of marginal utilities

Socially Optimal Level Ben:

xU 1 MU F ! ! xFB ( FB  FJ ) xU 2 MU C ! ! xC B C B 1 FB  FJ CB 100  FB ! ! ! 2 2( FB  FJ ) 2( FB  FJ ) CB 100  FB ! 2( FB  FJ ) MRS
J F ,C

B MRS F ,C

MRS

B F ,C

Jerry:

100  FJ ! 2( FB  FJ )

Socially optimal: sum MRS and set equal to price ratio

MRS
B F ,C

 MRS

J F ,C

(100  FB )  (100  FJ ) 200  ( FB  FJ ) ! ! 2( FB  FJ ) 2( FB  FJ ) 200  ( F ) ! 2( F ) 200  F pF 1 ! ! !1 2F pC 1 200  F ! 2 F F ! 66.67 Socially optimal amount

The private market will under-provide the fireworks. private market = 40 socially optimal = 66.67

Suppose the government recognizes that the private sector under provides fireworks by 26.67. Suppose it mandates that Ben and Jerry must each contribute $13.34 toward public firework provision.

Ben will now maximize U = 2ln(CB) + ln(FB + FJ+26.67) subject to (1)CB + (1)FB = 100 13.34 Can rewrite as a lagrangian:
L ! 2 ln(C B )  ln( FB  FJ  26.67)  P (86.66  C B  FB )

Jerry will do the same.

Ben: xL !
xFB

1 P ! 0 ( FB  FJ  26.67)

xL 2 ! P ! 0 xC B C B xL ! 86.66  C B  FB ! 0 xPB

Bens reaction function: Jerrys reaction function:

33.32  2 FJ FB ! 3 33.32  2 FB FJ ! 3

Combine the two reaction functions:

33.32  2 FB 33.32  2 3 FB ! 3

And solve:
66.64  4 FB 3FB ! 33.32  3 9 FB ! 99.96  66.64  4 FB

FB ! 6.67
FJ ! 6.67

Total firework provision will be FB + FJ +26.67 = 6.67+6.67+26.67 = 40.01 = 40 The government provision of fireworks has crowded out private provision. - complete crowd-out Ben and Jerry have returned to their optimal level of production and the socially optimal level has not been achieved.