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Lindahl Pricing
This is a mechanism in order to achieve the optimal outcome in the public goods setting. We know from before that
often in the case of public goods in a competitive equilibrium there is usually underproduction of the good relative to the
social optimum. This is because of the free rider problem and a general incentive for consumers to lie about their preferences.
In Lindahl pricing it is required that everyones willingness to pay for the public good i.e. demand curve is known. With
this we charge each person a fraction of the cost of producing the public good based on their WTP from the demand curve.
This makes this policy intractable in real world settings, but it provides a useful benchmark for policy outcomes because the
outcome achieved by Lindahl pricing is Pareto efficient as we will see. Thus in that sense Lindahl pricing can correct the
market failure created by the public goods problem and lead to the social optimal outcome.
The Lindahl problem can be framed in the context of a individuals deciding how to allocate income across two goods in a
competitive equilibrium: a private good (x) and a public good (z). To keep things simple we assume no firms in the economy;
just an exogenous amount of income per person that the government uses to magically produce the public and private good
in appropriate amounts for each person. Thus we have the following problem to solve:
maxxi ,z Ui (xi , z) s.t. px xi + i pz z = Ii and i, ni=1 i = 1
L: U (xi , z) i (px xi + i pz z Ii )
f.o.c:
(1) Ui,xi i px = 0
(2) Ui,z i i pz = nUz ni=1 i i pz = 0
U
M Cz
i,z
= M RSi = pixpz . So i M RSi = i pixpz = ppxz = M
These give: Ui,x
Cx , so the optimal condition is achieved for society as in
i
a competitive equilibrium the marginal cost of production is equal to the price of a good. We can also solve for i = M RSi ppxz
which you can think of the as the value of benefit of the public good accounting for the total cost in a specific way. Basically,
the higher a persons marginal utility for a public good the higher fraction of the total price they will pay.
From the above problem we see two things. First off Lindahl pricing can be achieved in a competitive equilibrium and thus
everyone is as well off individually as they can be. Second, we recover the social optimum amount of the good produced as
the social efficiency condition is achieved.
Let us do an example to see how this works in practice similar to the one you have on the problem set:
Consider a town consisting of two people: S and P. Each has a demand for fireworks during the fourth of July celebration. In order to produce these fireworks, town will tax individuals to achieve the social outcome. Suppose S has a demand
function of Ps = 1 1/100Qs and P has a demand function of Pp = 3 3/100Qp . Suppose the MC of producing fireworks is 1.
a) Solve for the socially optimal level of fireworks production. What is the equilibrium price?
We would like MSB=MSC which means M BS + M BP = 4 4/100Q = 1 as QS = QP for a public good. This gives Q = 75
and P = M C = 1.
b) Design a Lindahl pricing scheme to implement the optimum above and confirm that it does so.
The efficiency condition derived above was that i = M RSi ppxz . Here there is no other good, so the condition is i = MPBi =
Pi (Q) as P = 1. Thus for S this is 1 1/100 (75) = 1/4 and for P this is 3 3/100 (75) = 3/4. Note that person P pays
three times as much, and they demand three times the good of person S.
Regression Discontinuity
Like instrumental variables and diff-in-diff estimation this is another method to get at the causal effect of something using
observational data. The basic idea is that we have some continuous outcome Y as a function of a continuous predictor X. Due
to some policy, exogenous event, etc. there is a break in the predictor X where beyond some special value c i.e. X>c individuals get something different than individuals below X<c. This difference above and below c is also related to the outcome
Y. Thus at X=c there is a discontinuity in the regression line because for X<c the relationship with Y is different than for X>c.
Now a prior individuals with Xc i.e. in an interval (C-,C+) for X should be fairly similar in the outcome level due to X because their X values are similar. Thus focusing on individuals within that small neighborhood and comparing the differences of
outcome for people above and below c gives us an idea of the effect of the event on Y. Because these individuals are similar, the
difference in Y is the causal effect of the event. Note this requires the assumption that nothing else affects Y besides X. It also
requires that assignment to receiving the event or not based on an individuals X value be essentially random. Note that this
causal effect is really relevant for those at or near the cutoff and likely does not generalize well, so it has weak external validity.
Here is an example. In Chile there is a loan program for prospective college students. To be eligible you must score above
475 on a college placement test. This sharp cutoff makes this ripe for a RDD (regression discontinuity design) to measure the
effect of the loan program on college attendance. Individuals who scored near 475 are likely similar in ability and intelligence.
Their scores probably differed due to random variation on test day. We can assume that these individuals would all be equally
likely to attend college. With this quasi random assignment the effect of the loan program can be examined by the difference
in college attendance for those slightly above and below the cutoff point. Note the positive jump in estimated probability at
the cutoff.