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You are on page 1of 101

• Pareto Efficiency

• Market Failure: Competitive markets are

not efficient

• Solutions to the Free-Rider Problem: Clarke

Groves Mechanism

• General Policy Recommendation: Separate

funding from who benefits

Slide 1

Private vs. Public Goods

• Private goods are

– excludable: If you don’t pay you won’t get the good.

– rival: if you consume a certain amount of the good

there is less to consume for others.

• Public goods are

– non-excludable: If you don’t pay you can still get the

good.

– non-rival: your consumption of the good does not

diminish the amount available for others.

Slide 2

Private vs. Public Goods

• Remember that rivalness and excludability are the

keys to defining public vs. private goods

– Just because government supplies a good does not

make it public

• e.g. public education is largely a private good

– Just because a good is not supplied by government does

not make it private

• Many governments are doing nothing to reduce carbon

emissions; but reduction is clearly a public good.

Slide 3

Examples of Public Goods

• National defense

• Public safety

• Clean air

• Street lights (a very local public good)

• Child health, happiness (public good

primarily to their parents; to a lesser extent

to society)

Slide 4

Examples of Collective Goods

• These goods are non-rival but excludable

– Cable TV

– Websites

• Technically you could be charged to visit any website

(excludable)

• e.g. MOOCS (massive open online course)

Slide 5

Examples of Commons Goods

• These goods are non-excludable but rival

– Fisheries

– Well water

– Other open access resources

Slide 6

Impure public goods

• Goods occupying the middle ground between

these extremes: i.e., exhibit some excludability or

rivalness

– Roads: Costly to exclude people (given current

technology) but as more and more people use it

consumption becomes rival (congested).

– Polar bears: Rival when hunted; congestible when

viewed in person; non-rival and non-excludable when

enjoyed for pure existence value (i.e. when people get

utility from knowing polar bears exist even though they

can’t see them in person) Slide 7

Examples of GE models

• We will mostly work with simple examples

of general equilibrium models.

• One input, two outputs, two consumers

• The 2x2 production model with two

consumers: 2 goods, 2 inputs, 2 consumers

Slide 8

Assumptions for the 2x2

production model

• Two inputs: Capital K, Labor L

• Two consumption goods: private good x, pure

public good G

• Person 1 and person 2 (consumers): strictly

convex indifference curves (decreasing MRS

between goods).

• Producers: strictly convex isoquants (decreasing

marginal rate of technical substitution between

inputs). We also assume that production of the two

goods does not exhibit increasing returns to scale.

Slide 9

Problems society must solve:

• How to allocate the existing stock of capital

and labor efficiently between the production

of good x and the production of good G.

• How to distribute these goods efficiently

among the population once they are

produced.

Slide 10

Consumption Efficiency

• A distribution of goods is consumption

efficient if it is not possible to reallocate

these goods and make at least one person in

the economy better off without making

someone else worse off.

• Given a fixed amount of goods x and G,

both people will always consume the same

amount of the public good G, and hence we

can only make one person better off by

redistributing good x thus making the other

person worse off. Slide 11

Production Efficiency

• An allocation of inputs (K and L) is

production efficient if it is not possible to

reallocate these inputs and produce more of

at least one good in the economy without

decreasing the amount of some other good

that is produced.

Slide 12

Production Efficiency

max f ( L ,K ) + λ ( f ( L − L ,K − K ) − G)

x x x G x x

L x ,K x ,λ

Interior solution :

∂f x ∂f G

−λ =0

∂L x ∂LG

∂f x ∂f G

−λ =0

∂K x ∂K G

G = fG ( L − Lx ,K − K x )

Slide 13

Condition for Interior Production

Efficiency

• A given set of inputs available in an

economy should be allocated across sectors

until the marginal rate of technical

substitution for each pair of inputs is equal

in each sector.

Slide 14

The Production Possibility

Frontier with 2 Inputs

• While the set of Pareto efficient allocations

in the Edgeworth box of production makes

all the efficient input combinations visible,

the PPF gives us all the combinations of

goods that are production efficient.

• The PPF is the value function of the

problem that gives us production efficient

allocations as its solution.

Slide 15

From Edgeworth Box of Production to PPF

capital Good G

x=24,

x=12, G=20 x=30,

G=28 G=10

Good x

Good G labor

28

PPF

20

10

Slide 16

12 24 30 Good x

The Slope of the PPF

• With good x on the horizontal axis and good G on

the vertical axis, the absolute value of the slope of

the PPF represents the Marginal Rate of

Transformation (MRT) of good G for good x; it

indicates how many units of good G the economy

would have to sacrifice (by transferring inputs

from the production of good G to the production

of good x) in order to produce 1 more unit of good

x.

Slide 17

Units of x forgone to produce one

more unit of G

• Similarly, the marginal rate of

transformation (MRT) of good x for good

G, indicates how many units of good x the

economy would have to sacrifice (by

transferring inputs from the production of

good x to the production of good G) in

order to produce 1 more unit of good G.

Slide 18

Product Mix Efficiency

efficiency?

• We can have efficiency in production and in

consumption (trivially satisfied with one private

and one public good), and yet there is still room

for a Pareto improvement, because we are

producing too much of one good and not enough

of the other.

• Product mix efficiency puts together both sides,

consumers and producers. Slide 19

Solving for Pareto Efficient

Allocation

max u1 ( x1,G)

s.t. u2 ( x 2 ,G) = u2

s.t. x1 + x 2 = f x ( Lx ,K x )

s.t. G = f G ( LG ,KG )

s.t. Lx + LG = L

s.t. K x + KG = K

Slide 20

Using PPF, the problem is

max u1 ( x1,G)

s.t. u2 ( x 2 ,G) = u2

s.t. x1 + x 2 = x

s.t. G = G( x )

max u1 ( x1,G(x)) + φ ( u2 ( x − x1,G( x )) − u2 )

x1 ,x,φ

Slide 21

Pareto Efficiency with PG

• First Order Conditions are necessary and

sufficient

∂u1 ∂u2

−φ =0

∂x1 ∂ (x − x1 )

∂u1 ∂G ⎛ ∂u2 ∂u2 ∂G ⎞

+ φ⎜ + ⎟ =0

∂G ∂x ⎝ ∂ (x − x1 ) ∂G ∂x ⎠

Slide 22

Samuelson Condition (1954)

• Combining both equations from previous

slide ∂u1 ∂u2

∂G ∂ G ∂x

+ =−

∂u2 ∂u2 ∂G

φ

∂ (x − x1 ) ∂ (x − x1 )

∂u1 ∂ u2

Since −φ =0

∂x1 ∂ (x − x1 )

and (x − x1 ) = x 2

∂u1 ∂u2

∂G + ∂G = − ∂x

∂u1 ∂u2 ∂G

∂x1 ∂x 2

Slide 23

The Samuelson Condition

MRT tells us

1’s 2’s the marginal

MRS MRS cost of

MRT of x producing the

∂u1 ∂u2

for G public good

to society in

∂G + ∂G = − ∂x terms of the

units of the

∂u1 ∂u2 ∂G private good

society must

∂x1 ∂x 2 sacrifice.

MRS of person i tells us the marginal benefit of G expressed in

units of good x; person i is willing to give up MRS units of

Slide 24

good x for one more unit of G

The Samuelson Condition

• Efficient provision of public goods requires

that the sum of the marginal rate of

substitution of the private good for the

public good across all individuals is equal to

the marginal rate of transformation of the

private good for the public good.

Slide 25

Pareto-efficient conditions for an

economy with public goods

1. Allocate private goods until the point at which the

marginal rate of substitution between any two

private goods is equal and equal to the marginal

rate of transformation between these goods.

2. For efficient production, the marginal rate of

technical substitution of the inputs to production

of all goods must be equal.

3. Wherever public goods exist, the sum of the

marginal rates of substitution (for all people in

society) of private for public goods must equal the

marginal rate of transformation between these Slide 26

goods.

More on efficiency

• In the case of an economy with only private goods, the benefit to

society of the last unit of a private good provided (expressed as the

willingness to forgo units of another good) is equal to the benefit of the

one person in society who receives this last unit. If there are some

people who receive a higher benefit from the last unit than others, we

don’t have Pareto efficiency. Hence, the marginal benefit of a private

good must be the same across all people for the allocation to be

efficient.

• However, in the case of public goods, everybody is forced to consume

the same amount of the public good, but the marginal benefit for each

person of consuming this amount may differ at an efficient allocation.

The marginal benefit to society of providing this amount of public

good is equal to the sum of the marginal benefits received by all

people.

• This implies that the marginal rate of substitution of different members

of society for a public good (in terms of a private good) need not be

the same for efficiency to hold!

Slide 27

Exercise

• Suppose there are 2 consumers, Ara and Bahar,

and two goods, good x and good G. Ara’s utility

function is given by uA(xA, G) =xAG and Bahar’s

utility function is given by uB(xB, G) =xB1/4G3/4.

Both goods are produced with labor and capital

and the PPF is given by G(x) = 8 - x.

Slide 28

Exercise Cont’d

• Suppose Ara receives one unit of good x.

How many units of good x must Bahar

receive and how many units of G should be

produced for the allocation to be Pareto

efficient?

Slide 29

Answer

• We need to ensure that the Samuelson condition is

satisfied.

• MRSAra x for G+ MRSBahar x for G=MRTx for G

• We know that xB = x– 1, G = 8 - x

• xA/(8-x) + 3xB /(8-x) = 1

• 1/(8-x) + 3(x-1) /(8-x) = 1

• -2 +3x=8-x x= 2.5, G = 5.5, xB = 1.5.

Slide 30

Exercise Cont’d

• How does the Pareto efficient product mix

change as we let Ara reach higher levels of

utility?

Slide 31

Answer

max uB ( x B ,G) = x G 1/ 4

B

3/4

s.t. x A G = uA

s.t. x A + x B = x

s.t. G = 8 − x

(8 − x ) + φ (( x − x B )(8 − x ) − uA )

1/ 4 3/4

max x B

x B ,x,φ

Slide 32

Answer

• We need to ensure that the Samuelson

condition is satisfied.

• MRSAra x for G+ MRSBahar x for G = MRTx for G

• We know G = 8-x, and uA = xA(8-x)

• xA/(8-x) + 3xB /(8-x) = 1

• uA/(8-x)2 + 3(uA-8+x) /(8-x)2 = 1

• 4uA -24 + 3x=(8-x)2

Slide 33

Answer

• We find the Pareto efficient amount of x as

a function of uA.

• Implicitly given by

• 4uA - 24 + 3x(uA)=(8-x(uA))2

• And G(uA) = 8 – x(uA).

Slide 34

Answer Ct’d

• From last two equations (totally

differentiated with respect to x and uA)

• dx/duA = 4/(2x+19) >0,

• dG/duA = - 4/(2x+19) <0

• As we want to achieve a higher utility for

Ara, the product mix shifts in favour of

more of the private good and less of the

public good.

Slide 35

Efficient Provision of Public

Goods with Q-linear Prefs

• Let’s assume that both consumers have

quasi-linear utility functions of the form

ui ( x i ,G) = x i + γ i (G)

γ i '> 0,γ i ''< 0.

Slide 36

The Samuelson Condition

∂u1 /∂G ∂u2 /∂G ∂x

+ =−

∂u1 /∂x1 ∂u2 /∂x 2 ∂G

∂x

γ 1 ' (G) + γ 2 ' (G) = −

∂G

Slide 37

Demand for the public good

• Note that if we were to set-up the standard

utility maximization problem for each

consumer, we find pG

γ 1 ' (G) =

px

pG

γ 2 ' (G) =

px

Slide 38

Vertically adding demand

• Suppose px= 1. Then pG = γi’(G)

• For a given y, pG is equal to the amount of

good x the individual is willing to give up

for one more unit of good G.

The Samuelson Condition on LHS in the

case of quasi-linear preferences is adding

individual demands for the public good

vertically.

Slide 39

Price of G/ Marginal

Willingness to pay

γ1’(G1) + γ2’(G1)

γ1’(G1)

Social Marginal Benefit Curve

γ2’(G1)

Demand 2

Demand 1

G1 Public good

Slide 40

Efficient Provision of Public

Good

• We can draw the MRT in the above graph.

It tells us the marginal cost of producing the

public good to society in terms of the units

of the private good society must sacrifice.

• With strictly concave PPF this marginal cost

is increasing; with linear PPF this marginal

cost is constant.

Slide 41

Price of G/ Marginal

Willingness to pay

Social Marginal Cost Curve

Demand 2

Demand 1

Slide 42

Summary

• (Interior) Efficient provision of the public good

requires the Samuelson condition to hold; the sum

of marginal rates of substitution of the private

good for the public good must equal the marginal

rate of transformation.

• With quasi-linear preferences, this condition boils

down to adding individual demand for the public

good vertically and finding its intersection with

the social marginal cost curve.

Slide 43

Competitive Equilibrium

• Now that we understand Pareto efficiency in

a general equilibrium model with

production and a public good, we want to

find out if the competitive equilibrium in

this model is Pareto efficient.

• First discuss what happens in the

competitive equilibrium, then determine

whether it’s Pareto efficient.

Slide 44

What is the correct assumption

about consumer behaviour?

• However, there is a problem, when we discuss

public goods. What is the correct assumption

about consumer behaviour?

• Naïve consumer is not aware of the nature of

public goods and hence treats the good like a

private good.

• A more sophisticated consumer understands the

nature of the public good and wonders how many

units to buy, given that units of the good bought

by other consumers can also be consumed.

Slide 45

Naïve Consumer

• In the first approach, the answer is

straightforward. Each consumer treating

both goods as private will choose to buy the

goods where MRS = price ratio.

• If consumers are price takers, they all face

the same prices and therefore all their

marginal rates of substitution will be equal

in equilibrium.

Slide 46

Production Efficiency

costs. From profit maximization,

MRTS=factor price ratio (because cost

minimization is a necessary condition for

profit maximization).

– If all firms are price takers in the factor

markets, then all firms have equal MRTS.

– The competitive equilibrium satisfies

production efficiency.

Slide 47

Samuelson Condition Violated!

• Firms maximize profits. From profit maximization

of competitive firms (if the number of firms is

sufficiently large) P=MC.

– For any two goods, consumers set MRS=px/pG.

– From profit max a firm produces an amount of x where

px=MCx, and a firm produces an amount of G where

pG=MCG.

– This implies px/pG=MCx/MCG, but MCx/MCG=MRT

and therefore MRS=MRT, not sum of MRS=MRT!

– The competitive equilibrium is not efficient.

Slide 48

Private Contribution to the Public

Good Game

• Next, we consider more sophisticated consumer

behaviour.

• Consumers realize that units of the public good

purchased by other consumers will be available

for their consumption as well as units purchased

by themselves.

• We start with an example in which both

consumers have identical Cobb-Douglas utility

functions.

Slide 49

Exercise: Private Provision vs.

Efficient Provision

• In this exercise we contrast the private

provision of the public good with the

efficient public good provision. We can

think of the private provision as a game:

each person decides how much to contribute

to the public good. In the end all the

contributions collected are used to purchase

the public good (as many units as the

contributions buy).

Slide 50

The model

• Suppose we have two people, person 1 and

person 2 with the following utility function

over a private good (x) and a public good

(G)

ui ( x i ,G) = x i G

α 1−α

incomes of I1, and I2.

Slide 51

Efficient Provision

• (a) Write down the conditions that

describe the set of Pareto efficient

allocations.

• The optimality condition is given by:

∂u1 /∂G ∂u2 /∂G pG

+ =

∂u1 /∂x1 ∂u2 /∂x 2 px

(1− α ) x1 (1− α ) x 2 pG

+ =

αG αG px

px (x1 + x 2 ) + pG G = I1 + I2 Slide 52

Efficient Provision Cont’d

• Solve for the efficient quantity of the public

good G.

• We need the optimality condition and the

joint budget constraint:

(1− α ) x1 (1− α ) x 2 pG

+ =

αG αG px

αpG G

⇒ px ( x1 + x 2 ) =

(1− α )

px (x1 + x 2 ) + pG G = I1 + I2

pG G (1− α )( I1 + I2 ) * α (I1 + I2 )

⇒ = I1 + I2 ⇒ G =

*

,x =

(1− α ) pG px

Slide 53

Equilibrium Private Provision of

the Public Good

• Now suppose both agents try to maximize

their utility given the contribution of the

other agent to the public good. That is, we

want to find each agent’s best response

function.

max x i (G j + Gi ) + λ ( Ii − px x i − pG Gi )

1−α

α

x ,G ,λ

i i

(G )

1−α

α −1

FOCs αx i j + Gi − λpx = 0

( )

−α

……… (1− α ) x G j + Giα

i − λpG = 0

Slide 54

Solving for best response

function

• Want to know what is the optimal amount of

public good purchased by person i if person j

contributes Gj

• So we are looking for a solution Gi(Gj)

• Use FOCs and b.c. to get rid of xi.

αpG

xi =

(1− α ) px (

G j + Gi )

αpG

px

(1− α ) px( )

G j + Gi + pG Gi = Ii

(1− α ) Ii − αpG G j

( )

Gi G j =

pG

Slide 55

Efficient and Private Provision

• Draw a diagram with person 1’s

contribution to the public good on the x-axis

and person 2’s contribution to the public

good on the y-axis.

• We will see in the diagram why the Nash

Equilibrium is not efficient.

• Think about the Cournot Duopoly game.

Slide 56

Nash Equilibrium

• First present analytical results

• Then draw a graph using a symmetric setup

Slide 57

Nash Equilibrium

• Nobody has an incentive to deviate.

(1− α )I1 − αpG G2

G1 =

pG

(1− α )I2 − αpG G1

G2 =

pG

(1− α )( I1 − αI2 ) ( I1 − αI2 )

G1 = =

(1− α 2

) pG (1 + α ) pG

G2 =

( I2 − αI1 )

(1 + α ) pG Slide 58

Nash Equilibrium is not efficient

• Sum up private contributions in NE and

you’ll see they are lower than the efficient

G.

G1 + G2 =

( I1 − αI2 ) ( I2 − αI1 )

+

(1 + α ) pG (1 + α ) pG

(1− α )( I1 + I2 ) * (1− α )(I1 + I2 )

G1 + G2 = <G =

(1 + α ) pG pG

Slide 59

The best response functions

• Price of x =1, price of G = 2, Income of

each person = 200, alpha =1/2

Contribution

of person 2

100

Best response of person 1

50 Nash Equilibrium

Best response of person 2

50 100 Contribution of

Slide 60

person 1

Diagram

Along red line:

efficient amount of

Contribution public good

of person 2

increases better off

than in NE.

50

Utility of

person 2

increases

50 100 Contribution of

Slide 61

person 1

Neutrality result of inefficient

provision of G

• What would happen in the Nash equilibrium if we

were to change the distribution of income between

the two people, leaving their combined income the

same?

• We have seen that the the sum of contributions in

the NE is given by (1− α )( I1 + I2 )

G1 + G2 =

(1 + α ) pG

• A redistribution of income holding combined

income constant does not change the amount of

public good provided. Slide 62

Extra $ all spent on public good

• How come the level of public good does not

change?

• Surely the contribution of both people

changes.

• We can find out by totally differentiating

each person’s equilibrium strategy with

respect to the changes in each person’s

income, such that dI1+dI2 = 0

Slide 63

Poorer contributor reduces, richer

contributor increases contribution

dG1 =

( dI1 − αdI2 ) dI1 + αdI1

= =

1

dI1

(1 + α ) pG (1 + α ) pG pG

dG2 =

( dI2 − αdI1 )

=

1

dI2

(1 + α ) pG pG

Since dI1= - dI2, the increase in contribution due to the

increase in income by one person is offset by the

decrease in the equilibrium contribution by the other

person in the exact same amount. Total level of the

public good is unchanged.

Slide 64

Neutrality Result of Inefficient

Provision

• It can be shown that this neutrality result

holds even if people have different

preferences. They don’t have to be C-D

either. For any utility functions, as long as a

redistribution of income results in both

people contributing privately to the public

good, the total amount of the public good

purchased remains unchanged.

• Bergstrom et al. (1986). Slide 65

Increasing the number of

contributors

• What happens to the level of provision if the

number of contributors increases?

• It is straight forward to analyze a special

case of the previous set-up. Let’s assume we

have n identical individuals facing identical

budget constraints.

• Then the Nash Equilibrium is symmetric:

everybody contributes the same amount.

Slide 66

Increasing the number of

contributors

• To put this more formally,

(1− α )Ii − αpG ∑ j ≠i G j

Gi (∑ j ≠i )

Gj =

pG

G1* = G2* = ... = Gn*

(1− α )Ii − αpG (n − 1)Gi*

Gi* =

pG

(1− α )Ii

G =

*

i

(1 + α (n − 1)) pG Slide 67

Increasing the number of

contributors

• Comparative Statics: change n

for n ≥ 2 :

(1− α )Ii

Gi* =

(1 + α (n − 1)) pG

Individual contributions

∂Gi* −αpG (1− α ) Ii

= <0 decrease with n

∂n (1 + α (n − 1)) pG 2

n (1− α ) Ii Total

G = nGi =

* *

(1 + α (n − 1)) pG contributions

∂G *

= (1− α ) Ii

(1 + α (n − 1)) pG − αpG

= (1− α ) I

(1 + α ( n − 2)) pG

>0

increase

∂n (1 + α (n − 1)) pG

2

(1 + α (n − 1)) pG

2 with n

Slide 68

BBV and increasing n

• Note that BBV look at cases where they

increase n at the same time as they leave

total wealth in society the same. In this case,

it can be shown that more equal distribution

of wealth is lowering the public good

provision (Theorem 5).

• We considered the case of increasing the

number of agents and at the same time

adding Ii to the wealth of the economy with

each agent that we added. Slide 69

BBV and government provision

• BBV also look at the possibility of

government providing some amount of the

public good, while individuals still

contribute voluntarily

• Govt taxes individuals to finance public

good purchases.

• Question of crowding out: Are private

contributions reduced by the same amount

as government contributes? Slide 70

Crowding out

• Theorem 6.

• Assumptions: taxes are collected from

contributors and non-contributors. As

government provides some amount of the

public good, there is less than a dollar for

dollar reduction in private contributions

partial crowding out.

Slide 71

Theorem 6 in detail

• Complete crowding out: taxes collected

from people who contributed before and

taxes are smaller than contribution.

• Partial crowding out if:

– a) some of the contributors are taxed more than

their private contribution

– b) non-contributors are taxed as well as

contributors

Slide 72

Conclusion

• In the presence of public goods, private provision

of public goods is often inefficient.

• We have also encountered the problem of free-

riding: People try to get out of paying for a public

good knowing that if it is paid for by others, they

will still be able to consume the public good.

– Note that while equilibrium contributions may be

greater than zero, we generally expect them to be too

low.

• We will next talk about solutions to the provision

Slide 73

of public goods.

Achieving an Efficient Provision

of Public Goods

• The Demand-Revealing Mechanism or

Groves-Clarke Mechanism

– Exercise to see how the mechanism works

– Weaknesses of the Groves- Clarke Mechanism

Slide 74

Theoretical Solutions to the

Public Good Problem

• People have an incentive to lie about their true

preferences in order to get out of paying for the

public good while they can still benefit from its

consumption.

• We would therefore need a scheme that will give

people an incentive to reveal the truth about their

public good preferences to the government.

• To find such a scheme we will now take a look at

the work of Groves and Clarke.

Slide 75

Edward H. Clarke

• Discovered the demand revealing process as a

University of Chicago graduate student during the

late 1960s. He has written extensively on the

application of demand revealing processes which

were noted in the 1996 Nobel Prize awards in

economics. He is currently a senior economist

with the Office of Management and Budget in the

area of government regulatory management.

Slide 76

The Demand-Revealing

Mechanism

• A demand-revealing mechanism creates the

incentive for people to reveal their public

good preferences in a truthful manner.

• Here is how the demand-revealing

mechanism works.

Slide 77

5 easy steps…

1. A distribution of cost shares is announced.

2. Given these cost shares each person

reports the net benefit from consuming a

certain amount of the public good (net

benefit is equal to total benefit minus cost

share). People may or may not tell the

truth.

Slide 78

More steps

3. Based on their reports in 2, the level of public good that

maximizes the sum of reported net benefits of all people

is provided.

4. Based on their reports in 2, a tax for person 1 is

calculated as follows: Find the sum of net benefits for

each quantity of the public good without person 1. If the

level of public good at which the sum of net benefits

without person 1 is maximized changes from the level

determined in 3, person 1’s tax is equal to the difference

of the sum of net benefits at the new optimal level and

the level determined in 3 without taking person 1’s net

benefit into account for any of the quantities of the

public good.

5. Repeat step 4 for all the other people.

Slide 79

Example

Consider a community comprising three

individuals: Alice, Brenda, and Chip. They have

quasi-linear preferences with the private good

entering their utility functions linearly. A

benevolent planner is undertaking the provision of

a pure public good. The preferences of community

members are given in the following table.

Slide 80

Total Benefit of Public Good

Quantity

1 2 3 4

Person

Alice 60 110 150 180

Brenda 80 120 140 150

Chip 120 200 270 330

• The numbers in the table represent the total

benefits accruing to the person named at left for

the unit numbered above. So for example, Brenda

would receive a total benefit of 120 were two units

of the public good produced instead of one unit.

All terms are in dollars.

Slide 81

Question a)

• Assume that the good can be provided at a

constant marginal cost of $120. What is the

socially efficient level of the good?

Slide 82

Answer a)

• The socially efficient level of the public good

maximizes social net benefit, that is, total social

benefit minus total cost. Because we have only

four choices of quantities, we can directly

calculate the social net benefit (SNetB )and then

pick the quantity of the public good that yields the

highest SNetB.

• More generally, SNetB is maximized, where the

sum of marginal benefits equals the marginal cost.

If we cannot use fractions, then pick the quantity

that has a social marginal benefit closest to but

still greater than marginal cost.

Slide 83

Answer a)

• Finding highest SNetB.

Quantity

P 1 2 3 4

e

r Alice 60 110 150 180

s Brenda 80 120 140 150 SNetB

o highest,

n Chip 120 200 270 330 therfore

SB 260 430 560 660 optimal

Total Cost 120 240 360 480 quantity

is 3

SNetB 140 190 200 180

Slide 84

Answer a) Another way of

determining social optimum

70 60

130 100

• Table gives marginal benefit for each person and

social marginal benefit (add up marginal benefit at

each quantity). At a quantity of 3 we have SMB >

MC but at 4 units we have SMB<MC. Therefore

the efficient amount of the public good is 3 units.

Slide 85

Question b)

• Suppose we announce that all three

members have to share the cost of the public

good equally, that is, everybody pays $40

per unit but there is an extra tax on a person

whenever this person’s net benefit changes

the group decision. Calculate the net benefit

of each person (total benefit minus cost for

each person) and fill in the table below.

Slide 86

Answer b)

Quantity

1 2 3 4

P Alice 20 30 30 20

e

r Brenda 40 40 20 -10

s

Chip 80 120 150 170

o

n SNetB 140 190 200 180

these reports of the three people

Question c)

• Calculate the Groves-Clarke taxes for each

person.

Slide 88

Answer c)

• In the absence of Alice, three units of the public good

would be provided. Because Alice’s valuation of the public

good does not change the group choice, her tax would be

0.

Quantity

P

e

1 2 3 4

r Brenda 40 40 20 -10

s

o Chip 80 120 150 170

n

SNetB 120 160 170 160

these reports of Brenda and Chip Slide 89

Answer c)

• If we do not count Brenda’s marginal benefit, the quantity of the

public good would be four since this maximizes the sum of net

benefit from Alice and Chip. Brenda therefore needs to pay a tax in

the amount of the difference in the sum of net benefits of Alice and

Chip if the quantity of the public good is changed from 4 to 3 units.

That is, Brenda’s tax is equal to 190 –180 = 10.

Quantity

P

e

1 2 3 4

r Alice 20 30 30 20

s

o Chip 80 120 150 170

n

SNetB 100 150 180 190

these reports of Alice and Chip

Answer c)

• Finally, without Chip the quantity would be

2 not 3. Chip needs to pay a tax of

70-50=20.

Quantity

P 1 2 3 4

e

r Alice 20 30 30 20

s

o Brenda 40 40 20 -10

n

SNetB 60 70 50 10

2 units of public good will be picked given Slide 91

these reports of Alice and Brenda

Table with Tax

Quantity

1 2 3 4 Tax

P Alice 20 30 30 20 0

e

r Brenda 40 40 20 -10 10

s

Chip 80 120 150 170 20

o

n SNetB 140 190 200 180

for Alice: 30, for Brenda: 20-10=10, for Chip: 150-20=130.

Slide 92

Question d)

• Brenda is the one who prefers two units to

three units under this payment scheme. Has

she an incentive to lie?

Quantity

1 2 3 4

P Alice 20 30 30 20

e

r Brenda 40 40 20 -10

s

Chip 80 120 150 170

o

n SNetB 140 190 200 180

Slide 93

Answer d)

• Suppose she changes the choice from three

to two units by stating the following net

benefit schedule.

Quantity

1 2 3 4

P Alice 20 30 30 20

e

r Brenda b1 b2 b3 b4

s

Chip 80 120 150 170

o

n SNetB 100+ 150+ 180+ 190+

b1 b2 b3 b4 Slide 94

• We assume 150+b2 is greater than any of the other

sums of net benefits.

• Then only two units will be supplied.

• Brenda is now paying a tax for changing the

quantity from 4 to 2 units: 4 units would be

supplied without her and the difference in net

benefit of the other two is 190-150 = 40.

• This means Brenda’s net benefit from getting two

units is 40 but then she would have to pay a tax of

40, which implies an overall net benefit of 0. This

is lower than if she tells the truth and 3 units of the

public good are provided. Then she receives a net

benefit of 20 minus her tax of 10, that is, 20 –

10=10. Slide 95

No incentive to lie

• Brenda cannot make herself better off if she

lies.

• Note that this is true no matter which lie she

tells as long as the reported values b1, b2, b3,

b4 result in a group choice of 2 units.

• How much Brenda benefits depends on her

true net benefits for the different units and

the reports of all the other people.

Slide 96

Exercise

• Generalize above argument and show that

given the other people’s reports nobody has

an incentive to lie.

Quantity

1 2 3 4

P Alice a1 a2 a3 a4

e

Brenda b1 b2 b3 b4

r

s Chip c1 c2 c3 c4

o SNetB a1+b1 a2+b2 a3+b3 a4+b4

n +c1 +c2 +c3 +c4

Slide 97

Weaknesses of the Groves-

Clarke Mechanism

1. The Groves-Clarke tax doesn’t really generate a Pareto

efficient outcome. The level of the public good will be

optimal, but the private consumption could be greater.

We are taking away money from the people by imposing

the tax that they otherwise could spend on private

consumption (see Brenda’s and Chip’s situation). These

taxes have to be taken away completely, i.e. the money

collected through Groves-Clarke taxes would have to be

destroyed. On the other hand, the more people are

involved in the decision making process the less likely it

is that their valuation of the public good will change the

group decision. In this case Groves-Clarke taxes will

only rarely be collected.

Slide 98

Weaknesses of the Groves-

Clarke Mechanism

• There are equity and efficiency tradeoffs. While

it is efficient to supply the level of the public

good determined by the Groves- Clarke

mechanism, there are some people who might be

strictly worse off with this level of public good

than with a different amount (Brenda and Chip).

The Groves- Clarke mechanism implements a

solution that is potentially a Pareto improvement

over the private provision of public goods, but

we cannot compensate the losers to achieve an

actual Pareto-improvement.

Slide 99

Weaknesses of the Groves-

Clarke Mechanism

• Another weaknesses of the Groves- Clarke

mechanism is that it only is strategy-proof

(people have incentive to report truthfully)

if they have quasi-linear utility functions.

Slide 100

How does the government decide

on the level of Public Good?

of general revenues which are raised

independently of how people feel about

public goods levels (by and large)

Slide 101

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