Economics of the Public Sector

Lecture 5: Public Goods

Alfa Farah

Department of Economics
Diponegoro University

The 2nd Semester of 2019/2010

Focus Questions
1. What distinguishes public goods—those that are typically
provided by governments—from privately provided goods?
What do economists mean by pure public goods ?
2. Why will private markets undersupply pure public goods?
What is the free rider problem?
3. What are the special characteristics and challenges of global
public goods?
4. Why do governments provide goods that are not pure public
goods?
5. What determines an efficient supply of pure public goods?
How is the efficient supply affected by concerns about income
distribution? How is it affected by the fact that taxes required
to pay for the public good typically introduce distortions in
the economy?
6. In what sense is efficient government a public good?
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Pure public goods

Two main properties of pure public goods

I Non-Excludability It is impossible to exclude individuals from
enjoying the benefits of the goods
I Non-Rivalry The marginal cost of an additional individual
enjoying the good is zero (non-rival consumption). It is
undesirable to exclude individuals from enjoying the benefits
of the goods since their enjoyment of these goods does not
detract from the enjoyment of others

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 There are two basic forms of market failure associated with public
goods: underconsumption and undersupply
I In the case of non-rival goods, exclusion is undesirable
because it results in underconsumption
I The marginal benefit is positive; the marginal cost (of the
extra person watching the show) is zero.
I The underconsumption ia a form of efficiencs
I Without exclusion of these non-rival goods, however, there is
the problem of undersupply
I There is no incentive for supplying the good

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Paying for Public Goods

I If exclusion is possible, even if consumption is non-rival,

government might charge fee to those who benefit from public
goods ⇒ User Fee
I Example: Toll roads
I However, since the marginal cost of usage is zero (non-rival),
efficiency requires that the price should be zero.
I Charging a user fee leads to underconsumption and, thus,
inefficiency

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Paying for Public Goods
Charging a user fee leads to underconsumption.

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Free Riders
I Free Rider Problem the reluctance of individuals to
contribute voluntarily to the support of Public Goods
I This applies particularly when a good is non-excludable (such
as national defense), making the price system unfeasible

Example:Assume that everyone valued national defense, but

the government did not provide for it. Could a private firm
enter to fill this gap? To do so, it would have to charge for the
services it provided. However, because all individuals would
believe that they would benefit from the services provided
regardless of whether they contributed to the service, they
would have no incentive to pay for the services voluntarily
I Since charging a price to ration public goods is infeasible,
public goods are not likely to be provided privately
I There are few cases when non-excludable goods are privately
provided. This generally leads to undersupply (Example: light
house)
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Pure and Impure Public Goods

I Pure Public Goods: the marginal costs of providing them to

an additional individual are strictly zero and it is impossible to
exclude individuals from enjoying them. (i.e. national defense)
I Impure Public Goods: the marginal costs of providing them
to an additional individual is small, but not zero, and it is
possible, though it can be difficult or expensive, to exclude
individuals from enjoying them (or charge people to use
them). (i.e. the highway).

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Pure and Impure Public Goods

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Pure and Impure Public Goods

I For many goods it’s not whether or not the feasibility of

rationing (excludability), but rather the cost of doing so.
Costs of exclusion tend to be small for private goods, but they
may be large (even prohibitively so) for some publicly provided
goods
I Externalities can be viewed as a form of impure Public Goods,
in that whenever someone purchases more of a good with an
externality, others increase their consumption of said
externality (though in different levels and attributing them
different values)
I Accordingly, public goods can be seen as a form of extreme
externalities (everyone’s consumption increases equally)

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Pure and Impure Public Goods

I Local Public Goods the benefits of these are only enjoyed

locally, by those living in a particular community (ie: local
police security)
I Global Public Goods the benefits of these can affect anyone
in the world. (i.e. global environment, global health,...)
I Whenever there is a public good, there is a need for
collective actionn that is, individuals and firms acting
privately will result in an undersupply of the public good.
I No global government that provides for global public goods!

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Publicly Provided Private Goods

I Publicly Provided Private Goods are publicly provided

goods for which there is a large marginal cost associated with
supplying additional individuals (rival). Example: education
and health service
I Two rationales for their public provision
1. The costs of running a market would be high (and these goods
should be non-exclusive, in the case of education, for instance)
2. Distributive considerations/equity

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Distortion associated with Supplying Goods Freely

I If a private good is provided

freely, there is likely to be
overconsumption.
I Because individuals do not
have to pay for the good,
they will demand it until
the point at which the
marginal benefit they
receive from the good is
zero, in spite of the fact
that there is a positive
marginal cost associated
with providing it.

MC (Q) = P = 0

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Rationing Publicly Provided Private Goods
I It may be more efficient to provide the goods publicly, for
example in the case of high transaction costs, e.g. insurance
market

I Government compares
I The savings in transactions costs plus the gain from increasing
consumption Qe to Qo
I The loss from the excessive consumption (the shaded area
EFQ) and the loss from the distortions created by any taxes
required to finance the goods
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Rationing Publicly Provided Private Goods

I Given the inefficiencies arising from overconsumption when no

charges are imposed for publicly provided private goods,
governments often try to find some way of limiting
consumption ⇒ Rationing System (any method of
restricting consumption of a good)
I Three Methods of Rationing Publicly Provided Goods:
1. User Charges
I Advantages: those who benefit bear the costs
I Disadvantages: results in underconsumption; Administering
Pricing System adds transaction costs

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Rationing Publicly Provided Private Goods

2. Uniform provision: supplying the same quantity of the good to

everyone
I Advantages: saves on transaction costs
I Disadvantages: leads some to underconsume and others to
overconsume; high demanders may supplement public
consumption, increasing total transaction costs
3. Queuing: rather than charging individuals money for access to
the publicly provided goods or services, the government
requires that they pay a cost in waiting time
I Advantages: goods (like health care) allocated not necessarily
on basis of who is wealthiest
I Disadvantages: alternative basis of allocation (who has time
to spare); may be undesirable; time is wasted

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Distortion in Uniform Provision

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Efficiency Conditions for Public Goods
I Are public goods too much or too little?
I Pareto efficiency requires that a public good be supplied up to
the point at which the sum of the marginal rates of
substitution (over all individuals) is equal to the marginal rate
of transformation
I The sum MRS: how much of the private good all the members
of society together are willing to give up to get one more unit
of the public good, which will be consumed jointly by all.
I MRTS: how much of the private good must be given up to get
one more unit of the public good
I Efficiency requires that the total amount individuals are willing
to give up must equal the amount that they have to give up

The Samuelson Condition

n
X
MRSi = MRTS
i=1

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Demand Curves for Public Goods

I Individual preferences
I Individual tax price is
p
I Individual budget
constraint

C + pG = Y

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Demand Curves for Public Goods

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Efficient Production of Public Goods

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Distortionary Taxation and Efficient Production of Public Goods

I The feasibility curve gives the maximum output

(consumption) of private goods for any level of public goods,
taking into account the inefficiencies that arise from the taxes
that must be imposed to raise the requisite revenue.
I Because it becomes more costly to obtain public goods when
taxation imposes distortions, normally this will imply that the
efficient level of public goods is smaller than it would have
been with nondistortionary taxation
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Efficient Government as A Public Goods

I “Good government” possesses both of the properties of public

goods (non-rivalry and non-excludability)
I If the government is able to become more efficient and reduce
taxes without reducing the level of government services,
everyone benefits.
I The politician who succeeds in doing this may get some
return, but this return is only a fraction of the benefits that
accrue to others.
I In particular, those who voted against the politician who
succeeds in doing this gain as much as those who worked for
the politician’s election, and the individual who did not vote,
who attempted to free ride on the political activities of others,
benefits as much as either.

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