Public Eco Ppts

References:
Mueller: Public Choice

Hal Varian: intermediate Micro
Myles: Public Economics
Stealing As Prisoners’ Dilemma
Do Not Confess
B
A Confess
Do Not 1. 4.
Row Player’s
Confess (10,9) ( 7,11)
Preference:
2>1>3>4 Confess 2. 3.
(12,6) (8,8)
Public Good and Game of Chicken
D Contribute Do Not
G Contribute
Row Player’s
Preference: Contribute 1. 4.
2>1>4>3 (3, 3) (2, 3.5)
Do Not 2. 3.
Contribute (3.5, 2) (1, 1)
If D knows that G would much rather pay full cost and have the
fence than not have it at all – he is likely to ‘pre-commit’ and say
he doesn’t need the fence and will not pay.
Since D knows that G will anyways build the fence irrespective
of whether he contributes or not then D has no incentive to reveal
his true preference – D can act as FREE RIDER!
G too has a similar incentive to not reveal his true preference.
Cost sharing may not occur & danger is that fence may NOT
get built –
MARKET FAILURE DUE TO FREE RIDER PROBLEM!
EXAMPLE 2
In a building a fire department is supported voluntarily –

Individual X may refuse to pay
If fire breaks out in the house of X – fire will be extinguished –
even though X has not paid for supporting the fire system
It is feasible to exclude A but not desirable.
If A know this – there is no incentive for X to pay – X is a
‘FREE RIDER’
Free Rider problem occurs because Public Goods

have the properties of NON RIVAL CONSUMPTION
EXAMPLE 3
A Congested Highway
The cost of an additional vehicle is high
Greater wear and tear of road – greater waiting time for the
others already on the road – greater pollution – greater chance
of accident
But cost of exclusion is high – we have to keep someone to
collect the toll – his salary will have to be paid
Here it is desirable to exclude but not feasible !
MC of use
Impure Public Goods - Pure Private Good -
Congested Highway Health service
Pure Public Good - Impure Public Goods -

NATIONAL DEFENCE Fire Protection
Ease of Exclusion
Markets Fail in the Presence of Public Goods.

Externality
Externalities arise whenever the actions of one economic agent make
another economic agent worse or better off, yet the first agent neither bears
the costs nor receives the benefits of doing so.
Example: a steel plant that pollutes a river used for recreation
Externalities are one example of market failure
Externalities present a classic justification for government intervention

Rationale for State Intervention is provided in FIRST of the
TWO FUNDAMENTAL THEOREMS OF WELFARE ECONOMICS
First Theorem States… IF
households and firms act perfectly competitively, taking prices as parametric,
there is a full set of markets, and
there is perfect information,
then a competitive equilibrium, if it exists, is Pareto-efficient.

A Pareto Efficient Allocation can be described as an allocation where:
 There is no way to make all people better off or

 There is no way to make some people without making someone else worse off or
 All gains from trade have been exhausted or
 There are no mutually advantageous trades to be made
The first theorem guarantees that a competitive market will exhaust all of the gains
from trade – an equilibrium allocation achieved by a set of competitive markets
will necessarily be Pareto efficient.
Such an allocation may not have any other desirable properties but will necessarily
be EFFICIENT
In particular, the first theorem says nothing about distribution of economic

benefits. The market equilibrium might not be “JUST” but is necessarily EFFICIENT.
Let us start at the initial endowment, W, and imagine A selling
each unit of good 1 to B at a different price—the price at which B The First Welfare Theorem says that
is just indifferent between buying or not buying that unit of the the equilibrium in a set of competitive
good. Thus, after A sells the first unit, B will remain on the same markets is Pareto efficient.
indifference curve through W.
Then A sells the second unit of good 1 to B for the maximum

price he is willing to pay. This means that the allocation moves
further to the left, but remains on B’s indifference curve through
W.
Agent A continues to sell units to B in this manner, thereby

moving up B’s indifference curve to find her—A’s—most
preferred point, denoted by an X in Figure
It is easy to see that such a point must be Pareto efficient. Agent

A will be as well-off as possible given B’s indifference curve. At
such a point, A has managed to extract all of B’s consumer’s
surplus: B is no better off than he was at his endowment.
What about the other way around?
Given a Pareto efficient allocation,
can we find prices such that it is a
market equilibrium? It turns out
that the answer is yes, under
certain conditions. The argument
is illustrated in the Figure
Let us pick a Pareto efficient allocation.

Then we know that the set of
allocations that A prefers to her current
assignment is disjoint from the set that
B prefers. This implies of course that
the two indifference curves are tangent
at the Pareto efficient allocation. So let
us draw in the straight line that is their
common tangent, as in Figure
Can the construction of such a budget
line always be carried out? Un-
fortunately, the answer is no. Figure
here gives an example
Here the illustrated point X is Pareto

efficient, but there are no prices at which
A and B will want to consume at point X.
The most obvious candidate is drawn in

the diagram, but the optimal demands of
agents A and B don’t coincide for that
budget.
Agent A wants to demand the bundle Y,

but agent B wants the bundle X—
demand does not equal supply at these
prices.
The difference between the two Figures is that the preferences in
first Figure are convex while the ones in second Figure are not.
If the preferences of both agents are convex, then the common

tangent will not intersect either indifference curve more than
once, and everything will work out fine.
This observation gives us the Second Theorem of Welfare

Economics: if all agents have convex preferences, then there will
always be a set of prices such that each Pareto efficient
allocation is a market equilibrium for an appropriate assignment
of endowments.
Implications of the First Welfare Theorem
Let us consider the First Welfare Theorem. This says that any competitive equilibrium is Pareto
efficient. There are hardly any explicit assumptions in this theorem—it follows almost entirely from
the definitions. But there are some implicit assumptions.
One major assumption is that agents only care about their own consumption of goods, and not
about what other agents consume. If one agent does care about another agent’s consumption, we
say that there is a consumption externality. We shall see that when consumption externalities are
present, a competitive equilibrium need not be Pareto efficient.
To take a simple example, suppose that agent A cares about agent B’s consumption of cigars. Then
there is no particular reason why each agent choosing his or her own consumption bundle at the
market prices will result in a Pareto efficient allocation. After each person has purchased the best
bundle he or she can afford, there may still be ways to make both of them better off—such as A
paying B to smoke fewer cigars.
Another important implicit assumption in the First Welfare Theorem is that agents
actually behave competitively. If there really were only two agents, as in the Edgeworth box
example, then it is unlikely that they would each take price as given. Instead, the agents would
probably recognize their market power and would attempt to use their market power to
improve their own positions. The concept of competitive equilibrium only makes sense when
there are enough agents to ensure that each behaves competitively.
Finally, the First Welfare Theorem is only of interest if a competitive equilibrium actually
exists. As we have argued above, this will be the case if the consumers are sufficiently small
relative to the size of the market.
Given these provisos, the First Welfare Theorem is a pretty strong result: a private market,
with each agent seeking to maximize his or her own utility, will result in an allocation
that achieves Pareto efficiency. The importance of the First Welfare Theorem is that it
gives a general mechanism—the competitive market—that we can use to ensure Pareto
efficient outcomes.
The First Welfare Theorem shows that the particular structure of competitive markets has the
desirable property of achieving a Pareto efficient allocation.
Implications of the Second Welfare Theorem
The Second Theorem of Welfare Economics asserts that under certain conditions,
every Pareto efficient allocation can be achieved as a competitive equilibrium.
The Second Theorem is concerned with the converse of the First and its focus can
be summarized as follows:
Given a Pareto optimum, can a competitive economy be constructed for which the
Pareto optimum is a competitive equilibrium? In terms of an Edgeworth box, the
same question can be formulated as asking whether it is possible to decentralize all
points on the contract curve. Using the diagram, it can be seen that this is possible
in an exchange economy if the households’ indifference curves are convex. With
convexity, the common tangent at a Pareto optimum provides the equilibrium
prices. To decentralize the economy, a point on this budget line is chosen as the
initial endowment point.
The Second Theorem has important policy implication:
In designing policy, it is almost certain that a policy maker would wish to achieve a
Pareto optimum, otherwise welfare could be increased at no cost.
The theorem demonstrates that the objective of the policy maker can be achieved by
making the economy competitive selecting the equilibrium that is to be decentralized
and providing each household with sufficient income to afford their allocation.
The only policy instrument employed is a lump-sum redistribution of endowments to

ensure that each household has the required income.
Lump Sum Transfers (LST)
The strong implications of the Second Theorem for policy design have already been noted.
However, the practical value of the Second Theorem is dependent on the possibility of making
the lump-sum transfers of endowments that it requires. Without recourse to such transfers, the
decentralizations would not be possible.
The exchange economy illustrated in

Figure makes clear the role and nature of
lump-sum transfers.
The initial endowment point is denoted ω

and the Pareto optimum at point e is to be
decentralized. This requires the
endowment point to be moved to a point
on the budget line through e.
Assume that the new endowment point 𝜔′ leaves the distribution of
good 2 constant. This move can be supported by the transfer of 𝑥෤11 units
of good 1 from household 1 to household 2. Trading from 𝜔′ will lead to
the competitive equilibrium at e as required.
Such a transfer of part of an endowment from one household to another

is the most basic form of a lump-sum transfer.
The lump-sum nature of the transfer is due to the fact that neither
household can alter the size of the transfer by changes in their behavior;
there is simply no scope for such changes in the economy described.
The transfer is an optimal transfer if the resulting equilibrium at e maximizes

the policy maker’s objective function.
If at the equilibrium e the prices of the two goods are p1 and p2, then the value of
the transfer in Figure is p 1𝑥෤11 . The notional income of household 1 prior to
taxation is
𝑀1 = 𝑝1 𝜔11 + 𝑝2 𝜔12
Now, rather than actually redistributing quantities of the goods, the government
could tax household 1 an amount which reduces the income to:
and give household 2 an amount of income

If it is intended that the equilibrium be attained at e then T1 is the optimal lump-sum tax on
household 1 and −T1 is the optimal tax on 2, as this pair of taxes ensures the households face the
budget line through e.
The important point of this reinterpretation is that the tax scheme consisting of the taxes {T1,−T1} is
equivalent in its effect to the original transfer of endowment {−𝑥෤11 ,𝑥෤11 }.
This equivalence demonstrates that it is possible to view the transfers needed to achieve the
decentralizations as taking the form of either real transfers of goods between households or as
transfers of income in the form of lump-sum taxes. This description of lump-sum taxes can be easily
generalized to an H household economy in which a chosen equilibrium would be decentralized by a
vector of lump-sum taxes.
Since these taxes sum to zero, they represent
a simple redistribution of resources.
Lump-sum taxes have a central role in public economics due to their efficiency in achieving
distributional objectives.
It should be clear from the discussion above that the economy’s total endowment is not reduced by
the application of the lump-sum taxes. This point applies to lump-sum taxes in general.
As households cannot affect the level of the tax by changing their behavior, lump- sum taxes do not
lead to any inefficiency.
There are no resources lost due to the imposition of lump-sum taxes and redistribution is achieved
with no efficiency cost.
Having identified the nature and value of optimal lump-sum taxes, the question of their applicability
is now considered.
In practice, the endowment of most households is simply their future labour supply.
Given this, it would be impossible to conduct lump-sum transfers of endowments as a

quantity of future labour cannot be transferred from one household to another without the
reintroduction of slavery.
It is therefore possible to dismiss the idea of transferring quantities of goods, except in

very particular and inconsequential cases, and to focus upon the design of optimal lump-
sum taxes.
In order for a transfer, or tax, to be lump-sum the household involved must not be able to
affect the size of the transfer by changing their behavior.
It is clear that lump-sum taxes can be used, for example by taxing each household some fixed
amount a lump-sum tax is imposed.
Setting aside minor details, this was effectively the case of the U.K. poll tax.
This example motivates the following important observation. The efficiency of lump-sum
taxation rests partly on the fact that their imposition is costless but this was far from the case
with the U.K. poll tax.
In fact, the difficulties of actually collecting and maintaining information on the residential
address of all households made the imposition of a uniform lump-sum tax prohibitively
expensive.
Therefore, although the structure of lump-sum taxes makes them appear deceptively simple to
collect, this may not be the case in practice since the tax base, people, is highly mobile and
evasive.
However, the costs of collection are only part of the issue. What is the primary concern here is
the use of optimal lump-sum taxes - Optimality requires the tax to be based on all relevant
economic characteristics and households must not be able to alter these characteristics in
response to the taxes.
It may be possible to differentiate lump-sum taxes according to sex, age or eye-colour for instance,
but these are unlikely to be the relevant characteristics on which to base the tax.
For the exchange economy examples, the characteristics were the endowments and preferences of
the households.
More generally they may be the expected future labour incomes of the households or the
determinants of each household’s human capital.
Such characteristics are unlikely to be directly observable by the government and either it must
either rely on households honestly reporting their characteristics or the characteristics must be
inferred from the actions of households.
In the latter case, there is invariably scope for changes in market behavior, which implies the taxes
are no longer lump-sum.
When reports are the sole source of information, unobserved characteristics cannot form a basis for
taxation unless the tax scheme is such that there is an individual gain to truthful revelation.
As an example of the interaction between taxes and reporting, consider the following.
Let the system of lump-sum taxes be based on the characteristic IQ level.
If the level of tax was inversely related to IQ and if all households had to complete IQ tests, then the tax
system would not be manipulated since the incentive would always be to maximize the score on the test.
In contrast, if taxes were positively related to IQ, a testing procedure could easily be manipulated and the
mean level of tested IQ would be expected to fall considerably. This indicates the potential for mis-
revelation of characteristics.
These ideas have been developed formally by Mirrlees (1986) who presents theorems on the (im)
possibility of designing non-manipulable lump-sum tax schemes. The central theorem considers a
population of households who each have the utility function
Uh =Uh (c1xh1,..., cnxhn)

The households vary, however, in the values of the constants c = (c1,...,cn) that appear in the utility
function.
The preferences of each household are fully described by their c vector.
Since the cs are the only differentiating characteristic between households, any optimal set of lump
sum taxes must be based on these characteristics.
Now assume that the government cannot observe the c vectors, that households only truly report
their characteristics when they do not lose by doing so and that misrepresentation can only take
place by a household claiming that the values of the characteristics are above their true values.
With this formulation, a tax policy T = T (c) conditional on the characteristics can only be
administered, in the sense that it generates truthful revelation from the households, if the final
utility allocation generated by the taxes is non-increasing in c.
U h = U h (T (c)) = 𝑈 h (c)
The Mirrlees theorem shows that
𝑈h (c) will be increasing in ci with the optimal tax policy if good i is normal.
Since some goods must be normal, the policy optimal policy cannot be administered.
Externalities: Problems and Solutions
1
OUTLINE
1. Externality Theory
2. Private-Sector Solutions to Negative Externalities
3 Public-Sector Remedies for Externalities
4 Distinctions Between Price and Quantity Approaches to

Addressing Externalities
5 Conclusion
2
EXTERNALITIES: PROBLEMS AND SOLUTIONS
Market failure: A problem that violates one of the assump-

tions of the 1st welfare theorem and causes the market econ-
omy to deliver an outcome that does not maximize efficiency
Externality: Externalities arise whenever the actions of one

economic agent make another economic agent worse or better
off, yet the first agent neither bears the costs nor receives the
benefits of doing so:
Example: a steel plant that pollutes a river used for recreation
Externalities are one example of market failure
3
EXTERNALITY THEORY: ECONOMICS OF
NEGATIVE PRODUCTION EXTERNALITIES
Negative production externality: When a firm’s production

reduces the well-being of others who are not compensated by
the firm.
Private marginal cost (PMC): The direct cost to producers

of producing an additional unit of a good
Marginal Damage (MD): Any additional costs associated

with the production of the good that are imposed on others
but that producers do not pay
Social marginal cost (SMC = PMC + MD): The private

marginal cost to producers plus marginal damage
Example: steel plant pollutes a river but plant does not face
any pollution regulation (and hence ignores pollution when
deciding how much to produce)
4
5.1
Externality Theory
Economics of Negative Production Externalities
Chapter 5 Externalities: Problems and Solutions
© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber 6 of 33
EXTERNALITY THEORY: ECONOMICS OF
NEGATIVE CONSUMPTION EXTERNALITIES
Negative consumption externality: When an individual’s

consumption reduces the well-being of others who are not
compensated by the individual.
Private marginal cost (PMB): The direct benefit to con-

sumers of consuming an additional unit of a good by the con-
sumer.
Social marginal cost (SMB): The private marginal benefit

to consumers plus any costs associated with the consumption
of the good that are imposed on others
Example: Using a car and emitting carbon contributing to

global warming
6
5.1
Externality Theory
Negative Consumption Externalities
 A P P L I C A T I O N
The Externality of SUVs

  The typical driver today is in a car that weighs 4,089 pounds. The major culprits
in this evolution of car size are sport utility vehicles (SUVs) with an average
weight size of 4,500 pounds.
  The consumption of large cars such as SUVs produces three types of negative
externalities:
  Environmental Externalities:
  The contribution of driving to global warming is directly proportional to the
amount of fossil fuel a vehicle requires to travel a mile. SUV drivers use more gas
to go to work or run their errands, increasing fossil fuel emissions.
  Wear and Tear on Roads:
  Each year, federal, state, and local governments spend $33.2 billion repairing our
roadways. Damage to roadways comes from many sources, but a major culprit is
the passenger vehicle, and the damage it does to the roads is proportional to
vehicle weight.
  Safety Externalities:
  One major appeal of SUVs is that they provide a feeling of security because they
are so much larger than other cars on the road. Offsetting this feeling of security is
the added insecurity imposed on other cars on the road.
EXTERNALITY THEORY: POSITIVE
EXTERNALITIES
Positive production externality: When a firm’s production

increases the well-being of others but the firm is not compen-
sated by those others.
Example: Beehives of honey producers have a positive impact

on pollination and agricultural output
Positive consumption externality: When an individual’s con-

sumption increases the well-being of others but the individual
is not compensated by those others.
Example: Beautiful private garden that passers-by enjoy seeing
8
5.1
Externality Theory
Positive Externalities
EXTERNALITY THEORY: MARKET OUTCOME IS
INEFFICIENT
With a free market, quantity and price are such that P M B =

P MC
Social optimum is such that SM B = SM C
⇒ Private market leads to an inefficient outcome (1st welfare

theorem does not work)
Negative production externalities lead to over production
Positive production externalities lead to under production
Negative consumption externalities lead to over consumption
Positive consumption externalities lead to under consumption

10
EXTERNALITY THEORY: GRAPHICAL ANALYSIS
One aspect of the graphical analysis of externalities is knowing

which curve to shift, and in which direction. There are four
possibilities:
• Negative production externality: SMC curve lies above PMC curve
• Positive production externality: SMC curve lies below PMC curve
• Negative consumption externality: SMB curve lies below PMB curve
• Positive consumption externality: SMB curve lies above PMB curve
The key is to assess which category a particular example fits

into. First, you must assess whether the externality is associ-
ated with producing a good or with consuming a good. Then,
you must assess whether the externality is positive or negative.
11
PRIVATE-SECTOR SOLUTIONS TO NEGATIVE
EXTERNALITIES
Key question raised by Ronald Coase (famous Nobel Prize

winner Chicago libertarian economist):
Are externalities really outside the market mechanism?
Internalizing the externality: When either private negotia-

tions or government action lead the price to the party to fully
reflect the external costs or benefits of that party’s actions.
12
PRIVATE-SECTOR SOLUTIONS TO NEGATIVE
EXTERNALITIES: COASE THEOREM
Coase Theorem (Part I): When there are well-defined prop-

erty rights and costless bargaining, then negotiations between
the party creating the externality and the party affected by
the externality can bring about the socially optimal market
quantity.
Coase Theorem (Part II): The efficient solution to an exter-

nality does not depend on which party is assigned the property
rights, as long as someone is assigned those rights.
13
COASE THEOREM EXAMPLE
Firms pollute a river enjoyed by individuals. If firms ignore

individuals, there is too much pollution
1) Individuals owners: If river is owned by individuals then

individuals can charge firms for polluting the river. They will
charge firms the marginal damage (MD) per unit of pollution.
Why price pollution at MD? Because this is the equilibrium

efficient price in the newly created pollution market.
2) Firms owners: If river is owned by firms then firm can

charge individuals for polluting less. They will also charge
individuals the MD per unit of pollution.
Final level of pollution will be the same in 1) and 2)

14
5.2
Private-Sector Solutions to Negative Externalities
The Solution
THE PROBLEMS WITH COASIAN SOLUTIONS
In practice, the Coase theorem is unlikely to solve many of the

types of externalities that cause market failures.
1) The assignment problem: In cases where externalities

affect many agents (e.g. global warming), assigning property
rights is difficult ⇒ Coasian solutions are likely to be more
effective for small, localized externalities than for larger, more
global externalities involving large number of people and firms.
2) The holdout problem: Shared ownership of property

rights gives each owner power over all the others (because
joint owners have to all agree to the Coasian solution)
As with the assignment problem, the holdout problem would

be amplified with an externality involving many parties.
16
THE PROBLEMS WITH COASIAN SOLUTIONS
3) The Free Rider Problem: When an investment has a

personal cost but a common benefit, individuals will underin-
vest (example: a single country is better off walking out of
Kyoto protocol for carbon emission controls)
4) Transaction Costs and Negotiating Problems: The

Coasian approach ignores the fundamental problem that it is
hard to negotiate when there are large numbers of individuals
on one or both sides of the negotiation.
This problem is amplified for an externality such as global

warming, where the potentially divergent interests of billions
of parties on one side must be somehow aggregated for a
negotiation.
17
THE PROBLEMS WITH COASIAN SOLUTIONS:
BOTTOM LINE
Ronald Coase’s insight that externalities can sometimes be

internalized was useful.
It provides the competitive market model with a defense against

the onslaught of market failures.
It is also an excellent reason to suspect that the market may

be able to internalize some small-scale, localized externalities.
It won’t help with large-scale, global externalities, where only

a “government” can successfully aggregate the interests of all
individuals suffering from externality
18
PUBLIC SECTOR REMEDIES FOR
EXTERNALITIES
The Environmental Protection Agency (EPA) was formed in

1970 to provide public-sector solutions to the problems of ex-
ternalities in the environment.
Public policy makers employ two types of remedies to resolve

the problems associated with negative externalities:
1) price policy: corrective tax or subsidy equal to marginal

damage per unit
2) quantity regulation: government forces firms to produce

the socially efficient quantity
19
5.3
Public-Sector Remedies for Externalities
Corrective Taxation
5.3
Public-Sector Remedies for Externalities
Subsidies
PUBLIC SECTOR REMEDIES FOR
EXTERNALITIES: REGULATION
In an ideal world, Pigouvian taxation and regulation would be

identical. Because regulation appears much more straightfor-
ward, however, it has been the traditional choice for addressing
environmental externalities in the United States and around
the world.
In practice, there are complications that may make taxes a

more effective means of addressing externalities.
22
5.4
Distinctions Between Price and Quantity
Approaches to Addressing Externalities
Basic Model
MODEL WITH HETEROGENEOUS COSTS
Assume MD of pollution is $1 per unit of pollution
2 firms with low (L) or high (H) cost of pollution reduction q:
cH (q) = 1.5q 2 ⇒ M CH (q) = c0H (q) = 3q
cL(q) = .75q 2 ⇒ M CL(q) = c0L(q) = 1.5q

With no taxes, no regulations, firms do qL = qH = 0
Social welfare maximization:
V = max q H + q L − cH (q H ) − cL(q L) ⇒
qH ,qL
M CH = 1, M CL = 1 ⇒ q H = 1/3, q L = 2/3
Optimum outcome is to have the low cost firm do more pol-
lution reduction than the high cost firm
24
TAX VERSUS REGULATION SOLUTION
Socially optimal outcome can be achieved by $1 tax per unit

of pollution (same tax across firms):
Firm H chooses qH to maximize q H − cH (q H ) ⇒ M CH = 1
Firm L chooses qL to maximize q L − cL(q L) ⇒ M CL = 1
Uniform quantity regulation q H = q L = 1/2 is not efficient

because firm H has higher M C of polluting than firm L:
Proof: Firm H would be happy to pay firm L to reduce q L and

increase q H to keep q L + q H = 1, firm L is happier and society
has same level of pollution
25
Quantity Regulation with Trading Permits
Suppose start with quantity regulation q0H = q0L = 1/2 and

allow firms to trade pollution reductions as long as q H +q L = 1
Generates a market for pollution reduction at price p
Firm H maximizes pq H − cH (q H ) ⇒ M CH = p and q H = p/3
Firm L maximizes pq L − cL(q L) ⇒ M CL = p and q L = 2p/3
⇒ q H + q L = p. As 1 = q0L + q0H = q H + q L, in equilibrium p = 1

and hence qH = 1/3 and qL = 2/3
Final outcome qH , qL does not depend on initial regulation

q0H , q0L
Quantity regulation with tradable permits is efficient as long

as total quantity q0L + q0H = 1
26
5.4
Multiple Plants with Different Reduction Costs
MULTIPLE PLANTS WITH DIFFERENT
REDUCTION COSTS
Policy Option 1: Quantity Regulation (not efficient unless

quantity can be based on actual reduction cost for each firm)
Policy Option 2: Price Regulation Through a Corrective Tax

(efficient)
Policy Option 3: Quantity Regulation with Tradable Permits

(efficient)
28
CORRECTIVE TAXES VS. TRADABLE PERMITS
Two differences between corrective taxes and tradable permits

(carbon tax vs. cap-and-trade in the case of CO2 emissions)
1) Initial allocation of permits: If the government sells them

to firms, this is equivalent to the tax
If the government gives them to current firms for free, this is

like the tax + large transfer to initial polluting firms.
2) Uncertainty in marginal costs: With uncertainty in costs

of reducing pollution, tax cannot target a specific quantity
while tradable permits can ⇒ two policies no longer equivalent.
Taxes preferable when MD curve is flat. Tradable permits are

preferable when MD curve is steep.
29
5.4
Uncertainty About Costs of Reduction
5.4
Uncertainty About Costs of Reduction
CONCLUSION
Externalities are the classic answer to the “when” question

of public finance: when one party’s actions affect another
party, and the first party doesn’t fully compensate (or get
compensated by) the other for this effect, then the market
has failed and government intervention is potentially justified.
This naturally leads to the “how” question of public finance.

There are two classes of tools in the government’s arsenal for
dealing with externalities: price-based measures (taxes and
subsidies) and quantity-based measures (regulation).
Which of these methods will lead to the most efficient regula-

tory outcome depends on factors such as the heterogeneity of
the firms being regulated, the flexibility embedded in quantity
regulation, and the uncertainty over the costs of externality
reduction.
31
The Reason for collective choice – Redistribution
The State can be envisaged as coming into existence to satisfy the needs of ALL members of the
community or to help gratify the wants of only a PART of it. The fist corresponds to allocative efficiency
and the second to redistribution.
Market process enables a society to move from a point inside the Pareto Possibility Frontier (PPF) to a
point on it. This is allocative efficiency even though the point on the PPF is chosen arbitrarily
To obtain Pareto Efficiency in the allocation of Public Good, a collective choice process that is less
anarchic than the market is required.
A conscious choice of the quantities of Public Good to be produced must be made and along with it the
choice of means of paying for it.
The issue of the distribution of gains from collective action is more clearly visible in the allocation
of Public Good by a political process than it is in the allocation of Public Good by the market
exchange process
Redistribution as Insurance
Assume that there will be two income classes in the post constitutional society, with every
member of a given class having the same income, Yi and Y2 > Y1. Let r be the number of rich
in class 2 and p the number of poor in class 1.
An individual uncertain of her future position chooses a tax of T on the rich and a benefit
subsidy B to the poor so as to maximize the following objective function:
where π2 and π1 are the probabilities that she will be in classes 2 and 1, respectively
(π2 = r/(r + p), π1 = p/(r + p)). Assuming zero transaction costs in transferring income
rT = pB. (3.2)
Substituting for π1, π2, and T into (3.1) and maximizing with respect to B, we obtain
From this it follows
An individual who maximizes her expected utility given that she is uncertain over whether
she will be rich or poor will support redistributive taxes that equate the marginal utilities of
representative members of each group. If all individuals have the same utility functions, she
chooses taxes and subsidies to equate incomes across all individuals
In creating institutions to redistribute from the rich to the poor, the uncertain
individual insures herself against the possibility that she will be one of the poor.
Uncertainty over future position could lead to unanimous agreement to include institutions
for redistribution in the constitution. In this case the constitution becomes a kind of
insurance contract.
Question which arises is why should there be state provision of such an insurance instead of
market. Two main reasons have been given.
(1) The amount of risk borne by any single member of an insurance pool declines as the
membership of the pool grows. When the risks associated with new members are the same as
those attached to existing members, the optimal size of the membership in the pool is infinity.
Insurance becomes a sort of “natural monopoly” with the optimal size of the “insurance club”
being all members of society
(2) The risks of being poor are not the same across all individuals, however. Those who are of
below average intelligence or ambition have higher probabilities of being poor than the
average person; higher intelligence, more ambitious people have lower probabilities. If it is
possible for an individual to determine his own probability of being poor, but it is not possible
for a private insurance company to make this determination, the sale of insurance by a private
company could lead to an adverse selection problem.
Redistribution as a Public good
Under the second hypothesis, the rich are seen as transferring income to the poor, not because they are
uncertain about whether they might become poor, but out of empathy or similar altruistic motivation.
Each member of the highest income group is envisaged as gaining some satisfaction from the utility gains of
members of the lower classes. The highest income group acts as a sort of club that unanimously agrees to
transfer income from itself to members of the lower group(s)
Assuming three groups, with Y3 > Y2 > Y1, then each member of group 3, when voting, can be seen as
maximizing an objective function consisting of a weighted sum of the utilities of its own members and
those of members of lower-income groups
Assuming three groups, with Y3 > Y2 > Y1, then each member of group 3, when voting, can be seen as
maximizing an objective function consisting of a weighted sum of the utilities of its own members and
those of members of lower-income groups:
where n3, n2, and n1 are the numbers of individuals in groups 3, 2, and 1, respectively; T is the tax imposed
on the richest group, and B1 and B2 are the per capita subsidies to the other two groups.
Each member of the richest group places full weight on the utility of each member of its own group,
and partial weights (α1 ≤ 1, α2 ≤ 1) on the utilities of members of other groups. Substituting from the
budget constraint
and maximizing with respect to B1 and B2 yields
from which it follows that
If a member of the richest class places the same weight on the utilities of members of classes 1 and 2
(α1 = α2) and assumes that each derives the same utility from income, then (3.13) implies subsidies to
members of classes 1 and 2 so as to equate their marginal utilities of income.
Since Y1 < Y2, if the marginal utility of income falls with increasing income, then the incomes of the lowest
class must be raised to equality with those of class 2 before any transfers are made to class 2
A saintly altruist who placed equal weight on her own utility as on that of others (α1 = α2 = 1) would vote to
equate everyone’s income.
Everyday altruists who place more weight on their own utility than on the utilities of others (0 < α < 1)
will not favor transfers so large as to bring their own incomes into equality with those to whom they make
transfers.
Since charity is a purely voluntary act, whereas government redistribution programs are not, one wonders
why, if all the members of group 3 do favor redistribution, reliance is not made on private charities (clubs) for
redistribution.
An argument for government intervention relies again on the free-rider problem. If a member of group 3
wishes to see the welfare of all individuals in group 1 raised, and not just a few whom she knows personally,
she cannot achieve her goal alone.
If all members of group 3 feel likewise, they can achieve their goal by joint-collective action. But if a voluntary
association is employed, free-riding may ensue, and less than the Pareto-optimal amount of redistribution
may occur.
Redistribution as Taking/Grabbing
Almost no democratic system makes its collective decisions using the unanimity rule.
Once government action can be taken despite the opposition of some citizens, redistribution can take on
the form of pure involuntary transfers from the losers to the winners under the political process.
Let us assume again two groups, whose members obtain utility from income, and that own political
resources that they can spend to obtain additional income in the form of government subsidies.
Of course, only one group can obtain positive subsidies, so that the other group must use its political
resources to reduce its taxes.
Let Yi be the income of a member of the ith group,

Ui her utility, and
Ri her political resources where i = 1, 2
All members of group 1 have the same utility functions
U1 = U1(Y1 + B, R1),
Where,
(∂U1/∂Y1) > 0, (∂2U1/∂Y12 ) < 0, Having to use political resources (Ri) lowers utility
(∂U1/∂R1) < 0, and (∂2U1/∂R12) < 0
For Group 2:
For group 2 we have U2 = U2(Y2 − T, R2)
(∂U2 /∂Y2) > 0, (∂2U2 /∂Y22 )< 0,

(∂U2 /∂R2) < 0, and (∂2U2 /∂R22) < 0,
where T is the per capita tax required to provide B
we can simply define political resources in such a way that
B = B(R1, R2),
(∂B/∂R1) > 0, (∂2 B/∂R12) < 0

(∂B/∂ R2) < 0, and (∂2 B/∂R22) < 0
A member of group 1 chooses R1 so as to maximize

A member of group 1 expends her
political resources until the marginal
disutility from their loss [−(∂U1/∂ R1)]
just equals the marginal utility from the
extra subsidy this expenditure yields
[(∂U1/∂Y )(∂ B/∂ R1)].
A member of group 2, with the only difference

being that his marginal gain comes from
reduced tax payments.
Since B is a function of both R1 and R2, one’s optimal R1*

depends on R2, and the two groups are only in full
equilibrium when each has chosen its optimal R* conditional
upon the other group j being at its optimal Rj*
Political resources can take many forms. In a democracy there might be effort exerted by a group for
one party (handing out leaflets, stuffing envelops, telephoning) to bring about its victory. Here one
might expect groups with low opportunity costs of time (unemployed, retired) to do well at winning
subsidies.
Involuntary redistribution must make someone worse off, and can make everyone worse off.
We usually think of involuntary redistribution as money flowing from one group to the government and
out again to a second group, with the first group being made worse off and the second better off. Such
a situation would definitely occur through a pure tax/subsidy scheme if only one group expended
resources to
win the subsidy.
The fact that it was willing to spend its resources would imply that its gross benefits exceed the
resources spent.
If both groups expend resources to win subsidies, the end result may be that they are both worse off
than they would have been had they each not attempted to obtain a subsidy.
To see this assume that both groups spend money lobbying for a subsidy and that their efforts perfectly
offset one another. Neither group obtains any benefits from their lobbying, and both are worse off by
the amount of resources spent on lobbying.
Voting Rules
Social Welfare Function
and
Arrow Impossibility Theorem
Since all can benefit from the provision of a public good – obvious voting rule would be
unanimous consent.
Knut Wicksell (1896) was the first to link the potential for all to benefit from collective
action to unanimity rule.
The Unanimity Rule is the ONLY voting rule certain to lead to a Pareto preferred public
good quantity and tax share.
However, there are two main criticisms levelled against it
Criticisms of the Unanimity Rule
The unanimity rule is the only voting rule certain to lead to Pareto preferred public good
quantities and tax shares.
Two main criticisms have been made against it:
(1) A groping search for a point on the contract curve might take considerable time particularly
in a large community of heterogenous tastes.
The loss in time might easily outweigh the gains to those who are saved from paying a tax
exceeding their benefits from the public good.
An individual who is uncertain about whether he would be so ‘exploited’ under a less than
unanimity rule might easily prefer such a rule rather than spend the time required to attain full
unanimity.
(2) The second objection under unanimity rule is that it encourages strategic behaviour.
If A knows the maximum share of taxes that B will assume rather than go without the public
good, A can force B to point C on the contract curve by voting against all shares greater than
tc - All gains then accrue to A
If B behaves the same – the final outcome is dependent on the bargaining strengths of the
two individuals.
Bargaining can further delay the attainment of the agreement as each player has to “test”
the others willingness to make concessions.
Majority Rule & Redistribution

A committee concerned with providing public goods might choose as its voting rule the
simple majority rule if it placed enough weight on saving time - but speed is not the only
property that majority rule possesses.
Once issues can pass with less than unanimous agreement there is a redistribution from those
who are worse off because the issue has passed to those who are better off.
Ordinal utilities of two groups rich and poor depicted on the two axes
In the absence of the provision of any public good representative individuals from each group experience utility
levels represented by S and T – initial endowment point E with only pvt. goods.
The provision of the public good can by assumption improve the utilities of both individuals. Its provision thus
expands the Pareto frontier to XYZW.
The segment YZ corresponds to contract curve CC’
The process of transforming a
Unanimity rule – YZ segment
proposal unanimously
Rich in majority – XY segment supported into one supported
Poor in majority – ZW segment by only a simple majority
UR
Majority rule resembles that described by
outcomes, rich in Riker (1962), in
X majority
. which “grand” coalitions are
A Y transformed into minimum
Unanimity Rule Outcomes
B winning coalitions.
. Z
.C
S
E
Majority rule
outcomes, poor in
majority
Up
T W
Majority rule can lead to redistribution other than via the obvious route of direct cash transfers.
The pioneering effort in this area was by Tullock (1959).
Tullock described a community of 100 farmers in which access to the main highway is via small trunk roads,
each of which serves only 4 or 5 farmers. The issue comes up as to whether the entire community of 100 should
finance the repair of all of the trunk roads out of a tax on the entire community.
Obviously one can envisage a level of repairs and set of taxes on the individual farmers under which such a
proposal would be unanimously adopted.
But under majority rule it is to the greater advantage of some to propose that only one half of the roads are
repaired out of a tax falling on the entire population. Thus, one can envisage a coalition of 51 of the farmers
forming and proposing that only the roads serving them are repaired out of the community’s general tax
revenue (Tullock discusses other possible outcomes, which we take up shortly).
Such a proposal would pass under majority rule, and obviously involves a redistribution from the 49 farmers
who pay taxes and receive no road repairs to the 51 farmers whose taxes cover only slightly more than one half
of the cost of the road repair.
In the Tullock example, redistribution to the 51 farmers in the majority coalition takes place through the
inclusion in the entire community’s budget of a good that benefits only a subset of the community.
CYCLING
V2
Voters X Y Z X
V3
1 > > <
V1
2 > < >
3 < > > X Y Z
Community > > >

V1 = x > y > z
V2 = z > x > y
x & y: xPy – V1 V2 xPy V3 = y > z > x
y P x - V3
y & z: yPz – V1 V3 yPz Thus pair-wise voting can lead to an

z P y – V2 xPyPzPx endless cycle and the majority rule can
select no winner arbitrarily.
x & z: xPz – V1 zPx The reason for this cycle is that V2
zPx – V2 V3 preferences are DOUBLE PEAKED
Alternatives to Majority Rule
Plurality Rule: Choose the candidate who is ranked first by the largest no. of votes.
Condorcet criterion: choose the candidate who defeats all others in pairwise elections using
majority rule.
The Coombs System: Each voter indicates the candidate he ranks lowest of the m candidates.
Remove from the list of candidates the one ranked lowest by the most voters. Repeat the
procedure for the remaining (m-1) candidates. Continue until only one candidate remains.
Declare this candidate the winner.
Borda Count:
Give each of the m candidates a score of 1 to m based on the candidate’s ranking in a voter’s
preference ordering; that is, the candidate ranked first receives m points, the second one m-1,…,
the lowest ranked candidate one point. The candidate with the highest points is declared the
winner
Approval Voting:
Each voter votes for the k candidates (1 ≤ k ≤ m) he ranks the highest of the m candidates,
where k can vary from voter to voter. The candidate with the most votes is the winner.
Social Welfare Function
The traditional means for representing the values of the community in economics is to use a social
welfare function (SWF).
The seminal paper on SWFs is by Bergson (1938), with the most significant further explication by
Samuelson (1947, ch. 8). The SWF can be written as follows:
W = W(z1, z2, . . . , zn),
Where W is a real valued function of all variables, and

the zi s and W are chosen to represent the ethical values of the society or of the individuals in it
(Samuelson, 1947, p. 221).
The objective is to define a W and set of zi s, and the constraints thereon, to yield meaningful first- and
second-order conditions for a maximum W.
Although in principle any variables that are related to a society’s well-being (e.g., crime statistics,
weather data, years of schooling) might be included in the SWF, economists have focused on economic
variables.
The normative issue to be resolved with the help of the SWF is which point along the generalized
Pareto-possibility frontier should be chosen; what set of lump-sum taxes and subsidies is optimal.
Both Bergson and Samuelson speak of solving this question with the help of a variant of the SWF in
which the utility indexes of each individual are direct arguments in the welfare function
W = W(U1,U2, . . . ,Us ).
SWF can take several forms:
1. Benthamite or Utilitarian SWF 3. Bernoulli-Nash Social Welfare Function

𝑊 = σ𝐻 ℎ=1 𝑈
ℎ 𝐻
𝑊 = 𝜋ℎ=1 𝑢ℎ
2. Generalised Social Welfare Function 4. Generalized Bernoulli-Nash Social Welfare Function

𝑊 = σ𝐻 ℎ=1 𝑎ℎ 𝑢
ℎ
𝑊 = 𝜋ℎ=1𝐻
(𝑢ℎ )𝑎ℎ
5. Rawlsian or Maximin SWF

W= min[𝑢1 … 𝑢𝐻 ]
Arrowian Social Welfare Function
In extending the ideas of Bergson and Samuelson, Arrow asked the question: what should determine
the particular Bergson Social Welfare Function to be used?
In particular how would the function W (or more generally the social ordering R) depend upon
individual preference orderings? Or in other words what should be the collective choice rule?
Collective Choice Rule
A Collective Choice Rule is a functional relation f such that for any set of n individual orderings
(R1………Rn ) (One ordering for each individual)
One social preference relation R is determined R = f(R1………Rn )
Arrow’s use of the expression SWF is different from that of Bergson and Samuelson. A Collective
Choice Rule that specifies ordering for society is called a SWF by Arrow. Any ordering for the society
is a Bergson Samuelson SWF.
An Arrow SWF determines a Bergson Samuelson SWF on the basis of individual ordering.
Since it is possible to impose to set up a SWF or Collective Choice Rule in any manner consistent or
inconsistent, reasonable or wild, it is useful to impose some mild conditions on the form of the SWF.
In his “General Possibility Theorem” or since the theorem is negative, “General Impossibility
Theorem”, Arrow proved that a set of very mild looking conditions are altogether so restrictive that
they rule out not some but every possible SWF
GENERAL IMPOSSIBILITY THEOREM
The proof of Arrow’s Theorem is based on 2 axioms and set of 4 conditions
AXIOM A: Completeness For all x and y either xRy or yRx where R stands for preferred/indifferent to
AXIOM B: Transitivity For all x, y and z xRy and yRz implies xRz
The set of 4 conditions are:
1. UNANIMITY: (The Pareto Postulate)

If an individual preference is unopposed by a contrary preference of any other individual, this
preference is preserved in the social ordering
2. NON-DICTATORSHIP:
No individual enjoys a position such that whenever he or she expresses a preference between any
two alternatives and all other individuals express the opposite preference, his or her preference is
always preferred in the social ordering
3. UNRESTRICTED DOMAIN:
There are at least 3 among all the alternatives under consideration for which all logically possible
individual ordering of these three alternatives is admissible (elaborated upon in next slide)
4. INDEPENDENCE OF IRRELEVANT ALTERNATIVES

The social choice between any two alternatives must depend on the orderings of individuals over
only these two alternatives and not on their orderings over other alternatives
Example - Unrestricted Domain
The requirement that the rule must work for every logically possible
configuration of individual preference orderings is called the
condition of unrestricted domain
V1 = xPyPz
V2 = yPzPx
V3 = zPxPy
x & y: xPy: V1 V3 x>y

yPx: V2 Cycling – i.e assumption of
unrestricted domain is violated
y & z: yPz: V1 V2 y>z

zPx: V3
x & z: xPz V1 z>x x>y>z>x

zPx V2 V3
Example – Independence of Irrelevant Alternatives
1. The MAJORITY RULE is an appealing collective choice rule (CCR). However, it fails to satisfy the condition of
unrestricted domain (i.e. problem of cycling exists).
2. The method of BORDA COUNT also fails because it does not pass the condition of Independence of Irrelevant
Alternatives.
Suppose there are 3 alternatives x, y, z and three individuals. According to the method 3 marks are assigned to
the alternative ranked first; 2 marks are assigned to the alternative ranked second and 1 mark to the third
alternative.
The individual orderings are
V1: xPyPz
V2: zPxPy x y z
V3: zPxPy V1 3 2 1
V2 2 1 3
Here x and z receive 7
points and there is a TIE
V3 2 1 3
TOTAL 7 4 7
Now suppose that everyone’s ranking of x vis-à-vis z remains the same, but
individual 1 changes his/her mind about an irrelevant alternative viz., y and has
the following ordering
V1: xPyPz (original)

V1: xPzPy (changed – keeping the preference vis-à-vis x and z unchanged)
x y z
V1 3 1 2 Now x receives 7 points
V2 2 1 3 but z receives 8 points
V3 2 1 3 So z WINS
TOTAL 7 3 8
While everybody’s ordering of x and z are still the same, the social choice between x and z is not the same
This violates condition 4 i.e. Independence of Irrelevant Alternatives

PROOF of the THEOREM
Definition of a Decisive Set: A set of individuals D is decisive, for alternatives x and y in a given social
welfare function, if the function yields a social preference for x over y, whenever all individuals in D prefer x
to y and all others prefer y to x
In either case one of the proper subsets

of D is decisive for a pair of issues,
therefore by step 9 for all issues.
Steps 10-16 can be repeated for this

new decisive set, and then continued
until the decisive set contains one
member thus contradicting the non-
dictatorship postulate
The Intuition underlying the Proof
• The unrestricted domain assumption allows any possible constellation of ordinal preferences.
• When unanimously preferred alternative does not emerge, some method of choosing among the
Pareto Preferred alternatives must be found.
• The Independence of Irrelevant Alternatives assumption restricts attention to the ordinal
preferences of the individuals for any two issues, when deciding those issues
• But as we seen in our discussions of majority rule it is all too easy to construct rules that yield
choices between two alternatives but produce a cycle when three successive pair-wise choices are
made
• The transitivity postulate forces a choice among the three.
• The Social Choice process is not to be left indecisive. But with the information at hand i.e. individual
ordinal rankings of issue pairs – there is no method for making such a choice that is not imposed or
DICTATORIAL
Significance of Arrow’s Results
It has been known for a long time that some methods of combining individual preferences into social
preferences lead to inconsistencies.
Condorcet (1785) had noted intransitivities of majority decision almost two centuries ago
The most discussed case of such inconsistency is the so called “Paradox of Voting”. This example gives
a good introduction to the nature of the problem
V1: xPyPz x & y: xPy - V1 V3 x defeats y (2 votes to 1)

V2: yPzPx yPx – V2
V3: zPxPy
x & z: xPz – V1
zPx – V2 V3 z wins against x (2 votes to 1)
y & z: yPz – V2 V1 y defeats z (2 votes to 1)

zPy – V3
X defeats y (2 votes to 1) and y defeats z (2 votes to 1) – By transitivity rule x should defeat z

But we find that between x and z in pairwise voting as shown above z wins (2 votes to 1) – Thus majority rule leads
to inconsistencies
The importance of Arrow’s theorem lies in the fact that it shows that this problem occurs not only for the
method of majority decision, which is only one method of social choice, but for EVERY method known
or unknown that can be conceived of. There simply is no possibility of getting Social Welfare Function
such that it satisfies the conditions stated.
The importance of the General Possibility Theorem lies in the fact that we can predict the result in each
case i.e. NO SOCIAL WELFARE FUNCTION will satisfy the conditions.
The theorem is completely general and saves a long (and perhaps endless0 search
Public Goods and Publicly
Provided Private Goods
We need to make an important distinction, between public production and public provision. The two
are often confused, though both logically and in practice they are distinct.
The government provides for the National Defence, yet much of the production of the goods
purchased for national defence is within the private sector.
The government has, in many countries, a monopoly of the mail service, yet it charges for the use of
mail in a manner little different from that of private enterprise.
Characteristics of Publicly Provided Goods
It may be impossible, or extremely costly, to charge for the use of a specified commodity. In other words, it
may not be possible to exclude non-contributors. This is essentially a technical question, and depends on
the available technology.
In the case of television, calculation of the extent of use depends on it being possible to determine from
outside whether the receiver is in operation or on the employment of scrambling devices.
It has been suggested that automatic metering devices could be installed to record the passage of
vehicles through the highways system and that with large-scale computer networks it would be feasible to
charge for actual usage.
For some goods, such as national defence, it is hard to imagine that even future developments in information
processing will allow individual benefit to be determined; so that for these exclusion is indeed impossible.
Where exclusion is not technically impossible, it may still be decided to supply the
good publicly for certain reasons…
The first is that it may not be desirable on efficiency grounds to use prices to govern the usage of a
commodity. The effects of charging depend on (1) the conditions of demand and (2) the conditions on which
the good can be supplied to an additional individual.
If the demand is highly inelastic, then pricing has little effect on usage. In the extreme case, if demand is
completely inelastic, there is no efficiency loss from not charging for the commodity (although there may be
other arguments, such as raising revenue, as we have seen).
Many places do not charge for the quantity of water used, because it is judged that the benefits for metering
would be relatively small, demands not being very elastic, and insufficient to warrant the installation of
metering devices. (There may also be external economies in consumption—at least, that was an important
historical reason for public provision)
Standard discussions tend in effect to focus on the second aspect—that usage by one person does not
reduce the amount that others can consume. In other words, the cost of supplying a fixed quantity to
another individual is zero.
Examples typically given include television programmes (my listening to a TV programme transmitted over
the airwaves does not detract from others listening); information (my knowing something does not detract
from others knowing the same thing); and national defence. These are extreme cases, and are referred to
as pure public goods, where “each individual’s consumption of such a good leads to no subtraction
from any other individual’s consumption” (Samuelson, 1954)
More generally, there is a range of commodities that have the property that an increase in one person’s
consumption (keeping aggregate expenditure on the commodity constant) may not decrease the
consumption of other people by the same amount. If one person travels on a little-used highway, the
benefits of the road to others are reduced only slightly.
On this view, private goods are at one extreme of a spectrum, where an increase of one unit in the
consumption by Mr X reduces the consumption available to others by one unit; and pure public goods at
the other extreme, where an increase in Mr X’s consumption leads to no reduction for others. These polar
cases are sometimes characterized in the following way.
Let be the consumption by household h of the ith commodity. Then for private goods
where Xi is the aggregate supply.
In contrast, for a pure public good
It may be noted that this assumes no free disposal. For many public goods, such as defence, this may not be an
unreasonable assumption; on the other hand, for goods such as television, free disposal is possible, and should be
replaced by
The intermediate cases are somewhat harder to characterize, and various approaches have been
suggested in the literature. One is to write the consumption possibility frontier for the economy as being
for good i:
One is to write the consumption possibility frontier for the economy as being for good i:
𝜕𝜒/𝑋𝑖1 Slope of the private production line = -1

2 = −1
𝜕𝜒/𝑋𝑖
If the good is a public good then they are non-rival i.e.

increase in consumption of one does not affect the
consumption of 2
𝜕𝜒/𝑋𝑖1
=0
𝜕𝜒/𝑋𝑖2
An alternative approach is in terms of consumption externalities, and this has been developed by
Samuelson (1969). In this case the purchase of good i by household h may enter the utility function of
other individuals.
In this case the purchase of good i by household h may enter the utility function of other individuals.
In both cases, we have a problem of defining what it is that is being consumed, and how it is to be
measured. For instance, for television and radio broadcasts, the obvious unit to measure consumption is
“programmes listened to”. In this case, the first approach seems more natural.
On the other hand, if individuals privately purchase protective services (e.g., police guards), utility may be
a function of the level of “safety” in the community, which may be a function of the aggregate expenditure
on protective services, as well as on the private level of protection.
Individuals, in providing protection for themselves (and thus lowering the return to crime), are providing a
public good (safety), and the consumption externalities representation seems natural.
For instance, if P represents the total number of policemen available, and Ph represents the number of
policemen assigned to (“consumed by”) the household h, then ΣPh = P, and police appear to be a private
good, yielding consumption externalities.
If however what is consumed (negatively) is the expected number of crimes suffered by household h, denoted
by Ch, then we have a consumption possibilities curve
where an increase in the number of policemen reduces the crimes committed.
The third set of reasons for public provision relates to distributional objectives. This may stem either
from a general distributional goal, for example embodied in a social welfare function, or from principles
of specific egalitarianism.
Thus, distributional reasons are probably the primary rationale for the public provision of education —
either because it reduces inequality of endowments, or because access to at least a minimum level of
education is an objective in itself.
Optimum Provision of Pure Public Goods—Efficiency
In this section we consider the optimum level of provision of a single, pure public good, consumed in
quantity G by everyone. There is an aggregate production relationship:
F(X,G) = 0
where X denotes the vector of total private good production.
First-Best Allocation
The government of a fully controlled economy is assumed to choose the level of G, and the
allocation of private goods Xh to household h (where h = 1, . . . , H) to maximize an individualistic
social welfare function. If the individual utility function is Uh (Xh, G), then the social welfare
function may be written as
This is the basic condition for the optimum supply of public goods: the sum of the marginal rates of
substitution between the public good (and some private good) must equal the marginal rate of
transformation (ΣMRS = MRT).
There is a clear intuitive interpretation of these conditions for a full optimum. The marginal benefit of an
extra unit of a public good is the benefit that person 1 gets, plus the benefit that person 2 gets, etc. In
contrast, an extra unit of a private good is either given to person 1 or given to person 2.
The solution may be illustrated diagrammatically for the case where there are two individuals and two goods (X =
private good, G = pure public good).
There are two individuals and Figure shows in the upper part the indifference curves
two goods (X = private good, for citizen I and the production constraint AB.
G = pure public good).
Suppose we fix citizen I on the indifference curve UI.
The possibilities for citizen II are shown in the lower
part of Fig. by CD (the difference between AB and UI).
Clearly, Pareto efficiency requires the marginal rate of

substitution of the second individual be equal to the
slope of the curve CD (i.e., at point E).
But this is just the difference between the marginal

rate of transformation (the slope of the
production possibilities schedule) and the marginal
rate of substitution of the first
individual (the slope of his indifference curve). Thus,
we have
i.e.
The sum of the marginal rates of substitution

must equal the marginal rate of transformation.
Cornes and Sandler
Nash Cournot Equilibrium &

Pareto Optimality
INDIVIDUAL BEHAVIOUR
The individual's utility function, U(y, Q),
Exogenous money income, I, can be used either to purchase units of the private good or to
acquire additional units of the public good. The number of units of the public good acquired by the
individual is denoted by q. If there are n individuals in the community
where qh is the quantity contributed by individual h.
From the point of view of the utility function, the individual's own contribution and that of the rest of the
community are perfect substitutes.
However, the individual will be keenly aware of the distinction, since the former involves an opportunity
cost in terms of the private good forgone in acquiring q, whereas the latter involves no such cost.
Like the individual, we find the distinction important and find it useful to refer to the rest of the
community's contribution separately. This we denote by
Maximization of utility is subject to constraints. The simplest formulation assumes a linear trade-off
between y and q:
y + PQ q = /
This is a budget constraint, with PQ being the given money price of a unit of acquisition of the public good
It may equally well be thought of as reflecting any constant cost technology that converts the given quantity / of
primary resource (e.g., labor services) into either of two final goods, in which case pQ is the marginal rate of
transformation between the public good and the private good.
The total contribution, Q, may be thought of as producing the final public good, Z, with decreasing returns to scale:
utility function would be U[y, Z(Q)]

Since the budget constraint holds with equality, it can be used to eliminate the private good from the
utility function, making it possible for the individual's utility to be defined as a function of the two
quantities q and Q:
෨ we generate the family of indifference curves in

As a first step in exploiting the function 𝑈(𝑞, 𝑄),
෨ space implied by the individual's preferences. Clearly, higher values of 𝑄෨ imply more-
(𝑞, 𝑄)
preferred allocations.
Thus we have ICs map as given below
The indifference map is truncated by the vertical line BB, which corresponds to the value of q
that would, by itself, completely exhaust the consumer's budget.
The individual's choice of q cannot be determined
without reference to the value of 𝑄෨
The simplest and most common assumption is that

the individual is a price taker with respect to 𝑄෨
This envisages the individual as choosing the most

preferred level of q consistent with his/her budget
constraint given the current value of 𝑄෨
For any 𝑄෩ we can imagine the horizontal line as

representing the feasible set facing the individual
whose behaviour we are analysing.
The point of tangency between such a line and an IC

represents the individual’s optimal choice given the
prevailing level of 𝑄෨
The locus of such points of tangency is the Nash-

Cournot reaction curve
This locus, which is the curve NN in Figure 6.1, is

often called the individual's reaction curve.
Looking at points on the NN reaction curve algebraically
We know that movement along any IC curve implies by definition unchanged utility
Utility can be expressed in terms of either
Therefore along any indifference curve
The optimum entails equality of marginal cost and marginal benefit

Nash-Cournot Equilibrium
Consider an economy consisting of two consumers, each of whom behaves as does the individual
modeled in the preceding section.
Their preferences and income levels may differ, but they face the same price p^ for the public good.
We shall also suppose that there is one private good, whose price is unity throughout. Each
individual has the problem
The two implied utility functions

are represented by
indifference curves in Figure 6.4
We must now introduce our equilibrium concept, that of Nash

Suppose that each individual can be thought of as deciding upon a quantity to contribute
to the public good. Then the pair of quantities
is Nash Equilibrium if
That is, each individual's chosen contribution is a "best response" to the other's.
A possible justification of such an equilibrium concept runs as follows. Suppose each is to choose a
contribution level. At the time when this choice is made, each knows the other's budget constraint and
preferences. Moreover, this is common knowledge – not only does each know, but each knows that the
other knows, and so on.
Individual A may now think: "If I expect B to contribute 𝑞ത 𝐵 , my most preferred contribution will be 𝑞ത 𝐴 .
Now, if B expects me to contribute 𝑞ത 𝐴 , Bs most preferred contribution — given that I know her
preferences and that she is a utility-maximizer, will be 𝑞ധ 𝐵 . If 𝑞ത 𝐵 ≠ 𝑞ധ 𝐵 then there is an inconsistency
between belief and action for at least one of the individuals.
In this two-person example, the rest of the
community's contribution is simply the other
individual's provision.
Measuring individual B's contribution along the

vertical axis, we obtain an indifference map and
reaction curve for individual B in the same way as
for individual A.
The Nash-Cournot equilibria of the game described

earlier are depicted graphically as the points of
intersection of the two individuals' reaction curves.
At such an intersection - the point E in Figure 6.4 -
each is choosing his or her optimal q given the
other's current contribution.
The aggregate provision of the public good implied

at E may be read off by drawing a line through E of
slope - 1 and measuring the distance between its
intersections with either axis and the origin - for
example, OT.
A Nash-Cournot equilibrium has several noteworthy features:
First, it is typically not Pareto-efficient. The shaded area of Figure 6.4 constitutes a
region of mutual advantage with respect to E, consisting as it does of allocations that
Pareto-dominate the Nash-Cournot equilibrium.
A second feature is that, in general, even in an economy of identical individuals, there is

no guarantee that the equilibrium is unique.
If one is prepared to imagine equilibria as possible end points of an adjustment process,

the prospect of multiple equilibria suggests that one might examine the conditions for
local stability
Figure 6.5 depicts equilibria in an economy
consisting of two identical consumers.
The two reaction curves are reflections of one

another about the 45° ray through the origin,
implying identical consumers.
There exists a symmetric equilibrium, but it is

unstable. On the other hand, there are two locally
stable equilibria.
At each, one individual perceives his or her

companion making a small contribution and is
consequently encouraged to contribute more
E substantially, whereas the companion, perceiving
generous social provision, is led to take a relatively
1 2 easy ride.
3 At pt. 1, A feels he wants to contribute more so

E’ moves to point 2
At 2 B, feels that A has anyways increased

contribution to he reduces his contribution and they
move to point 3
This continues till they reach E’

Returning to the previous figure i.e. 6.4….
We see that the locus PP, which passes through the

points of tangency between the two individuals' sets of
indifference curves, represents the set of Pareto-
efficient allocations given the values of 𝑝𝑄, 𝐼 𝐴 𝑎𝑛𝑑 𝐼 𝐵
We shall show that it represents the set of Pareto-efficient points
Geometrically, a Pareto-efficient allocation is characterized by equality of the slopes of the

individuals' indifference curves.
Which can be simplified to i.e.

𝑈𝑦𝐴 𝑈𝑦𝐵 𝑚 𝑛
Let =m 𝑝𝑥 = +
𝐴
𝑈𝑄
and
𝐵 =n 𝑚𝑛 𝑚𝑛
𝑈𝑄
1 1 1
𝑝𝑥 𝑚 − 1 = 𝑝𝑥 = +
𝑝𝑥 𝑛 − 1 𝑛 𝑚
(𝑝𝑥 𝑚 − 1)(𝑝𝑥 𝑛 − 1) = 1
1 1
𝑝𝑥 = 𝐵 + 𝐴
𝑈𝑦 𝑈𝑦
𝑝𝑥2 𝑚𝑛 − 𝑝𝑥 𝑚 − 𝑝𝑥 𝑛 + 1 = 1 𝑈𝑄𝐵 𝑈𝑄𝐴
𝑝𝑥 (𝑝𝑥 𝑚𝑛 − 𝑚 − 𝑛) = 0 𝑈𝑄𝐵 𝑈𝑄𝐴

𝑝𝑥 = +
𝑈𝑦𝐵 𝑈𝑦𝐴
Since p is not equal to zero, it implies
𝑝𝑥 𝑚𝑛 − 𝑚 − 𝑛 = 0 𝑝𝑥 =MRSB + MRSA
𝑝𝑥 𝑚𝑛 = 𝑚 + 𝑛
This is the familiar Samuelson condition, which says that provision of a public good should be
taken up to the point at which the marginal rate of transformation equals the sum over all
individuals of the marginal rates of substitution between the public and the private goods
෍ 𝑀𝑅𝑆 = 𝑀𝑅𝑇
Comparing this with the expression below clarifies the sub-optimality in the Nash case
In Nash case, individuals adjust their own contributions independently of their neighbours and
therefore will add to the public good only to the point at which their private marginal rates of
transformation 𝒑𝑸 𝐞𝐪𝐮𝐚𝐥𝐬 𝐭𝐡𝐞𝐢𝐫 𝐩𝐫𝐢𝐯𝐚𝐭𝐞 𝐌𝐑𝐒
Voluntary provision of public goods with Mueller p.18
constant returns to scale
Letting Gi be the contribution to the public good of individual i , then the total quantity of public good supplied is
G = G1 + G2 + G3 +· · · Gn. (1)
Let each individual’s utility function be given as Ui (Xi , G), where Xi is the quantity of private good i consumes
Now consider the decision of i as to how much of the public good to supply, that is, the optimal Gi , given her
budget constraint
Yi = Px Xi + PgGi
where Yi is her income and Px and Pg are prices of the private and public goods, respectively.
In the absence of an institution for coordinating the quantities of public good supplied, each individual must
decide independently of the other individuals how much of the public good to supply.
In making this decision, it is reasonable to assume that the individual takes the supply of the public good by
the rest of the community as fixed.
Each i chooses the Gi that maximizes Ui , given the values of Gj chosen by all other individuals j .
Individual i ’s objective function is thus
(2)
Maximizing (2.2) with respect to Gi and Xi yields
(3)
(4)
from which we obtain
(5)
as the condition for utility maximization

Each individual purchases the public good as if it were a private good, taking the purchases of the
other members of the community as given.
This equilibrium is often referred to as a Cournot or Nash equilibrium, as it resembles the behavioral
assumption Cournot made concerning the supply of a homogeneous private good in an oligopolistic
market.
Now let us contrast (2.5) with the condition for Pareto optimality. To obtain this, we maximize the
following welfare function
(6)
where all γi > 0.
Given the positive weights on all individual utilities, any allocation that is not Pareto optimal – that is,
from which one person’s utility can be increased without lowering anyone else’s – cannot be at a
maximum for W
Thus, choosing Xi and Gi to maximize W gives us a Pareto-optimal allocation.

Objective function
The aggregate budget constraint
(7)
we obtain the first-order conditions
(8)
where λ is the Lagrangian

(9) multiplier on the budget
constraint
𝜆𝑃𝑔 (A)
From (8) ෍ 𝛾𝑖 =
𝜕𝑈𝑖ൗ
𝜕𝐺
𝜆𝑃𝑥
From (9) 𝛾𝑖 = (B)
𝜕𝑈𝑖
For i= 1……n ൗ𝜕𝑋
𝑖
𝜆𝑃𝑥 (C)
Hence σ 𝛾𝑖 = Σ 𝜕𝑈𝑖
ൗ𝜕𝑋
𝑖
Equating r.h.s of (A) and (C) 𝜆𝑃𝑔 𝜆𝑃𝑥

=Σ
𝜕𝑈𝑖ൗ 𝜕𝑈𝑖
𝜕𝐺 ൗ𝜕𝑋
𝑖
Thus 𝜆𝑃𝑥 𝜕𝑈𝑖 (10)

Σ 𝜕𝑈𝑖 ൗ𝜕𝐺 = 𝜆𝑃𝑔
ൗ𝜕𝑋
𝑖
𝜕𝑈𝑖ൗ 𝜕𝑈𝑖ൗ
𝜕𝐺 = 𝜆𝑃𝑔 𝜕𝐺 𝑃𝑔 (11)
෍ or `෍ =
𝜕𝑈𝑖 𝜆𝑃𝑥 𝜕𝑈𝑖 𝑃𝑥
ൗ𝜕𝑋 ൗ𝜕𝑋
𝑖 𝑖
It can be shown that public goods provision in (11) i.e. under Pareto provision, is greater than in (5) i.e. under Nash
𝜕𝑈𝑖ൗ 𝜕𝑈𝑗
ൗ
𝜕𝐺 = 𝑃𝑔 − ෍ 𝜕𝐺
𝜕𝑈𝑖 𝑃𝑥 𝜕𝑈𝑗 (12)
ൗ𝜕𝑋 𝑗≠𝑖 ൘𝜕𝑋
𝑖 𝑗
𝜕𝑈𝑗
If X and G are Normal goods then ൗ
෍ 𝜕𝐺 > 0
𝜕𝑈𝑗
𝑗≠𝑖 ൘𝜕𝑋
𝑗
Hence (12) is smaller than (5)
To take a numerical example
MRS of Public for Private good under MRS of Public for Private good under Pareto = 6/1
Nash = 8/1 i.e. 8 units of public good i.e. 6 units of public good given up for 1 unit of
given up for 1 unit of private good X private good X
Since 8 has been given up under NASH and 6 is given up under PARETO.
This implies that greater G is being provided under PARETO than under NASH
Thus for a community greater than one individual, Gn/Gp will fall i.e.
less than Pareto optimal quantity of Public Good is supplied voluntarily.
Greater the size of the community, greater will be the gap
To achieve the Pareto-optimal allocation, some institution for

coordinating the contributions of all individuals is needed.
Mugrave
Voluntary Exchange Models

Lindahl solution
Considering the purely fiscal problem of providing for the satisfaction of public goods, its solution
involves three sets of decisions
1. Total amount of Public Expenditure and taxes

2. Allocation of total public expenditure among goods and services for satisfaction of various social
wants
3. Allocation of total taxes among various individuals
These three decisions are mutually interdependent and must be rendered jointly
Let us consider a community of 2 taxpayers A and B and one type of social good only
Its supply furnishes benefits to both, A & B whose benefit shares may be considered joint products
Jointly A & B must contribute enough to cover the total cost of whatever volume of social goods is
supplied – individually each will have to pay less as the other contributes more
B’s offer to contribute certain percentage of the total cost of various amounts of social goods may be
interpreted from A’s point of view as a supply schedule of social goods and A’s offer may be interpreted
similarly from the viewpoint of B.
In the figure the volume of social goods is
measured on the horizontal axis
The combined unit price including the contributions

of both A&B us measured on the vertical axis
Lines aa and bb show the demand curves for social

goods of taxpayers A&B respectively. tt shows the
aggregate demand schedule
Since both must consume the same amount of

social goods, tt is obtained by vertical addition of
the individual schedules – tt shows the combined
price per unit of social goods
Ss is the supply schedule
The equilibrium output OE is determined where tt

and SS schedules intersect.
Taxpayer A will pay Opa and B will pay OPb

For smaller amounts the combined offer price
exceeds the unit cost
At OG for instance the offer price exceeds the

unit cost by SI. This would lead to an increase in
supply
Not more than OE can be supplied as for large

amounts the combined offer price will fall short
of unit cost
At amount OC for instance, the offer price falls

short by KS, thus supply will reduce to OE
where cost is covered.
In this way equilibrium output is said to be

established at OE
In figure 2 that follows, the same argument is

presented in Lindahl terms
On the horizontal axis we measure the units quantity of social
goods
On the left vertical axis we measure the percentage of total cost

contributed by A
On the right axis we measure the percentage contributed by B
The curve a1a1 is A’s demand schedule transcribed from aa in figure

1 – price now being measured as percentage of cost
Taxpayer A is willing to pay 100% for output OG, the amount at

which his demand schedule intersects the supply curve
He is willing to pay 50% for OC which will be available to B at 50%

cost
The curve b1b1 is a similar demand schedule for B calculated

from bb in figure 1, use being made now of inverted scale of
percentage contributions
B is willing to contribute 100% for OU which will be the amount
available to A
B will contribute 75% for OF - this will be available to A at 25%
The equilibrium output remains at OE, where a1a1 and b1b1 intersect
and both shares add up to 100 per cent.
Here, A contributes ED, and B contributes DH per cent. For any amount
in excess of OE, the combined cost shares that A and B are willing to
accept fall short of 100 %
For output OC, for instance, the combined contribution falls

short of the total by JM%. The amount OC cannot be supplied and the
output must be reduced
For any supply below OE, both A and B are willing to offer better terms
than the other demands. At ON, for instance, total offers exceed costs
by RZ per cent.
If A contributes fraction NR, supply ON will be available to B at TR, even

though he would be willing to pay TZ if needed.
If B contributes TZ, A will purchase this amount for NZ, even though he
would be willing to con tribute NR.
If A contributes NJ and B contributes TJ , both pay less than they would

be willing to contribute.
From this Lindahl concludes that both parties will vote for larger 4. Since A's hare equals NJ , he will vote
amounts until OE is reached. to expand output to OQ. Since B's share
equals JT, he will vote for OC.
Thus, the revenue-expenditure process for the satisfaction of social
wants is determined by a competitive process similar to that which 5. Presently, B will find out that he cannot
applies in the private market. obtain OC at the cost share TJ. At output
OC, A will contribute NM only, leaving MT
Critique/Appraisal to B.
1. Considering the predominantly compulsory nature of the revenue
expenditure process the assumption of voluntary exchange is
unrealistic
2. Lindahl’s solution assumes that a Cournot type duopoly situation will

apply and equilibrium will be reached at the output OE. This need not
happen.
3. We begin with a situation where output equals ON and assume that

A contributes NJ while B contributes TJ. Following the Cournot case, we
suppose that A and B both disregard the effect of their votes upon the
other's cost share. The position at J leaves both A and B with a price
below what they would be willing to pay.
6. At this point (MT) B will not vote for OC, he will vote for
a smaller supply and the adjustment continues till output
OQ is reached and agreed on by A and B
7. This output OQ is not Lindahl’s solution and it is only

the most favourable result given cost shares NT/TJ
Thus given Cournot behaviour there is nothing in the

model that makes output level OE inevitable
8. Moreover, it is hardly realistic to assume that each

voter disregards the effects of changes in quantity upon
his price. Once such effects are allowed for,
considerations of strategy enter.
9. The final solution becomes the result of a bargaining

process, and it need not be at OE.
10. For output < OE along UDY and to the left of it,
combined contributions exceed total costs. Exact shares
of A and B will depend on their bargaining skills.
The problem will not vanish when the number of voters increases. Individuals can free ride on the
contributions of others
For large numbers each individual’s contribution is so small that it cannot affect supply.
The preceding critique of the voluntary exchange model focused on the assumption that true
preferences will be revealed.
The second flaw arises from the partial equilibrium setting of the model in which the satisfaction of
social wants is considered independently of private wants – Samuelson said that the must be re-stated
in General equilibrium terms.
Restatement in Terms of General Equilibrium - Optimal Solution with Known Preferences
In order to examine this aspect of the problem, let us assume that true preferences are revealed and
known. How, then, can the government arrange for an optimal allocation of resources between
private and social wants?
In Figure 4-3 the total output of social goods is measured on the vertical axis,
and that of private goods, on the horizontal axis. The curve FE is a
transformation schedule, showing what combinations of social and private goods
may be produced.
The combination o he chosen will depend upon the preferences of our two
consumers, A and B, and upon the distribution of income between them.
As before, we assume that the satisfaction of social wants is to be determined

on the basis of a given proper distribution of income.
In order to define this distribution let us assume that only private goods are
produced.
We then specify that A’s income in terms of private goods equals OC and B’s
income equals OD, where OC+OD=OE (total output)
To simplify matters, we assume further that the distribution of factor income

between A and B is similar for all compositions of output between social and
private goods; therefore their shares always equal OC/OE and OD/OE
respectively For consumer A, this means that no
provision for social wants must be
In planning for the satisfaction of social wants, it is assumed that the undertaken which would leave him in
government proceeds on the premise of the "new" welfare economics, whereby a worse position than he would be if
arrangement X is to be preferred to arrangement Y, if a change from Y to X he consumed OC of private goods
improves the position of either consumer without hurting the other.
Let us measure A's consumption. of social goods on the vertical
axis and his consumption of private goods on the horizontal axis.
Now, let OC be A's income terms of private goods and i1C his
indifference curve through C.
No arrangement for the satisfaction of social wants can be made

that places A on an indifference curve lower than i1C and he will be
indifferent between various points thereon.
At the same time A’s position on i1C will not be of indifference to B.

B will prefer certain locations of A to others.
B’s consumption of social goods must be the Of all the combinations on this path, B prefers W where
same as A’s and B’s consumption of private DM is tangent to his indifference curve i2. Here B retains
goods must equal the total supply of private OK of private goods to obtain OG of Social goods.
goods minus A’s consumption
A located at V in figure 2 retains OS of private goods and
The DM curve shows B’s consumption of surrenders SC of potential private goods to obtain OG of
social and private goods that results as a social goods.
moves up along i1C
If A is located at V in figure 2, B is located at

W in figure 3.
Both receive OG of social goods.
The total output of private goods equals OL of

which A receives an amount OS (fig.2) and B
receives an amount OK=OL – OS
Applying the same procedure to each level of

social good we obtain the path DM in figure 3.
The cost of social goods is divided between A & His level of indifference is the same as it was in the absence of
B in the ratio of KD to SC with A paying the larger public goods while A has moved to higher IC and position has
share improved
On balance, A is as well off as in the absence of We thus obtain the greatest gain that A can derive from the
social goods since he has remained on i1C, while supply of social goods provided that B’s initial position is not
B's position is improved since he has moved harmed.
from i1D to the higher indifference curve i2W.
We also obtain the greatest gain that B can derive without
We now reverse the argument and obtain curve harming A.
CN in figure 2 as the path travelled by A while B
moves up along i1D in figure 3
Among all points on CN, the point of tangency

with an IC or P will be best for A
Now A contributes QC of potential private goods

to obtain OJ of social goods and B who is located
at T in figure 3 contributes RD of potential
private goods to obtain the same OJ of social
goods.
B now contributes the larger share.

Along the vertical axis of the figure we measure an ordinal
index of welfare for A, and along the horizontal axis, a similar
index for B.
If no public goods are produced, A is located at C in Figure 2

and his indifference level is given by i1C similarly, B is located
at D in Figure 3 and his indifference level is given by i1D.
Both are at the 'lower limit of their respective welfare levels,

as shown by point z in the figure .
If the government decides to leave B's position unchanged, an

arrangement for public services may be made that raises A to
indifference leve! i2P, indicated by x in the figure
This places A at P in fig 2 and B at T in figure 3
The supply of social goods equals OJ and that of private goods

equals OU in figure 1.
If the government decides to leave A’s position
unchanged an arrangement for public services can be
made that raises B to indifference level i2W.
This arrangement indicated by y in the figure above

places B at W in figure 3 and A at V in figure 2
The output of social goods equals OG and that of private

goods equals OL in figure (1)
The area zyx in figure above shows the infinite number of

possible solutions that leave A, B or both better off than
at z where no public services are supplied.
In choosing among them the government will select a

point on xy since any point south-west thereof permits an
improvement by moving towards the utility frontier.
The choice among the infinite number of possible
points on xy – all of which are optimal in the Pareto
sense – cannot be decided on the basis of the simple
condition that total welfare rises if the position of any
person is improved without worsening that of another
As we move from y to x, A’s position is improved and

B’s is worsened.
To choose among these solutions a SWF is required

that permits us to evaluate the social gain or loss
resulting when A’s position is improved at the cost of
B or vice versa.
This need does not arise in the allocation of The General Equilibrium view thus points to a second flaw
resources between various private wants where in the voluntary-exchange model. Even if all preferences
various individuals may consume different amounts of are revealed, there is no single best solution analogous to
any one product. the Pareto optimum in the satisfaction of purely private
wants.
The simple welfare condition leads to a single solution
and the optimal allocation of resources is determined Instead we arc confronted with large number of solutions,
uniquely on the basis of a given state of distribution. all of which are optimal in the Pareto sense.
A major flaw in the Voluntary Exchange Models is that it crucially hinges on voluntary
revelation of preferences – which is an unrealistic assumption
So one needs a way to get people to reveal their preferences –
One line of advance from this is towards CLUB GOODS where by volunteering to be a
member of a club preferences are revealed
or LOCAL PUBLIC GOODS in which the act of residing in a location reveals preferences
for local public goods being provided
The second line of advance is to generate INCENTIVE COMPATIBLE MECHANISMS

which makes honest revelation of preferences worthwhile
An Incentive-Compatible Mechanism for
Preference Revelation
Preference revelation is a very important issue in the
provision of public goods. But the free-rider problem has
long been regarded as intrinsically unsolvable in our world
of imperfect knowledge and individual self-interest.
Thus the discovery of an incentive-compatible mechanism

whereby self-interested individuals are induced to reveal
their true preference for public goods can be rightly hailed
as a landmark in the theory of public goods.
The Clarke Groves Mechanism (C-G) is seen in the figure
where the horizontal axis measures number of units of a

public good costing $ 1 each or just the total of $
expenditure on the public good.
The horizontal line through $ 1 represents the MC curve

Step 1: Each consumer is allocated a (percentage) share of the
total cost of providing the public good, with where si is
the cost share of individual i. Thus the cost of production of the
good (irrespective of the amount produced) is adequately covered
by these levies.
Step 2: Consumers are then asked to report their MV

curves (they need not be linear) which are then summed
vertically to give
whose intersection with the MC curve determines the

amount of the public good to be supplied as X0
Step 3: Each consumer j, in addition to his share in the total

cost of production discussed in step 1, has to pay a Clarke-Groves
tax determined in the following manner. A horizontal line is
drawn through the point $(1-sj). This line is labelled MCi≠j since it
is the MC to all consumers other than j.
The curve
is then drawn in. This is the aggregate MV of all consumers other

than j. It intersects the MCi≠j curve at a point (F) to the left of X0
Since the MVj lies higher than the line through $sj at
X0 .
The C-G tax on consumer j is the difference MCi≠j and

σ𝑖≠𝑗 𝑀𝑉 𝑖 from N to X0 or the Δ FHG.
Drawing Tj as the mirror image of σ𝑖≠𝑗 𝑀𝑉 𝑖 the tax

also equals Δ ABC where BC = HG
If 𝑀𝑉𝑗 lies below sj at X0 the C-G tax is the shaded

region in the lower figure
Rationale for C-G TAX
Point n is the amount of the Public Good that would be

supplied if j were to report his MV as identical with his
cost share i.e. the horizontal line at $ sj .
This is the level of supply preferred by all consumers

other than j, as a group, given sj, since it is at this point
N, that σ𝑖≠𝑗 𝑀𝑉 𝑖 intersects MCi≠j
By reporting a MVi either above or below $ sj , consumer j Suppose false MVj is MVj1
causes the amount of Public Good to differe from N and all
other consumers suffer a loss of Δ ABC The gain is reduction in tax plus reduction
in cost contributions
By making j pay precisely Δ ABC, he is under reporting
the MV curve. Reduction in tax: CBED
Reduction in cost: BX0X’E
TOTAL reduction in cost: CX0X’D
Tj
F Reduction in benefits: CCX0X’F
C NET LOSS CX0X’F - CX0X’D = ΔCDF

D
A
E B
MVj Hence no point in under
reporting the MV curve
MVj1
X’ X0
Suppose j mis-reports MV to MVj’ in the
adjacent figure. The supply of public
goods rises to X’.
His marginal valuation on the extra

amount X0X’ is the area C X0X’L
But he has to pay an extra X0X’MB in

cost share plus an extra CBMR as C-G
tax.
Thus the net loss of mis-reporting is

ΔCLR.
The best strategy for the individual is to

report the MV curve truthfully.
The argument is true for an individual j

is true for any j = 1…I.
Hence all individuals will be motivated

to reveal their true preference
Cornes and Sandler – ch. 11
CLUB GOODS
A club is a voluntary group of individuals who derive mutual benefit from sharing one or more of the
following: production costs, the members' characteristics, or a good characterized by excludable
benefits.
A number of aspects of the club definition deserve highlighting
Privately owned and operated clubs must be voluntary; members choose to belong because they
anticipate a net benefit from membership. Thus, the utility jointly derived from membership and from the
consumption of other goods must exceed the utility associated with Non-membership status. This
voluntarism serves as the first characteristic by which to distinguish between pure public goods and club
goods.
Clubs involve sharing, whether it be the use of an impure public good or the enjoyment of the desirable
attributes of the members. Sharing often leads to a partial rivalry of benefits as larger memberships
crowd one another, detracting from the quality of the services received.
Crowding or congestion depends on some measure of utilization, which could include the number of
members, the total number of visits to the club's facilities
As membership size expands, both costs and benefits arise: Costs involve increased congestion, while
benefits result from cost reductions owing to the sharing of provision expense associated with the club
good.
By adding a cost offset to the benefits derived from expanding the membership size, crowding leads to
finite memberships, a second characteristic serving to distinguish club goods from pure public goods.
For the latter, crowding costs are zero, and therefore new users can be included always at a net benefit
owing to reduced per-person assessments.
Because clubs are often exclusive, with finite memberships that are subsets of the population, the
disposition of the nonmembers of a given club is a third distinguishing characteristic of club goods For
pure public goods, all individuals can be members without crowding taking place, so that nonmembers
do not exist.
The entire population is in a single provision association for pure public goods. For club goods,
nonmembers to a given club have two options: They can join another club providing the same club good,
or they may not join any club offering the club good.
If all population individuals are allocated among a set of clubs with no overlapping or Non-assigned
individuals, the population is partitioned by the set of clubs. The number of clubs then becomes an
important choice variable. When, however, some individuals do not belong to any club supplying the club
good, then the population is not partitioned.
A fourth distinguishing feature of club goods is the presence of an exclusion mechanism, whereby users'
rates of utilization can be monitored and nonmembers and/or nonpayers can be barred. Without such a
mechanism, there would be no incentives for members to join and to pay dues and other fees.
The operation and provision of an exclusion mechanism, such as a turnstile or a toll booth, must be at a
reasonable cost. By "reasonable" we mean that the associated cost of the exclusion mechanism must be
less than the benefits gained from allocating the shared good within a club arrangement.
A fifth distinguishing attribute of club goods concerns a dual decision. Since exclusion is practiced,
members with user privileges must be distinguished from nonmembers.
Moreover, the provision quantity of the shared good must be determined. Insofar as the membership
decision affects the provision choice, and vice versa, neither can be determined independently. For pure
public goods, however, only the provision decision needs be considered - the membership is the entire
population.
The kind of clubs that we deal with are homogeneous clubs whose members have identical tastes and
endowments. If either tastes or endowments doffer than the club is called heterogeneous or mixed.
BASIC MODEL: Homogenous Clubs with Fixed Utilisation Rates
In the basic model, we assume the existence of two goods: a private good (y) and a club
good (X)
The homogeneous members possess the same tastes and endowments. A representative member's taste is
represented by a utility function,
where
yi is the ith member's consumption of the private good
X is his or her consumption of the club good, and
s is the membership size.
Since the utilization rate of the club good is the same for all members, we have xi = X for all members,
where xi is the ith member's utilization rate of the club facility, and X is the size of the club facility. Hence,
each member is viewed as using what is available.
The Utility function satisfies standard requirements: In particular, an increase in either good will augment
utility - the indifference curves will be convex to the origin in goods space. The utility function will be twice
continuously differentiable. This latter assumption allows us to take up to two derivatives; hence, s is
implicitly assumed to be continuous.
The marginal utility derived from additional members may be positive for small memberships, owing to
camaraderie, but eventually crowding will occur, and marginal utility will become negative.
Congestion therefore results in a decrease in utility as membership size expands beyond some point s
The existence of both a costless exclusion mechanism and congestion implies that the club good is not a
pure public good in the Samuelson sense, even though club provision is consumed equally by all
members.
Each member attempts to maximize utility

subject to a resource constraint
This resource or budget constraint depends on the two goods used and the overall club
membership size.
An increase in either good raises cost to the individual so that
Since all members are identical, and since club costs are equally shared among members, a
membership increment will reduce resource expenditures for each member — that is
In other words, each member must pick up a smaller share of the club's total costs as membership
expands, if other things remain constant.
The representative member maximizes utility subject to the budget constraint in (2). The
following first-order conditions result from this maximization:
Equation (3) is the provision condition for the shared good, and it indicates that for each member the
marginal rate of substitution (MRS) between the club good and the private good must be equated to the
marginal rate of transformation (MRT) between these two goods.
Thus, for the club good, members equate their marginal benefit with their marginal cost.
The i superscript denotes the individual, and hence MRT^ refers to the individual's marginal cost ratio
between the two goods. If, at the margin, the club is breaking even in providing the public good, the
sum of the members' marginal costs (or payments) must equal the club's marginal cost of provision
Equation (3) then indicates that the usual Samuelson provision condition for public goods holds for the
club good
In the basic model, the provision condition for the club good does not differ significantly from that for a
pure public good, except in terms of the number of individuals aggregated by the summation index and
the interaction of the provision and membership conditions.
The novel aspect of club analysis shows up in the membership condition, expressed in (4)
For within-club optimality, a representative member equates the MRS between group size and the
private good [left-hand side of (4)] with the associated MRT [right-hand side of (4)], thereby achieving
equality between the marginal benefits and marginal costs from having another club member.
These marginal benefits are normally negative owing to crowding, and the corresponding marginal
costs are negative owing to cost reductions derived from cost sharing.
Since, by assumption, a whole member must be added (or removed) from the club, the membership
condition may not be satisfied as an equality. That is, going from s to s + 1 members may reverse an
inequality between the two sides of (4).
When this discreteness problem occurs, members should be added, provided that marginal benefits
exceed marginal costs. The membership size prior to the reversal of the inequality is optimal.
A pure public good club could accommodate the entire population, because marginal benefits from
new members are zero and therefore are always greater than the corresponding negative marginal
costs. Consequently, pure public goods do not require a membership restriction.
For the provision condition, the MRS between the
member's resource constraint two goods is equated with the individual's share of
the marginal costs of provision. Cross-multiplying
by s in (6) gives the standard Samuelson provision
condition, equating the sum of the MRS values
and the marginal cost.
L = U(y, X, s) +λ (I – y – C(X,s)/s)
Optimal membership requires an equality between
𝜕𝐿 𝐶 the relevant MRS and the marginal costs of
= 𝑈𝑥 − 𝜆 𝑥ൗ𝑠 = 0
𝜕𝑋 increasing the membership size. The latter
includes increased maintenance fees (i.e., Cs/s)
𝜕𝐿
= 𝑈𝑦 − 𝜆 = 0 and reduced membership fees, owing to sharing
𝜕𝑦 [i.e., - C(.)/s2 ]
𝜕𝐿 In this alternative representation, full financing
= 𝑈𝑥 − 𝜆[{𝑠𝐶𝑠 − 𝐶 . ]/𝑠 2 = 0
𝜕𝑋 always results, since the budget constraint divides
the club costs among the members.
Then
𝑈𝑠
= 𝐶𝑠Τ
𝑠 − 𝐶(𝑋,𝑠)ൗ𝑠2
𝑈𝑦
LOCAL PUBLIC GOODS
The theory of local public goods differs in that goods are assumed to be specific to a particular
geographical location, and consumers, in deciding on their location, can exercise choice with respect to
the quantity and types of public goods provided.
For some public goods there may be no spatial restriction (for example, the benefits from research and
development); but for others the benefits, although available at no additional cost to new residents, are
confined to one community (possibly with some spill-over to neighbouring communities).
The construction of sea defences benefits those protected by the sea wall; the transmission of a television
programme benefits those within a certain distance of the transmitter.
we examine some of the implications of the local nature of such public goods and their provision by local
communities.
Local Public Goods and the Market Analogy
The mobility of individuals between communities supplying local public goods has a number of major
implications. It is in particular relevant to the problem of the revelation of preferences.
Much of the interest in local public goods was stimulated by the intriguing suggestion of Tiebout (1956)
that, if there were enough communities, individuals would reveal their true preference for public goods
by the choice of community in which to live (in much the same way as individuals reveal their
preferences for private goods by their choices).
Where there is a wide range of choice, all those deciding to live in the same community would have
essentially the same tastes, and there would be no problem of reconciling conflicting preferences.
Moreover, it is often asserted that such a local public goods equilibrium would be Pareto-efficient.
Just as the consumer may be visualised as walking to a private market place to buy his goods, . . . we
place him in the position of walking to a community where the prices (taxes) of community services are
set. Both trips take the consumer to the market. There is no way in which the consumer can avoid
revealing his preferences in a spatial economy. [Tiebout, 1956, p. 422]
This parallel ignores however certain key characteristics of local public goods. One of the most
important of these is the essential non-convexity associated with the provision of such goods
In the case of local public goods, non-convexities are inherent in that the cost of supplying a given
quantity of a public good (e.g., a local radio programme) to an additional individual is zero (in the pure
case).
when there is a limited number of communities, they may attempt to

make themselves more attractive to outsiders, acting in this way analogously to monopolistically
competitive firms.
In a local public goods equilibrium, there may well be fewer communities to satisfy the needs of all
consumers.
There are the issues raised by redistribution. The rich may attempt to segregate themselves from the
poor, in part because there is a large element of redistribution involved in the provision of education and
other services of the local community. By moving to their own communities, the rich can avoid this
redistribution.
Optimum Provision of Local Public Goods
For a pure public good that is not spatially limited (such as the benefits from research and development),
the issue of the number and size of communities does not arise. Where however the benefits from a
public good are spatially restricted, this issue is important.
As far as the public good is concerned, it is indeed natural to ask why there should be more than one
community. If the addition of a person does not detract from the benefits enjoyed by others, then—from
this point of view—the optimum allocation would involve everyone living in the same community.
Against this, however, must be balanced the diminishing returns to labour with a fixed quantity of land, or
the declining utility arising from congestion (e.g., as residential density increases). Moreover, for some
public goods congestion may set in beyond a certain size of community.
We focus on a single pure public good, considering the balance between the increasing returns inherent
in its provision and the decreasing returns to labour as the population within a community is increased.
We assume at this stage that all individuals are identical and examine the optimum allocation over a
number of identical communities.
Basic Framework
The model is a highly simplified one, in which total output, Y, in a community can be used either for
private consumption (X per person) or for the public good, G, in that community. It is assumed
that output is an increasing, concave function of the number of workers in the community, N:
On the assumption that everyone in the community is identical and is treated the same, the aggregate production
constraint gives:
For fixed N, this defines the consumption opportunity set illustrated in Fig. 17–1.
We assume that individuals have identical preferences,
represented by the utility function U(X, G)
If the government chooses G to maximize U for a given

level of N, this gives the point of tangency in Fig. 17–1.
The condition for a maximum of U is that
L = U(X, G) + 𝜆 (𝑌 − 𝑋𝑁 − 𝐺)
𝜕𝑈
= 𝑈𝑥 − 𝜆𝑁 = 0
𝜕𝑋
𝜕𝑈
= 𝑈𝐺 − 𝜆 = 0
𝜕𝐺
𝑈𝐺 𝜆
=
𝑈𝑥 𝜆𝑁
which is the conventional result that the sum of the marginal rates of
𝑈𝐺 1 𝑁𝑈𝐺
= substitution equal the marginal rate of transformation (ΣMRS = MRT ).
𝑈𝑥 𝑁 or =1
𝑈𝑥
#Note MRT = Px /Pg and assumption made was that same good can be
used either as public good or pvt good, hence price Px = Pg hence =1
As we increase N, output, and hence the maximum level of public goods, increases (since f' (N) > 0) but
the maximum level of consumption per capita ( f (N)/N ) decreases.
The variable N opportunity locus is the outer envelope of the fixed N opportunity loci (Fig. 17–2)
This outer envelope may be characterized by taking a fixed

value of G and then varying N to maximize X. Since
𝜕𝑌
= 𝑋 = 𝑓′(𝑁)
𝜕𝑁
Now substitute for X
𝑓′(𝑁)N+G=f(N)
G = f – f’N
G = f – f’N
This condition has an interesting interpretation
Since f' is the marginal product of labour, f –Nf‘ is output minus wage payments if workers are
paid their marginal product.
Thus if the level of public exp is fixed, but pop is variable, the pop that maximises consumption per
capita is such that rents equal public good expenditure
This has been dubbed the “Henry George” theorem (Stiglitz, 1977), since not only is the land tax
non-distortionary, but also it is the “single tax” required to finance the public good.
COST BENEFIT ANALYSIS
In principle Cost Benefit Analysis (CBA) is straight forward. An investment project can be viewed as
representing a perturbation of the economy from what it would have been had the project not been
undertaken.
To evaluate whether the project should be undertaken we look at the consumption levels of
individuals of all commodities at all dates, under the two different situations. If all individuals are
better (worse) off then the project should be accepted (rejected).
If some individuals are better off and some worse off, adoption of the project depends on how we
weight the gains and losses of different individuals.
A rational individual always weighs up the advantages or disadvantages of a particular action to

herself and may also consider to who these advantages accrue.
Depending on whether the individual is a selfish rationalist or a pure altruist he would consider net
gains to himself or may totally disregard gains to himself.
Substituting benefits for advantages and costs for disadvantages we can set up a very useful
proposition. This is that CBA merely formalises a common-sense concept of rationality. This
essence of CBA, however, is that it is not confined to decisions that affect one individual. It relates to
social decisions that affect a group of individuals.
Does the characteristic of rationality remain if we extend it to the social context? The basic argument
underlying CBA is that this rationality does remain. That is, if we leave a group of individuals to work out
their own personal CBAs we can simply aggregate the results to secure a social evaluation.
What is being aggregated over here is not a set of political votes but rather a set of money valuations – all
positive valuations indicate net gains while negative valuations indicate net costs to the person expressing
them.
To analyse the idea of “collective rationality” we should be able to see that adding up “money votes” in this
way effectively allows for the two types of ‘balance of advantage’.
First, each individual will have carried out own CBAs.
Second, once these individual are recorded some will show net benefits and some will show net costs.
The essence of collective rationality argument is that it is legitimate to aggregate the individual money
votes in such a way that the difference between the votes in favour and the votes against defines the
concept of Net Social Benefit.
Individual Benefits Costs Benefits - Costs
Consider the following:
1 10 11 -1
2 10 7 3
3 12 2 10
4 7 10 -3
5 6 14 -8
Total 45 44 +1
Individuals 1 to 5 have various (arbitrary) benefits and costs arising from an individual project.
It can be observed that three of personal net benefit are negative and two positive. If each individual is
treated as a single voting unit, a simple majority rule would lead to a rejection of the project.
But using money values has led to the result that society appears “better off” by accepting the project.
An important principle being made use of in the above example is the Kaldor-Hicks compensation
principle.
If individuals paid out 12 units of their 13 units net gains to individuals 1, 4 and 5 they would still have 1
unit left over between them while individuals 1, 4 and 5 would have zero net gains – they would be no
worse off than they were before.
Political Votes and Economic Votes
The example above illustrates the distinction between one person one vote principle of
political voting and the kind of vote recorded in CBA.
The difference arises because we have used money votes in CBA.
Money values permits some expression of the intensity of preferences in the vote. It is this
aspect that gives economic voting an advantage over political voting in some cases.
It must of course be remembered that Arrow’s Impossibility Theorem holds true here as
well.
While individuals may all behave rationally, collecting their votes together and securing a
net overall result may contradict some principles of rationality.
Value Judgements and Cost Benefit Analysis
CBA deals with economic votes. Since these are expressed in the market place they reflect
individuals Willingness to Pay (WTP). WTP for benefits is a familiar concept though WTP for costs is
non-sensical. What is meaningful, however, is the idea of WTP to avoid costs that would otherwise
be incurred or being prepared to accept compensation for costs actually suffered. Thus economic
votes relate to two things:
(i) An underlying political vote for or against the project in question.
(ii) The power of the individual to pay or be paid
The second aspect demonstrates that economic votes are dependent upon the individuals ability to
pay i.e. upon his income and wealth.
This is most obvious if we think of WTP, but not quite so obvious id we think of compensation.
One would expect compensation to be linked to not income but the loss involved.
However, if we measure that magnitude in terms of the sum of money necessary to restore the
individual to her original level of welfare, this will in general be correlated with her income.
On the basis of the above we can establish 2 value Judgements of CBA
(i) That individual preferences should count

(ii) That individual preferences should be weighted by some ‘intensity factor’ which will be correlated with
individuals’ income
Both of these statements are likely to face considerable disagreement on the following count:
(i) A decision which reflects individual preferences is a good decision but may not be agreeable to all. It can be
argued that some decision may need to be made ‘’on behalf of’’ the people since they are not always the best
judges of what is good for society.
(ii) A voting system in which those with higher income have a greater say poses even more problems. This is
clearly offensive to egalitarians. A change in (ii) will quite possibly change the outcome of our CBA. It says
that the prevailing income distribution should be used when evaluating projects. It is open to vary it and ask
what would happen if we evaluated the project as if the income distribution were different. It is clear in any
case that some judgement about a desirable income distribution is implicit in any CBA
Investment Criteria
The principle of CBA is to weigh up the advantages and disadvantages, the costs and benefits of any project.
Ideally these costs and benefits are expressed in money terms.
Each individual cost and benefit item i will have a quantity qic and qib and a price pic and pib . In any one year
costs are given by
𝑐 𝑐
𝐶𝑡 = ෍ 𝑞𝑖,𝑡 . 𝑝𝑖,𝑡
And benefits by
𝑏 𝑏
𝐵𝑡 = ෍ 𝑞𝑖,𝑡 . 𝑝𝑖,𝑡
In turn these costs and benefits will be distributed through time
We could simply add up the costs and benefits upto some time period T, which is called the time horizon.
T is set most frequently by the economic life of the investment which will in general be shorter than its physical life.
If we add up the costs and benefits we could obtain an expression for NET BENEFITS
𝑁 𝐵 = ෍[𝐵𝑡 − 𝐶𝑡 ]
𝑡=0
However, this expression neglects an important factor. If we adopt the basic value judgement that
individual preferences ought to count we must incorporate the fact that individuals may prefer present
consumption to future consumption i.e. individuals will prefer a unit of benefit now rather than later even
if the existence of the benefit in the future is certain.
They discount the future. They are said to have a ‘time preference’ and the rate at which they discount
the future is called the ‘marginal time preference rate’ (MRTP)
Thus the expression for N(B) is more accurately written as:
1 1 1 1
N(B)= 𝐵0 − 𝐶0 [ ]+ 𝐵1 − 𝐶1 + 𝐵2 − 𝐶2 + ⋯…+ 𝐵𝑇 − 𝐶𝑇
1+𝑟 0 1+𝑟 1 1+𝑟 2 1+𝑟 𝑇
More compactly,
𝑇
1
𝑁 𝐵 = ෍(𝐵𝑡 −𝐶𝑡 )
(1 + 𝑟)𝑡
𝑡=0
𝑇
or
𝑁 𝐵 = ෍(𝐵𝑡 −𝐶𝑡 )𝑑𝑡
𝑡=0
1 The expression dt is called the discount factor

where 𝑑𝑡 = and it is determined by the time period t and
(1 + 𝑟)𝑡
the discount rate r
The expressions above express future costs and benefits in terms of how they would be viewed from
the standpoint of the present.
Hence, net benefits are to be now understood as ‘net benefits as viewed from the present standpoint’
which we call NET PRESENT VALUE
NPV(B) = GPV(B) – GPV(C)
Three contexts arise within which the NPV criterion must be used to evaluate projects:
(i) Accept-Reject: Here the agency must decide whether a given project is to be accepted or not
(ii) Ranking: The agency may have a series of investments all with positive NPVs. How does it
rank them?
(iii) Mutual Exclusion: The agency may have to decide between two projects simply because
undertaking one may mean that the other cannot be undertaken
(i) Accept-Reject: Faced with a single project, the NPV rule dictates that it should be accepted if
NPV > 0, and rejected if NPV < 0. If NPV = 0 the agency would be indifferent.
(ii) Ranking: In the context of unlimited funds all projects with NPV > 0 should be accepted. However,
the more realistic context is always one of rationing. In such a case the agency has to rank projects
in order of desirability and work down the order till the budget is exhausted. However, the ranking
should not be done on the basis of NPV alone
Consider the following table:

Project GPV(C) GPV(B) NPV GPV(B)/GPV(C)
X 100 200 100 2.0
Y 50 110 60 2.2
Z 50 120 70 2.4
If a capital constraint of 100 units exists NPV ranking of X,Y,Z would result and only X would be chosen
with Net benefits of 100. However, it is apparent that both Y and Z can be chosen within the constraint
of 100 units and this would yield joint benefit of 130.
The final column seems a better way of ranking projects: ranking by benefit-cost ratios
(iii) Mutually Exclusive Projects
Where the choice is between projects, the general rule is to select the project offering the highest
NPV. However, it should be clear whether ‘exclusivity’ between X and Y is strict of some
combinations of X and Y are permissible.
These combined projects should be treated as if they were extra projects. In any case the rule of
selecting the highest NPV applies.
Internal Rate of Return
The calculation of NPV requires the use of some social discount rate r which is assumed to be derived
independently.
An alternative approach to investment appraisal is IRR and compare it directly to the social rate of
discount. The IRR is in fact another name for Keynes’ MEC.
It is calculated by setting discounted net benefits stream equal to the initial capital outlay and solving
the equation for the value of the discount rate. That is…
𝑇
1
෍ 𝐵𝑡 − 𝐶𝑡 . = 𝐶𝑜
(1 + 𝑟)𝑡
𝑡=1
𝑇 𝑇
1 1
or ෍ 𝐵𝑡 . = ෍ 𝐶𝑡 .
(1 + 𝑟)𝑡 (1 + 𝑟)𝑡
𝑡=1 𝑡=0
is solved for r and C0 is the initial capital outlay
The rule for accepting a project is accept if r* > r where r* is the IRR and r is the
predetermined discount rate. If r* < r reject the project
Multiple Roots Problem
In computing IRR it is quite possible to obtain more than one solution rate.
This is true because the equation to be solved is a polynomial: if the polynomial is of degree n, there will
be n solution rates.
Therefore if a projects’ IRR has two solutions say 10% and 15% while r =12% there appears to be no clear
cut criterion for acceptance or rejection
The only roots of a polynomial equation which are of interest are those with positive and real values.
The number of positive roots can be found by Descartes’ Rule of Signs.
If the decision formula is expressed as an equation in I, the IRR, the positive roots can be indicated. Thus
in the simple 2 period case:
𝐵1 1+𝑖 +𝐵2
𝐵1 𝐵2 = k((1 + 𝑖)2
(1+𝑖)2
+ =𝑘
(1+𝑖) (1+𝑖)2
𝐵1 1 + 𝑖 + 𝐵2 = k(1+2i+ 𝑖 2)
−𝑘𝑖2 + 𝐵1 − 2𝑘 𝑖 + 𝐵1 + 𝐵2 − 𝑘 = 0
𝐵 1 + 𝐵 1i + 𝐵 2 = k + 2i + ki 2
−𝑘𝑖2 + 𝐵1 − 2𝑘 𝑖 + 𝐵1 + 𝐵2 − 𝑘 = 0
So that the sequence of signs before the terms in i is - , + There is only one change of
sign so there is one positive root.
If the sequence of signs were -,-,+,+ one would still have one positive root
However, the sequence -,+,- has two changes and hence two positive roots.
This sequence is perhaps most appropriate for public investment projects: initial expenditure
(-), followed by positive returns (+) and then negative returns (-) as the project ages, possibly
costing money to dismantle and scrap.
In the case where the sequence is -,+,- some rules have been suggested by which valid IRRs can be
distinguished from ‘invalid’ ones
Suppose we have 2 positive roots i1 and i2 with i2 > i1, formulate the following rules:
(a) i2 < e < i1 accept the project NPV
(b) e < i1 reject the project
(c) e > i2 reject the project
where e is the social discount rate. Rule (a) can be shown diagrammatically NPV
i2 i
i1
SHADOW PRICES
Thus far we have assumed that existing market prices (weighted, where necessary, for
distributive reasons) were the appropriate valuations to use when performing social CBA. This
requires:
(i) Item in question was one to be judged in terms of individual preferences as revealed in
the market
(ii) Individual was free to choose how much to consume of the good at a fixed market price
With respect to inputs one requires that the price of the input in question was equal to the
value of its marginal product.
When these assumptions are not fulfilled market prices will no longer necessarily be
appropriate valuations to use in appraisals.
It is then necessary to replace market prices by ‘’shadow prices’’ which reflect the social value
of outputs and inputs concerned.
A shadow price emerges as a marginal valuation imputed to an input or an output at the optimum in an
optimisation problem. At the optimum activities will only be undertaken if the value of their outputs is at
least as great as the cost of inputs measured in shadow prices.
In the sense just mentioned shadow prices exist for all inputs and outputs whether traded or not and
where some combination of market mechanism and government intervention is functioning well this
shadow price will be reflected in the current market prices.
In CBA the term ‘shadow price’ is reserved for a price that is imputed as opposed to being taken directly
from market transactions, whether this is because no market price exists or because market price is
considered to be inappropriate. Nor is the term restricted to valuations in the neighbourhood of the overall
optimum; where constraints render optimisation infeasible, it is used for ‘second best’ valuations too.
The use of market prices for valuation purposes will be improper if:
(a) Market prices are not equal to MCs
(b) MC does not reflect the true social cost of resources
In an imperfectly competitive world prices will tend to be above MC and external effects will exist, so that
(a) and (b) pertain. The sources of these divergences are:
(i) Imperfect Competition: In product market under market imperfection P> MC. Therefore market
prices will overstate the proper shadow price to be applied to output. With imperfection in factor
markets, factor prices = MRP < VMP Consequently the market price of a factor will not be an
appropriate shadow factor price
(ii) Unemployment of Resources: If a public project employs a resource which would otherwise have
been unemployed, the true cost to society of employment is (virtually) zero. In recession the shadow
cost of labour is closer to zero than it is to the wage actually paid.
(iii) Increasing Returns: The existence of IRS will mean that MC < AC. Therefore if P=MC evaluation
of benefits at market prices will involve losses. But losses have to be financed and methods of
financing them have welfare effects
(iv) Taxation: Market prices will contain elements of indirect taxation or may be below true cost if a
subsidy is involved. To correct for any biases in valuation all output should be valued, net of indirect
taxes and subsidies i.e. at factor cost
(v) External Effects: External benefits and external costs are not priced in the market. Consequently,
ignoring external benefits will lead to the benefits of the project being undervalued; costs will be
undervalued if external costs are present
(vi) Public Goods: The benefits of public goods cannot be restricted to particular groups by pricing
policies. If benefits are yielded, those who receive the benefits as a by-product of the supply to a
particular section of the population will, if they act rationally, understate their true valuation of the benefit
knowing that they will obtain the product free as long as it is supplied to at least one person. Clearly the
market price will not be a valid indicator of the social benefit in this case.
The Second Best Problem

The shadow pricing argument suggests that benefits should be valued at prices which reflect MCs.
In the presence of imperfection this rule is modified so that benefits are valued at marginal social costs.
It must ne remembered that this rule will be relevant for policies designed to move an economy in the
direction of a Pareto social optimum.
However, a problem arises if prices are not equated with marginal social costs throughout the
economy. If marginal social cost pricing is adopted in the public sector but not in the private sector will
the economy be nearer a Pareto optimum than if neither sector used the appropriate shadow prices?
It has been suggested that marginal social cost pricing in this context may move the economy away
from a Pareto optimum i.e. given that a ‘first best’ is not obtainable, it is not possible to state what
pricing rule in the public sector will take the economy as far as possible towards a Pareto optimum.
This is the essential point of Lipsey and Lancaster’s theory of Second Best.

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References:

Mueller: Public Choice

Public Good and Game of Chicken

In a building a fire department is supported voluntarily –

Free Rider problem occurs because Public Goods

Pure Public Good - Impure Public Goods -

Markets Fail in the Presence of Public Goods.

Example: a steel plant that pollutes a river used for recreation

Externalities are one example of market failure

Externalities present a classic justification for government intervention

First Theorem States… IF

households and firms act perfectly competitively, taking prices as parametric,

there is a full set of markets, and

there is perfect information,

then a competitive equilibrium, if it exists, is Pareto-efficient.

 There is no way to make all people better off or

In particular, the first theorem says nothing about distribution of economic

Then A sells the second unit of good 1 to B for the maximum

Agent A continues to sell units to B in this manner, thereby

It is easy to see that such a point must be Pareto efficient. Agent

Let us pick a Pareto efficient allocation.

Here the illustrated point X is Pareto

The most obvious candidate is drawn in

Agent A wants to demand the bundle Y,

If the preferences of both agents are convex, then the common

This observation gives us the Second Theorem of Welfare

The only policy instrument employed is a lump-sum redistribution of endowments to

The exchange economy illustrated in

The initial endowment point is denoted ω

Such a transfer of part of an endowment from one household to another

The transfer is an optimal transfer if the resulting equilibrium at e maximizes

and give household 2 an amount of income

Given this, it would be impossible to conduct lump-sum transfers of endowments as a

It is therefore possible to dismiss the idea of transferring quantities of goods, except in

Let the system of lump-sum taxes be based on the characteristic IQ level.

Uh =Uh (c1xh1,..., cnxhn)

The preferences of each household are fully described by their c vector.

2. Private-Sector Solutions to Negative Externalities

3 Public-Sector Remedies for Externalities

4 Distinctions Between Price and Quantity Approaches to

Market failure: A problem that violates one of the assump-

Externality: Externalities arise whenever the actions of one

Example: a steel plant that pollutes a river used for recreation

Externalities are one example of market failure

Negative production externality: When a firm’s production

Private marginal cost (PMC): The direct cost to producers

Marginal Damage (MD): Any additional costs associated

Social marginal cost (SMC = PMC + MD): The private

Negative consumption externality: When an individual’s

Private marginal cost (PMB): The direct benefit to con-

Social marginal cost (SMB): The private marginal benefit

Example: Using a car and emitting carbon contributing to

The Externality of SUVs

Positive production externality: When a firm’s production

Example: Beehives of honey producers have a positive impact

Positive consumption externality: When an individual’s con-

Example: Beautiful private garden that passers-by enjoy seeing

With a free market, quantity and price are such that P M B =

Social optimum is such that SM B = SM C

⇒ Private market leads to an inefficient outcome (1st welfare

Negative production externalities lead to over production

Positive production externalities lead to under production

Negative consumption externalities lead to over consumption