Topics on Public Goods

Public Goods and and Pareto Efficiency – An Example with Income Redistribution
Reference: Leach (2004), chapter 11

Simple economy:

– 2 groups, A and B, with 2 individuals each

– Different income levels, y A and yB

– Total income: 2 y
 y A + yB =
y

 ( y A , yB ) : Income distribution

– c Ai : Consumption of individual i in group A

– c p : Consumption in low income group

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– Preferences:

U Ai = cαAi c1p−α and U Bi = cαBi c1p−α

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 <α <1
2

 Utility of individuals in low income group depends only on their own

consumption

• Utility levels at the initial allocation ( yB= y − y A ):

 α y
( )
1−α
 y A y − y A if y A ≥
2
UA = 
 y
y A if y A <
 2

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  y
 ( y − y A ) if y A ≥
2
UB = 
( y − y )α y1−α if y < y
 A A A
2

• Pareto efficient allocations are such that:

(1 − α ) y ≤ y A ≤ α y

 If there is high inequality in the income distribution, redistribution can increase the
utility of both groups

If the initial income distribution is not Pareto efficient, will rich individuals provide
voluntary transfers (charity) to the poor?

- Suppose that group A are the rich individuals

- Each individual in group A can make a voluntary charity transfer

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Choice of transfers:

 Assume that y A > α y

 Initial income distribution is not Pareto efficient

 Transfers: v1 , v2

Utilities:
1−α
 v1 + v2 
( y A − vi )
α
U Ai =  y − y A + 
 2 

1−α
dU Ai α −1  v +v 
−α ( y A − vi )  y − y A + 1 2 
=
dvi  2 

+ ( y A − vi )
α (1 − α )  y − y +
v1 + v2 
−α

 A 
2  2 

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dU Ai  α 1−α 
=
U Ai  − + 
dvi y
 A 1 − v 2 ( y − y A + v1 + v )
2 

 Can be (+) or (-)

 If (-) for v1 > 0 , then transfer will be 0

 If (+), transfer is such that:

α 1−α
− + =
0
y A − v1 2 ( y − y A + v1 + v2 )

(1 α ) y A − 2α y − α v2
 v1 =+

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Reaction function:


≥
(1 + α ) y A − 2 y
 0 if v
α
j
vi = 
*

(1 + α ) y − 2α y − α v if v < (1 − α ) y A − 2 y
 A j j
α

 Nash equilibrium (interior) : Transfers ( v1* , v2* ) such that both reaction functions are
satisfied simultaneously

At the Nash equilibrium, we have:

(1 α ) y A − 2α y − α v j and vi = v j , therefore
vi =+

(1 + α ) vi =+
(1 α ) y A − 2α y

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 2α y
 v=
*
yA −
1+ α
i

Pareto efficiency requires that transfers be at least equal to: y A − α y

2α y
But: vi* = y A − < y A − α y , since 2 > 1 + α
1+ α

 Charity transfers do not lead to Pareto efficiency

 Redistribution role for the government based on efficiency rationale!

 An increase in redistribution starting from the Nash equilibrium increases the utility
of all individuals

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Decentralized Supply of Public Goods – A Neutrality Result

Reference: Hindriks and Myles (2013), chapter 5

Consider the following problem of decentralized supply of a public good:

 Agent i’s voluntary contribution to public good supply solves:

Max u ( xi , G ) subject to: xi + G = yi + G−i and G ≥ G−i

{ xi ,G}

G− i : sum of the contributions of all agents except i.

Therefore, yi + G−i can be viewed as the full income of agent i.

 If the contribution of individual i is 0, then G = G−i and xi = yi

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Neutrality result: G is independent of the distribution of income among contributors

 Transferring incomes across agents in the set of contributors does not change total
contributions and does not change utility levels

All will change their contribution by the amount equal to their change in income

Basic intuition:

• Agents have different incomes

 Contributors will be the one with relatively high incomes

 For contributors in a Nash equilibrium:

uGi
– i =1
ux
– G is the same for all

 Both these conditions can only hold if xi is the same for all contributors.

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 All contributors have the same utility level, independently of their income.

 yi + G−i is the same for all contributors

Since xi must be same for all contributors in the Nash equilibrium, then in
response to a redistribution of income, we will have: ∆yi =∆gi for all contributors

No change in G (and no change in yi + G−i )

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Some implications:

• If the government taxes contributors and uses the revenues to finance additional
spending on G:

Government expenditure will crowd-out private provision on a one-for-one basis.

If some of the government contribution is taken from non-contributors, then G will
increase.

All contributors are better-off.

Non-contributors may be better-off or worse-off.

Government cannot do anything about the under-provision problem until private

contributions are entirely crowded-out, or until it takes income from non-contributors

A mix of public and private expenditures may not be particularly appropriate.

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An simple example with international collective action

Simple setting:

• m countries, i = 1,..., m
• Individuals in all countries have the same utility function: u ( xi , G )
• xi : per capita consumption of private goods
• G : international public good

• ni individuals in country i , each with identical income wi

• Country size: ni wi

• Each countries’ government contributes on behalf of its residents an amount gi

m
 G = ∑ gi
i =1
gi
Tax imposed on each resident in country i is
ni

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 • Each country takes the contribution of the other m − 1 countries as given: G−i = ∑ g j
j ≠i

• Problem of government in country i :

gi
Max u ( xi , gi + G− i ) Subject to xi + =
wi
{ xi , gi } ni

FOC:
uGi
ni i < 1 for non-contributing countries
ux

uGi
ni i = 1 for contributing countries
ux

Samuelson condition holds within each contributing country

But world optimum requires that the Samuelson condition applies on a worldwide
basis

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Implications:

• If populations are identical, but per capita incomes are not:

– The contributors are the higher per capita income countries

– Residents of contributing countries have the same welfare levels (implication of
neutrality theorem)

• If identical per capita incomes across countries, but different populations:

– The smallest countries do not contribute.

– Residents of non-contributing countries are better-off

Larger countries contribute more in per capita terms because they internalize a
larger share of the benefits -- smaller private consumption, lower welfare.

• Larger countries, in either population or per capita incomes, contribute a larger share
of their national incomes to international public goods.

Disproportionate burden sharing

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Mechanisms for supplying public goods

Reference: Hindriks and Myles (2013), chapter 5

• Mechanisms to induce agents to reveal valuations.

• Examples of applications:

• Group of firms that can benefit from a public input (infrastructure), or from a new
technology (R&D)
• Group of local communities that can benefit from common infrastructures
• Groups of governments that are jointly providing an international public good
such as: pollution abatement, foreign aid, military defense, etc.

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Example 1 :

• N agents

• MRTGX = 1

• Utility of agent i: Vi(G) + Xi

• Suppose that each agent pays a tax Ti

⇒ Individualized tax

• Individual budget: Xi + Ti = Wi

⇒ Wi: initial income

• Tax of the form: Ti = tiG

with Σi ti = 1

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• Taking ti as given, the G that maximizes the utility of agent i solves:

Max Vi ( G ) + X i
G

s.t. X i + Ti =
Wi

or Max Vi ( G ) + Wi − Ti
G

⇒ FOC: Vi ' ( G ) − ti =0

⇒Marginal utility of G equals marginal tax rate

⇒Solution gives individual i’s preferred level of G: Gi*(ti)

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Lindahl allocation:

• A Lindahl allocation is a vector of tax shares, or Lindahl prices, (t1, …, tN) and a level
of G* such that Gi*(ti) = G* for all i.

⇒Vector of tax shares such that everyone has the same preferred G*

⇒Revenues raised will exactly pay for the public good since Σi ti = 1

⇒G* will satisfy the Samuelson condition

N
• Summing the FOCs gives: ∑V ( G ) = 1
i =1
i
'

⇒Tax share of everyone is related to its marginal benefit

⇒Lindahl allocation involves an efficient supply of public goods and balances the
budget.

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Problem in implementing this solution:

• Need information about the marginal benefits to set the correct ti .

• Agents have no incentives to reveal their true preferences.

⇒Does not really get around the free-riding problem.

⇒Need mechanisms that will induce agents to truthfully reveal the marginal benefits they
derive from the public good.

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Example 2:
• Agents’ preferences over public and private goods:
, X i ) Vi ( G ) + X i
U i ( G=

• N agents, i = 1,…,N
• MRTGX = 1

Mechanism:
• Regulator asks agents to report their Vi functions
• Given these reports, chooses the level of provision of the public good, G*, to satisfy:

∑ Vi ' ( G* ) = 1
i

• Tax liability of agent i is set by the rule:

T=i G* − ∑ V j ( G* )
j ≠i

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• Tax liability of agent i is the amount of public good supplied less the sum of utilities
reported by everyone else.

Equilibrium:
• Since G* is chosen by the regulator such that

∑ Vi ' ( G* ) = 1
i

then if agents are telling the truth about their preferences, G* will be efficient.

• In choosing his report Vi, agent i solves the following:

Max Vi ( G * ) + X i
s.t. X i + Ti =
Wi

or equivalently, Max Vi ( G * ) + Wi − Ti

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• Dropping Wi (constant) and using
T=i G* − ∑ V j ( G* )
j ≠i

The problem can be written as

 
Max Vi ( G* ) − G* − ∑ V j ( G* )
 j ≠i 

⇒The agent is in effect choosing G* taking Vj as given

⇒Then the problem of the agent consists in maximizing the net surplus from G,

∑V ( G ) − G
i
i

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⇒ The agent and the regulator are effectively maximizing the same objective.

⇒ The tax functions allows to perfectly align the individual incentives with the
objective of the regulator

⇒ FOC: ∑ Vi ' ( G* ) = 1
i

⇒ If anyone were to mis-represent his preferences, his true welfare would decreased
⇒ Incentive to tell the truth.

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Solution:
• Revelation of true preferences – incentive-compatible
• Efficient level of G
• But nothing guarantees that the budget will be balanced

Potential problem: Requires a central authority to implement the mechanism

⇒ May be a problem in the context of international public goods, including pollution

reduction initiatives

The Lindahl and Groves-Clarke-Loeb mechanisms may not be very practical when the
number of agents involved is large.

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