Chapter 3 Public Goods

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re Public Finance
7> and Public Choice
qe ! Second Edition aS | 7
7 9 John Cullis and Philip Jones
oH
en cmnge meena ee
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3.1 Introduction approach is demonstrated-with respect to an economy
that produces a public good.
Buchanan (1986) is critical of this almost mechan-
The main objectives of this chapter are threefold. istic approach, to economics; by comparison, he
First, the intention is to define the concept of public stresses a methodology that looks at the process of
goods and discuss the conditions necessary for Par- interaction between individuals in the economy. He
eto-optimal provision of public goods. To do this it focuses upon the processes of exchange, which affect
will be necessary to explain the characteristics of a how resources are allocated. Such analysis is described
public good. A second objective is to consider those as the study of political economy. ‘Efficiency’ is deter-
goods which, though not pure public goods, never- mined notso much by those mathematical conditions
theless bear some of the characteristics of pure public that emerge from the maxima of a constrained social
goods. An attempt is made to outline ways of provid- welfare function, but by the consent of individuals to
ing a taxonomy of goods according to the degree of proposals for the reallocation of resources. Bucha-
publicness that they possess. Finally, the question is nan’s approach to the optimal provision of public
raised of the provision of such goods in the market or goods would be that of a contractarian solution,
by government finance and/or production. Will indi- whereby individuals are prepared to accept the
viduals reveal their preferences for such goods so that attendant ‘tax’ or, rather, “exchange” arrangements
governments may provide them in a Pareto-optimal associated with public good provision.
way? Buchanan’s position has been consistent. In 1986
These objectives are quite narrowly defined, but he wrote:
i throughout the chapter it is our intention to use the
i
Jt analysis of public goods as another illustration of the What should economists do? My 1962 as well as my 1982
'
difference in approach between the ‘traditional’ pub- response to this question was to urge that we excise the
5
lic finance scholar and the public choice scholar. In maximising paradigm from its dominant place in our tool
kit, that we quit defining our discipline, our ‘science’, in
traditional public finance theory the conclusions that terms of the scarcity constraint, that we change the very
arise with respect to the conditions that are required definition, indeed the very name’ of our ‘science’, that we
to produce an ‘optimal’ quantity of the good are stop worrying so much about the allocation of resources and
virtually identical to those developed by the public efficiency thereof, and, in place of this whole set of ideas, that
choice school. It should be noted that in this chapter we commence concentrating on the origins, properties and
the difference between the two stands proud in terms institutions of exchange, broadly considered.... The ap-
of their respective methodologies. The standard " proach to economics that I have long urged and am urging
methodology of traditional public finance is in here was called ‘catallactics, the science of exchanges, by
terms of the maximization of a function (e.g. utility some nineteenth century proponents. ... This approach to
function, social welfare function) subject to con- economics, as the subject matter for inquiry, draws our
attention directly to the pracess of exchange, trade and
straints (e.g. a given state of technology and a fixed
agreement, or contract. (Buchanan 1986, p. 20)
supply of factors of production). By this methodo-
logy, the conditions for ‘efficient’ resource allocation As this chapter proceeds it will become clear that we
are established. In chapter 1 the technique was out- switch our approach from one that asks; ‘what con-
lined with respect to an economy that produces pri- ditions will be required to achieve Pareto optimality?’
vate goods, and in section 3.3 below the same to one that asks: ‘will people voluntarily consent to

46 PUBLIC FINANCE
AND PUBLIC CHOICE
, {
— oS of providin
good? In this way bo
th tra
SperaRSSs are employ ditional and
‘
i . (3.1) X= Xi + Xp In] 4
ed in dealing ivineh By contrast, from Samuelson’s definition it follows
curv’
ns outlined. Readers e order™,
May note this ch oe that, for public goods, each individual may consume
approach as the disc
ussi ik usual.
ginphasize on unfolds Howeves all of the good, In the case of a public good (G), the ,
the distinction, a comp ‘ indi)
arison of Store total amount consumed is the same for each indi-
: (and 3.3) with sectio price
n 3.5.2 should pr vidual, so that
While our main purp:
; OS 1S to tackl, e ‘h e
eA
:
ua ns
the questio
g
derog7s
outlined above, once ag (3.2) Ge. =G, = Gp over
; ain, a comparison ofal ternat- be national duct
ive approaches is possible. An example of such a good is said to -
defence, inthe specific sense that, if defence expendit detde
vidual opti .
ure deters attack on a nation, then each indi
resident may enjoy fully the addition al security cre- may ae
3-2 What are public goods? ated by such expenditure. It will be possible to say
s when the char-
ne
exce
more about examples of public good
analysed more thor-
acteristics they bear have been
7 lt
A public good (sometimes referred to as a ‘collective oughly.
indi
good’ or a ‘social good’) was defined b y Samuelson (at &
(1954, p. 387) as one ‘whi enjoy j 3.2.1 Non-rival consumption ee
the sense that each individual's consumption ofsucha a
One characteristic implied, or, rather, described, by Oe
-_good leads:to no subtraction fro r indi-
the definition of public goods is that they are non-
. vidual’s consumption of that good’. Itwas emphasized of one (Big
rival in consumption; i.e. the consumption
that public goods differ markedly from private goods, individual does not reduce the benefits derived by all It ee
which ‘can be parcelled out among different indi- other individuals. Onc implication of this character- no:
viduals’ (Samuelson 1954, p. 387). In the case then istic is that, when considering aggregate demand for Pati?
of a private good, it is possible to refer to total con- the good, individuals’ demand curves must be added >t
effi
sumption as the sum of each individual’s consump- vertically rather than horizontally. Compare the
tion. If X is, as before, a private good (e.g. apples, eS
familiar demand and supply diagram for private ing
loaves of bread), and if there are two individuals A goods with that for public goods in Fig. 3.1 (where fin
and B, then total consumption X, is the sum of each we assume there are no problems with the revelation tO
individual’s consumption: of demand curves).
fro
Oke
oO <=
$
Price
Price
q Qeir
(b) Public good

(a) Private good
Figure 3.1 Aggregate demand: public choice and private goods,
ak
io.
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© eg.
47 procedure 15 [0 dt For example, al benefits of individu
a ls equals [Ne tet pe tat.
that eachh individual should be
as pri ce.
ree de mands at each The market
> d B deman ds sq’. q®. production, and (b) h
2 *
in ce OPOPA demands q” andition is clearly horizontal, margina | benefit that eac
taxed according to the
RP
- ;
ad (or private) Z00%-
; Fe rand is gt. The rice. The marginal cost of pro- | derives from the public -rivalness in consumpt
ion
7 refore possible to The characteristic of non eri ng the
own by MC. It is the ortant part in alt
An over at
equilibrium context,
the Parcto- in this way plays an imp ion s in the
detect, in this partial eto-optimal condit
If produc ers price at specification of the Par
ever, in order to Gemon-
Z the good.
optimal quantity of each individual will
consume case of public goods. How
ves
marginal cost, then,
as
so doing to draw the dernand cur
t fro m strate this, it is necessary
SUR
ginal benefi ic of a
the good when the mar timal’ quantity to be pro- for the individuals. The sec
ond character ist
exceeds the price, the ‘op ility, throws doubt on the
d is q’*”. At this position public good, non-excludab
> duced of the private goo to more than cover OF likelihood that it is possib le to know anything reliable
individuals are willing either
cover the resource costs of about the demand curves
of the individuals. This
(at the margin) just to , if anything, preferences
<n pane
3 good. From the dia- characteristic suggests that
roducing an extra unit of this are likely to be und er-
that the condition for optimal
provi- for public (or private) goods
, gram, it is clear
revealed.
' sion is
3.2.2 Non-excludability
Ste MS eck
, provided there are that consumers cannot -
[thas been shown in chapter | that The second characteristic is
nomy, this condition is ibitive cost) be excluded fromcon-
) no other distortions in the eco (at less than proh
ty provided is an vided, one indi-
a Pareto-optimal (i.e. the quanti sumption benefits. If the good is pro l consumption
efficient one). al cannot deny another indivi dua
fF demand curves of vidu
s, markets may
: In Fig. 3-1(b), Di and Dy, are the of the good. In the case of private good good may be
good G. In order to
individuals A and B for a public operate such that con sum pti on of the
it is not sensible it. An indi-
contingent upon payment ofa ‘price’ for
D,+,
find the aggregate demand
es as distinct
ws—*Aas
to talk about the qua nti ty A con sum
vidual ma y ed consumption of the good unless
be deni
es. By definition,
from the quantity that B consum ty he is able to establish property rights to the
good.
can consume the same quanti been
each individual However, with public goods, if the good has
mes more
of the public good. In this case it beco provided by one individual he has no sanction to
* (sSatim a
A would
appropriate to ask how much individual prohibit or restrict consumption of the good. Even
if
+
A pay for_ given, B quant ity of the poe ae oF the individual has the sanction, there is no
ready
much would pay for a given quantity of
individual nce
{
At q indi- mechanism by which it can be enforced. The abse
the de a Ee
pay fp of such excludabilit y almost inevit ably appear s to
vidual A would pay & and individual B would
NS
curve is cause aa probl
cause em ofof preference revel
problem ation for such
for this quantity. The aggregate demand oods. If individuals may consume a good without
therefore D!,,; itis established by repeating this addi-
Pee
having to pay for it, there may be an incentive to ‘kee
tion at every quantity level. It should be clear that r the cost of
addition is now vertical, ie. addition over price at quiet, in the hope that others will hea provided, it
SS
pr : i dis
any quantity.
~
is
In this case, if again the marginal cost curve also worth bearing in mind that conditions which
emerge
shown as MC, the Pareto-optimal conditions can be.
' itis
eg.
ow
sensitive to the assumpti
areory which the
onons
from economic the
shown to be satisfied when the sum of the marginal theory is based. It is not the case that a certain set of
equilibrium
benefits or demands of the two individuals equals the conditions will hold in all cases. For example, suppose
that thereare
change in
marginal cost. As such, by the Benefit Principle of private good X: the
i
two individuals A and B consum ing a
and arises when Aand B
Taxation, individual A would pay a tax of O4 and the marginal costs of production is dMC,
good,
ay a tax of Oty; i.e. each indi- each demand one more extra unit. Then, even for a private
individual dMC,. Moreov er, suppos e that, for a public good,
MBB + MBP =
vidual would a tax equal to the marginal benefit to the marginal benefit for individual A and individ ual B is equal to
=
them of the go via the public sector. By zero: then it must, by definition, be true that MB, = MEP
comparison with the case above, it is now optimal that MC, = G (see Mishan 198 1a).

48 PUBLIC FINANCE AND PUBLIC CHOICE
can be enjoyed at no personal cost. This ist he strategy

of a ‘free rider’ Yet it will obviously fail when each
individual plays the same strategy. If eve
3-3 The general model for
attempts to free-ride nothing will be provided sods public goods
free ride for anyone becomes impossible. _
Buchanan (1968) illustrates the problem by way °
of a pay-off matrix similar to Table 3.1. Assume that The preceding discussion of taxation and the provi-
an individual is*one of many who would benefit to sion of public goods has been presented in a partial
equilibrium framework. It is also possible to deter-
the extent of £10 if a public good were provided
She is asked to contribute only £5 to its provision,
mine, within a general equilibrium analysis, the con-
_ ditions that must exist for Pareto optimality to be
Therefore, if she contributes (and others also con- attained when an economy provides private and
tribute), the good may be provided such that in public goods. The efficiency conditions emerge
the pay-off matrix her net return is £5. Of course, within an approach first developed by Samuelson
if others attempt to free-ride and hence do not (1955). The discussion and the solution should be
contribute she will have lost her £5 contribution compared with the Pareto-optimal conditions for
(as no refund is possible). By contrast, if she attempts economies that provide only private goods (presented
to free-ride (refuses to contribute) and others cover - in chapter 1).
the costs of provision, she cannot be excluded and In Fig. 3.2 the transformation curve is shown fora
her pay-off is £10. Moreover, if she does not contrib- particular economy as TT in part (a). This shows the
ute and others also free-ride, she cannot lose any- production possibilities of the economy. If the eco-
thing. Therefore each individual’ faced with the nomy operates efficiently, it will be on the boundary of
decision to contribute voluntarily to a public good this production frontier. The boundary shows the
chooses the best ‘pay-off’ and attempts to free-ride combinations of the two goods (X—a private
even though all would gain £5 if everyone contribu- - good—and G—a public good) that can be produced.
ted, Here is a rationale for government intervention. It It has a slope of MRT,x. The question is, How should €
resources be allocated? What combination of private ¢
is arguable that it is in everyone's interests to pay taxes
and public goods should be produced?
to finance the production of the good—provided, of
Itis inevitable that, when a question is posed in this
course, that the taxes are determined appropriately
(e.g, as illustrated in Fig. 3.1 (b)). The problem is that manner, a normative decision must be reached. In
the information used in part (b) of the figure, i.e. Samuelson’s analysis a strong normative decision is
individuals’ demand curves, is not likely to be readily made explicitly. Pareto optimality requires that the
revealed. economy operates at a point at which it is impossible
to make one individual better off without making
another individual worse off. Samuelson’s approach
Table 3.1 Pay-olfs from public goods: voluntary is to decide just how well off one individual is going to
contribution versus free riding be and then to search for that combination of private
and public goods which makes the other individuals
Outcomes
as well offas possible. In this way, he is interpreting the
Strategies Others contribute Others free-ride requirements of Pareto optimality as making any
(good provided) (good not provided) individual as well off as possible, provided that the
other individual is made no worse off than some
Individyatcontributes (£10 — £5) = £5 —£5 reference level of welfare.
maps
individual free-rides £10 fo
In Fig. 3.2(b) and (c) the indifference curve
In (b) the
for two individuals A and B are shown.
A and
indifference curves are shown for individual
the
_ The optimal provision of public goods was estab- the initial decision is made explicitly to hold A on
level of
lished in Fig. 3.1 given that the demand curves of indifference curve 2, in this way fixing her must
individuals could be determined. The issue of free welfare. Now, by definition, each individual
The
riding is one to which we will return, but, continuing consume the same amount of the public good.
with the assumption that preferences for public indifference curve [2 shows the alternative quantities
goods
rae are known,
; we now turn to a general equilib- "of good Xand good G that keep A on the fixed level of
= : a
of the optimum provision of public welfare. Therefore, when individual A consumes Og
(a)
of good G, she will also consume gl (in both
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PUBLIC GOCES
.
45
Repeating this process for every
Or) possible output of
the public good [e.g Oj) produces,
in Part (c),2 curve
| equal to CC. This curve is, in effe
ct, the set of con-
T tr og sumption possibilities available to
assuming that A is kept on I2. It has beeindividual B
» : * ;
: .
deducting [? from TT, bearing in mind
n derived by
} 4 i ONG that, when
5 +
. * units of the public good are provided for one
. as ’‘ . vidual they are also provided for the indi-
’ ' me other The
Pog Pe
remaining problem is now simply to ind
that output
‘evel for private and public goods which
Maximizes
: i . the welfare of individual B. This, of course
, wiil
be shown by the tangency point betwee
w@ 9 = jf 28 5 7 Befe n Ig and the
curve CC. In the example showm, the Par
ef ' eto-efficient
; allocation of resources for the econom
7 ; y would be
g ‘ that Og public goods were provided and
' + * g2 private
am ~ 3 ‘ Z oods
; ™~ Si, With reference to the tangency at point
aS
‘ we Se.SE as} that the tangency has been found by deductin

3, it is clear
g (at Oz)
Ca AE
- 4
p aL
the MRS,, for individual A from MRT,,
and then
‘ si t A
;
ee
i*nx_f equating the MRS. of individual B

gm
: : ; :
; ‘ ft -o the slope of
ah i
CC {in part (c))—which by definition
eo
is (MRT,.—
9 MRS_). Obviously, instead of stating
Cie
| ma J z i Get the condition

Ra
Og| | a: as ,
; : : (3.5} MRSE = (MRT. — MRSS
cy
’
1 ‘
we can write this more easily as

*
“Me
'
(3.6) a; MRS; = MRTgx
; .
+e
SS
!
This condition becomes the ‘top
1
-level’ condition (see
chapter 1) for Pareto optimality in an
economy that
‘
i produces public and private goods.

The approach by Sarnuelson was
(c) ao Cc
Cet in the development of the theo
high ly significant
ry of public goods. It
was not without criticism, howeve
r. For example, the
approach is obviously individu
alistic, focusing as it
Figure 3.2 Public goods in a general equi
librium model, does on the marginal rates of substitut
individuals. However, would indi ion of the
viduals’ preferences
and (b)) of the private good in order to be the same (in terms of the way
remain on the in which they treated
indifference curve I2. However, if this were Provision in the public sector)
so, indi
- as their preferences
vidual B would similarly be able to consume revealed in choices between goods
Og of the in the private sec-
public good, and the amount of the private tor? Colm (1956) offers this criticis
good that m as a considera-
would be available for him if the economy operated tion in determining the optimal provis
ion of public
efficiently would be (g2 — §1), which is goods. Mus grave and Musgrave (1989) argue that
equal to g3 in approach of Samuelson (1955) woul the
Part(c) of the diagram. Repeating this line d be improved if
ment makes clear that when, for example, of argu- the decision-on the correct income distribu
the total tion could
amount of the public good is equal be separated further from the efficiency cond
to Om, the total itions in
amount of the private good produc the analysis. However this is, in general, not
ed by an efficient an easy
economy would be m4. Of this total of option.
Private goods, in this connection, itis worth noting that the whol
m5 (in both (a) and (b)) mu
be s
cont e
sumed byA ifher process described above can be notionally repeated
welfare level is to be kept constant.
would leave m6(= m4 — m5) availablThis , of course,
e for B.
for each indifference curve for individual A, so that a
utility possibility frontier similar to that in Fig. i.6 in
chapter1 can be derived in the Presence of the public

good. All 4 points on ae such a frontier; wou Id meet (by stich ag lo preclude lighthouse provision, even if they
may have been provided sub-optimally. These oe
construction) condition (3.6), leaving the vexed ques: vations lend to confine pure public goods to benefits
tion of a social welfare function to solve the equity- that are of an intangible kind, such as the feeling
income distribution issue. of
security felt by many as a regult of deterrence-lype
Even if the equity matter were solved via the estab- defence. Samuelson's position with respect to thie
lishment ofa fair income distribution, the ‘free rider’
problem remains, Why would preferences of indi- co
question of obser vability was to emphasize a distinc-
tion between pure public goods and pure private
viduals be revealed? Also, at this juncture, it is worth goods (Samuelson 1969); between the extremes
considering that the efficiency conditions involve there will exist impure public goods which may be
different MRS. (or MB) for individuals suggesting readily observable, but how can a taxonomy of such
that no single common price ratio (tax price) is goods be established?
appropriate for all. This increases the problem of
preference revelation, for it suggests that discrimin- 3.4.1 Excludablility and non-rivatness in
atory pricing is appropriate for public goods, (Stu-
consumption
dents may reflect that, for private goods and services,
such price discrimination is a feature of monopoly One approach to this question was to focus on the
characteristics of public goods, i.c. on non-rivalness
and not competitive markets. However, the distinc-
tion between the two scenarios is that with monopoly in consumption and non-excludability (Head 1962;
provision the profit-maximizing output would be Peston 1972). In Table 3.2, four categories of goods ate
MR, + MR, = MC, (not MB,+ MB, = MC,); i.e.
identified. Goods in category D are non-rival in con-
the monopolist would act by reference to marginal sumption and non-excludable: they are pure public
revenues and not marginal benefits.) goods. Those in category A are rival in consumption
These are all points to consider, butat this juncture, and excludable: they are pure private goods. Goods
having recognized the important contribution of
that fall in category B are rival but non-excludable.
Common resources may prove an example. Let us
Samuelson, we turn to a very fundamental criticism
assume, in the spirit of the case discussed in chapter
ofthe whole theory: ie. do public goods really exist, or
2, that bees from the hives of different beekeepers
are they just a theoretical construct?
collect the nectar from a nearby orchard of apples.
The blossom is rival: nectar collected for one hive is
unavailable to another. Even so, it may be inconceiv-
3-4 Pure and impure public able to try to deny any particular honeybee access; i.e.
the situation is non-excludable
goods (Meade
contrast, goods in category C are non-rival in con-
1952). By
sumption but excludable, A toll booth may exclude

One of the criticisms of the concept of public goods traffic from roads unless payment is made, yet if the
was that such goods were not obvious in the real world road is not congested one car may utilize it with no
(Margolis 1954). Where is it possible to perceive loss of benefit even though other cars are also con-
goods that perfectly satisfy the non-rivalness defini- suming the road service. Similarly, admission to a
tion of Samuelson (1954)? In the provision of law and theatre (circus, swimming pool) has the potential of.
order (or medical care), the use by individual A exclusion, but (below capacity limits) each individual
of the
law courts (or hospitals) subtracts from admitted may consume services without subtracting
consumption
by individual B if they must now wait. from the benefit of others. Here the market could be
In so
Even defence,
far as it is associated applied, but the existence of at least limited non-
|
with Protection,
may
not completely satisfy the description
good in the of a public rivalness indicates that exclusion would cause ineff-
purest sense (Sandler 1977).
are employed in the north, If armies
will this not detract from
Protection for communities Table 3.2 Ataxonomy of goods .
_ ie in the south? Indeed,
ae ‘ another exampl
ice e of public goods qu
ee { 1954)—li oted Excludable Non-
ame ghthouses—su
bsequent
eae that thes excludable
oe ae piston with e Were traditionally asso-
in the private sect
SK 1979). Market or (Coase Rival A 8
failure was clearl Non-rival c D
y not
Fig
{
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PUBLICGOODS 51
ES- careS
ciency. (One person could be made better off by the external effect in so far as she redu
consumption of the good without fully denying con- ces the chance of
infection for all other individuals
sumption to another.) with whom she
comes into contact. The concept of
externalities was
Tate
The usefulness of this technique may be questioned
SPS
examined in chapter 2. Here it is clear
that the external
¥
inso faras ‘the same “good” may fall into one category effect associated with consumption of a
eS
private good
*
on oneset of circumstances and into another category may itself bear the characteristics ofa publ
on other sets’ (Peston 1972, p. 14). Even so, within ic good. For
a
example, education may improve an indi
the different categories it is possible to develop the vidual’s
earning potential, but at the same time it may
janet
requirements facil-
PPE
for efficiency in provision. Perhaps the itate basic research, creating non-rival and non-
best example here relates to category C. Buchanan excludable knowledge or information which bene
(1965) developed a theory of clubs and-established fits
others in the community. Such development, in term
™
theconditions for optimum output and membership. s
hare
of culture or technology, may then bear public good
EMEAa
Clubs are consumption-sharing arrangements pro-
characteristics. Recognition of the private—publ mix
viding goods from which consumption can be ic
ST
means that goods can be viewed as having private
="
excluded but for which consumption by one member benefits as well as external effects which bear the
may be non-rival with consumption by another mem- characteristics of public goods. (For a clear distinc-
SRINIY
ber (belowcapacity limits). The theory
of clubs will be tion between public goods and externalities, see Evans
developed and' applied below.
1970.)
Take for example education. In Fig. 3.3 the demand
3-4.2 Mixed goods/quasi-public goods curve for education is shown as D,. This is the
demand that would be forthcoming, at differen
A second approach to the classification of impure t
prices, in the market for education. It teflects
public goods focuses on the mix of services that stem the
private benefits that students believe they will enjo
from the provision of the good. Suppose for instance y
as a result of education, These may be viewed as the f
that A derives benefits from being inoculated against ‘private return’ &
polio; she creates not only a private benefit but also an e
on the inco $
2
g
2
Price
MSB
MC
ot8 ervesey
Q,/t
oo PTET TER

52 PUBLIC FINANCE AND PUaLIcC CHOICE
receive during their working |i 5 ;

daa: IE Laivene: sec at fs eva of educa.
In a similar vein, Weisbrod (1988) tries to use the
benefits) contingent upon education thee bisa manner in which goods are financed as an indication
fits from education will differ from the eva bene of the public-private split. The more public good |
fits. The value of external benefits to othe:is asta eflects there are, the less may organizations finance |
community is indicated by the line £ This shee themselves by sales, as there are no direct property a
what the rest of the community would pay for ‘he rights to goods that can be enjoyed on a non-exclud-
various levels of education shown on the x axis, Add- able basis. ‘The more, instead, the organization will
ing vertically the values of E to the private demand rely upon donations, gifts or grants to finance provi-
sion. This split may be thought symptomatic of the
gives the line MSB, This shows that there are positive
mix between public good output and private good
social benefits from education over and above the
output, and, in this way, the more that an organiza-
private benefits. The extesnal gains that arise from tion relies upon gifts, grants and donations, the more
education may include the benefits to others of: (a) eligible it may be to subsidy. Weisbrod (1988) argues
the research undertaken at educational establish-
along these lines in defending the subsidy given to
ments; (b) the more cultural environment and the non-profit organizations. ,
heritage for future gencrations; (c) the screening
device which education provides for the labour
market to determine the quality of labour; (d) the 3-4-3 Consumption sharing ;
improved decision-making of voters and the beha- Yet another approach to the question of taxonomy
viour of educated citizens. Blaug (1965) has a com- was developed by Buchanan (1968). In Fig. 3.4 (drawn
prehensive list of factors (many of which he on the assumption of a given population and given
questions) to distinguish the social rate of return on property rights) a relationship is depicted between the
education from the private rate of return. Some of degree of indivisibility and the number of people P
these factors (e.g. cultural environment and consuming the good. At one extreme are purely pri-
heritage) have the characteristic of a public good; vate goods (category (1}), which are fully divisible >
that is, they can be consumed by one individual in between single persons (or single households); at the
society without reducing the amount available for other extreme are goods that remain fully indi-
ee
consumption by others. Indeed, it is for this very visible over large groups, in the sense that each
reason that it is often supposed that the market will member of the group may consume the same good.
not properly internalize such factors in the decision- An example offered is mosquito-spraying; the bene-
making calculus of individuals. In Fig. 3.3 it is clear fits from this service are probably indivisible between
that the private demand at price OP is only Oq? and individuals in one specific suburb. In essence, the key
that this is less than the socially optimal output Oq° is the extent to which sharing is possible. Category (2)
(ie. the point at which the marginal social benefit may refer to fire extinguishers that are shared (indi-
MSB of education is equal to the marginal cost MC visible) between a small number of neighbours.
swimming pools,
i
of education). ' Category (4) could represent
This approach to dealing with the blend of private- which are uncongested when used by small numbers.
nessand publicness in goods is dealt with by Musgrave By contrast, item (3) may refer to services such as
(1969). Obviously, it provides an important frame- inoculation against disease, which when experienced
work for policy purposes. We have already demon- by any individual provides an additional degree of
strated in chapter 2 just how pervasive such external protection for everyone else with whom that person
effects can be. To operationalize this approach, how- comes ‘into contact. Of course, item (5) is a pure
ever, may prove more difficult. One attempt may be to public good, an example of which is national defence
take the ratio of spillover benefit to private benefit and expenditure which deters aggression. —
think ofa taxonomy between | and 0. Measuring the It may be argued that goods such as (1) should’ be
may be
effect of spillover benefit and private benefit is a prob- left to market provision. Goods in category (2)
lem to be considered in chapter 6, when we look at left to voluntary arrangements between the individual
(4)
ae Itwill be clear that estimation of members of small groups concerned. Category
arguably contains goods that are provided by clubs.
However, in “iacinl a ania problems. sector by
lave : = yee it would be Possible to take ‘Clubs’ ate arrangements in the private
which goods that are, to a degree, non-rival in con-
indicator of che on ln . aan benefits as.an the
poblienee: Private-public mix and the extent of sumption are voluntarily provided. Typically, fee)
*- + sat ¢t a there ig a membership
This document is available free of charge on StuDocu com

— a
J voappaananenrio" gta
PUBLIC GOODS 53
Pad ieee
Degree
of (4)
indivisibility (5)
TS
Sy=*
3 | @
Q)
St i
a)
psBae
Size of interacting BToup
a
ai
Figure 3.4 Consumption sharing.
“ae
capataee eS
Source: Buchanan (1968).
but itis by no means private (i.e. below capacity limits

In considering the first of these questions, we 2re
consumption is non-rival). Buchanan (1965) has dealing very much with the public choice approach to
made an important contribution in the analysis of collective good provision, which places far more
such goods: he has established efficiency conditions emphasis on exchange and agreement. It has already
for the provision of such goods via clubs. These will be been argued in chapter? that the Cozsian approach to
: discussed again in chapter 12, where the analysis is
ES
resolving the problem of externalities places greater
applied to local government expenditure. emphasis on voluntary exchange. Will individuals
In this way discussion of impure public goods engage in voluntery exchange to provide a public
enables consideration of the appropriate provision good?
of a range of goods bearing both ‘public’ and ‘private’
_4 characteristics. In some instances this has called into -
question the ‘appropriate’ role of the public sector. 3-5-1 Voluntary provision of public goods
Such goods which are not perfectly public may be Johansen (1977, p. 147) notes: ‘Ido not know of many
better supplied within the market. We turn in the later historical records or other empirical evidence which
chapters to consider the ‘appropriate’ role of the state. show convincingly that the problem of correct revela-
tion of preferences has been of any practical signific-
ance. The problem of free riding is one that has been
illustrated in the most extreme context in section 3.2,
3.5 Free riding and public good but how reliable is this prediction?
Bohm (1971, 1972) reports that, in an experiment
provision wherein individuals were made to feel that they were
members ofa large group, they honestly revealed their
It has been argued that public goods will not be preferences for which (non-excludabie) television
optimally provided because individuals will not hon- programme to watch. Perhaps this was because indi-
estly reveal their preferences. There are at least two viduals generally behave honestly, and, perhaps out o!
issues here. First, will any
of the public good be volun- a sense of duty, make their preferences known with
tarily provided? Secondly, are there mechanisms that respect to contributing to a public good. This is so-
can be applied to bring about an honest revelation of called ‘free revelation’. There is also the ‘Joint contract
preferences? hypothesis’, which notes that ex ante the provision Oo: a
.

“g4 PUBLIC FINANCE AND PUBLIC CHOICE ¢
(asst |
can be made excludable. [fit is clear that shown that, in the case both of small groups and To h
public good forth-
unless the cost of provision of the public good is impure public goods, some agreement may be sion of ove
covered ex ante there wil! be no public good, the coming with respect to the voluntary provi pact
individual placed in this ‘joint contract’ context may collective goods. the it
1a preference. Bargaining in a small group ther §
(i981), on the basis of game-
3-5.2
Ee Pu and Ames l marper>
theoretical experiments, suggest that individuals do Ithas already been shown in section 3.3 that in genera oon
are equilibrium the Pareto-optimal conditio ns fe or the
not attempt to free-ride. Kim and Walker (1984) are are that See
the 5- :
critical of such studies in that the experiments provision of a public good can
contaminated by invalidating factors (eg. in their MRS’. = MRT,x, and equivalently in partial equilib- gooc
of the marginal benchits of
good is not pure; public | rium the (vertical) sum
ciments the pu blic s individuals should equal the marginal cost.
In, q
te; there are misunderstanding that
oods are not discre a sma ll gro up; Asomewhat different wa y
of deriving this same rule
som eti mes
and vagueness; the groupis ‘purified, so as can be establis hed by followi ng the approach of i.¢.,1
etc.). When the experimental setting is Buchanan (1968). As Congleton notes, the g:
fi ¢ rider issue more clear ly, there is
sah
cost
and Buchanan's approach to the analysis of public goods reaches
oe fhe riding. However, McCaleb
After a review of such the same conclusion about the optimal level of a public
Wagner (1985) are sceptical. ‘we would have good, but viaa different route. As usual, his line of reasoning
studies, they conclude (p. 489): vide
designed in emphasises the private exchange analogy. To Buchanan, the
that choice settings could be optimal level ofa public good is simply the amount that an
full free riding would
which something very close to conducted in exhausts all potential gains to trade, given initial endow-
ther
emerge’, but ‘results from experiments ments and some specification of property rights. (Congle- forr
us a long way from
“purified” settings . __ still leave through which
ton 1988, p. 144). Og
understanding the social processes indi
It is well worth studying this particular derivation
real world choices are made. oe
have placed too because (a) it confirms the conditions for optimal
It may be, then, that economists provision of public goods and (b) it shows that,
pou
and that indi-
great an emphasis on the free rider deciding where bargaining is possible, there are cases in which Ons
viduals consider broader issues when however, individuals may agree to the ‘tax’ conditions required
shor
whether or not to reveal a preference. Here,
wih
$
for the provision of public goods.
we retain the usual ‘Homo economicus’ assumption In Fig. 3.5 the demand curves fora public good for
and continue with the view that individuals are moti- two individuals A and B are shown as D, and Dy
be
vated by selfish goals. Even so, Buchanan (1968) has ind
Ba G3
sho
Price Price ie 7
ma
Pasy
5,=MC-D, wh
vides
def
MC ve ‘es
2 Cos
I 1
ro
ou
a i '
6 po EDK
1 1
t 1
fy 1 i
t '
roo4 D,
Og/t 0 q® q! Qg/t
(a)
(b)
Figure 3 25 P .
hic Public gt This document is available free of charge on StuDocu com

PUBLIC GOODS 55
(assumed identical for expositional simplicity). 3-5-3 The Lindahl-Johansen solution “*

To help the exposition, the marginal costs MC of
providing a public good are assumed constant. In As long as there are some gains from trade in the
part (a) the demand curve of individual A represents provision of public goods, it can be expected that
some mechanism might arise to secure some of the
the most that she would-be prepared to pay towards gains. In an early contribution, Lindahl (1919) dis-
the provisionof a public good. As it never covers the
marginal costs of providing the good, individual A cussed the question of the determination of the op-
alone would not consume any of the good. In part (b) timal provision of public goods and the assignment of
tax shares. This-approach was revised by Johansen
the same is seen to be true of individual B; i.e. alone he
cannot cover the marginal costs of providing the (1963) and is interesting, in that it tackles the question:
goed. ina bargaining-type context. Two individuals A and B
gain utility from a private good Xanda public good G
In part (b) ‘the curve S, represents the minimum
that individual A would require to supply the good; whose tax shareis hforAand(1 — A) for B. Withgiven
total revenue Ydivided between A and B as Y, and Yj,
Le., itis the vertical difference between the demand for
the budget constraints of the individuals will be
the good on the part of individual A and the marginal
cost of the good as shown in part (a). In part (b), (3.7) Y¥, =X, +hG
individual B would be willing to pay Oty per unit of (3.8) Y= X+(1-— ANG
Oq? units of the public good, but, at minimum, indi-
vidual A would require only that B pays Ot, per unit in so that
an agreement to provide Og° of the good. There are (3.9) Y=Y44+Yy=X+X+G
then clear gains to both from bargaining, and this The conventional price consumption curve can be
form of bargaining is possible up to an output of illustrated as in Fig. 3.6. The price consumption
Oq'. For quantities up to Og! the amounts that both curve for A is derived by varying h from zero to one.
individuals aré prepared to pay per unit will cover the Ash falls, the equilibrium points (1, 2, 3) suggest the
total costs involved in providing the good. At this conventional outcome, i.e. that more public good is
point individual A and individual B will each pay demanded at a lower tax share. Whereas the original
Ot, and each will enjoy a consumer surplus as utility Function for A and B (illust r A)
shown by triangle t)P1. takes the form Spy
Since voluntary co-operation is possible up to,
but not beyond, output Oq!, this output level would (3.10) U, = Uj(%a, i
be one that is optimal against the criterion that 3
=
\,‘
individuals must consent to such an arrangemert. o ;
Bargaining over the question of whether output Ms a. ?"
"oo
should be increased by one more unit can lead
individuals to output Oq' but certainly no further.
ey
This output level, it should be noted, is one at
which the consumer surplus enjoyed by both indi-
viduals is maximized. It is also the point at which, by
definition, the sum of the marginal benefits (i.e. the
vertical addition of D, and D,) is equal to marginal
costs.
The quantity of the good Oq' accords with the
output at which the sum of the marginal benefits is
. equal to the marginal cost. Since it is always possible,
up to this point, to find a basis for agreement between
individuals by which one individual can be made
better off without another being made worse off,
increasing the output of the public good to Oq'
would be a Pareto improvement. It is also a move to
Cy
which each person would agree. The approach to
determining the output and cost-share of a public
qf good is similar, though not identical, in nature to Figure 3.6 The price consumption curve for the private and
that presented by Erik Lindahl (1919). public good.
a0 Downloaded by Yashodeep #480 (yashodeeparya@gmail.com)

9G
U, = U(X, G) and equivalently for B:
: (3.11) aUp
E MRS}, = 55,/5h
_
it is convenient in the analysis to express them in aU,G
terms of h and G, which can be done by rewriting
(3.7) and (3.8) as (3.19) _ + aU,/8G
a-h)_}
Se G QU,/O%
(3.12) X,=¥%—AG
as horizontal wae
(3.13) M=%—-(l-A)G The tax prices are representedre han Le tit
h taxsha
Fig. 3.7 because, at eac
so that the utility functions become much of G as m a
respectively can choose as ce con s a
(3.14) U, = U, (Ya — hG, G) their utility. Again, the sha
pe of the pri
re . :
Cs reflect that mo
(3.15) Us = Us[% - (1-h)G, G] tion curves PCC, and PC overal l
chosen at lower tax sha res. Figure 3.7 gives the
This enables a counterpart of Fig. 3.6 to be con- are forms of demand cur
ves
hand picture. PCCa and PCCz Fig.
structed, with the axes labelled for tax shares ofh. With hsetat h’ in
for Gat the different values Gp, which are inconsist-
the public good G (see Fig. 3.7). The slope of A’s ts
indifference curve between Gand his the ratio of the 3.8, A wants G, and B wan
ent quantitie s. For eff ici ency and stability, in the
marginal utility of Gto the marginal utility ofA, which on the contract curve . C) and
(i.e
caelterticr
sense of being
Soar
. , and G* must be
‘
can be derived in two steps as follows:

both wanting the same quantityA”
aU, dU, , AU, achieved at point 1. That is for an
equilibrium point
| MUG = So= = -hohae*++ 3G
a
(3.16)
Toe
on the contract curve:

s
ERTL
_ OU, __,0U, (3.20) MRS), = MRSz, = 0

WPltite tesa) agen
(3.17) MU,h = ar Gay

ON
)_
AW/I
h_ 1 0U,/aG_U-h G 1_.,
Bet LER
with | G 8U,/OX
G GOU,/OX%, . G
MUG_ yapch = 8U,/9G _h 1 9U,/dG
MU,h*—«8U,/dh_ GG OU, /OX, (3.21)
which is reduced to
(3.18)
For B For A
(l-A)=0 hel
(l-k)= 1 fh=0
Figure 3.7 Price consumption curve between tax shares and the public good.
—— This document is available free of charge on StuDocu com

a. pan AWE D CO ac Si: tps fe eae
hieve point 2 on qh sharin
rather than 1 on & arran:
ang ements.
av R - Po in t 3 is the equivalent of po : As noted above B
for individual A. a int 2 eory of clubs to exp
ye This illustrates the t d
element. In thebilateral unsatisfactory - Bie :
Se, mo nopoly-type context, Lin reset
(swimeging nov
dahl thought that in the - clubs (e.g. Providin
aS the‘ " valuki es Unepreferred by thecaseinofdi dispute the lower of g theatrical entertai
vide goods that, below co
os of
nment)
th 4 € viducat
alsh “awoultld hea ; tion levels
© outcomes teto 21453 with 'nVide consumptioeln. To deteie
inate, limi
S eqequaual.l. (N(NB:B: $2 sod 43 etMEWASappronima poin eng oFt rmine the optimal que
52 and 43 are irreleva tely OE :
00s d to prov tohephe
> and B gain by moving
from 5 t
nt because both A
ee
: ‘
om
: fare of club members.

» Since th both hand G
pointt on wi
onn the bargaining table a
Sy
In part (a) of the figure the

w
ri
will always be pre the

ae contract curve » curve C, shows hy
ferable. While the ‘gains fr Average cost per member
a
SR:
om trade cost of producing a given qu of the club falls. The a
* This particular result arises anti ty of the good ;
# transformation frontier between bec ause Lindahl employs a linear
G and X: aS More people join the clu
a swimming pool b and share the costs
is provided, the average
? 5
For B ForA
3) (l-h)=0 hel =
ie:
{
i ip beeeereeeeeee PCC,
! he Bosco
i ! oa PCC,
»
i
Wo
17 '
|
'
* mot
7 .
Po
4 :
|
{(Il-A}=1 h=O0
1 1 :
»
CQ
>
wo
Figure 3.8 The Lindahl-Johansen approach.
Downloaded by Yashodeep #480 (yashodeeparya@gmall.com)

a
$8 Pugiic FINANCE ang PUBLIC CHOICE
ce
cost and Total

txal j
&,
benefx | oe
:"
Per ‘ oN
perton : ~ F
‘ bd .
-™ ¥
7
&, = ' ‘
| “SN ‘
he“Re SS ‘\.
j \ ee \.
SS *
| apes Yee
i : ; ¢,
8 5, 5, No. of o Q, Qit
on a
club
. (a) members
2a RRS
On |
Ma.
ty
ta aS
whi
han
sun
clul
ea
iol
9 M, No. of exis
club inc
()
i
Figure 3.9 Optimum size of clubs.
Source: based on Buchanas (2955).
each member falls as more join the club. The benefit person might be greater (B,,) and, though
the cost per
per person for a swimming pool of this dimension is person might rise (e.g. to C;,), the increase in quant
shown to vary as the number of club members ~
ity
would increase the optimal membership
size to S,.
increases. Initially it may rise (e.g. the prospect for For any quantity of the good in question
there is an
team sports such as water polo may increase benefits); optimal membership. In part (c) of the figure,
a= we
however, after a particular number have joined the record the optimal number of club members for
=
any
=
=] club, congestion will be experienced and benefit per quantity of the goods as Np:.
=
person will fall. When membership is 5,, the differ- In Fig. 3.9(b), we begin by assuming a given
num-
7 ence between benefit per person S, and cost per per- ber of club members. At the extreme, a swim
ming
son C; isata maximum, ie. distance 12. If the size of pool may be consumed privately by one indiv
idual.
the swimming pool were larger then the benefits per The costs to that individual of increasing the size
tlhe
of
etl
This document is available free of charge on StuDocu.com eo

™ PUBLIC GOODS 59
the pool increase as C,. If the benefits enjoyed by the On — Og, G = 0, along O ~ Og, Xs = 0 and along
individual varied as B,, then it is clear that she would O — Og, X, = 0.) Further becduse of the properties
not purchase any quantity of the good. However, if a of the equilaterial triangle 7
group of individuals formed a club, the costs per Xx + Xp + G= Wat Wy = W-
person would be reduced to Cy while the benefits,
(16 + 34 + 20 = 70)
given non-rivalness in consumption, would not fall
as much (i.e. only to By). From this cost and benefit Where Wa and Wg are A's and B's initial (wealth)
function relating toa club size of&, the optimal quant- endowments and it is a “70 unit’ society (All the arith-
ity is Qs (i-e., net benefit per club member is max- meticin this section is based on this 70 unit equilateral
imized at Q,). For any given club size, then, there is an mpeugle and is rounded to give whole units. Given this
optimal quantity (optimal-sized swimming pool). all the illustrated triangles are replica’s of each other
This information is recorded as Qop: in Fig. 3.9(c). with consistent notation.) The prices of the private
In so far as it is possible to record the optimal and public good are adjusted to both equal unity bya -
membership size for any given quantity and the op- suitable choice of units. Illustrative indifference
_» timal quantity for any given membership size, it is curves (for X and G as normal goods) for A and B
possible to solve for the optimal quantity and optimal are depicted in Fig. 3.10 and from point 1 preferred
membership simultaneously. In part (c), if the mem- allocations for A lie within the hatched area as they
bership ts N; itis clear that the optimal quantity is Q;, involve more X, and njore G than point 1. The shaded
but at quantity Q, the optimal number of members is area to the north-Wegt of point 1 has an identical
N,. With a membership of N, the optimal quantity is interpretation for indivi
Q,, and so on, Eventually, at point 1, there is the Ley (1996) now usg¢s this framework to illustrate
solution for the optimal quantity and the optimal four results from the literature on public goods.
membership size. (i) Nash equilibrium
It should be emphasized that the above solution A Nash equilibrium arises when the pair of strategies
maximizes the welfare of members, and in the case of (an allocation between A and B) is such that each of
one club this may not maximize the welfare of society. the players (persons A and B) choice is optimal given
(For those conditions necessary to maximize welfare. the opponent's strategies. In Fig. 3.11 the initial
of society when only one club is established, see Ng wealth allocation is that associated with point 1 invol-
1973.) Nevertheless, the point is made that goods ving Wa = Xa = 26 units and Wk = Xg = 44 units,
which bear the characteristic of non-rivalness in con- L.€. zero units of G. As illustrated the share of wealth
sumption can be provided voluntarily in markets via going to A is the ratio of distances O, — 1/O,—
clubs. There is no necessity for government interven- Os = 3/8 and to B is Og — 1/O, — Op = 5/8. IFB
tion to ensure that the good will be provided. The ~ enjoys 44 units of X and makes no contribution to G
existence of the possibility ofexclusion means that the then A must adjust individually
along the line 1-2. LfA
incentive to reveal preferences is present. enjoys 26 units ofX and makes no contribution to G
then B must adjust along 1-3. If B moves first and
maximizes utility on Jj at point 4 along the line 1-3
3.5.5 Private provision of pure public goods providing 26 units of G then A’s adjustment path,
Section 1.8 introduced the properties of a (Winch) because of the non-rivalness of G becomes the line
equilaterial triangle in the context of second-best 4-5. A now maximizes utility dt point 6 on indiffer-
problems. Those same properties are revised here ence curve J}. Such a point cannot be a resting place
closely following the work of Ley (1996) to illustrate because B’s adjustment line now becomes 7-8 and
various results concerning public goods. There are - point 9 is duly chosen as the utility maximizing posi-
twa goods; a private good X and a public good G tion on indifference curve Ij. This zig-zag adjustment
and again two individuals\A and B who are not ident- process has a limit at point 10 where a Nash equili-
ical. Reinterpreting point m Fig. 1.9 in the setting brium is achieved, i.e, given the allocation decision of
of Fig. 3.10, in what Ley terms a Kolm triangle, would B(A) then A(B) has no incentive to alter his or her
now indicate A enjoys 16 nits of the private good allocation. Point LO is the cross over point of A’s
(Xq), B enjoys 34 units of the private good (Xs) and reaction curve ra and B’s reaction curve rg. Inspection
they both enjoy 20 units of the public good makes it clear that point 10 would also be achieved if
(Gi = G§ = G; Ga, Gg without the ‘c’ superscript is the process of adjustment began with A at point 11. At
the amount of public good each individual pays for the Nash equilibrium X, = 10 units, Xj = 30 units
whereas G is the quantity they consume). (Along and G = 30 units with Ga = 16 units and Gg = ]4

.
i ‘ ates
l <2
i‘ Nome
;o pl S
A OF
Je
Figure 3.10 The Winch/Kolm triangle.
units. Quantities X,,X%_ and G are found using the independent of the income distribution. Figure 3.12
perpendiculars to the sides of the triangle as with Fig.
reproduces the key features of the Fig. 3.11 initial
3.10. The amou of nt
public good provided by Aand B allocation between A and B. Moving point | to the
individually
is found by putting in the perpendiculars left in Fig. 3.12 raises the share of income going
to the O, — Og axis from the bases (point 12 for A to B.
The effect‘of this would be to attenuate B’s reacti
paint 14 for B) of the Nash equilibrium adjustment curve
on
rs and extend A’s along the dashed segment
lines for A 14-15, for B 12-13.
ra. However, until the share indicated of
The triangle contains much information. While by extending
12-13 to the axis O, — Oy is reached the
point 10 is a Nash equilibrium it is not a Pareto m— rm
crossover point is unaffected, The same is true
optimum. At point 10 the indifference curves I} and if the
share going to A is increased and point | moves
Ig cross and therefore the contract curve cannot run to the
right. Within Amin, Bmax: Amax,; Bmin the shares to A
through point 10. It can be seen that a tangency and B will not affect the crossover Point so that the
between A's and B’s indifference map must be in the Nash equilibrium is independent of the income dis-
hatched area to the north of point 10. In the hatched tribution within that range.
area both A and B would be on higher indifference
(ili) Stackelberg equilibrium
curves but Nash adjustment will not put them in that
A common alternative equilibrium to Nash is
region. It is also clear that thé ‘northness’ of a Pareto the
optimum Stackelberg equilibrium which assigns dominance to
means a greater amount of public good
one of the individuals (players). The dominance takes
would be provided, i.e. Nash equilibrium involves a
the form of making the first move. As the rich are
less than optimal amount of the public good.
almost invariably‘at an economic advantage indi-
(ii) Redistribution of income vidual B is assumed to be dominant. Using Fig. 3.13
Ley illustrates Warr’s (1983) neutrality theorem that the best B can do is to maximize his position given the
indicates within limits the Nash equilibrium at 10 is reaction curve of A, ra. Points on ra to the right of 10

a]
Cus re ea cho nes
OF De
ge
12.1 Introduction from each locality. D, represents the demand of indi-
viduals in locality Aand Dg represents the demand of
é=3 In this chapter we focus on some fundamental ques- individuals in B. The marginal casts of previding this
tions pertaining to the fiscal activities of local author- perticular local public good G are assumed to be
Pa ities. In particular, two related questions are, How constant. The price each individual is asked to pay is
ee
= large should local authorities be? and What gains, if shown 2s P = MC in the diagram. (This would be
a any, are derived from fiscal decision-making at a local each individual's share of the overall marginal costs.)
Se
ay level? Traditionally, public finance theory hes In this diagram, ifa centralized regime p~-vided a
approached these issues using the assumption that single uniform level of the good, the level cf output
governiment is motivated by pursuit of the “public provided could be shown as 2 compromise vetween
= interest’. the demands of the individuals in each locality, ic. a
F The intention again is to illustrate the difference ievel of O8. Such a quaraty is lower than the amount
between the traditional theory of public finance anc that would be cemanded by the representztive indi-
the public choice approach. The literature on the vidual A but more than would be demanded by the
. impact of intergovernmental grants is particularly representative individual B. Inevitably, welfare losses
‘ useful for this purpose. The public choice school are experienced by each of these owo individuals. The
once more offers explanations for economic phenom- losses are Showa as inangles 123 and 145. Triangle 123
. indicates the loss that arises because individual A does
ena that cannot be easily explained by traditional!
public finance theory. It is left to readers to assess Noi consume 2s much as she would choose if there
whether such explanations zppear reasonable or con- were no need to compromise. She would gladly pay
wits trived.
12.2 The welfare gains from

multiple fiscal units: the
decentralization theorem
The welfare gains from decentralization are often
considered by reference to those deadweight losses
that result from centralization (Oates 1972). Assume
that the population of a particular nation-state is
divided into two distinct localities. A local public
good is to be provided in each locality and it is
assumed that there are no inter-juriscictiona! spil-
lovers. The cost is to be shared equally by residents.
In Fig. 12.1 we illustrate the demand for the local
public good of two ‘representative’ individuals, one Figure 12.1 The welfare loss of centralization.

CHOICE
294 «PUBLIC FINANCE AND PUBLIC tiplier
expendi ture z mul oh
the government act tor
these would economies, ay ‘willvashav € fect imp of local
e less
923q° for the additional units 3q’, but ngle 145 i
will be low and fisc al pol icy e the
- :
Tria
cost only 913q* to be made available. stabilization purposes. In C
pers
experienced by will fallon oe
indicates the welfare losses that are fiscal mxp ans ion , for exa mpl e,
mu Hy eriin
more than he
individual B because he is consuming for the addi- from other local economies. The fiscal Any
then be reduced.
would otherwise choose. He pays q°51q the expansionary loc ali ty will
n
tional units q°q but he values them
at only q°544. may be forced to incura
just the quant- parti cular local government to hav e an
[feach area could provide itselfwith deficit in order
dweight losses extremely large bu dget ec on om y: é
ity of the good thatit requires, these dea the local
permits each expansionary effect on prove effe c-
could be avoided. Decentralization quantity of the economy may not
5. Similarly, a local . Whe n
locality to provideitself with the of redistribution policy
‘decentralization tive for the operation ween loc al aut hor iti es, a
good it prefers. This illustrates the indivi dua ls are mob ile bet
on its
theorem’, which is described by
ows:
Oates as foll to impose a higher tax
local economy seeking cre ate an
on of which isdefined would simply
For a public good—the consumpti upper-income residents loc ale .
total population and for to move to another
over geographic subsets of the incentive for such residents lly,-a cen tra l
level of output of the le internationa
which the costs of providing each for the central gov- If individuals are less mobi poli-
good in each jurisdiction are t he
same to effect redistribution
nt—it will always government is more able poo r,
ernment or the resp ecti ve local gove rnme be away fromam |the
nt
for local governme cies. The rich tend to want to ion as the
be more efficient or at least as efficient same jurisdict
o-eff icien t levels of output for their but the poor want to bein the
to provide the Paret
ons than for central government to pro-
respective jurisdicti
rich.
output across all
vide any specified and uniform level of
jurisdictions. (Oates 1972, p. 35)
12.3 The optimum size of local

points to add.
There are, however, a number of
if q” and q?
1. As Oates (1979a) notes, in Fig. 12.1,
were close, then g would provide a close
ter the
approxima-
diff erence in authorities: an application of
tion. It is evident that the grea
tastes and preferences, the greater the
welfare losses. the theory of clubs
ae
zed prov isio n increase
Welfare losses from centrali
ing
with heterogeneity. In chapter 4 an analysis of consumption-shar
er,
welfare loss
2. As in other cases, the deadweight more arrangements was based on Buchanan’s (1965) theor
y
The
depends on the price elasticity of demand. nd of clubs. Here, following Musgrave and Musgrave
inelastic the demand curves (the steeper the dema (1989), our objective is to show how this theory can
will be
curves at points 5 and 3 in Fig. 12.1) , the larger e
of local
be applied to the question of the optimum siz
of the shaded triangles. The sizes of the
the area authorities. By ‘optimum’ we mean efficient, and by
triangles are the key to the losses from centralization. size we refer to the number of residents and the total
, Brad-
In an attempt to estimate these welfare losses expenditure on local public goods. In order to discuss
ated a multi plica tive
ford and Oates (1974) estim the analysis of Musgrave and Musgrave, it is helpful to
schoo l expen ditur es).
demand function (for local set it ina four-quadrant diagram, similar to that used
umer sur-
They used this to estimate the loss in cons by Sandler and Tschirhart (1980).
hetical
plus that would rise from adherence to a hypot nd-
Sem,
was an expe The question of how many individuals Nshould be
uniform level of expenditure. (This
&
resident ina local authority is considered in quadrant
iture level equal to the existing average level.)
wv
a
II of Fig. 12.2. The costs per capita of providing a

oe
mies of
3. In the above analysis, if there are econo particular local public good (e.g. street lighting, fire
ence
scale in the production of the good, this will influ service, education) depend on the number of resid-
,
the optimum size of the locality. Other things equal
tne
ents who share the total cost. The curve A illustrates

there will be a greater case for taking advantage of the
wo
costs per capita; as more people live in the locality, ur

lower average costs of larger communities. there isa reduction in the share that each resident pays
4. The above efficient gains from decentralization
@
pe
of the total cost Tincurred by providing some service

arise as government deals with its allocative functions. level of the good in question. If we assume that the
By contrast, there is more widespread agreement that total cost is constant, then curve Awill bea rectangular
the macroeconomic stabilization function will be better
hyperbola. It is an average cost curve for citizens fora
performed by central government than by local gov-
constant level of output. However, by comparison, the
ernments. Because of the openness of small local
StuDocu Co
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LOCALGOVERNMENT 295
[ * Total cast
. and total
benefit
per person
aft
i
Ill
Figure 12.2 ‘Optimum’ local community.

alt
Source: adapted from Sandler and Tschirhart (1980) “Theory of Clubs: An Evaluative Survey’, Journal of Economic Literature, xviii, Pp. 1486.
u
curve A’ shows the marginal savings in per capita cost This is the marginal cost Savings experienced as a
as the number of residents increases. The curve meéas- consequence of increasing the number in the locality.
ures the amount by which A falls as the population of Increasing the number of residents reduces the
the locality increases. It shows the fall in average costs costs of a fixed level of the public good. On the other
as numbers increase by one additional individual. [FT hand, as more individuals settle in the locality, costs of
is the total cost of providing the good, then the change _ crowding will be experienced by the residents. The
in per capita costs of providing the good is public good in question is nota pure public good (see
chapter 4) but one whereby congestion costs are
(12.1) d(T/N)/dN = T/N? experienced as capacity levels are reached. The B

——__
296 PUBLIC FINANCE AND

PUBLIC CHOICE
In so far‘as bot
h these questions have to be
incteases, By comparison, simultaneously, it is important solved
B’ shows the marginal per to utilize the other
capita crowding costs, ie. quadrants in Fig. 12.2. A 45 degree line is used
quadrant ILI to transpose quantities from the hor}in
the amount by which
crowding costs increase as the .
_{n interpreting the curves population increases, zontal axis on to the vertical axis
A’ and B;, it is possible to . In quadrant |V
think of curve A! as a marginal informat ion derived from quadrants | and II
reduction in costs)
beneht curve (ie. lated. The line Nop: plots the are co}.
associated wit optima
residents for any given quantity of l number of
h increases in the
population and of curve B’ the public good,
as a marginal cost curve
associated with an increase (This is derived frorn quadrant II.) The line Qo:
in the population, In this plots
context it should be clear tha the optimal quantity of the good for
t the optimal number of any number
residents in the locality is N!, (The popu resid ent in the neighbourhood. (This
is derived
should lation size from quadrant I, via quadrant II].) The intersection
be increased to the pointat whi
gains to residents ch the marginal of the two curves indicates the sim
are made equal to the margin ultaneous solution
to club residents as a result al costs to the two problems.
of increasing the number
in the locality; i.e, the Proper Moving back from quadrant IV through
ty rights are vested with quandrant
existing club members.) IIT to quadrant I, we see that this
- However, it will be obviou implies that Og?
should be produced, Tracing upw
independent of the total sizes that this solution is not ard
IV to quadrant II, the optimal num s from quadrant
of the service provided. ber is ON2.,
For example, suppose that The model as discussed may app
the level of output of the ear rather simplis-
g0od increased. The total tic, and th €re are qualificatio
ns that might be made.
cost may as a consequence
increase. The A’ curve would 1. Musgrave and Musgrave (19
be shifted upward to A. 89) note that tech-
Itis possible also that the increased nica
l economies of scale may be
alleviate the crowding cost ass expenditure might Provision of increased quantitie experienced in the
s of a local public
ociated with a greater good. Above it
number of people, and in this is assumed that the marginal
case the B' curve would increasing output are themselve costs of
shift to the right, thereby inc s increasing,
reasin
ber of individuals for the comm g the optimal num- 2. Not all benefits ofa locally
we illustrate the shift in both
unity. In the diagram
are experienced by provided public good
A and B functions to A’, the locality
that provides it. For
and By respectively. It is evi example, some portion
dent then that the optimal of the benefits may spi
number of residents increa to residents in another ll over
ses to N?. The important locality. Topham (1983)
point is that the optimal numb that this may not affect the optima argues
er of residents for a dents in the locality but l number of res
local authority can be determ
ined only when the would influence the opt i-
‘appropriate’ quantity of the Provision of the good, imal
local public good is 3. The above analysis
determined.
has been undertaken
In quadrant I, D is an assumption that indivi on the
individual’s demand duals ‘have similar tas
schedule for the good in que
stion, For simplicity it similar incomes; i.e. we tes and
is assumed that tastes and have used the assump
income are identical tion ofa
betwee n res
idents, and therefore, onc
is a ‘representative individua e again, this
l’ for the locality. M, “© 8COUP
is the per capita marginal cost curve. It sho with multiple—- Broupings,
together,
ws haw advantages of cost- shar some
Costs increase for each resident
as the quantity of the ing may be lost. The of the
local public good increases. On of how Broupings o ccur question
face value, the ques- will be considered
tion of what output of the goo section. in the next
d to produce appears 4. If individuals of
quite easy to resolve. The soluti similar income w
on would appear to ere grouped
be Oq!. Yet it has already been might be unstab] e.
Binal costs of the good will argued that the mar- for a local publi If the taxes
be a function of the higher as a consequenc
ome
number of people € go
inthe community, and theref
ore e of higher income, od were
might enjoy a greater
My, Ma, My relate to differ
ent numbers (e.g. 100, 200 quantity ofa local publ the poor
300 residents in the community). It is obviou , they were resident ina ic good if
high-income area,
oe eee
that, until the question of s then well be a tendency for zon

the optimal number of i ing on the part of
individuals in the community meome groups in orde high-
is resolved, itis impos- r to exclude the Pocr,
sible to determine how much of the good sho 5. The optimal siz e of the local author
Provided. uld be on the kind of public ity depends
good under considerat
be evident to the rea ion. It wil]
der that it is the
element of
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charge on StuDocu.com
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a
natok}
Eon I~ 4 there would be no limit to the size of the locality. If her preferences.
ey
J , there were no congestion costs the optimal size of a _iIt should be clear, with respect to the decentraliza-
locality would be infinite. However, a given locality tion theorem, that the Tiebout effect increases the
may be responsible for the provision of more than one welfare gains from decentralization:
local pablic good, and local public goods will differ
according to their capacity limits and the congestion household mobility means that differences in local prefer-
ences and in the policies of local government may reinforce
costs thereby created. It may be impractical to have each other... In other words household mobility shifts the
local authorities of different sizes for each and every trade-off between local autonomy and national standard
local public good that any locality may provide. decisively in favour of local autonomy because it increases
the homogeneity of such preferences between local jurisdic-
te
tions. (Hughes 1987, p. 5)
} 12.4 The Tiebout hypothesis: Holcombe (1983) illustrates the Tiebout equilib-
rium using a diagram similar to Fig. 12.3. In part
‘voting with your feet’ (b) of the figure the vertical sum of three individuals
with different demand curves (D,, Ds and D3) fora
=
Followinga discussion of the optimal size of clubs, itis local public good G is ED. With a marginal cost of
appropriate to consider how individuals take up club provision ofG equal to OT and equal tax shares, the
ee
membership, i.e. how they choose a local authority in equilibrium quantity (either on a DD= MC ora
eea
which to.reside. Tiebout (1956) argued that indivi- median voter argument) is Og’. For this outcome
ne
duals select the local community whose provision of for individual 1, whose demand curve is Dj, there is
local public goods and tax prices best satisfies their a welfare loss from over-provision of triangle 145. For
preferences. Tiebout's analysis was framed as a direct individual 3 the welfare loss from under-provision is
7
.
rf
*
response to Samuelson’s (1954) conclusion that indi- triangle 123. Ifthere are competing local jurisdictions,
viduals would not reveal their preferences for public individual 1 can ‘exit’ to a community of like-minded
goods. Tiebout, however, argued that in a local
com- individuals, and similarly for individual 3. In an ideal
munity context individuals would reveal their prefer- outcome there would be three communities with
ences, by moving to the locality that best reflected equilibrium as in parts (a), (b) and (c) of the figure.
their tastes and offered the preferred tax—benefit
mix Ifin each community there are (three) identical indi-
(if mobility was relatively costless). As Hughes
has viduals (each enjoying a situation where their demand
observed, equals OP,) there are no welfare loss triangles. In each
community there is a different level of provision of
so as, in effect, to
a we may assume that households will move
whose policies local public goods Oq!, Og? arid Oq’. Given fiscal
subscribe to the clubs (local governments) migration, welfare losses from allocatively different
prefe rence s. This is equivalent
most closely match their own prefer- outcomes from some individuals’ equilibrium quan-
hing cons umer
to the competitive processes of matc buye rsan d tities can be avoided, Individual 3 has expressed pre-
t with many
encesand cost conditions in a marke
under appro priat e ferences for a greater provision of the local. public
sellers and it is possible to show that
will characteri se good by moving toa jurisdiction which offers greater
conditions similar efficiency properties their
the ultimate equilibrium of the distr ibuti on of households provision of the local public good. Voting with
!987, p. 5) feet, both individual | and individual 3 no longer
across local authorities. (Hughes level of
experience the welfare loss of consuming a
problem for the provi- to
Samuelson (1954) noted the m
i.e. the proble provision of a local public good which is different
sion of public goods by large groups, that which they would prefer.
bout hypothesis
- of preference revelation. The Tie In this way the “Tiebout hypothesis’ is
obviously of
at
individuals reveal
appears to mitigate this, in so far as considerable theoretical importance. It stands
as a
Ohi)
r feet’. For exam-

their preferences by ‘voting with thei qualification to the problems of public
good provi-
on libraries and the as an
to act
ple, those who like expenditure sion, But, in practice, how likely is it
the same persuasion. answer this question it
arts can reside with others of equilibrating mechanism? To
ot
r forms of fiscal of discussion.

Those with a preference for othe is possible to refer to at least two areas
ve local ‘club’ else-
expenditure will join their respecti First, there is the restrictiveness of the assumptions
offered a different
where. [f each local community
298 PUBLIC FINANC
E AND PUBLIC
CHOICE
t
fale
a cah le oe a
R ieee
an
seaieel calle2
hk
Oth
Figure 12.3 Tiebout

adjustments.
Source: based upon
Holcombe (1983) Pub
EEal
tic Finance end the Pol

itica! Process, Southe
rn Mlinois Universi ly Press,
Wlinois. .
that underly the Tiebout
mechanism. On the basis
analysis by Tresch (1981) of obtain alternative jobs or
, Hughes (1987), Musgra without having to worry
and Musgrave (1989) and Boad ve about transport costs to their
way (1979), attention Place of work. Housin
can be drawn to the assump considerations are also imp
tions required to make ortant. In the UK, for
mobility efficient , Secondly, there is empiri example, there is evidence
cal work that the local authority
which looks for evidence council house system has red
that fiscal considerations uced mobility over long
play any part at all in the dec distances for those who see
ision of individuals to k housing in this sector
reside in a particular locality. (Hughes and McCormick 198
1).
12.4.1 The Tiebout mechan Externalities
ism: underlying The movement of a househ
assumptions old from one locality to
another may cause extern
alities in the form of
The following list of assumptions, congestion. For a welfare-m added
which is by no aximizing equilibrium,
means exhaustive, adds a note of the Tiebout mechanism
scepticism to the Must create a situation
claim that individuals can easily whereby it is impossible for
locate in the local any individual to increase
communities that reflect their prefer
ences, utility asa result of changing
when there are externali communities. However,
Full knowledge of all the communiti ties even costless mob
es’ may not be sufficient to ility
characteristics attain this result. As ind
duals migrate, externali
It is assumed that the individual has comp ties are experienced by ivi-
lete infor- already resident in the
community, those
mation of the local taxes and expenditures. This literature (see, for
example, Buchanan and
Costless mobility Wagner 1970, Bu chanan and Goetz 1972, Flatters,
The mechanism functions only if fiscal consideratio Henderson and Mieszkowsk
ns i 1974) has been dis-
playa decisive role in location choice. Of course, cussed by Boadway (1979). As
other sume that individuals
factors, such as job Opportunities, friendship and migrate between districts until
the
family ties, typically play-their part. Ithas beenalle from being resident in one loc benefit they derive
ged ality is equal to the
that the assumption that only fiscal consideratio benefit theyderive from being in anothe
ns are benefit (utility) derived fro r. If total
important ‘makes the voting by feet hypothes m being in locality X is
is some- denoted by TB,
what unrealistic, exceptina setting where people work and total benefit fro
in the inner city and may choose among the subu TB,, then equilibrium occurs where m being in Y is
rbs
for residence’ (Musgrave and Musgrave 1989, p.
453). (12.2) TB, = TB,
Costless mobility implies that there are no work prob-
But will this prove a welfare
lems, i.e. that households can move without havi maximu
ng to individual moves to a region, she may m? When an
add congestion
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LOCAL GOVERNMENT 299
‘
© ided by one
club). Benefits prov
locality (ic. in the
@26060@ @'
jur isd iction. The

If MCx represents
* gosts to already crowded facilities.ng one more person locality may spill over into another pro-
ofaddi ma y ‘at ern ali ze’ this spillover bya
= marginal congestion costs maximum requires that two loc ali tie s
gai nin g.
y bea
Alternatively, there mad later
na wel far e of dir ect bar
~ to region X, the cess
rnme nt. (This is discusse
TR-MG= TB, — MG, role for a central gove modifica-
3123) ° 9 r.) Bit her way, there will be a
al commun- in this chapte
l moving into a loc outlined above.
- Because the individua gestio n cos ts that this tion to the analysis
h the con
‘| © tyis not concerned wit idents, her decision to
move
Non-static preferen
ces
ng res during
public services change
implies for exi sti TB, and
difference between IF preferences for local
will be determined by the poi nt added strains for the
Ti ebout
incentive to move ata the life-cycle, there are
TB, and there will be no whe n ages individuals havea
pri ority
TB,. Equilibrium occurs mechanism, Atcertain
when FB, is equal to . (No te s for children: later they
wil l be
n (12.3). is satisfied for educational facilitie ilities for old-age pensioners.
equation (12.2) rather tha with the entrant, who is
- that now the property rig
ht is more concerned with fac as
either households move
able to join any club she wis
hes.) The implication is that s con sis t
ument which Boadway local communitie
eS One variant of this arg circumstances changé: OF needs change si mu l-
impact of migration whose
of individual households
ee
to the
(1979) discusses relates
re of local taxes (which has
on tax costs. The sha nt taneously.
account in TB,) is releva
already been taken into empirical
~ for other existing memb ers of the locality. As noted in
12. 4.2 The Tiebout hypothesis:
m size of clubs, the
Se our discussion of the optimu l reduces the taxes ~ fests
arrival of an additional individua a given improbability of all the
above assumptions
pay to finance The Tiebout proposition.
that existing residents have to
& , the benefit of one
level of expenditure. As a result existing residents)
obtaining casts doubt on the
So how can we test whethe
al conditions play
r fisc
more resident in X (to the new and dec isi on to res ide inalocalcommunity?
tax paid by the marginal any rolein the
is TB, + t where & is the education expenditures
ms of congestion, it is Oates (1969) focused on quality of
immigrant. Ignoring proble es per pupil and used this as a mea
sure of the
requir
argued that a welfare optimum public services in 53 northe
rn New Jersey municipa-
TB, + & = TB + fy as people move into an
(12.4) lities. If property is fixed, then,
services, they will
Free migration will result in
an optimum only if area that has a superior set of public
Oates found that
te = ty, that is, if the total tax
bill for a marginal drive up property prices in that area. ated to the tax
rel
ons. A priori,
regi
individual is the same in the two tax bill per person property values were negatively cor
tha t sch ool exp end itures per pupil
there is no,reason to exp ect that the rate. He also found
y ated, i.e. that
will be the same in both regions.
However, Topham and. property values were positivel rel
inflow to the
(1983) raises a question-mar
k over this criticism. If additional fiscal spending attracted an
esis that
"A there were a divergence in tax bills,
r things
then, othe locality. These results support the hypoth
in
equal, there would be a preferenc
e to reside in the. individuals are willing to pay more in order to live
locality where the tax bill is lower.
If one area were to communities that provide high-quality services.
n
-turn out to be a tax haven, proper
ty and house prices While Oates interprets the relationship betwee
exp end itu re
would rise (capitalizing the favourable
tax bill) in this capitalization and effective local taxes/
bout
area, so reducing its TB. to indicate the explanatory power of the Tie lton
hypothesis, Edel and Sclar (1974) and Hami m
an is
Economies of scale -(1976) are sceptical. If the Tiebout mech iture
for public goods, exp end
When there are diverse préferences worked, then no capitalization of taxes/
to produce m ked
the number oflocal communities required
This might would be expected. If the Tiebout mechanis wor s
an equilibrium would be extremely large
. itie
missing out and individuals were mobile, then local commun
imply many small communities, thereby would contain individuals with the sam e fisc al pre-
tence
on possible gains that would arise from the exis ferences and the tax/expenditure patterns would per-
local
of economies of scale in the production of fectly reflect these preferences. In effect, there would
output. be no reason to move ina Tiebout equilibrium. There-
Benefit spillover fore the existence of tax and expenditure capitaliza-
t
In the analysis above, the assumption was that all of tion would reflect a disequilibrium; iLe., the Tiebou
the benefits were experienced by those residents in the equilibrium would not have been attained. (More-

guage
Per
oy SHARES
Capita
eipenditures
lot of
i preference
4
{
Effective tax rate
Figure 12.4 Migratory incentives.
over, it is not sufficient to argue that the Tiebout

equilibrium is being reached if capitalization falls over Per
capita f
time—see Pauly (1976) and Chaudry-Shah (1988).) expenditures EJF
Aronson (1974) and Aronson and Schwartz (1973)
develop a framework that indicates relatively attract-
ive destinations. In Fig. 12.4 the axes measurea ‘bad’
effective tax rate (x axis) and ‘good’ per capita local
government expenditures (y axis). For anyone in jur-
isdiction 1, any location to the north (3), west (2) or
north-west (4) generally must be superior (less of a
bad, more of a good or both). Hence jurisdictions
should gain population relative to 1 if they are at, say,
2,3 or 4. The process can be repeated for jurisdiction 4.
The test the authors apply is that destination jurisdic- 0 Effective tax rate
tions 2, 3 and 4 should gain residents relative to the
origin town 1. Evidence from local government areas Figure 12.5 Optimal location,
in both the UKand the USA offered empirical support.
A minor extension to this would be to imagine an
efficient jurisdiction’s frontier, EJF in Fig. 12.5, which for individuals to move to thé one they most prefer,
offers the higher per capita expenditure for any effect- and hence there should be a greater homogeneity of
ive tax rate or, equivalently, the lowest effective tax preferences within those localities. They confirmed
rate for any given per capita expenditure. Imposing there was substantially greater homogeneity of
individual 7s indifference curve on the figure, is ‘ideal demand within suburbs located near many other
home’ is jurisdiction A, achieving utility ,. communities. By contrast, where there were few
Another approach to testing the Tiebout hypoth- other communities exit was less easy and there was
esis was suggested by Gramlich and Rubinfeld (1982). more heterogeneity.
They considered homogeneity of preferences by refer-
ence to responses to survey questions. If the Tiebout 12.4.3 The EC budget: public finance vs.
mechanism is relevant, then there should be some public choice
effect of the costs of moving on the pattern of prefer- In this section the ohiective is to wil the pre-
ences; that 18, when ther This document is available free of charge on StuDocu.com : finance the opera-

Per
Capita
expenditures
ae a of
preference
age
w
ee e
free
STS
Effective tax rate
Figure 12.4 Migratory incentives.
over, it is not sufficient to argue that the Tiebout

equilibrium is being reached if capitalization falls over Per
time—see Pauly (1976) and Chaudry-Shah (1988).) capita I
expenditures EJF
Aronson (1974) and Aronson and Schwartz (1973)
develop a framework that indicates relatively attract-
ive destinations. In Fig. 12.4 the akes measure a ‘bad’
effective tax rate (x axis) and ‘good’ per capita local
government expenditures (y axis). For anyone in jur-
isdiction 1, any location to the north (3), west (2) or
north-west (4) generally must be superior (less of a
bad, more of a good or both). Hence jurisdictions
should gain population relative to 1 if they are at, say,
2,3 0c 4. The process can be repeated forjurisdiction 4.
The test the authors apply is that destination jurisdic- 0 Effective tax rate
tions 2, 3 and 4 should gain residents relative to the
origin town L. Evidence from local government areas Figure 12.5 Optimal location.
in both the UKand the USA offered empiricalsupport.
A minor extension to this would be to imagine an
efficient jurisdiction’s frontier, EJF in Fig. 12.5, which for individuals to move to thé one they most prefer,
offers the higher per capita expenditure for any effect- and hence there should be a greater homogeneity of
ive tax rate or, equivalently, the lowest effective tax preferences within those localities. They confirmed
rate for any given per capita expenditure. Imposing there was substantially greater homogeneity of
individual ?’s indifference curve on the figure, 1’s ‘ideal demand within suburbs located near many other
home’ is jurisdiction H, achieving utility JL. communities. By contrast, where there were
few
Another approach to testing the Tiebout hypoth- other communities exit was less easy and there was
esis was suggested by Gramlich and Rubinfeld (1982). more heterogeneity.
They considered homogeneity of preferences by refer-
ence to responses to survey questions. If the Tiebout 12.4.3 The EC budget: public finance vs.
mechanism is relevant, then there should be some public choice
effect of the costs of moving on the pattern of prefer- In this section the objective is to cotpare the pre-
ences; that is, when there are many localities it is easy scriptions of traditional public finance fer the opera-
LOCAL GOVERNMENT 301
- tion of the EC budget with those that might be derived

Agricultural Guidance and Guarantee Fund but this
q : from a public choice analysis. Lessons from the liter- has been falling as a share of the budget (see Table 12.1
q “ature on fiscal federalism may be applied when for- for details of expenditure in 1991).
4, mulating the role of the budget in the European Until 1970 the EC budget was funded by direct
ro
] * Community. Fiscal federalism literature offers pre- contributions made by member states. Since 1970 it
scriptions concerning the assignment of fiscal
menus eee
tasks has been financed from the ‘own resources’ of the EC.
to the EC budget, However, the role of the budget “Own resources’ are those taxes that member states
might be quite different ifa public choice critique of have agreed should be deemed the resources of the
government were relevant? Once again, the objective EC. Initially (in 1970) they comprised three elements:
is to contrast arguments m traditional (social (i) customs duties levied on goods imported from
optimality) public finance (as to.how public policy outside the EC, (ii) agricultural and sugar levies, (iii)
prise ESR ERROR

should be pursued) with explanations from public ashare of the VAT revenue raised in each country. The
She
choice theory (of how public policy actually is pur- VAT contribution is the amountof revenue that would
=
sued). In this section concern focuses on expenditure be raised from levying a specific VAT rate (e.g. 1 per
and redistribution (as the macroeconomic funeNons cent VATrate) on astandardized
or ‘harmonized’ base.
of the EC budget are discussed in section 11.4). In recent years the finances of the budget have been
_ In 1957 the Treaty of Rome provided that expend- reformed. The ‘Delors package’ was meant to apply
iture of EC institutions would be financed bya general oughout the period 1988-92. It proposed that: (i)
budget. The budget has grown significantly since
1957. Today it remains small in relation to the
national budgets of member states, accounting for
SK about 1.1 percent of EC GDP in 1992 (by comparison uniformly under a Commission Directive so that high
with the budgets of member states’ national govern- consumption and low income member states would
ments which averaged 30 per cent of national GDP). not be unreasonabl charged) (Hitiris.1994) and (ii)
;3
However, in absolute terms the Community budget is that a new, ‘fourth ‘xesource’ be added to ‘own :
almost equal to Greece’s GDP (Hitiris 1994). The resources. This new soutce of finance would provide ;
growth of the budget is shown in Fig. 12.6. The main the revenue required to cover expenditure in excess of
area of EC expenditure has been on agricultural policy the traditional ‘own resotyrces’ (including VAT
(particularly to guarantee prices) by the European receipts). The budget would be subject to an overall
rab
ou
a
=>
o
T
U
1] a
hey
: o Total EC spending
oo
2c 08
3 i
—
‘ ee “=
porn
ae ee
3
.
0.6
§ /
; ;
z “\U/’ FEOGA (agricultural policy)
3 6x E
: wi
4 4 0.4
Ve
L L Demi po (ig fy
1990
1 rT 1 1
1985
02 A. i 1.
i971 1975 1980
1971-92.
Figure 12.6 The European Community budget in relation to member state’s GDP,
Source: Smith (1992) with permisr” ~ ~***~ '--** fa- Pineal Ceding

3O2 PUBLIC FINANCE AND PUBLIC CHOICE
Table 12.1 Expenditures made in 1991, by sector and recipient member states (Ecu m.)
Member state - ald EAGGF Regional Social Fund Repaymentby Othar Toaat
uarantee Guidance Fund Member States
|
ee
Belgium 1,459.4 13 464 = 653, 12.5 1,039.1 2.634.0 (4.9%)

Denmark 1,215.6 14.1 13 45.8 4.2 88.8 1,379.8 (2.6%)
France 6,332.7 362.9 323.2 513.5 63,2 556.0 B, 152.5 (15.2%)
Germany 4,990.5 181.0 94.8 239.7 252.9 838.5 6,597-4 (12.3%)
Greece 2,211.8 223.4 537.2 349.1 = 367.0 3,688.5 (6.9%)
oF
Irish Republic 1,628.7 153.6 411.9 403.8 101.5 110.3 2,809.7 (5.2%)
nnewee
5.347.0 203.8 710.8 414.5 6.7 629.5 7,311.2 (13.6%)
Italy _ 240.2 268.5 (0.5%)
Luxemburg 2.8 5.5 18.3 1.8
Netherlands 2,469.8 15.2 34.6 122.5 211.6 146.0 2.9998 (5.6%)
Portugal 316.4 196.9 971.2 379.3 49.4 315-1 2,228.2 (4.1%)
3,300.3 420.3 1,488.8 697.0 482.3 486.0 6,874.8 (12.8%)
Spain
UK 2,252.7 98.5 \ 530.1 636.9 137-6 413.6 4,069.5 (7.6%)
TOTAL 3,527.8 1,886.4 \ 5,178.6 3,869.3 1,320.8 5,231.0 49,008,5 (91.9%)
wer
® Figures in parentheses show the percentage of the total budget allocated. The remaining 8.9% unallocated includes payments for overseas aid and
administratipn. i
Source: Bladen-Hovell and Symans (1994).
ceiling for the total of all own resources of 1.2 perce t In February 1992 the Commission published a
of EC GNP. The proportion of farm spending in th - document referred to as the ‘Delors II’ package. This
budget was expected to decline from two-thirds to 56 proposed further reform. The real value (in 1992
per cent by 1992, with a rise in the share of the struc- prices) of EC expenditure was to be increased from
tural funds financing regional and social policy CU 67 billion in 1992 to ECU 87.5 billion in 1997.
(Hitiris 1994). From an equity point of view, the Priority should be given to (i) additional expenditure
effect of introducing the GNP-based resource would on economic and social cohesion, (ii) promotion of
be to make the EC tax system more closely tied tothe ‘a favourable environment for competitiveness, and
principle of ‘ability to pay. Contributions in 1992 of (iii) foreign aid. Agricultural spending was permitted
member states are shown in Table 12.2. to increase in real terms but it was to continue falling
(Ecu m.) \
Table 12.2 Own resources in 1992 by member state . \
\
Member State Type of resource
Agricultural Sugar and Customs GNP-based ow VAT-based own — Total own

isoglucose duties resource . fesource resources
levies
832.5 294.3 2,388.4

Belgium 84.1 69.4 1,074.9
6.3 39-4 222.3 189.3
Denmark 14,170.2
‘ 747 321.8 1,548.9 1,719.0--
France
3,546.0 2,413.3 16,596.5
Germany 142.0 333.0 831.2
16.9 178.1 111.5
Greece 16.2 469.7
12.0 153.2, 54.4
Ireland 2.0 8,572.9
346.1 124.2 1,037.4 * 1,787.2
Italy 108.2
11.5 17-4
*
0.1 - 3,447.8
Luxemburg 400.1
108.4 78.2 1,160.7
Netherlands 117.0 103.0 ; 806.9
117.2 0.1
Portugal 5,052.8
141.3 50.0 555-8 774.2
Spain 7,398.0
177-9 67.7 2,236.5 = 146459-3
UK 4,666.0 §7,917-6
1,216.2 4,112.4 11,599-9 9,323.1
TOTAL {100.0)
(1.9) (20.0) (16.1) (60.0)
(% of total budget) (2.1)
.
Source: Bladen-Hovell and Symons (1994)
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Chapter 3 Public Goods

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7 9 John Cullis and Philip Jones

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(b) Public good

Figure 3.1 Aggregate demand: public choice and private goods,

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can be enjoyed at no personal cost. This ist he strategy

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‘ we Se.SE as} that the tangency has been found by deductin

i*nx_f equating the MRS. of individual B

| ma J z i Get the condition

we can write this more easily as

i produces public and private goods.

chapter1 can be derived in the Presence of the public

sumption but excludable, A toll booth may exclude

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receive during their working |i 5 ;

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but itis by no means private (i.e. below capacity limits

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(assumed identical for expositional simplicity). 3-5-3 The Lindahl-Johansen solution “*

a0 Downloaded by Yashodeep #480 (yashodeeparya@gmail.com)

can be derived in two steps as follows:

on the contract curve:

_ OU, __,0U, (3.20) MRS), = MRSz, = 0

(3.17) MU,h = ar Gay

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: fare of club members.

In part (a) of the figure the

will always be pre the

Figure 3.8 The Lindahl-Johansen approach.

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cost and Total

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Figure 3.10 The Winch/Kolm triangle.

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12.2 The welfare gains from

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12.3 The optimum size of local

II of Fig. 12.2. The costs per capita of providing a

ents who share the total cost. The curve A illustrates

costs per capita; as more people live in the locality, ur

of the total cost Tincurred by providing some service

_______ Downloaded by Yashodesp emetreor)=

Figure 12.2 ‘Optimum’ local community.

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296 PUBLIC FINANCE AND

that, until the question of s then well be a tendency for zon

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r feet’. For exam-

r forms of fiscal of discussion.

Figure 12.3 Tiebout

tic Finance end the Pol