PF02-Public Goods

Public Finance
Public Goods
Sun Go
Chung-Ang University
Overview Definition Efficient provision Free rider Public choice Exercise Summary
Review
Welfare economics
I Efficiency
I The 1st and 2nd welfare theorems
I Market failures
Three key questions for assessing public policy

I Will it have desirable distributional consequences?
I Will it enhance efficiency?
I Can it be done at a reasonable cost?
Sun Go Public Goods 2/59

Overview
Public goods
I What are public goods?
I Efficiency provision of public goods
I Free riders problem
I Preference revelation mechanism
I The Lindahl model
Textbook
I Ch. 4
I Ch. 6


Definition

Public goods
A good whose consumption is both nonrival and nonexcludable

I Nonrivalry
I Once it is provided, the additional resource cost of another
person consuming the good is zero
I Nonexcludability
I To prevent anyone from consuming the good is either very
expensive or impossible

Examples
Rival Nonrival
Excludable Private goods Natural monopoly
Nonexcludable Common resources Public goods
I Private goods: pizza

I Natural monopoly: subway, highway, lecture, wifi
I Common resources: basket ball or foot ball play ground,
bench, public beach
I Public goods: national defense
I Note: all these categorizations are somewhat arbitrary and not
absolute.

Question
Does everyone value public goods equally?

Question
Does everyone value public goods equally?

I Public goods need not be valued equally by all
I Even though everyone consumes the same quantity of the
good
I Sunshine, rain, national defence, clean air
I Negative value can be also possible

Examples
Some things that are not conventionally thought of as commodities

have public good characteristics
I Social honesty
I Social trust
I Clean air, rainfall, sunshine

Private provision
Public goods can be provided privately

I Honesty
I Flowers in the garden
Private goods are not necessarily provided exclusively by the private

I Many publicly provided private goods
I Medical service, vocational education, housing
Public provision of a good does not necessarily mean that it is also

produced by the public sector


Efficient provision of public goods

Example: Private goods
Example: two goods, two people

I Demand curves
I A: P = 7 − 2QA
I B: P = 7 − QB
I Market: P = 7 − (2/3)QTotal
I Supply curve
I P = Q − 0.5

Market demand

Market equilibrium

Market equilibrium
I At price pf = 4
I Adam consumes 1.5, Eve consumes 3
I Total quantity demanded is 4.5
At the equilibrium, the allocation of fig leaves is Pareto efficient

I A = MRS B
MRTa,f = MRSa,f a,f
I The necessary condition for Pareto efficiency is satisfied

Example: Public goods
Adam and Eve enjoy displays of fireworks

I A fireworks display is a public good: nonrival and
nonexcludable
I Suppose
I The current display consists of 19 rockets.
I Can be extended at a cost of $5 per rocket
I Adam would be willing to pay $6 to have one more rocket
I Eve: $4 for one more rocket
I Q: Is it efficient to increase the size of the display by one

rocket?
I A: compare the marginal benefit and marginal cost
I MBsocial = Adam’s $6 + Eve’s $4 = $10
I MC = $5 per rocket

Vertical summation
Deriving the group willingness to pay for a good

I Private goods: People consume different quantities at the
same price
I Public goods: People consume equal amounts, but the WTP
are different, and their MRSs are different

Efficiency condition
Efficient when the group WTP equals the MC to produce a unit
I A + MRS B
MRTa,f = MRSa,f a,f

Example
Demand
I A: MWTPA = −(2/25)QA + (38/5), QA < 95
I E: MWTPE = −(2/25)QE + (28/5), QE < 70
I Social demand
I MWTPTotal = −(4/25)QE + (66/5), Q < 70
I MWTPTotal = −(2/25)QA + (38/5), 70 =< Q < 95
Supply
I P = (1/25)Q + (21/5)

Vertical summation

Vertical summation


Free rider’s problem

Problems in achieving efficiency
Do market forces lead to the efficient level of public goods?

I It depends in part on the extent of people’s revelation of true
preferences for the public good
I In the private market, no incentives to lie about their true
preference
I For a public good, people have an incentive to lie

A free rider
I Someone who lets other people pay while enjoying the benefits
himself
I With a free rider problem, the public good would be provided
less than the socially optimal level
I The free ridership is not given
I Examples: Fund drives led by volunteers
I The importance of the free rider problem is an empirical
question
I Recent experimental studies show that the free rider problem
exists, but there are also some provisions of public goods

Preference revelation mechanism
Consider a government providing a public good (= rocket) using

tax revenue (paid in apples).
I The government asks people to tell their own demand curves
for the public good.
I Using this information, the government provides the Pareto
efficient quantity of the public good to the people and assign
each a tax.
I The tax rule
I Whenever the level of public good provision increases by a
unit, an individual’s tax bill is "the incremental cost of that
unit minus the value that everyone else puts on the increase."

Now, a taxpayer’s marginal change (∆T i ) in the tax bill when

provision of the public good is increased by a unit is
X
∆T i = MRTra − ( j
MRSra i
− MRSra )
j
X
j
= MRTra − MRSra
j6=i
1 i−1 i+1 n
= MRTra − (MRSra + · · · + MRSra + MRSra + · · · + MRSra )
(1)

Equation (1) means that

I The increase in the individual’s tax bill when an extra unit is
provided is independent of the individual’s own (reported)
valuation of the unit
I Therefore, an individual taxpayer has no incentive to lie about
the demand curve
I Everyone will reveal the true preference to maximize utility
An individual would like to see the public good provided in an

amount such that
∆T i = MRSra
i
(2)

Substituting from equation (1) for ∆T i gives us
X
i j i
MRSra = MRTra − ( MRSra − MRSra )
j
1 i−1 i+1 n
= MRTra − (MRSra + · · · + MRSra + MRSra + · · · + MRSra )
(3)
Which is
X
i j i
MRTra = MRSra +( MRSra − MRSra )
j
X (4)
j
= MRSra
j

This shows that the government provision of the public good when
everyone reports the true demand curve is Pareto efficient.

Problems
I Would taxpayers understand this system?
I Do they know their demand curves?
I How could the government collect all the information?

Privatization
Would privatization solve the free rider’s problem?


Public choice approach

The Lindahl model
(This is also explained in Chapter 6 of Rosen & Gayer’s text)
We consider the Eden’s firework example again. The marginal cost

to provide one more unit of the public good is shared by Adam and
Eve. Denote
I S A = Adam’s share of the cost
I S E = Eve’s share of the cost
I SA + SE = 1

The Lindahl model
This means that when the market price per rocket is Pr ,

I Adam’s price per rocket is S A Pr
I Eve’s is S E Pr
Also, if the total cost to provide z units of the public good is C ,

I Adam’s share of the cost is S A C
I Eve’s is S E C

The Lindahl model
For any particular value of S A

I Adam demands some quantity of rockets, which is shown by
Adam’s demand curve DrA
I To derive Adam’s demand curve, think about total cost and
Adam’s total willingness to pay

The Lindahl model

The Lindahl model
Adam’s indifference curves have an inverted U-shape. For a given

level of the cost share, we can find z ∗ that maximized utility. These
z ∗ s constitute the demand curve DrA .

The Lindahl model
Similarly, we can find Eve’s demand cureve DrE .

I The two graphs can be combined similarly to the Edgeworth
box
I The y axis shows Lindahl prices (S A , S E )
I The equilibrium is (z ∗ , S A∗ , S E ∗ )
I Here, Adam and Eve (unanimously) agree on producing z ∗ at
a Lindahl price (S A∗ , S E ∗ ))

The Lindahl model


Exercise

Setting
Gyeonwoo and Jiknyeo

I Public good: Romantic songs
I A numeraire x (Px =1)
Assumption
I G and J cannot collude with each other
I Pr =1
I Each has income = 100
I Utility of i = Ui = U(ri , xi ) = 2lnxi + lnF
I where F = rg + rj

Private provision
Assume Nash bargaining

I G knows J will choose rj to max Uj
I J knows G will choose rg to max Ug
G’s U-Max problem

I To choose (rg , xg ) to max Ug = 2lnxg + ln(rg + rj )
From the budget constraint

I Pr rg + Px xg = 100
I x = 100 − rg

Private provision
G’s U-Max problem again

I G chooses rg
I To max Ug = 2ln(100 − rg ) + ln(rg + rj )
F.O.C.
2 1
I − 100−rg
+ rg +rj =0
I 2(rg + rj ) = 100 − rg
I 3rg = 100 − 2rj
I rg = 13 (100 − 2rj )

Private provision
Note:rg depends on rj
I As rj increases, G will demand the songs less ( rg falls)
I Free rider’s problem
J’s U-Max problem is identical to G’s

I rj = 31 (100 − 2rg )

Private provision
Nash equilibrium
I rg = 13 (100 − 32 (100 − 2rg ))
I 3rg − 100 = − 23 (100 − 2rg )
I 9 rg − 150 = 2rg − 100
2
I 5 rg = 50
2
I Thus, rg = 20
Similarly,
I rj = 20
I F = rg + rj = 40

Social optimum
MRSrg,x = MRSrj ,x = MRTr ,x = MCr
MCx =1
MUrg MUrj
I
MUxg
+ =1
MUxj
g
I MUrg MUrj
+ =1
MUx MUxj
∂U g /∂r ∂U j /∂r
I
∂U g /∂x + ∂U j /∂x
=1
U = 2lnx + ln(rg + rj )
1 2
I MUr = rg +rj and MUx = x
MUr 1/(rg +rj ) x
I MRS = MUx = 2/x = 2/(rg +rj )
g 100−rg
I MRS =
2(rg +rj )
100−rj
I MRS j =
2(rg +rj )

Social optimum
Thus,
100−rg 100−rj
I
2(rg +rj ) + 2(rg +rj ) =1
I 2(rg + rj ) = 200 − (rg + rj )
200
I F = rg + rj = 3 ≈ 66.7 > 40

Inequality
Consider income inequality

I Ig = 125
I Ij = 75
I Now G chooses rg to max Ug = 2ln(125 − rg ) + ln(rg + rj )
F.O.C.
2 1
I − 125−rg
+ rg +rj =0
I 2(rg + rj ) = 125 − rg
I rg = 13 (125 − 2rj )
Similarly, J chooses rj to max Ug = 2ln(75 − rj ) + ln(rg + rj )

I rj = 13 (75 − 2rg )

Inequality
Nash equilibrium
I 3rg = 125 − 2rj = 125 − 23 (75 − 2rg ) = 75 + 43 rg
I 5 rg = 75
3
I Thus, rg = 45
Similarly,
I rj = −5, but rj ≥ 0
I Thus, rj = 0 (a corner solution)
I F = rg + rj = 45
Still underprovided, but closer to the social optimum

Crowding out
Now assume Ig = Ij = 100 again

I Fpvt = 40 < 66.7 = Fso
What if government charges tax to provide additional F up to F ∗ ?

Fso −Fpvt 66.7−40
I Tax for each = 2 = 2 = 13.3

Crowding out
Now G chooses rg to max

Ug = 2ln(100 − 13.3 − rg ) + ln(rg + rj + 26.6)
2 1
I F.O.C.: − 86.7−rg
+ rg +rj +26.6 =0
I 2rg + 2rj + 53.2) = 86.7 − rg
I rg = 31 (33.5 − 2rj )
Similarly,
I rj = 31 (33.5 − 2rg )

Crowding out
Then,
I 3rg = 33.5 − 32 (33.5 − 2rg )
I 5 rg = 33.5
3 3
I Thus, rg = rg = 6.7 < 20
Perfect crowding out

I F = rg + rj + 26.6 = 6.7 + 6.7 + 26.6 = 40


Summary
Re-cap: Public goods

I What are public goods?
I Efficiency provision of public goods
I Free riders problem
I Preference revelation mechanism
I The Lindahl model
Next class:
I Externalities (Ch. 5)

PF02-Public Goods

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PF02-Public Goods

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Public Finance

Three key questions for assessing public policy

Sun Go Public Goods 2/59

Sun Go Public Goods 3/59

Sun Go Public Goods 4/59

Sun Go Public Goods 5/59

A good whose consumption is both nonrival and nonexcludable

Sun Go Public Goods 6/59

I Private goods: pizza

Sun Go Public Goods 7/59

Does everyone value public goods equally?

Sun Go Public Goods 8/59

Does everyone value public goods equally?

Sun Go Public Goods 9/59

Some things that are not conventionally thought of as commodities

Sun Go Public Goods 10/59

Public goods can be provided privately

Private goods are not necessarily provided exclusively by the private

Public provision of a good does not necessarily mean that it is also

Sun Go Public Goods 11/59

Sun Go Public Goods 12/59

Efficient provision of public goods

Sun Go Public Goods 13/59

Example: Private goods

Example: two goods, two people

Sun Go Public Goods 14/59

Sun Go Public Goods 15/59

Sun Go Public Goods 16/59

At the equilibrium, the allocation of fig leaves is Pareto efficient

Sun Go Public Goods 17/59

Example: Public goods

Adam and Eve enjoy displays of fireworks

I Q: Is it efficient to increase the size of the display by one

Sun Go Public Goods 18/59

Deriving the group willingness to pay for a good

Sun Go Public Goods 19/59

Efficient when the group WTP equals the MC to produce a unit

Sun Go Public Goods 20/59

Sun Go Public Goods 21/59

Sun Go Public Goods 22/59

Sun Go Public Goods 23/59

Sun Go Public Goods 24/59

Free rider’s problem

Sun Go Public Goods 25/59

Problems in achieving efficiency

Do market forces lead to the efficient level of public goods?

Sun Go Public Goods 26/59

Sun Go Public Goods 27/59

Preference revelation mechanism

Consider a government providing a public good (= rocket) using

Sun Go Public Goods 28/59

Preference revelation mechanism

Now, a taxpayer’s marginal change (∆T i ) in the tax bill when

Sun Go Public Goods 29/59

Preference revelation mechanism

Equation (1) means that

An individual would like to see the public good provided in an

Sun Go Public Goods 30/59

Preference revelation mechanism

Substituting from equation (1) for ∆T i gives us

Sun Go Public Goods 31/59

Preference revelation mechanism