rower Dooce aT Ms The Mathematics of Public Goods Provision vate provision of public goods and discuss how government intervention affects that provision. This analysis uses the tools of game theory, a method used by economists to solve problems in which multiple parties interact to make a decision | nn this appendix, we present the mathematics behind the analysis of the pri- Setup of the Example Imagine that Ben and Jerry live by themselves far away from others. They choose between consuming a private good, X, with a price of $1 (P, = 1), and a public good, fireworks, with a price of $1 (Pp = 1). They each have an income of $100, Because fireworks are a public good, the total amount provided is the sum of the amount provided by each individual: F = F, + F).Each indi- vidual (i) has a utility function of the form: U = 2X log(X) + logis + F) which he maximizes subject to the budget constraint: X, + R= 100 Private Provision Only Initially, Ben and Jerry provide the public good on their own, with no govern- ment intervention. A question for modeling private provision is how Ben and Jerry will behave, given that each knows the other will also provide fireworks. ‘Game theory models designed to answer questions such as these typically assume Nash bargaining: cach actor solves for his or her optimal strategy given the other actor’s behavior, and an equilibrium exists if there is a set of mutually compatible optimal strategies. The Nash equilibrium is the point at which each actor is pursuing his or her optimal strategy, given the other actor's behavior, ‘Combining the equations for the utility fanction and the budget constraint, Ben solves a problem of the form: Max U = 2 X log(100 — Fp) + log(Fe + F) 215216 PART 2 EXTERNALITIES AND PUBLIC GOODS Differentiating this expression with respect to FB, we obtain: =2/(100 = Fy) + 1/(F, + B) = 0 which we can solve to generate: (100 — Fy)/(2 X (Fg + F)) = 1 and therefore: Fy = (100 — 25/3 Note the fice rider problem implied by this equation: Ben's contribution goes down as Jerry’s contribution goes up. ‘We can solve a similar problem for Jerry: = (100 — 2F)/3 This yields two equations in two unknowns, which we can substitute one into the other to solve for Fy and F;, Doing so, we find that Fy = F; = 20,0 the total supply of fireworks is 40. Socially Optimal Level How does this compare to the socially optimal level of provision? The social optimum is the quantity at which the sum of the individuals’ marginal rates of substitution equals the ratio of prices (which is 1 in this example). Each indi- vidual’s MRS is the ratio of his marginal utility of fireworks to his marginal utility of private goods, which we obtain by differentiating the previous util- ity function with respect to fireworks and then again with respect to private goods. So the optimal amount of fireworks is determined by: (100 = Fy/[2 x (Fy + 5] + (100 — F)/(2 x (Fy + KY) = 1 ‘Using the fact that total fireworks F = Fy + Fj, we can rewrite this equation as (200 - Fy/2F = 1 Solving this, we obtain F = 66.6. This quantity is much higher than the total provision by the private market, 40, due to the fice rider problem. The public good is underprovided by the private market. Different Types of Individuals Suppose now that Ben has an income of $125, while Jerry has an income of only $75. In that case, Ben maximizes: U= 2X log(l25 — Fy) + log(Fs + F) So Ben's demand for fireworks is: Fx (125 — 25/3 Jerry, in this case, maximizes his utility U = 2X log(75 - F) + log(Fs + F))Puatic Goons So Jerry's demand for fireworks is F, = (95 ~ 2Fy/3 Solving these two equations, we find that Fy = 45, and F, = —5. Because individuals can't provide negative fireworks, this means that Jerry provides no fireworks, and the total supply is 45. This quantity is higher than the private quantity supplied when Ben and Jerry have equal incomes. Thus, having ‘one actor with a higher income leads the outcome to be closer to the social optimum. Full Crowd-Out Suppose the government recognizes that the private sector underprovides fireworks by a total of 26.6 in the original example. It therefore attempts to solve this problem by mandating that Ben and Jerry each contribute $13.30 toward more fireworks, Will this solve the underprovision problem? In fact, it will not; such a mandate will simply crowd out existing contri- butions, Under the mandate, Both Ben and Jerry now maximize their utility, which has the form: Max U = 2 X log(X) + log(Fy + Fy + 26.6) Each maximizes that utility funetion subject to the budget constraint X + = 100 = 13.3 Solving this problem as above, we find that the optimal level of fireworks pro- vision for both Ben and Jerry falls to 6.7 each, so that total provision (public of 26.6 plus private of 13.4) remains at 40. By reducing their provision to 6.7, Ben and Jerry can return to the private solution that they find to be optimal, which is total spending of $20 cach, and a total of 40 fireworks. As discussed. in the chapter, however, full crowd-out is only one of a range of possible out- comes when government provides a good that is also provided by the private sector. CHAPTER 7 27this page left intentionally blank