Ec201 Weeks 5-6

Ec 201: Principles of Microeconomics
Public Goods and Externalities
Tim Besley
February 2022
TJB (LSE) Ec 201 February 2022 1 / 67

Week 4/5: Lectures 8-10: Living Interdependently: public
goods and externalities
By living in the same economy, individuals take actions which

in‡uence the well-being of others.
This can create pollution or failure to provide things which are
collectively valuable.
We will show why the market system will typically fail to deal
adequately with collective consumption.
We will also explore ways of dealing with this equitably and e¢ ciently.

The Problem of Social Order
How to establish a social order is the heart of many issues in social

science
people can take actions which a¤ect the well-being of others
agreeing to trade with them
acts of aggression and violence
helping others out
The market system as we have studied it so far is a model of social

order
individuals interact solely through markets with interactions mediated
through market prices
Bringing in public goods and externalities fundamentally alters the
challenges involved in establishing a social order
raises fundamental issues around how a society is organized
this is because interdependence is not well-managed via markets

The Problem of Social Order
There are two main traditions:

Social contract:
social order is established through …nding ways of creating
organizational structures that facilitate cooperation
although this cannot be handled in markets, the metaphor of a contract
between individuals still applies
the problem is how to enable contract-like solutions to emerge
Hobbesian tradition (Force majeur)
social order needs strong coercive authority
mainly focuses on government rather than other solutions to living
interdependently
We will explore both solutions below when we have introduced the

idea of public goods and externalities

Types of Goods
The goods that we have studied so far have two key properties
depletability
more for one means less for another
excludability
individuals bene…t from consumption exclusively
But many goods are not like this.

Types of Goods
Depletable Non-depletable
Excludable Lentils Software code
Non-excludable Common land Free to air TV
Note that this applies equally well to bads as well as goods

indeed there are examples where a good to one person is a bad to
another
e.g. playing loud music, air pollution

Living interdependently
Non-excludability is critical when people live together in an

interdependent way
We may not be able to choose the consumption of goods that enter
our utility functions
e¤ects could be local as when litter is left on the ground in a
neighborhood
but could also be global as in the case of carbon emissions
We will explore the implications of this for a world where individuals
make independent decisions
as would be the case in a pure market system.

The Tragedy of the Commons
Term coined by Russell Hardin (1940-2017)

a situation in a shared-resource system where individual users acting
independently according to their own self-interest behave contrary to
the common good of all users by depleting or spoiling that resource
through their collective action
Many things that we consume are common resources
such as the planets environment or whether we live in safe
neighbourhoods
we take actions which a¤ect how much common resource there is for
others to share
so we need to …nd ways of living together more e¤ectively.

Climate Change as a Negative Externality

Climate Change as a Negative Externality

A Pure Public Good
Suppose that there are N goods as in our core model above but good
1 is special
it is a pure public good
with individuals enjoying equally their own consumption and that of all
members of society
We therefore write utility as
U i G , x2i , ..., xNi
where
G = F x11 , x12 , ...x1M .
and F ( ) is a function that is increasing in each argument.
We will focus on the case where G is a public good, i.e. U i is
increasing in G .
But the we could write many di¤erent models which capture a rich
array of situations
Examples
Perfect substitutes case:

M
G = ∑ x1i
i =1
Now only total consumption matters

Complements
M
G = ∏ x1i
i =1
In this case everyone has to work together to produce the good

Next Steps
We will explore the logic of consumption using a canonical example of

two people A and B
We will show that there are two forms of public good problem which
re‡ect the logic of free-rider problems
the prisoners’dilemma
the assurance game
Both create the possibility of Pareto ine¢ cient outcomes
We will then explore “solutions” to this including a possible role for
government

A canonical example
To …x ideas, we will look the implications of public goods in a

small-scale society of just two individuals
labelled A and B
There are two goods x1i and x2i
assume that x1i 2 f0, 1g
there is a …xed level of income mi which can be used to purchase good
1 or 2
also set prices such that p1 = p2 = 1
the budget constraint is mi = x1i + x2i .

A canonical example
Suppose that utility function is linear in both goods
U i G , x2i = γG + x2i .
where γ 2 [0, 1] is a parameter which re‡ects how valuable good one

is compared to good two.
This will allow us to explore the logic for choosing x1A , x1B very
simply
re‡ecting the interdependence in consumption decisions.
We will think of these as individuals
but they could be countries thinking about reducing climate emissions.

Example: The Need for Collective Security
Two people face a common enemy

since they live in the same location, it is the joint e¤ort to provide
security which matters
i.e. security is a public good
Thus G is a measure of how secure they are against enemy attack
The parameter γ represents how much security matters
which could depend on the strength of an external threat
Providing security is costly

it requires each individual to give up another activity which they enjoy
Will they protect themselves or live in an insecure environment?

Example: Reducing Greenhouse Gas Emissions
Two countries are deciding how much to engage in costly measures to

reduce climate emissions
such reducing dependence on fossil fuels and embracing renewables
such as increasing forest cover by planting trees
such as encouraging people to eat less red meat
The measure G denotes the total (global) e¤ort at doing this
The parameter γ denotes how costly the problem is and hence how big
the bene…ts are from reducing emissions
Will countries choose to invest in mitigation measures or live in a
world where a climate catastrophe is more likely?

Nash Equilibrium
Understanding consumption choices now requires us to use the logic

of game theory
interaction between individuals A and B is a game
We will look for a Nash equilibrium
each agent takes the choice made by the other agent as given and then
chooses their best outcome
at equilibrium both are doing the best that they can given what the
other is doing
We explore this by constructing the payo¤ matrix associated with all
combinations of actions by both individuals.

The Payo¤ Matrix
To construct this note de…ne
Û A x1A , x1B = γF x1A , x1B + mA x1A
and
Û B x1A , x1B = γF x1A , x1B + mB x1B
Then the payo¤ matrix is
x1B = 0 x1B = 1
x1A = 0 Û A (0, 0) , Û B (0, 0) Û A (0, 1) , Û B (0, 1)
x1A = 1 Û A (1, 0) , Û B (1, 0) Û A (1, 1) , Û B (1, 1)

Public Goods Provision as a Prisoners’Dilemma
Most of you will have heard about this but you may not have realized
that this is essentially a story about public goods
The fact that the prisoners’can confess or not a¤ects each others’
payo¤s
So confession is just like x1i in the model where
x1i = 1 is staying silent
x1i = 0 is confessing
We will now how this …ts for a canonical example of public goods
provision

Public Goods Provision as a Prisoners’Dilemma
Assume that G = x1A + x1B

hence G 2 f0, 1, 2g
Then we can write the utility of individual A as
h i
Û A x1A , x1B = γ x1A + x1B + mA x1A
and for individual B

h i
Û B x1A , x1B = γ x1A + x1B + mB x1B
Individuals choose x1i 2 f0, 1g

but note that we could allow x1i 2 0, mi with identical conclusions
this is because preferences are linear

The Payo¤ Matrix
To be speci…c about the solution and to write down the matrix let
mA = mB = 2
γ = 0.8 < 1.6 = 2γ
We need to see what the payo¤ will be for each con…guration of
decisions
For example, if x1A = 0 and x1B = 1 then
UA = γ + 2 = 2.8
B
U = γ + 1 = 1.8
Other entries are constructed similarly

test yourself if you are unsure

The Payo¤ Matrix
We put individual payo¤s in order with payo¤ of individual A …rst
x1B = 0 x1B = 1
x1A = 0 (2, 2) (2.8, 1.8)
x1A = 1 (1.8, 2.8) (2.6, 2.6)
The Nash equilibrium will be x1A = x1B = 0

The Payo¤ Matrix
To understand this, note that with
x1B = 0 x1B = 1
x1A =0 (2, 2) (2.8, 1.8)
x1A = 1 (1.8, 2.8) (2.6, 2.6)
it is always best for A to chose x1A = 0 regardless of the value of x1B is

The reasoning is symmetric for both players.

Key Assumptions
The key requirements for this …nding is that γ < 1

the personal bene…t from contributing is less than the gain
so it is not in any individual’s personal interest to set x1i = 1
The logic would carry over to a community of any size
" #
γ ∑ x1k + x1i + mi x1i < γ ∑ x1k + mi
k 6 =i k 6 =i
if γ < 1

Implications
This is called the “free-rider problem” since each individual gets a

bene…t from the contribution of the other
but she pays none of the cost when the other person provides the good
The outcome that is achieved is Pareto ine¢ cient
A and B get 2 each
whereas with x1B = x1A = 1, they would each get 2.6
so both could be strictly better o¤ if they could make di¤erent decisions
But this is not compatible with their incentives
so if we think about the decision over x1i being made in a market, then
the market fails

The Idea of Market Failure
This simple world of consumption of a public good illustrates the idea

of a market failure:
A market failure is where it is possible to make everyone better o¤ with
some other choices
The …rst fundamental welfare theorem does not hold with a public
good
Why?
When there is interdependent consumption, individuals cannot optimize
over everything in their utility function
The market does not allow we to choose my neighbour’s consumption,
only mine
and there is no reason to think that my neighbour will do what I would
like
especially when she has to pay the cost of doing something which I like

An assurance game
Suppose that we are still in a world where x1i 2 f0, 1g

But that
N
G = ∏ x1i
i =1
with γ > 1
Now the public good is provided only if everyone contributes
In the two person case G = x1A x1B

Payo¤ Matrix
Now consider two individuals as above

Assume that γ = 1.2 and mA = mB = 2
implies that contributing to the public good is individually worthwhile
as long other people contribute
Now if for example, if x1A = 0 and x1B = 1 then
UA = γ x1A x1B + 2 = 2
UB = γ x1A x1B + 1 = 1
Other entries are constructed similarly

test yourself if you are unsure

The Payo¤ Matrix
We put individual payo¤s in order with payo¤ of individual A …rst
x1B = 0 x1B = 1
x1A =0 (2, 2) (2, 1)
x1A =1 (1, 2) (2.2, 2.2)
We will look for a Nash equilibrium of this game

Nash Equilibria in the Assurance Game
There are now two equilibrium points:

x1A = x1B = 1
x1A = x1B = 0
The …rst equilibrium is Pareto superior to the other, i.e. 2.2 > 2
…nding a way to the best equilibrium requires coordinating expectations
about what the other player will do
player A needs assurance that player B will choose x1B = 1.
The key concern is still about free-riding
contributing to the public good is not worthwhile if the other party
does not do so

Nash Equilibria in the Assurance Game
As in the prisoners’dilemma example, the …nding holds equally well

for M individuals
Note that
Û i x11 , x12 , ..., x1M = γx1i ∏ x1k + mi x1i .

k 6 =i
Then there are two Nash equilibria if
mi 1 < mi < γ + mi 1
if γ > 1
The …rst has x1i = 0 for all i and the second has x1i = 1.

Solutions to the free-rider problem
“Voluntary” cooperation
evolve ways of negotiating and/or punishing free-riders
Government intervention
have the government take over provision and/or …nancing of the good
We will now explore these possibilities

“Voluntary” Cooperation
Lin Ostrom (1933-2012)

“Voluntary” Cooperation
Small scale societies often use negotiation to solve free rider problems
good examples are households and families
But the requirements are more demanding in prisoners’dilemmas
than assurance games
societies …nd ways of punishing defectors or those who do not make the
best choices
this could be explicit or indirect punishments
the use of punishments is one reason that voluntary is in quote marks
Many organizations try to organize cooperative means of solving

free-rider problems
this has been extensively studied by anthropologists
there are also many lab experiments exploring public goods games

Is self-interest the right assumption?
In the examples above, we assumed that individuals care only about

themselves
This is the classic economic assumption but perhaps less warranted
when there is interdependence
But there are many ways of relaxing self-interest
Altruism – individuals care directly about each others payo¤s
Reciprocal preference – individuals care conditionally about the actions
of others
It is arguable that there is biological basis in such preferences
Can these solve the free-rider problem?

Evidence from Lab Experiments
There is now a lot of experimental evidence in controlled environment

which close …t the kind of framework that we have studied here.
a group of M individuals are give “tokens” which they can use to
contribute towards a public good where
" #
Ui = γ ∑ [contribution by k ] + tokens-contribution by i
k
with γ < 1 < Mγ.

So self-interest says that [contribution by k ] = 0 for all k
Pareto e¢ cient outcome is [contribution by k ] =tokens for all k

Evidence from Lab Experiments
These experiments have been running thousands of times

Typical contributions are between the self-interested outcome and the
Pareto e¢ cient outcome
There is some evidence that this varies across cultures/sub-populations
Contributions tend to decline when the experiment is run multiple times
Some kinds of pre-experiment communication makes a di¤erence
The question is why this happens.

Reciprocal actions and free-riding
Now suppose that individuals punish free riders

A imposes a penalty of size π if x1A = 1 and x1B = 0
B imposes a penalty of size π if x1A = 0 and x1B = 1
This is known as negative reciprocity
Can this solve the free-rider problem?

What happens to the payo¤ matrix in the prisoners’dilemma?
x1B = 0 x1B = 1
x1A =0 (2, 2) (2.8 π, 1.8)
x1A = 1 (1.8, 2.8 π ) (2.6, 2.6)
This will lead to an equilibrium with x1A = x1B = 1 if
π > 0.2

There are two key assumptions

it is possible to detect free-riding
punishments are possible
Although it goes beyond what we are studying in this lecture, we can
think of π as future exclusion
In many settings punishment can also take the form of withdrawing
cooperation in future
But studying this requires a model where cooperation takes place over
time
This again is realistic in smaller scale forms of cooperation

Application to Climate Change
Since there is no e¤ective world government, voluntary cooperation is

the main vehicle
Scope for inducements and punishments is limited
Getting a global solution is di¢ cult
Enforcing the Paris accord on 2 degrees
Failure to get meaningful action at Madrid in 2019
Is there scope for changing political incentives and hence objectives of
government?

Application to Climate Change
Global inequality is also a challenge in terms of costs and bene…ts

Advanced Topic: The Coase Theorem
Will discuss only if we have time
Named after Ronald Coase (1910-2013)

Suppose that individual A owns the public good
so it can be provided only if she says so
but she can collect contributions from B
A o¤ers a contract to B comprising a level of public goods depending
on how much B contributes
n o
G , x1B
which may (implicitly) include a promise of her own contribution: x1A .

Consider the example where G 2 f0, 1, 2g and x1i 2 f0, 1g

Suppose that A sets G = 0 if x2B = 0
Now B will choose x1B = 1 if
γG + mB 1 mB .
This holds if γ = 0.8 and G = 2

And A is also better o¤ compared to G = 0.
So we have solved the free-rider problem!
This example generalizes to a community of M people.

What is going on?

The market system solves the problem once ownership rights are
established
although requires a legal framework to enforce the contract
the legal threat of zero public goods provision can induce private
contributions
The Coase Theorem is generally used to argue that we do not
necessarily need government if property rights can be de…ned
but probably best thought of as a di¤erent way of thinking about why
public goods are di¤erent.
However, there are examples where the Coase theorem could apply?
Coase has a wonderful essay on the “Lighthouse in Economics” to
motivate this

The Role of Government
It is arguable that a lot of what government does is to interfere in

markets for public goods
What government brings to the table is the possibility of coercion
consumption could be regulated when it has bene…ts to others
e.g. compulsory vaccination
or the government could take over decisions about the provision of
public goods
defence
In the latter case, it can use its coercive taxing power to fund public
good provision
Whether government uses its coercive power for public bene…t is an
issue that we will explore later
for the moment, we will explore the role of government under the
assumption that government is cares about social welfare
Directly Regulated Provision
The government could mandate in the prisoner’s dilemma example

that
x1A = x1B = 1.
But that mandate assumes that government
can observe x1i
has su¢ cient coercive power
We will suppose that the government has the ability to issue a …ne for
setting x1i = 0

Directly Regulated Provision
Now the payo¤ of each individual is

h i
Û i x1A , x1B = γ x1A + x1B + mi x1i 1 x1i π
Now, it is worthwhile to set x1i = 1 if
γ+π > 1
so that the …ne has to be larger enough to create an incentive not to

free-ride
the …ne will need to be larger, the lower is γ.
in our prisoners’dilemma example, π > 0.2 will su¢ ce
Instead of a …ne, the government could also subsidize provision

Direct Provision
Trying to regulate private provision may not be easy

for example, it may be very di¢ cult to monitor x1i
So now suppose that the government can levy a tax on everyone and
use this to fund G
We will focus on the case where
M
G = ∑ x1i
i =1
The government collects taxes from income at rate t for everybody

and chooses how much to spend on G
Its budget constraint is:
M
G =t ∑ mi
i =1

Direct Provision
Not all government spending is on public goods in the classical sense

Based on conservative categorization for the OECD:

Direct Provision
Let us begin with the linear example and ask when the government
will optimally spend
Suppose that there is a maximum tax rate τ above which people will
evade their taxes
i.e. t < τ
Suppose also that the government is Utilitarian
Then its objective function is
M
W (t ) = ∑ γG + mi (1 t)
i =1
" #
M
= [(Mγ 1) t + 1] ∑ m i
i =1
after substituting in the government budget constraint

Direct Provision
Now ask what happens if we raise t above zero?

Will this raise social welfare
M
∂W (t )
= (Mγ 1) ∑ m i
∂t i =1
which is positive if Mγ > 1.

i.e. it looks at the sum of the bene…ts of the public good across the
population
Indeed if this holds, the government will set t = τ, maximal provision
of the public good
This is called the Samuelson rule for provision of a public good
named after Paul Samuelson (1915-2009)

Direct Provision
This argument is highly intuitive

The value of reduced private consumption (good 2) has to be
compared to the increase in consumption of the public good.
The public good has to be paid for
with an income tax, this means reducing each person’s income, and
hence consumption of good 2, proportionately
this is illustrative only and other tax systems could be studied
The public good bene…ts everyone

so valuation is M γ not γ as in the case of a private good

Direct Provision
The Samuelson rule is more conventionally stated when utility is not

linear
U i G , x2i
where x2i = (1 t ) mi
Now !
M M
W (t ) = ∑U i
t ∑ m , (1
i
t) m i
i =1 i =1

Direct Provision
Then the optimal provision of a public goods maximizes W (t ) or

∂W (t )
=0
∂t
which implies that
! !
M M
∂U i ∂U i
∑ ∑m i
∂G
m i
∂x2i
=0
i =1 i =1
which trades o¤ increases in public consumption against losses in

private consumption.
Note that what matters for this trade o¤ is
∂U i /∂G
MRS i =
∂U i /∂x2i
the relative value of public and private consumption
Cost-Bene…t Analysis
The Samuelson rule can be related to cost-bene…t analysis

this is the most widely used method for assessing the value of public
interventions
The bene…ts are !
M M
∂U i
∑ ∂G ∑m i
i =1 i =1
and the costs are

M
∂U i
∑ mi ∂x i
i =1 2
These can be computed for speci…c public spending proposals.

i
tricky issue is how to measure ∂∂UG
were the 2012 London Olympics a good idea?

Happiness and the London Olympics
Paul Dolan and LSE colleagues looked at this:
http://eprints.lse.ac.uk/67677/1/dp1441.pdf
But e¤ects went away after about a year!

Bringing in Distribution
This is already implicit in what we have looked at as there is

diminishing marginal utility of private consumption
But we can do this more explicitly using a social welfare function
It is also interesting to look at government intervention to provide
public goods when incomes di¤er
so with an income tax not everyone pays the same amount
m i di¤ers
we could also have di¤erences in bene…ts from the public good
γi di¤ers
We can also relate provision of a public good to the Utility Possibility

Frontier from earlier lectures

Bringing in Distribution
Develop a two person example

Incomes are such that mA > mB so that with an income tax, A pays
more than B
Assume still that γ is the same for both individuals
In the absence of government, we know that there will be no public
goods provided.
Allow for a social welfare function which values utility di¤erently
1 φ 1 φ
γG + mA (1 t) + γG + mB (1 t)
W (t ) = .
1 φ
Recall that φ > 0, re‡ects a preference for equality
The government budget constraint is
h i
t mA + mB = G .

Key Observations
There is no guarantee that with government intervention, every

citizen is better o¤ with government intervention than without
this will tend not to be the case when the income distribution is very
unequal and/or there are divergent preferences
With a preference for equality, government intervention can increase
social welfare even if one agent loses out
this is because the social welfare function weights the gains of the
worst o¤ individual more than the better o¤ individual
but this may mean trading o¤ losses against bene…ts
If some citizens are better o¤ and some are worse o¤, then politics is
going to matter
and we will return to this in a later lecture.

Numerical Illustration
Suppose that
mA = 9 &mB = 1
t τ = 0.5
Then
UA = γA G + m A [1 t ] = tγA 10 + 9 [1 t]
B
U = γB G + m B [1 B
t ] = tγ 10 + [1 t]
after using G = t mA + mB .

Note that
∂U A
= γA 10 9
∂t
∂U B
= γB 10 1
∂t
The following three observations are immediate
If γA < 0.9, then A will be worse o¤ when the public good is provided
via taxation
If γB > 0.1, then B will be better o¤ when the public good is provided
via taxation
If γA + γB > 1, then total Utility is higher when the public good is
provided via taxation

Suppose that γB > 0.1 and γA + γB = 1, then any social welfare

function with φ > 0 will favour providing the public good

Suppose that γB > 0.1 and γA < 0.9 with γA + γB > 1, then any
social welfare function (including Utilitarian) with φ 0 will favour
providing the public good

Suppose that γB > 0.1 and γA > 0.9, now there is a Pareto
improvement (and the social welfare function does not matter) for the
case for providing the public good

Take Home
Once consumption patterns become intertwined, then independent

market-based decision are generally not Pareto e¢ cient
Thus the …rst fundamental welfare theorem fails
Markets are not e¢ cient (the most widely used de…nition of market
failure)
Responding to this varies by context
solutions with small groups can use local information and social
punishments
for larger scale public goods, the state generally gets involved
but then there is no guarantee that there is a Pareto improvement over
the no-state outcome
so the case for government intervention has to be considered case by
case and politics matter.

Ec201 Weeks 5-6

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Ec 201: Principles of Microeconomics

Public Goods and Externalities

TJB (LSE) Ec 201 February 2022 1 / 67

By living in the same economy, individuals take actions which

TJB (LSE) Ec 201 February 2022 2 / 67

How to establish a social order is the heart of many issues in social

The market system as we have studied it so far is a model of social

TJB (LSE) Ec 201 February 2022 3 / 67

There are two main traditions:

We will explore both solutions below when we have introduced the

TJB (LSE) Ec 201 February 2022 4 / 67

But many goods are not like this.

TJB (LSE) Ec 201 February 2022 5 / 67

Note that this applies equally well to bads as well as goods

TJB (LSE) Ec 201 February 2022 6 / 67

Non-excludability is critical when people live together in an

TJB (LSE) Ec 201 February 2022 7 / 67

Term coined by Russell Hardin (1940-2017)

TJB (LSE) Ec 201 February 2022 8 / 67

TJB (LSE) Ec 201 February 2022 9 / 67

TJB (LSE) Ec 201 February 2022 10 / 67

Perfect substitutes case:

Now only total consumption matters

In this case everyone has to work together to produce the good

TJB (LSE) Ec 201 February 2022 12 / 67

We will explore the logic of consumption using a canonical example of

TJB (LSE) Ec 201 February 2022 13 / 67

To …x ideas, we will look the implications of public goods in a

TJB (LSE) Ec 201 February 2022 14 / 67

Suppose that utility function is linear in both goods

where γ 2 [0, 1] is a parameter which re‡ects how valuable good one

TJB (LSE) Ec 201 February 2022 15 / 67

Two people face a common enemy

Providing security is costly

TJB (LSE) Ec 201 February 2022 16 / 67

Two countries are deciding how much to engage in costly measures to

TJB (LSE) Ec 201 February 2022 17 / 67

Understanding consumption choices now requires us to use the logic

TJB (LSE) Ec 201 February 2022 18 / 67

To construct this note de…ne

Û A x1A , x1B = γF x1A , x1B + mA x1A

Then the payo¤ matrix is

TJB (LSE) Ec 201 February 2022 19 / 67

TJB (LSE) Ec 201 February 2022 20 / 67

Assume that G = x1A + x1B

and for individual B

Individuals choose x1i 2 f0, 1g

TJB (LSE) Ec 201 February 2022 21 / 67

Other entries are constructed similarly

TJB (LSE) Ec 201 February 2022 22 / 67

We put individual payo¤s in order with payo¤ of individual A …rst

The Nash equilibrium will be x1A = x1B = 0

TJB (LSE) Ec 201 February 2022 23 / 67

To understand this, note that with

it is always best for A to chose x1A = 0 regardless of the value of x1B is

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The key requirements for this …nding is that γ < 1

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This is called the “free-rider problem” since each individual gets a

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This simple world of consumption of a public good illustrates the idea

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