Equilibrium in private markets is determined at the intersection of the demand curve and the supply

curve. When, for one reason or another, the demand for a commodity increases, its demand curve shifts
up, the price rises, and this induces fi rms to produce more. Thus, the price system conveys information
about a change in individuals’ tastes to fi rms. Similarly, when, for one reason or another, a commodity
becomes less costly to produce, its supply curve will shift down, the price will fall, and individuals will be
induced to shift their consumption toward the now-cheaper commodity. Again, the price system has
conveyed information about the change in technology from fi rms to consumers. Indeed, one of the
central results of modern welfare economics, as was pointed out in Chapter 3, is that in a competitive
economy, the resulting resource allocations are effi cient. Decisions about resource allocations in the
public sector are made in quite a diff erent manner. Individuals vote for elected representatives; these
elected representatives, in turn, vote for a public budget; and the money itself is spent by a variety of
administrative agencies. Thus, there is a major diff erence between how an individual decides to spend
his or her own money and how, for example, Congress decides to spend the public’s money. The vote of
a member of Congress is supposed to refl ect the views of constituents, not just the representative’s
own views. In deciding how to vote, members of Congress face two problems: fi rst, they must ascertain
the views of their constituents, and second, because these views are likely to diff er, they must decide
how much weight to assign to various positions.

THE PROBLEM OF PREFERENCE REVELATION

Individuals may express their views about the desirability of one private good versus another by a
simple action—by buying the good or not—but there is no comparably eff ective way that individuals
can express their views about the desirability of one public good versus another. Elections of public offi
cials convey only limited information about voters’ attitudes toward specifi c public goods; at best, they
convey a general notion that voters prefer more or less government spending. Even if individuals were
asked directly about their preferences, would they truthfully and meaningfully reveal them? In recent
years, politicians have increasingly turned to polls to ascertain voters’ preferences, and although they
have found the polls to be useful, they have come to treat the results with extreme caution. For
instance, in today’s environment of exploding government defi cits, polls consistently show strong
sentiment toward reducing the defi cit. However, no consistent picture emerges concerning the trade-
off s: some polls suggest that voters would be willing to pay higher taxes or accept expenditure cuts to
reduce the defi cit, but other polls (confi rmed to some extent by voting patterns) suggest otherwise.
Although in polls voters consistently say they believe that the government should spend less on
assistance to foreign countries, when asked how much should be spent, they give a number
considerably in excess of what the United States is currently spending. Unless individuals are faced with
concrete trade-off s, under which they actually have to give up something to get more, say, of another
good, it is diffi cult to get them to think hard about their choices. In addition, there are special problems
in inducing individuals to reveal truthfully their preferences concerning public goods. If what they have
to pay does not depend on their answer, then there is a tendency to ask for more of the good: one
would normally like more public goods as long as one does not have to pay for them. However, if what
an individual says aff ects how much he or she has to pay, there is an incentive for the individual to
pretend that he or she enjoys the good much less than he or she really does— the individual knows that
the answer will have a negligible eff ect on the total amount supplied, and he or she would like to be a
free rider.1 In private decisions, the decision maker knows his or her own preferences. In public
decisions, however, the decision maker must ascertain the preferences of those on whose behalf he or
she is making the decision. This is the fi rst important diff erence between public and private resource
allocations.

INDIVIDUAL PREFERENCES FOR PUBLIC GOODS

Collective decision making is diffi cult because diff erent individuals have diff erent views, for instance,
about how much should be spent on public goods. They diff er for three reasons. Sometimes there are
simply diff erences in tastes. Just as some individuals prefer chocolate ice cream and others vanilla,
some people prefer public parks and education, whereas others prefer private goods, such as video
games and cars. This book will not have much to say about these matters of tastes. The other two
sources of diff erences are incomes and taxes. Richer individuals have higher incomes, so normally they
prefer to spend more on all goods, both public and private. When the government spends more on

all goods, both public and private. When the government spends more on public goods, however, richer
individuals often have to pay a relatively large share of the additional cost. In the case of private goods,
rich and poor individuals typically pay the same price; with public goods, in eff ect, richer individuals
typically have to pay a higher price. The tax price is the additional amount an individual must pay when
government expenditures increase by one dollar. The tax price multiplied by total government
expenditures equals the individual’s tax payment. A higher tax price by itself means that richer
individuals would want a lower level of expenditures on public goods. With an income eff ect leading to
a higher desired demand, however, and a price eff ect leading to a lower desired demand, the net eff ect
is ambiguous.

INDIVIDUAL’S CHOICE OF “MOST PREFERRED” LEVEL OF GOVERNMENT EXPENDITURES The

individual’s most preferred level of government expenditures occurs at the tangency between the
budget constraint and the indifference curve. (A) As shown, with proportional taxation, individuals
with lower incomes face a lower tax price (fl atter budget constraint). The income and substitution
effects work in opposite directions, so it is ambiguous whether the most preferred level of
government expenditure is higher or lower. (B) As shown, with uniform taxation, all individuals face
the same tax price, so there is only an income effect. Rich individuals prefer higher levels of
expenditure. (In this example, the rich and poor are assumed to have the same indifference curves—
preferences—and differ only with respect to the budget constraints.)

Given the individual’s tax price, we can derive his or her preferred level of public goods expenditure, as
illustrated in Figure 9.1. Individuals with diff erent incomes face diff erent budget constraints; the
preferred levels of public goods expenditure are at the tangencies of the indiff erence curves with the
budget constraints. Diff erent individuals will diff er with respect to their preferred level of expenditures.
With proportional taxation, poorer individuals face.

UTILITY DEPENDS ON LEVEL OF GOVERNMENT EXPENDITURE Utility is maximized at the point of

tangency between the indifference curve and the budget constraint. The farther away the actual level
of expenditures from the preferred level of expenditures, G*, the lower the level of utility.

lower tax prices, and on that account, their preferred level of expenditures, GP, is higher. Poorer
individuals have lower incomes, however, and with lower incomes they demand less public as well as
private goods. The net eff ect is ambiguous. Figure 9.1A illustrates the case in which the substitution eff
ect (lower tax price) dominates the income eff ect, so the poorer individual does prefer a higher level of
public goods than the richer person. With uniform taxation, there is only an income eff ect, so high-
income individuals will prefer higher levels of public expenditure (Figure 9.1B); with progressive income
taxation, lower-income individuals will face a lower tax price than with proportional taxation, so their
preferred level of expenditures will be even higher than with proportional taxation. Figure 9.2 shows
how utility depends on the level of government expenditures. The individual’s most preferred level of
expenditures occurs at G*, but utility is maximized under a budget constraint, at the point of tangency
with the indiff erence curve. The further away the actual level of expenditures is from the preferred
level of expenditures, G*, the lower the level of utility. Figure 9.3 indicates the relationship between the
level of utility and the level of public goods expenditure for three diff erent groups—the rich, the poor,
and the “middle,” assuming a particular tax system. Each has its own preferred outcome, and utility
decreases as expenditures deviate either above or below that level. For expenditures above the middle,
the marginal benefi ts of increased public expenditure are less than the marginal costs the individual
bears in additional tax payments, whereas the converse holds for expenditures below the preferred
level.