MWG 11.A-11.

D: Externalities and Public Goods

Extended discussion of government subsidy to induce social optimal level
of public good production
Recall from the slide file (slide 26/27) that market equilibrium with individual
subsidy si for consumer i, is characterized as below where p⇤h is the equilibrium price:

• Consumer i’s problem is

⇣ X ⌘
max i hi + h⇤k + si h i p⇤h hi
hi 0
k6=i
0 ⇤
P
which solves as i (h ) + si  p⇤h (with equality if h⇤i > 0) where h⇤ = k h⇤k .

• The industry firm solves maxq p⇤h q c(q) and supplies equilibrium output level
q ⇤ characterized by FOC p⇤h  c0 (q ⇤ ) (with equality if q ⇤ > 0).

• Together with market clearing condition h⇤ = q ⇤ , market outcome h⇤ satisfies

0 ⇤
i (h ) + si  c0 (h⇤ ) with equality if h⇤i > 0, 8 i. (2)

• Thus, the market outcome restores social optimum, i.e., h⇤ = ho , if si is set at

X
s⇤i = 0 o
k (h ) 8i
k6=i

because then the condition (2) coincides with the condition for social optimum
P
when h⇤ = ho , i.e., 0i (ho ) + s⇤i = k 0k (ho )  c0 (ho ) for every i.

Now, consider the case that the social optimum is positive (h0 > 0), so that the
P
social optimum condition is k 0k (ho ) = c0 (ho ). Then, the condition (2) holds for
all i as an equality when h⇤ = h0 and si = s⇤i , regardless of how the total demand
P
h⇤ is divided into individual demands h⇤1 , h⇤2 , · · · , h⇤I (subject to k h⇤k = ho ). That
is, since the subsidy s⇤i incentivizes every consumer i to demand hi so that total
provision of pubic good is ho (when the price is p⇤h = c0 (ho )), in equilibrium each
consumer demands so that his demand and all others’ demands add up to ho . In
particular, it is an equilibrium that only one consumer, say i, demands h⇤i = ho and
all others demand zero, i.e., h⇤k = 0 for k 6= i.
From this, we further deduce that ho can be induced by o↵ering subsidy si = s⇤i
for one consumer i but sk = 0 for all others k 6= i, because then it is optimal for i to
demand h⇤i = ho as above and for k 6= i to demand h⇤k = 0 since equation (2) holds
as a strict inequality for i = k when h⇤ = ho and sk = 0. By the same token, ho can
be induced by o↵ering si = s⇤i for any subset of consumers and si = 0 for the rest.

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