Chapter 7: Public Goods I.

Optimal Provision of Private Goods A numeraire good is a good for which the price is set to $1. - choice between goods depends on relative price not absolute price

Public Economics Dr. Sauer

(The numeraire good is placed on the vertical axis when considering a budget constraint.) Ben and Jerry are deciding their consumption of cookies and ice cream. - let cookies be the numeraire - look at choice of ice cream Each will have individual demand for ice cream. - as price falls, Qd rises - different Qd for each individual A. The Market Outcome

Market Demand is found by horizontally summing the individual demand curves. At $2, what is market demand? The market demand is the SMB of ice cream consumption. The market supply is the SMC of ice cream production. The market outcome is found where SMB = SMC. Consumers demand different quantities at the same price.

B. Optimal Consumer Choice using the tangency condition

A consumers optimal choice is found at the tangency of - budget constraint - indifference curve That is, when: MRS = slope of budget constraint BC slope = - px py

MRS = - MUx MUy

MRS is the rate you are willing to give up good y to get one additional unit of good x. Ben: In market equilibrium: An individual will adjust consumption until their MRS equals the market price ratio. If the price of an ice cream cone is $2 and the price of cookies is $1, then the price ratio is 2. This means: In equilibrium, each individual is indifferent between trading 2 cookies to get one ice cream cone. Individual marginal utility levels for each good can still differ. Suppose Ben is consuming 1 cone and 1 cookie and his marginal utilities are as follows: MUic = 7 MUc 3 Suppose Jerry is consuming 2 cones and 1 cookie and his marginal utilities are as follows: MUic = 3 MUc 2 C. Market Supply On the supply side, equilibrium in competitive markets requires that Pic = MCic Jerry:

Since we know that in equilibrium on the demand side Pic must equal MRSic,c, we have: MCic = MRSic,c The private market outcome is also the social-efficiency-maximizing outcome. With no market failures, MRS at any quantity = SMB of that quantity marginal value to individual = marginal value to society MC at any quantity = SMC of that quantity marginal cost to producers = marginal cost to society SMB = SMC II. Optimal Provision of Public Goods Suppose Ben and Jerry are choosing between cookies (numeraire) and missiles. 2

**individuals cannot choose their own specific consumption of a public good** - whatever amount is provided is consumed equally by all The choice therefore is over willingness to pay for a given quantity.

For the 1st missile, Ben would be willing to pay $2 and Jerry would be willing to pay $4. Market Demand is found by vertically summing the individual demand curves. - market demand is SMB as well
Price

Supply = MC = SMC Optimal level: SMB = SMC

$6

Q missiles

A. Mathematically: The SMB is the sum of each individuals valuation: The SMC is the marginal cost of production. Social-efficiency-maximizing level:

MRSBm,c + MRSJm,c = SMB

MRSBm,c + MRSJm,c = MC 3

Example: Suppose Ben and Jerry live far from others. It is the 4th of July and they want to celebrate. They care about the consumption of ice cream and fireworks. - ice cream is a private good $1 per unit - fireworks are a public good $1 per unit - ice cream is the numeraire Suppose they have identical preferences. Each individual will face

or

MUF = MUic to determine how many ice cream cones and fireworks each will buy. MRSBF,ic + MRSJF,ic = 1

The socially optimal level of fireworks is:

since preferences are identical, rewrite as:

Each will privately choose the level where

MUF = MUic

Even though the socially optimal level is MUF = (1/2) MUic - fireworks should be consumed until their MU is half that of ice cream - more fireworks consumption in socially optimal outcome (to decrease the MU, consume more of the good) - private market outcome is less fireworks because of the free-rider problem

B. Underlying Mathematics Ben and Jerry live by themselves and far away from others. - each has income of $100 They each choose consumption over a private good, fried chicken and a public good, fireworks. - each are priced at $1 per unit Both Ben and Jerrys preferences can be expressed as U = 2ln(C) + ln(F) where F = FB + FJ Ben will maximize: Can rewrite as a lagrangian: Jerry will do the same. L = 2 ln(C B ) + ln(FB + FJ ) + (100 C B FB )

1. Private Provision of a Public Good How will each behave, given that the other will also provide some of the fireworks? Nash Bargaining = solve for own optimal strategy, given the others behavior Ben: L 1 = = 0 FB ( FB + FJ ) L 2 = = 0 C B C B L = 100 C B FB = 0 B Bens Reaction Function: FB = 100 2 FJ 3

Jerrys Reaction Function: FJ = 100 2 FB 3

Combine the two reaction functions: And Solve:

Total firework provision will be

FB + FJ =

How does this compare to the socially optimal amount? - need to sum MRS - MRS is ratio of marginal utilities 2. Socially Optimal Level Ben: MU F = MU C = U 1 = FB ( FB + FJ ) U 2 = C B C B

Socially optimal:

sum MRS and set equal to price ratio

The private market will ______________-provide the fireworks. private market = socially optimal = Suppose the government recognizes that the private sector under provides fireworks by 26.67. Suppose it mandates that Ben and Jerry must each contribute $13.34 toward public firework provision. Ben will now maximize: Can rewrite as a lagrangian: Jerry will do the same. Ben: L 1 = = 0 FB ( FB + FJ + 26.67) L 2 = = 0 C B C B L = 86.66 C B FB = 0 B Bens Reaction Function: FB = 33.32 2 FJ 3 L = 2 ln(C B ) + ln(FB + FJ + 26.67) + (86.66 C B FB )

Jerrys Reaction Function: FJ = 33.32 2 FB 3

Combine the two reaction functions: And Solve:

Total firework provision will be FB + FJ +26.67 = The government provision of fireworks has crowded out private provision. - complete crowd-out Ben and Jerry have returned to their optimal level of production and the socially optimal level has not been achieved.