Public Goods

What is a Public Good

• A good with shared benefits
• The “public-ness” of a good has to do with
its’ innate features and the legal
framework
• Not whether it is publicly or privately
financed
• Not because supply is determined by
public policy
 Public Goods
• A public good is a good that is non-
excludable and non-rival in consumption
• Whereas only one person at a time
benefits from a private good, multiple
people benefit from a public good at the
same time.
 Taxonomy of Goods
Degree of Rivalry (congestibility)
Rival Non-Rival

Club goods
Excludable

Private Goods
Degree of Excludability

Markets very Markets relatively

efficient efficient
Non-Excludable

Commons Goods Public Goods

Tragedy of the Free-rider

commons problem
 Congestibility
• Public goods can be pure public goods or
congestible.
Pure public good Congestible public good

MB MB

MBn

MBn

n n
 Market provision of Public Goods
• Markets often struggle when it comes to
providing public goods
• Free-riding means somebody is attempting to
benefit from a public good without paying for it.
• Markets can and do provide some public goods
• non-rivalry is not cause of difficulty in providing
public goods, but rather non-excludability is
• If everyone attempts to free ride, the public good
is not provided
 Public and Private Goods
• For private goods, to aggregate demand
curves (willingness to pay) we sum the
individual demand curves horizontally
• For public goods, we sum the individual
demand curves vertically
• The difference comes from rivalry—while
only one person can consume a private
good, any number of people can consume
a public good
 P or
MB

P2+P1 Demand
Supply
If this good is a private
good, we sum the demand
curves horizontally to derive
the market demand curve

If this good is a public

P2 Market Demand good, we sum the
demand curves vertically
to derive the market
demand curve

P1 In principle, the supply

D2 curve for a public good
is the same as for any
other good
D1

Q
 P or
MB Supply
The efficient quantity of the
P2+P1 public good to be provided is
where demand=supply, or
where the sum of the
marginal benefits equals the
marginal cost
n

�MB
i =1
i = MC
P2
While this works for private
goods, you run into problems
Demand trying to create markets for
public goods—rather than
P1 telling people they can buy as
D2
much as they want at the
market price, you are asking
them to pay how much Q* is
D1
worth to them!

Q* Q
 Deception!
• If the police were funded entirely by asking
citizens to pay them what the citizens
thought the police were worth to them,
what would happen?
• People would misrepresent their personal
benefits
 $ S
Imagine this is societies
supply and demand for some
public good, and that your
contributions make up a very
small part of total
$alot contributions. If you under-
represent your demand, what
happens to the demand
curve?
D Did you see it move? It did, I
swear!
What happens when everybody
acts this way?

alot Q
 Free-Riding
• Nearly all individuals have incentive to free
ride on the provision of a public good
• The amount of the public good actually
provided will probably be somewhere near
the amount demanded by the person with
the highest willingness to pay
• Especially in large groups, free riding will
lead to massive under provision of the
public good
 Public goods as Prisoners’
Dilemma
• 2 Players
• Strategies are to contribute or not to
contribute to the public good
• Public good works like this. Players can
choose to invest 10 dollars in public good.
If they do so, each player gets a benefit of
$7.50 each
 Public goods as Prisoners’
Dilemma
Player 2

Contribute Not Contribute

15 17.50
Contribute Pareto Superior

15 7.50
Player 1
7.50 10

Not Contribute Nash

Equilibrium
17.50 10
 Public goods as Prisoners’
Dilemma
• Role of government is to move from “state
of nature” (that is, the Nash equilibrium) to
the Pareto preferred outcome
• Compulsory taxation and public financing
of the project
 Supply and types of public goods
• So far, we have assumed (at least
implicitly) that the supply of a public good
is additive in nature
• Quantity supplied=Σ of contributions
• If this is the case, free-riding is rational but
inefficient
 Other types of public goods
• Weakest Link public goods—a good such that
the level of the public good that prevails is the
amount purchased by the individual who
purchased the least.
• Volunteer public goods—a good such that, once
a single person has provided it, it is provided for
everybody (a.k.a. best shot public goods).
• Volunteer is the opposite of a weakest link public
good.
 Volunteer public goods
• Volunteer public goods will tend to be
provided, despite the fact that free riding in
this case is rational
• Examples:
• Security
• Stopping to help a broken down motorist
• Free riding is rational and efficient
 Volunteer public goods
• The amount of the public good received by
any one person is identical to the quantity
received by anyone else
• If zi is the contribution made by the ith
member of society, and Gi is the amount of
the public good consumed by that member
• G=max{z1,z2,…zn}=G1=G2=…=Gn
 Why is free riding efficient?
• Consider 4 individuals who incur costs to provide
this public good:
• z1=$12
• z2=$18
• z3=$7
• z4=$13
• Because G=max{z1,z2,…zn}=G1=G2=…=Gn, and
max{z1,z2,…zn}=$18, everybody gets $18 worth
of the public good and the other $32 spent is
wasted!
 Who will volunteer?
• If individuals are heterogeneous, you will
likely see the least-cost individual or
greatest-benefit individual volunteer.
• Example: Say a woman is being mugged
on a busy street—who will help her?
• Likely the person with the most to gain, or
person with lowest cost
• Otherwise, you might wind up in a game of
“chicken”
 Volunteer goods and the game of
chicken
• 2 Players
• Each can decide to provide the volunteer
good or not
• The volunteer good is worth $20 to each
individual, and it costs $5 to provide it.
• If the volunteer good is not provided, each
gets a payoff of $5
 Volunteer goods and the game of
chicken
Player 2

Provide Free Ride

15 20
Provide

15 15
Player 1
15 5

Free Ride

20 5

Multiple Nash Equilibria!

 Multiple equilibria?
• Both are Nash equilibria because, once you get
there, neither individual has an incentive to
change what he or she is doing.
• This type of game is also referred to as a
chicken game or a hawk-dove game.
• In a game such as this one, the players do not
have dominant pure strategies, and it is best for
them to play a mixed strategy, which involves
randomly choosing among the pure strategies.
 Mixed Strategies
• In a mixed strategy equilibrium, each player
randomizes between each possible strategy in
such a way to make the other player indifferent
between all of his choices
• What is the intuition?
• If you contribute every time, the other guy will
never contribute, and you’d like to free ride
• If you never contribute, you run the risk of not
having the good produced, which you do want.
 Solving the Mixed Strategy
Equilibrium
• Let P2 be the probability that player 2
provides the public good.
• Player 1 earns 15P2+(1-P2)15 if he
provides the public good himself
• Player 1 earns 20P2+(1-P2)5 if he does not
• Player 2 knows this, and must keep him
indifferent between providing and not
providing, so:
 Solving the Mixed Strategy
Equilibrium
• 15P2+(1-P2)15= 20P2+(1-P2)5 and we
solve for P2=2/3
• By the same logic, P1=2/3 as well
• What is likelihood that the public good
gets provided?
• 8/9 (4/9 that they both provide it, 2/9 that 1
does and 2 doesn’t, and 2/9 that 2 does
and 1 doesn’t)
 Understanding the Mixed Strategy
Equilibrium
Player 2

Provide Free Ride

As the cost of providing
15 20 the public good rises (that
Provide (A) (C) is, as C rises relative to A),
the likelihood of provision
15 15 falls.
Player 1 As the loss associated
15 5 with the good not being
(A) (B) provided falls (that is, B
Free Ride rising relative to A and C),
20 5 the likelihood of provision
also falls.
 Which equilibrium?
• Which of the three equilibria will prevail in
a simultaneous move game?
• Signalling/Pre-commitment
• Focal points
• Social Norms
• Sequential Decisions and last mover
 Volunteer Public Goods in a
Sequential Game

Player 1 No
e tP
i d ro
rov vid
e
P
No
No t Pr
Player 2 t e o
e Pr i d vid
v id ov o v e
Pr
o ide Pr

15 15 20 5
N.E.
15 20 15 5

Use backward induction—Player 1 Player 1 knows that if he provides, player 2

moves first, and determine what player 2 will free ride, and player 1 gets a payoff of
would do in either situation in order to 10. If 1 doesn’t provide, player 2 will, and
determine what he should do! player 1 gets a payoff of 20
 Volunteer Public Goods in a
Sequential Game

Player 1 No
e tP
i d ro
rov vid
e
P
No
No t Pr
Player 2 t e o
e Pr i d vid
v id ov o v e
Pr
o ide Pr

15 15 20 5
N.E.
15 20 15 5

How does this differ from the simultaneous The oval represents an “information set,”
move game? The nature of the information or the notion that player 2 doesn’t know
sets! which of those nodes he is at.
 Weakest-Link public goods
• The amount of the public good received by
any one person is identical to the quantity
received by anyone else
• If zi is the contribution made by the ith
member of society, and Gi is the amount of
the public good consumed by that member
• G=min{z1,z2,…zn}=G1=G2=…=Gn
 Weakest Link public goods
• Volunteer public goods will tend to be provided,
because free riding in this case is irrational
• Examples:
• Levees
• Technological standards
• Health/disease control
• Airport security
• Free riding is inefficient and irrational
 Why is free riding irrational?
• Consider 4 individuals who incur costs to provide
this public good:
• z1=$12
• z2=$18
• z3=$7
• z4=$13
• Because G=min{z1,z2,…zn}=G1=G2=…=Gn, and
max{z1,z2,…zn}=$7, everybody gets $7 worth of
the public good. If the consumer who put in $7
actually valued it at (say) $12, free riding has
harmed him!
 What is the likely outcome?
• If individuals are heterogeneous, you will
likely see an amount provided equal to the
amount wanted by the lowest value
demander.
• Unless the decisions are made
sequentially, you wind up in a coordination
game.
 Weakest link goods and
coordination games
• 2 Players
• Each can decide to provide the public
good or not
• The weakest link good is worth $55 to
each individual, and it costs $15 to provide
it.
• If the volunteer good is not provided, each
gets a payoff of $20
 Weakest link goods and
coordination games
Player 2

Provide Free Ride

40 20
Provide

40 5
Player 1
5 20

Free Ride

20 20

Multiple Nash Equilibria!

 Coordination games v. Hawk-
Dove/Chicken games
• In a coordination game, both players want
to play the same strategy
• In a hawk-dove or chicken game, both
players want to play different strategies.
• Both types are going to have multiple
equilibria, both in pure and mixed
strategies.
 Solving the Mixed Strategy
Equilibrium
• Let P2 be the probability that player 2
provides the public good.
• Player 1 earns 40P2+(1-P2)5 if he provides
the public good himself
• Player 1 earns 20P2+(1-P2)20 if he does
not
• Player 2 knows this, and must keep him
indifferent between providing and not
providing, so:
 Solving the Mixed Strategy
Equilibrium
• 40P2+(1-P2)5 = 20P2+(1-P2)20 and we
solve for P2=3/7
• By the same logic, P1=3/7 as well
• What is likelihood that the public good
gets provided?
• 9/49 (16/49 that neither provide it, 12/49
that 1 does and 2 doesn’t, and 12/49 that
2 does and 1 doesn’t)
 Which equilibrium?
• Which of the three equilibria will prevail in
a simultaneous move game?
• Again, the answers may be found through
such mechanisms as Signalling/Pre-
commitment, Focal points, Social Norms,
and Sequential Decisions
 Weakest Link Public Goods in a
Sequential Game

Player 1 No
e tP
i d ro
rov vid
e
P
No
No t Pr
Player 2 t e o
e Pr i d vid
v id ov o v e
Pr
o ide Pr

40 5 20 20
N.E.
40 20 5 20

Use backward induction—Player 1 Player 1 knows that if he provides, player 2

moves first, and determine what player 2 will as well, and player 1 gets a payoff of
would do in either situation in order to 40. If 1 doesn’t provide, player 2 won’t
determine what he should do! either, and player 1 gets a payoff of 20
 Weakest Link Public Goods in a
Sequential Game
• If the game is sequential, and all agents
are homogenous, the public good will be
produced efficiently.
• If agents are heterogeneous, however, we
may still not get the efficient amount of the
public good.
• Consider a 2 person society where one
person wants $1,000,000 worth of the
public good, the other wants $2.
National Defence as a public good
• War (or the threat of warfare) may be enough to
justify a government.
• Consider a game between 2 countries
• Each can spend $1T on military or not
• Without spending, GDP in each country is $5T
• If one spends and the other doesn’t, the spender
can invade and take money—we’ll assume that
they destroy $1T worth of stuff and take $3T
home with them
 Military Spending as Prisoners’
Dilemma
Country 2

Not Spend Spend

$5T $8T
Not Spend Pareto Superior

$5T $1T
Country 1
$1T $4T

Spend Nash
Equilibrium
$8T $4T

Despite the fact that both countries would prefer the equilibrium without militaries, it is
unstable. If country 1 arms, country 2 has to arm or else they’ll get a payoff of $1T. If
country 1 doesn’t arm, country 2 has an easy target for improving their welfare.
 National Defence as a public good
• But doesn’t the same logic apply to individuals
within a country, deciding to volunteer for service
or not (or to contribute money to defence)?
• Everybody in the country would prefer to free
ride on the contributions of everyone else.
• Without some coercive taxation and public
financing of military, the country will wind up
overrun by their neighbours!
 Public Finance and Public Supply
• For most prisoners’ dilemma type goods,
and many weakest-link type goods, there
is some potential for a government to
improve on the anarchic outcome by
overcoming the free rider problem
• 2 methods—public finance and public
supply
 Public Finance and Public Supply
• Public Finance—government raises
revenues, and then contracts out to
private firms.
• Public Supply—government raises
revenues, and uses these revenues to
produce the public good themselves.
• Overcoming free riding problem makes a
case for public finance, but it does not
necessarily make a case for public supply!
Information and Public Goods
 Information and Public Goods
• From here, we’ll mostly stick to discussing
public goods that are prisoners’ dilemmas
in nature.
• For these goods, the quantity of the public
good supplied is the sum of individual
contributions.
• n=the number of people contributing
• zi=the contribution of individual i
 Information and Public Goods
• The quantity of the public good G
available to the entire population of n
people is: n
G = �zi
i =1

• The individual contributions are to be

provided through coercive taxation.
 Information and Public Goods
• Two simplifying assumptions have been
made so far, at least implicitly:
1. All individuals value the public good by
the same amount
2. The government has full information on
how much each individual values the
public good
 Heterogenous Individuals
• If individuals have different valuations,
efficiency dictates that each person pays
his/her marginal valuation of the good in
taxes:
• Ti=MBi for all I
• Thus, the tax T simply replaces the price
that people won’t truthfully pay
 Imperfect information
• What if, however, the government doesn’t have
full information?
• Individuals have no incentive to accurately reveal
their marginal valuations
• Government can not determine efficient amount
of the public good!
• Recall efficiency condition:
n

�MB
i =1
i = MC
 n

�MB
i =1
i = MC

P,
MB

P=MC

�MB
i =1
i

G* Q
 Imperfect information
• If the government doesn’t have full
information then the government confronts
the identical information problem that was
the whole reason for wanting a government
to finance the public good!
 Optimal pricing and the Lindahl
solution
• Assume 2 individuals, person 1 and
person 2
• They each share the cost of the public
good, and pay a proportion of the cost of
the public good, s1 and s2, where s1=1-s2
(alternately, Σsi=1)
• Thus, if the per-unit price is P, person 1
pays P1=s1P
 Lindahl Pricing
Cost shares This is the demand curve for
person 1. Note that if he has to
s1=1, s2=0 pay for the entirety of the public
good, he doesn’t want any of it!
As the portion of the good he
MB2 has to pay for falls, he wants
s2*
more of it!
This is the demand curve for
person 2.
s1 s2 The two together are like
supply and demand—any
money spent by 1 (1’s demand)
MB1 is essentially supply for person
s1*
2!
This solution is not only efficient,
but also Pareto optimal!
s1=0, s2=1
G*
Q
 Information and Lindahl Pricing
Cost shares Does either person have incentive
s1=1, s2=0 to free ride? What if person 1
misrepresents his MB curve?
His share falls, and the output
MB2 falls. Does person 1 benefit by
s2*
doing this?
His welfare falls by this purple
area…
s1 s2 But increases by this red area.
In fact, it looks like he’d prefer
to misrepresent his MB curve
s1* MB1 even more!

s1=0, s2=1
G*
Q
 Information problems
• It should be obvious by now that, if
individuals would free ride on the provision
of a public good without government
intervention, they’ll do it if the government
gets involved as well.
• So, how to get them to reveal honestly?
 Information Revelation
• How can we get individuals to reveal their
true MB information?
• What if we assure people that we will
finance the project through general
taxation?
• Result: overstating benefits and
overprovision!
• One solution: Clarke tax—individuals have
incentive to truthfully reveal
 Cost-Benefit Analysis
• Many reasons for using CBA
• Individuals have no incentive to accurately
reveal preferences
• Suppliers (both private and public) may
have incentives to misrepresent their costs
 Cost-Benefit Analysis
• Goal of CBA is to maximize social welfare, W
n
W = �Bi (G ) - C (G )
i =1
• Presumably (or perhaps hopefully) W>0
• If we take the derivative of W with respect to G
and solve for the first order condition (i.e.
maximize W w.r.t. G), we get:
n

�MB
i =1
i = MC
 Cost-Benefit Analysis
C(G) The goal of CBA is to:
1. Determine what the total
benefit curve looks like…
$ n

�B (G)
i =1
i
2. Determine what the total
cost curve looks like…
3. And determine the
optimal quantity of the
public good (the quantity of
G that maximizes the
distance between TB and
TC)…

G*
G
 Cost-Benefit Analysis
We can also show this
using marginal valuations:

$
Max W= ΣMB-MC

MC

ΣMB

G* G
 Estimating the value of life
• How much do you value your life?
• The value of human life is not infinite
• While we don’t ask this question directly,
we do use market prices to try to estimate
the value of a human life…
 Estimating the value of life
Say there are two identical Let’s assume that the
houses: market price of the first
The only difference between the house is $40,000 more than
two is that the second one is the second house, and that
located next door to a nuclear the probability of dying is
power plant. 1% more at the second
And we all know who is the house:
safety inspector at this particular
nuclear power plant… V=$40,000/1%=$4,000,000
Which house are
people willing to pay
more to live at?
Why?
 CBA and Time
• Benefits and Costs of public goods
generally extend over a period of time
• Most goods have costs now and benefits
later (generally any time any building is
undertaken)
• Some goods have benefits not and costs
later (environmental damage, for example)
• To value a good over time, we need to
choose a discount rate
 Discount rates
• A discount rate, r, tells us how much we
value the present relative to the future
• If r=0, then we care about the future just
as much as today
• If r=∞, then we care only about today
• The choice of discount rates is very
important in determining whether or not a
project gets funded.
 Two methods of time valuation
• Choose a discount rate and calculate the
NPV (net present value)
• Calculate the IRR (internal rate of return)
—the discount rate at which the project
breaks even
• In both cases, higher is better
 Risk and Uncertainty
• With time comes risk and uncertainty:
• Will a project be relevant in 10-20 years?
• What will the costs of a project be in 20
years?
• What is the appropriate amount of risk for
a government to take on?
 Other considerations
• Equity and distributional effects
• General caveat: It is more efficient to do
pure transfers than to create an inefficient
public good for distributional reasons.
 Locational Choice
• “Voting with your feet”
• Different communities/governments create
different bundles of public goods financed
through taxation.
• Individuals move to the community with
the best mix of taxes and goods for them.
• Logic of federalism yields efficient supply
of many public goods by creating a
“market” for public goods.
Public Financing for Public
Goods
 Public Goods—how much
• Unfortunately, we may never know how much is
efficient!
• Governments lack the required information to
make efficient choices and implementing Lindahl
solutions
• CBA, Clarke taxes, and federalism provide
potential means of figuring out information
• We’ll proceed, assuming that the government
has figured out the efficient quantity.
 Public Goods—How to pay for
them?
• Lots of methods, but all boil down to taxes.
• Issuing government debt is little more than deferred
taxation (Ricardian Equivalence or fiscal illusion?)—
however, can be important to ensure that future
beneficiaries of public goods pay for them.
• Inflation is a tax on people who hold currency
(seigniorage tax)
• All taxes reduce welfare via two components—transfers
(recall rent seeking, however) and DWL
• The government receives the transfer
• The DWL is never to be seen again!
 Excess Burden/Dead Weight Loss
Consumer Surplus S-T
This area is Taxes drive a “wedge”
P the tax Note that it does not matter
S between the price paid by
revenue if the tax is levied on the
consumers and the price
raised by the suppliers…
received by suppliers—buyers
government pay more than sellers receive
Or the consumers…
PD
And here’s Here we consider a per-unit
tax The tax incidence and
the dead tax
P* deadweight loss are
weight loss PD is the price paid by
identical
demanders, and …
PS
PS is the price received
by sellers
QT is the new amount sold
D

QT Q* Q

Producer Surplus D-T

 Excess Burden/Dead Weight Loss
• While it is possible for individuals to
receive some benefit from the transfer, it is
impossible to receive any benefit from the
DWL
• DWL is greater the more elastic the supply
and/or demand curve are
• As the tax rate increases, the dead weight
loss increases by disproportionately more
Excess Burden/Dead Weight Loss

If we start with a tax with

this DWL
P S
A small increase in the
tax rate adds this amount
of DWL
From this point, a same-
sized increase in the tax
rate adds this amount of
DWL

Q
 Other sources of inefficiency
• Administrative costs
• Enforcement costs
• Costs of compliance
• Avoidance costs
• Evasion costs
• Rent-Seeking Costs
 Why is all this important?
• For every one dollar the government
spends, they take far more than a dollar
out of the economy.
• How much is called the marginal cost of
government funds
• What is the MCF? Estimates range from
$1.2 to well over $4!
• Often depends on how many types of cost
are considered.
 Taxes without excess burden
• Property taxes
• Taxes on inelastic goods
• Lump-sum/poll taxes
 Who pays the tax?
• Tax incidence refers to the question of
who bears the burden of a tax
• Government can not influence tax
incidence!
• Tax incidence is determined by the relative
elasticities of the supply and demand
curves
• Whichever is more inelastic will bear more
of the burden of the tax
 Tax Incidence
Here, demand is relatively inelastic Here, demand is relatively elastic
as compared to supply. Hence, as compared to supply. Hence,
demanders bear most of the suppliers bear most of the burden
burden of the tax of the tax
Burden borne
Burden borne
by demanders
by demanders
t

Burden borne t
by suppliers Burden borne
by suppliers
 Surplus revenue
• Sometimes government have more money than
they know what to do with!
• Cut taxes—this reduces DWL, improves
efficiency, and generally increases incomes
• Repay debt—this reduces the tax burden of
future generations
• Why not just spend it on something else—this
often leads to the flypaper effect and ratchets.