Chapter 5

Public Goods
 Reading
• Essential reading
– Hindriks, J and G.D. Myles Intermediate Public Economics. (Cambridge: MIT Press,
2005) Chapter 5.
• Further reading
– Andreoni, J. ‘Impure altruism and donations to public goods: a theory of warm-glow
giving’, Economic Journal (1990) 100: 464—477.
– Abrams, B.A. and M.A Schmitz ‘The crowding out effect of government transfers on
private charitable contributions: cross sectional evidence’, National Tax Journal
(1984) 37: 563—568.
– Bergstrom, T.C., L. Blume, L. and H. Varian ‘On the private provision of public
goods’, Journal of Public Economics (1986) 29: 25—49.
– Bohm, P. ‘Estimating demand for public goods: an experiment’, European Economic
Review (1972), 3: 55—66.
– Cornes, R.C. and T. Sandler The Theory of Externalities, Public Goods and Club
Goods. (Cambridge: Cambridge University Press, 1996) [ISBN 0521477182 hcr]
Chapters 6–10.
 Reading
– Cullis, J. and P. Jones Public Finance and Public Choice, (Oxford:
Oxford University Press, 1998) [ISBN 0198775792 pbk] Chapter 3.
– Isaac, R.M., K.F. McCue and C.R Plott ‘Public goods in an experimental
environment’, Journal of Public Economics (1985), 26: 51—74.
– Itaya, J.-I., D. de Meza and G.D. Myles ‘In praise of inequality: public
good provision and income distribution’, Economics Letters (1997), 57:
289—296.
– Oakland, W.H. ‘Theory of public goods’ in A.J. Auerbach and M.
Feldstein (eds.), Handbook of Public Economics (Amsterdam: North-
Holland, 1987) [ISBN 044487612X hbk].
– Samuelson, P.A. ‘The pure theory of public expenditure’, Review of
Economics and Statistics (1954) 36: 387—389.
– Warr, P.G. ‘The private provision of a pure public good is independent of
the distribution of income’, Economics Letters (1983) 13: 207—211.
• Challenging reading
– Groves, T. and J. Ledyard ‘Optimal allocation of public goods: a solution
to the ‘free rider’ problem’, Econometrica (1977) 45: 783—809.
 Reading
– Itaya, J.-I., D. de Meza and G.D. Myles ‘Income distribution, taxation
and the private provision of public goods’, Journal of Public Economic
Theory (2002) 4: 273—297.
– Foley, D.K. ‘Lindahl’s solution and the core of an economy with public
goods’, Econometrica (1970) 38: 66—72.
– Laffont, J.-J. ‘Incentives and the allocation of public goods’, in A.J.
Auerbach and M. Feldstein (eds.), Handbook of Public Economics.
(Amsterdam: North-Holland, 1987) [ISBN 044487612X hbk].
– Milleron, J.-C. ‘Theory of value with public goods: a survey article’,
Journal of Economic Theory (1972) 5: 419—477.
 Introduction
• National defense: all inhabitants are
simultaneously protected
• Radio broadcast: received simultaneously
by all listeners in range of the transmitter
• These are both public goods
• If many consumers benefit from a single
unit of provision the efficiency theorems do
not apply
 Definitions
• A pure public good satisfies:
– Nonexcludability If the public good is supplied,
no consumer can be excluded from
consuming it
– Nonrivalry Consumption of the public good by
one consumer does not reduce the quantity
available for consumption by any other
• A private good is excludable at no cost
and is perfectly rivalrous
 Definitions
• Goods can possess
different combinations of Non-
rivalry and excludability Rivalrous
Rivalrous
• Club goods are studied in
chapter 6
Private Club
• Common property Excludable
Good
Good
resources are studied in
chapter 7
Common
• These are both examples Non- Property
Public
of impure public goods Excludable Good
Resource

Figure 5.1: Typology of goods

 Private Provision
• Each consumer has an incentive to rely on
others to provide the public good
• The reliance on others is called free-riding
• This leads to inefficiency since too little
public good is provided
• All consumers will benefit from providing
more public good
 Private Provision
• Consider two consumers who allocate
their incomes between a private good and
a public good
• The consumers take prices as fixed
• Each consumer derives a benefit from the
provision of the other
• This introduces strategic interaction into
the decision processes
• The Nash equilibrium has to be found
 Private Provision
• Let g h be the provision of
Budget
consumer h g2
Constraint
• Fig. 5.1 shows the
preferences of consumer
1
• Assume consumer 2
2
provides g g2

• The utility of consumer 1

1
is maximized at ĝ
• Varying g 2 traces out the
locus of choices for ĝ 1 g1
consumer 1
Figure 5.2: Preferences and choice
 Private Provision
• Fig. 5.2 constructs the g2
Budget
locus of choice for Constraint
consumer 2
• If consumer 1 chooses to
1
provide g consumer 2
2
chooses ĝ ĝ 2
• The locus of chooses is
given by the solid line
• This is the best-response
function g1
g1
Figure 5.3: Best reaction for 2
 Private Provision
• The Nash equilibrium is g2
where the choices of the
two consumers are the
best reactions to each
other
• Neither has an incentive
to change their choice ĝ 2
• This occurs at a point
where the best-response
functions cross
• The equilibrium choices
1
are ĝ and ĝ 2 ĝ 1 g1
Figure 5.4: Nash equilibrium
 Private Provision
• The private provision
g2 Locus of Pareto
equilibrium is inefficient Efficient Allocations
• But it is privately rational
• A simultaneous increase
in provision by both
consumers gives a ĝ 2 Set of Pareto-
Pareto improvement Improvements

• Pareto-efficient
allocations are points of
tangency between ĝ 1 g1
indifference curves Figure 5.5: Inefficiency of equilibrium
 Efficient Provision
• At a Pareto-efficient allocation the indifference
curves are tangential
• This does not imply equality of the marginal
rates of substitution because the indifference
curves are defined over quantities of the public
good purchased by the two consumers
• Instead the efficiency condition involves the sum
of marginal rates of substitution and is termed
the Samuelson rule
 Efficient Provision
• The tangency condition is
dg 2 dg 2
|
1 U 1const .
 |
1 U 2const .
dg dg
• Calculating the derivatives
U 1x  U G
1
U G2
1

UG U x2  U G2
• The marginal rate of substitution is
U Gh
MRS Gh , x 
U xh
 Efficient Provision
• The tangency condition then becomes
1 2
MRS G ,x  MRS G,x  1
• This is the Samuelson rule
– The sum of marginal rates of substitution is equated
to the marginal rate of transformation between public
and private goods
– The marginal rate of substitution measures the
marginal benefit to a consumer of another unit of
public good
– The marginal rate of transformation is the marginal
cost of another unit
 Efficient Provision
• For two private goods the efficiency condition is
MRS i1, j  MRS i2, j
• Why the difference?
– An additional unit of a private good goes to either
consumer 1 or consumer 2
– Efficiency is achieved when both place the same
marginal value upon it
– An additional unit of public good benefits both
consumers
– The marginal benefits are therefore summed
 Allocation through Voting
• The level of public good provision is
frequently determined by voting
• Political parties promise different levels of
provision
• Majority voting determines which party
wins
• Need to assess whether this attains
efficiency
 Allocation through Voting
• There is a population of H voters
• The cost of the public good is shared equally
• Consumer h has income M h
• The utility function is

 h

 h G 
U x ,G  U  M  ,G 
 H 
• Each consumer votes for the value of G that
maximizes utility
 Allocation through Voting
Private
good
• Rank the consumers by
income so
M 1  M 2  ....  M H
• Fig. 5.5 shows that the
preferred levels of public
good satisfy Public
good
G1  G 2  ....  G H Utility

• Assume an odd number

of voters
• The median voter will be
decisive m
• Their choice G will win Public
the vote G1 Gm GH
good

Figure 5.6: Allocation through voting

 Allocation through Voting
• The choice of the median voter satisfies
m m G 
max U  M  ,G
G  H 
• The necessary condition can be written as
m 1
MRS 
H
• So voting achieves efficiency only if
H MRS h
MRS m  
h 1 H
 Allocation through Voting
• Can any prediction be made?
– Income has a long right tail
– If MRS falls with income the median MRS is
greater than mean
– This implies voting results in Gm exceeding the
efficient level
• There is no guarantee that voting will
achieve efficiency
 Personalized Prices
• With private goods
consumption is adjusted
to equate marginal Private Public
valuation with market
price good good
• With public goods it is not Price Same Different
possible for consumers to
adjust consumption
Quantity Different Same
• This suggests adjusting
prices to match the
valuations of the fixed
quantity Table 5.1: Prices and quantities
• This is the basis of
personalized pricing
 Personalized Pricing
• Personalized pricing can be achieved by setting
the share of the public good financed by each
consumer
• The Lindahl mechanism asks each consumer to
announce public good demand as a function of
share
• The shares are adjusted until all consumers
demand the same quantity
• If the demands honestly reflect preferences the
equilibrium is efficient
 Personalized Pricing
• The tax shares for the
G1 G2
two consumers are 1 and
2
• The shares satisfy 1 + 2
=1 G* G*

• The budget constraint of

h is xh + hGh = Mh
Reaction Reaction
• Gh is chosen to maximize of 2 of 1

utility 1 2
• Equilibrium shares
ensure G1 = G2= G* Figure 5.7: Lindahl equilibrium
• Efficiency is achieved
 Personalized Pricing
• The choice problem is

max G h U h M h   h G h , G h 
• This has necessary condition
U Gh
 h
U xh
• Summing over consumers
1
UG U G2
  1  2  1
U 1x U x2
• The allocation satisfies the Samuelson rule
 Personalized Pricing
• Personalized pricing suffers from two
significant drawbacks
– There are practical difficulties of
implementation when there are many
consumers
– The Lindahl mechanism is not incentive
compatible and consumers have an incentive
to announce false demand functions
 Personalized Pricing
• Assume consumer 1 is G1 G2
honest
• If consumer 2 were also
honest the equilibrium
would be eL eL
• The equilibrium can be
moved to eM if consumer 2
announces a false eM
demand function
• Allocation eM maximizes
the utility of consumer 2 1 2
given the demand Figure 5.8: Gaining by
function of consumer 1
false announcement
 Mechanism Design
• Consumers will make false
announcements if this is advantageous
• This will distort the outcome
• Mechanism design is the search for
allocation mechanisms that cannot be
manipulated
• A preference revelation mechanism
ensures true preferences are revealed
 Mechanism Design
• Understatement
– The benefit of the
Player 2
public good is vh = 1
– Cost of 1 is met by 0 1
those reporting rh = 1 0 0
0
– Announcements either Player 1
0 1
rh = 0 or rh = 1 1 1 1
2
0 1
– Provided if r1 + r2 ≥ 1 2
– Nash equilibrium is rh =
0, h = 1, 2 Figure 5.9: Announcements
– No provision and payoffs
 Mechanism Design
• Overstatement
– Benefit of the public Announcement
good is v1 = 0, v2 = ¾ 3
of Player 2
4 1
– Cost of 1 is shared
0 1
equally 0 1 4
0 2
– Reports are r1 = 0 or 1, Announcement
of Player 1
1 1
r2 = ¾ or 1 1 4 4
1 1
2 2
– Provide if r1 + r2 ≥ 1
– Equilibrium r1 = 0, r2 =
1
Figure 5.10: Payoffs and
– Inefficient provision overstatement
 Mechanism Design
• The Clarke-Groves mechanism ensures
– True values are revealed
– The public good is provided only when it
should be
• The allocation of cost is taken as given
• Consumers report their net benefits
(benefit – cost)
• Public good is provided if sum of net
benefits is positive
 Mechanism Design
• If the public good is provided side
payments are made
• These side payments reflect the fact that
extracting the truth is costly
• The side payments internalize the net
benefit of the public good to other players
 Mechanism Design
• Net benefits are vh = -1 or
vh = 1 (the mechanism Player 2
must work for both)
-1 +1
• Reports are rh = -1 or rh =
1 0 v2 1
-1
0 v1  1
• The public good is Player 1
v2 1 v2 1
provided if r1 + r2 ≥ 0 +1
v1  1 v1  1
• If provided the payoffs
are v1 + r2 for player 1 and
v2 + r1 for player 2
• The rh in the payoffs are Figure 5.11: Clarke-Groves
the side payments Mechanism
 Mechanism Design
Player 2 Player 2

-1 +1 -1 +1

-1 0 0 -1 0 2
Player 1 Player 1
+1 2 0 +1 0 2

v1  1 v1   1

Figure 5.12: Payoffs for Player 1

• When v1 = -1 a truthful report is weakly dominant for player 1

• When v1 = 1 player 1 is indifferent between truth and false
statement
• The mechanism ensures there is no incentive not to be
truthful
 Mechanism Design
• The mechanism ensures truthful reports
and efficient provision of the public good
• The drawback is the cost of the side
payments
• If v1 = v2 =1 the total cost of the side
payments is 2
• The side payments must be financed from
outside the mechanism
 More on Private Provision
• The private provision model predicts
inefficiency
• The model also makes additional
predictions that can be contrasted to
evidence
• These predictions also have implications
for government policy
 More on Private Provision
• Consider a transfer of  g2
from consumer 1 to
consumer 2
• The transfer shifts the
indifference curves from ĝ 2  
the solid to the dashed
 
• The point gˆ 1  , gˆ 2  
ĝ 2

delivers the same utilities

after the transfer as the
 
point gˆ 1 , gˆ 2 did before
• The best response ĝ 1   ĝ 1
g1
function also shifts
Figure 5.13: Effect of income
transfer
 More on Private Provision
g2
• Consumer 1 reduces
contribution to the public
good by 
• Consumer 2 raises ĝ 2  
contribution by 
• Total public good ĝ 2
provision remains at
G  gˆ 1  gˆ 2
• Consumption of private
good does not change ĝ 1   ĝ 1
g1
• The equilibrium is
invariant to the transfer Figure 5.14: New equilibrium
 More on Private Provision
G H 3
• Assume H identical H 2
consumers
• Let G be provision of all
consumers but one
• Symmetry of equilibrium Pareto-
implies G Efficient
g
H 1
• As H increases the Reaction
Function
equilibrium moves up the
reaction function g
• The contribution of each
individual tends to zero Figure 5.15: Additional consumers
 More on Private Provision
• The predictions of the model have been
tested using experiments
• The typical experiment gives participants a
fixed income to spend
• Income can be divided between a public
good and a private good
• The private good has higher private
benefit and the public good a higher social
benefit
 More on Private Provision
• Fig. 5.16 shows typical
payoffs
• It is individually rational to
spend all income on the
private good Private Good Public Good

• It is socially optimal to Private Benefit 5 1

spend all income on the Social Benefit 5 10
public good
• The Nash equilibrium of
Figure 5.16: Public good experiment
the one-shot game has
no investment in the
public good
 More on Private Provision
• In experiments average contribution to the
public good is 30 to 90 percent of income
• Most observations fall in the 40 to 50
percent range
• Among students the contribution to the
public good is lowest for economists and
falls with number of year of economics
• Repeating the game results in lower
contributions in later rounds
 More on Private Provision
• A number of explanations have been proposed
for these results
– The players may not use non-Nash conjectures. This
response has the problem of being arbitrary
– Consumers may derive a warm glow from making a
contribution. The warm glow raises the benefit and so
raises contribution
– Social interaction can be admitted. This could be a
social custom or a consideration of fairness
 Fund-Raising Campaigns
• The model used so far has a single round of
voluntary contributions
• If consumers observe the equilibrium is
inefficient they may wish to have a second round
of contribution
• The same logic can be applied repeatedly
suggesting efficiency may be approached afer
numerous rounds
• This logic is now assessed using a fund-raising
game
 Fund-Raising Campaigns
• In the fund-raising game a target level of funds
must be achieved before a public good can be
provided
• The game has an infinite horizon
• The target for funds is C
• There are two identical players (X and Y) who
derive benefit B from the public good
• The good is socially desirable with B < C < 2B
• Both players have discount rate d for delaying
completion for one period
• The players alternate in making contributions
 Fund-Raising Campaigns
• In a contribution campaign the contributions are
paid at the time they are made
– This form of campaign is used if no credible
commitment can be made
• Assume it is now the turn of X to make a
contribution at time T
• The maximal contribution X will make to finish the
campaign is xT = [1 – ]B
• At T – 1 the maximum contribution Y will make
(knowing X will finish the campaign at T) is yT–1 =
[1 – 2]B
• This reasoning can be continued back in time
 Fund-Raising Campaigns
• This process is shown in Total
Fig. 5.17 Contributions

• Summing these C
xT
contributions gives yT 1
xT  2
[1 – ]B + [1 – 2]B yT 3
+ 3[1 – 2]B + …= B ...
xT  4

• The total contributions

never exceed the
individual valuation T Time
• The contribution
campaign will never
finance the public good Figure 5.17: A contribution campaign
 Fund-Raising Campaigns
• In the subscription campaign donation pledges
are made
• Contributions are only made when and if
pledges are sufficient to finance the public good
• This alters the strategic structure and the
amount raised is equal to the total valuation of
the contributors
• Start at time T with X about to make a pledge
• The maximum X will pledge to finish the
campaign is xT = [1 – ]B
 Fund-Raising Campaigns
• The maximum that Y will pledge at T – 1 knowing
that X will complete the campaign is yT–1 = [1 –
2]B
• Summing these pledges gives
[1 – ]B + [1 – 2]B +  [1 – 2]B + …= 2B
• It is therefore possible to fund the project
because C < 2B
• This result shows that allowing contributions to
be repeated may remove the inefficiency but
requires the ability to make binding
commitments