Chapter 4

Public Goods and Political Economy

Prepared and Taught by Lecturer: YIN SOKHENG, Master in Finance

The Concept of A Public Good

Public good: A good that is made to be financed by taxation and paid for by government. Private good: A good that has excludability and rivalry Pure public goods share two characteristics Nonrival Cost of another person consuming the good is zero Nonexcludable Very expensive to prevent others from consuming the good
Instructed by YIN SOKHENG, Master in Finance
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Examples of Public and Private Goods

Public Goods
National defense House cleaning in an apartment with many roommates Fireworks display Music file sharing Uncongested freeway

Private goods
Pizza Health care Congested freeway Public housing

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Valuation of Public Goods

Everyone consumes same quantity of public good
Q Q A Q B Qc ...

Marginal benefit of public good varies by person In the housecleaning example, different roommates value the clean apartment differently.

Instructed by YIN SOKHENG, Master in Finance

Private Goods can Be Provided by the Public Sector

These are called publicly provided private goods. Public housing is rival (one family consumes one apartment) and excludable (easy to prevent consumption).

Instructed by YIN SOKHENG, Master in Finance

The Socially Optimal Quantity of the Public Goods Figure 4.1 The height of each familys MB curve shows the maximum dollar amount that family would pay for an additional foot of thickness. We assume that each height, uses the same material, and surrounds the entire island; the only issue is how thick to make the wall. We label the families H (height), M (medium), and L (low) according to the height of the familys MB curve.
Instructed by YIN SOKHENG, Master in Finance
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Figure 4.1
Equations:
MBH = 450 15Q MBM = 300 10Q MBL = 150 5Q We can write MB = 900 30Q If Q = 10, MBH = $300, MBM = $200, and MBL = $100. If Q = 0, MBH = $450, MBM = $300, and MBL = $150. If Q = 30, MBH = $0, MBM = $0, and MBL = $0. A 1-foot-thick wall costs $600 (MC)to build
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Figure 4.1 The Socially Optimal of a Public Good

$900 $800 $700 $600 $500 $400 $300 $200 $100 -

MC

MC>MBH MC>MBM, MC>MBL

MBH MBM MBL I 2 I 4 I 6 I 8 I 10 I 12 I 14 Wall thickness (feet)

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Figure 4.1 The Socially Optimal of a Public Good

$900 $800 $700 $600 $500 $400 $300 $200 $100 -

MB > MC

MC MB

I 2

I 4

I 6

I 8

I 10

I 12

MBH MBM MBL I 14 Wall thickness (feet)

Thickness <10, MB > MC Thickness of 10, MB =MC Thickness > 10, MB < MC

Instructed by YIN SOKHENG, Master in Finance

Figure 4.1
A 1-foot-thick wall costs $600 (MC)to build At a thickness of 10 feet, MB =MC MBH = $300, MBM = $200, and MBL = $100 MB = $600 ($300 + $200 +$100) = MC At a thickness of 0 feet, MB >MC MB = $900 ($450 + $300 +$150) > MC At a thickness of 12, MB <MC MB = $540 ($270 + $180 +$90) <MC

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Figure 4.1 Conclusion

The efficiency quantity of a public good is the quantity at which the sum of the MBs of all who consume the good equals the MC. By contrast, the efficiency quantity of a private good is the quantity at which the MB of the person who consumes the good equals the MC. Hence,
At the efficiency, socially optimal quantity of a public good, MB =MC. At the efficiency, socially optimal quantity of a private good, MB =MC.

So 10 feet is the socially optimal (efficiency) thickness of the wall.

Instructed by YIN SOKHENG, Master in Finance

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Political Economy
Each family alone (even H) would be unwilling to pay even a 1-foot wall if it must pay the entire $600 per foot itself. Assume that the three families get along well and are glad to cooperate. Then families sit down and together draw Figure 4.1.

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The Cost-share
The cost-share is the price that the family must pay per unit of the public good. Suppose the families agree that, since their MBs are in the ratio of 3:2:1, they will share the cost in the ratio of 3:2:1. In other words, costs will be shared in the same ration as benefits. With cost-shares decided, each family looks at its own MB curve, compares the height of its MB at each foot of thickness to its costshare (price) and decides how thick a wall it would want.
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A Unanimity
To achieve unanimity, they must agree to cost-shares that are in the same ratio as their MBs. All three (families) will then support a 10-foot wall and enjoy a net benefit when it is constructed. So 10 feet was the best wall for all three families given their cost-shares.

Instructed by YIN SOKHENG, Master in Finance

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Majority-Rule Voting and the Median Voter

Each family must know its cost share in order to know how to vote; each will decide how to vote by comparing its MB to its cost-share. So with these cost-shares, voters unanimously prefer a 10-foot wall. With majority voting, the outcome will be what the median voter prefers. The socially optimal quantity will be chosen under majority-rule voting if the median voter prefers it; otherwise, not. To get the median voter to prefer the social optimum, it is necessary to assign the median voter the cost-share that will cause that voter to prefer the socially optimal quantity.
Instructed by YIN SOKHENG, Master in Finance
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Majority-Rule Voting and the Median Voter

Table 4.1 Majority-Rule Voting
Choice First Thick H M Intermediate Thin L Thin D

Second Intermediate Thin Third Thin Thick

Intermediate Thick Thick Intermediate

For the moment, ignore family D, assume the three families voting are H, M, and L.

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Majority-Rule Voting and the Median Voter

Figure 4.2 Voter Preferences
Choice

1st

2nd

3rd

M, L

Thin

Intermediate

Thick

Wall thickness

Only voter D has two peaks.

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When There Are Many Families

The legislature will need to have the power of taxation. Optimal Taxation Proportional tax: A tax that applies the same tax rate to all households regardless of income. Progressive tax: A tax that applies a higher tax rate to high-income households.

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The Behavior of Government

Decisions about public goods are made by a legislature (perhaps with the approval of as executive) not by citizens directly. The legislators are elected by the citizens to represent them. Of course, this dose not automatically meant that the legislature will do what the citizens want.

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Public Choice, Government Failure, and Constitutions Market failures

Governments use the pollution tax and tradable permits to correct the externality Governments collect revenues to provide the public good

Government failures
Restrict the functions of government

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