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Motivating questions
What are public goods? How do they relate to externalities? When is a public good provided optimally? How can we find out peoples preferences for public good provision?
Reading
Varian, Chapter 36 Morgan Katz and Rosen, Chapter 18
Less good on this topic.
Introduction
With externalities we saw how two parties could trade to a Pareto optimal solution. However when there is more than one party experiencing the externality it is necessary for agreement to be reached on the value of the externality. This is particularly true in the case of non-depletable externalities, when all parties experience the externality equally. In this case the externality problem becomes a public good problem.
Non-excludable
If I buy a public good, I cannot stop you from consuming it as well.
This generates a free-rider problem, individuals do not need to pay, therefore they do not reveal how much they value the good.
They both consume units of the public good, the TV (either = 0 or = 1). They have utility functions given by 1 1 , and 2 2 , respectively.
Likewise, when 2 = 2:
2 2 2 , 1 = 2 2 , 0 .
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But from the definition of the reservation wage this means providing the TV is a weak Pareto improvement if:
1 1 1 , 1 1 1 1 , 1 and 2 2 2 , 1 2 2 2 , 1 .
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Free riding
Suppose each person has a wealth of 500 and values the TV at 100. Suppose also that the TV costs 150. It is Pareto optimal to buy the television. but each individual has an incentive to free ride. Look at the game below. Does either player have a dominant strategy?
Individual A Buy
Individual B Buy Dont Buy 25, 25 100, -50
Dont Buy
-50, 100 0, 0
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When utility functions are increasing, the following condition is sufficient for Pareto efficiency:
Given consumer 2s level of utility, consumer 1 is as well-off as possible.
Why do we not need an equivalent condition with the roles of the two individuals reversed?
Thus we just need to choose 1 , 2 and , to maximise 1 1 , subject to the constraints that:
2 2 , = ( is some fixed utility level), and: 1 + 2 + = 1 + 2 (the budget constraint).
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FOCs:
FOC 1 : 0 = FOC FOC
1 , hence = 1 . 1 1 2: 0 = 2 , so = 1 1 . 2 2 2 1 1 : 0 = 1 + 2 , thus:
= .
Hence: 1 + 2 = .
1 1 2 2
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Thus the solution can be written as MB1 + MB2 = MC. So, the optimality condition is that the marginal social benefit is equal to the marginal social cost.
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MRS
MRS2
Efficient provision of a public good: The sum of the MRS must equal the marginal cost. Private good: consumers would set their own MB equal to the marginal cost, i.e. MRS1 = MRS2 = MC.
MRS1
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and MRS2 = 1 2.
MRS is how much of the private good would be required to compensate for 1 less unit of the public good. If the public good is reduced by 1 unit this will cost 1, it takes only 3 to compensate both individuals for the loss.
So its optimal to reduce the amount of the public good thats provided.
Alternatively, if MRS1 = 2 3 and MRS2 = 1 2 then the total marginal benefit of an extra unit of public good is worth more than it costs.
So its optimal to increase the amount of the public good thats provided.
ECO 2051 Intermediate Microeconomics 18
Examples (1/2)
A town has one private good (bottles of beer) and one public good (size of the town skating rink in square metres). Beer costs 1, and the skating rink costs 5 per square metre. There are 500 citizens all with an income of at least 5000. All citizens have the same quasi-linear utility function.
, =
64 .
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Examples (2/2)
Suppose in the fishery/factory example from lecture 3.2, there were two fisheries. As before, the steel firm has total cost , . The first fishery one has total cost 1 , . The second fishery has total cost 2 , .
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1 1
1 ,
i.e. MRS1 = 1.
still have MRS2 = 1, so there is still too little of the public good unless MRS1 = 0, which only happens when = 0.
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Hayley
50 50 50
Nancy
100 75 100
Chris
150 250 110
Value to Society,
300 375 260
Outcome of Vote
YES NO YES
In the aggregate, it appears X is preferred to Y, Y is preferred to Z and Z is preferred to X. Standard Condorcet paradox. But if X, Y and Z are different levels of public good provision, is it really plausible that people would have all of these preferences?
Single-peaked preferences
Collective intransitivity is avoided if all preferences are single peaked. This rules out all or nothing preferences such as those held by person C (assuming X, Y and Z are ordered as we would expect).
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B Z Y X
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That half the population want more expenditure and half want less does not mean it is an efficient outcome.
Maybe the half that want more all want a large amount more, whereas the other lot only want a little less.
The Vickrey-Clarke-Groves mechanism is a general solution to this problem, at least when individual preferences are quasi-linear.
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Step 2:
Find the alternative 1 , , that maximises
Step 3:
Charge individual a fee of:
1 ,,
max
> 0.
AKA: Clarke tax If an individual has no effect on (they are not pivotal) this will be zero.
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. +
They cannot affect the final term, so they would like to choose their report such that the thing the social planner maximises corresponds with the first two terms.
But setting will do this!
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Example
Person A
B C
Value 50
50 250
Fee 0
0 100
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1 2 3 Total
60 10 20 90
20 80 0 100
What fees do the three voters pay under the VCG mechanism? Demonstrate that they are incentive compatible.
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Summary
We answered two key questions in this topic:
What is the optimal allocation of public goods?
Important to see the difference between the conditions for public and private goods.
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