Public Economics

Assignment
Vaishali V, HS10H039








1. Explain why the economy will be closer to an efficient equilibrium when congestion
occurs with a small club membership level
A club good is a good that is either nonrivalrous or partly rivalrous, but for which exclusion by the
providers is possible. This concept of exclusion implies that the act of voluntarily choosing to become a
member of a club is a form of preference revelation, which has important implications for the attainment
of market efficiency. While clubs and local public goods have been treated interchangeably, the
discussion of the former has focused more on issues of efficiency with homogenous populations. The
analysis of club goods includes not only the quantity of good or service to be provided, but also the size
of the club membership so as to prevent congestion.
In the simplest model of a club, that is, with a homogenous population of consumers who are identical in
terms of taste and income and where one private and one club good is provided, the decision to be made
relates to how much of the club good to supply and how many members to admit.
Suppose each consumer has a utility function U(x,G,n) where x is the consumption of a private good, G
provision of the club good and n the number of club members. Then utility increases in x and G, but
decreases in n if there is congestion. If the cost of providing G units of the club good is C(G), then the
budget constraint of a member with income M when the cost of the club is shared equally between
members will be

()

The decision problem is then to choose G and n such that the welfare of a typical member is maximized.
This can be expressed as

*+
(
()

The first-order conditions for this optimization problem produce the following equations:

(1)

(2)
Here equation (1) describes the Samuelsons rule describing the level of public good G the club should
supply and equation (2) describes the efficient level of membership for the club.
Two cases emerge in the analysis of economy wide efficiency of club goods. In the first case, the efficient
size of the club is small relative to total population. This applies when the club suffers from significant
congestion so that the size of the efficient club membership is small relative to the size of the total
population. The other situation is when the efficient size of the club is large relative to the total population
due to limited congestion or a smaller population. The economy will be closer to an efficient equilibrium
in case of small clubs due to the following reason.
Suppose the population of the economy increases in size. Initially, with a small population, there will be
(a) Some of the population who are not in the optimally sized club or else (b) Every club will different
slightly in size from the optimum.
In (a), as the size of the population increases, the number of those who are not in an optimally sized club
becomes trivial compared to the total population and the deviation from efficiency tends to zero. In (b), as
population increases, the deviation of each club from the optimum size becomes less and less and thus
again the inefficiency tends to zero. In both cases, an increase in the population size eventually wipes out
the deviations from efficiency. If the population size is infinite, then it can be divided exactly into an
infinite number of optimal size clubs, where the provision of the public good is efficient for each club and
the economy as a whole.
Thus, if the efficient membership of each club is small relative to the total population, a large number of
clubs will be formed with each having the correct number of members and providing the efficient level of
services, leading to efficiency for the economy as a whole.

2. Using signaling model construct an example in which a government unaware of workers
productivity can improve the welfare of everyone compared to the separating equilibrium
by means of cross-subsidization policy but not by banning signaling
In the presence of asymmetric information where either party has more information on the good being
purchased or sold than the other, mechanisms such as signaling and screening can help improve the
market efficiency. Signaling for instance, is a mechanism by which the more informed players in the
market signal to the less informed players about the quality of the product so that both parties can be
benefited by the process. Some examples of signaling include employment references in the labor market
and warranties in the durable goods market. Signaling is different from screening as in the former, more-
informed players use signals to help the less-informed players find out the truth about the product, unlike
the latter where the less-informed players used mechanisms to get more information about the product.
For a signal to be effective, it must satisfy certain criteria. First, it must be verifiable by the receiver or the
less-informed agent. Second, it must be credible and finally the signal must be costly for the sender to
obtain and the cost must differ between various qualities of the sender. This also means the signaling
model revolves around the timing of actions, where the informed agent moves first and invests in
acquiring a costly signal. Equilibrium is reached when the chosen investment in the signal is optimal for
each informed agent and the inferences of the uninformed about the meaning of signals are justified by
the outcomes.
A basic model of productivity signaling in the labor market is considered below. Suppose there are two
identical firms which compete for workers through the wages they offer. The set of workers can be
divided into two types depending on their productivity low-productivity and high-productivity. It is also
assumed that without any signaling, the firms cannot judge the productivity of the worker.
In this case, the workers can signal their productivity by being educated. Education itself does not alter
productivity, but it is costly to acquire. Investment in education will thus be worthwhile if it can earn a
higher wage. To make it an effective signal, we assume that obtaining education is more costly for the
low-productivity worker than for the high-productivity one, so that both do not have the same incentives
for acquiring it.
Let

denote the productivity of a high-productivity worker and

denote the productivity of a low-

productivity worker with

>

. The workers are present in the population in proportions

h
and
l
, such
that
h
+
l
= 1. The average productivity in the population is given by
()

Competition between both firms ensures that this is the wage that would be paid if there were no
signaling and the firms could not distinguish between workers. Further, for a worker of productivity level
, the cost of obtaining education level e is
( )

which satisfies the property that any given level of education is more costly for a low-productivity worker
to obtain.
The firms offer wages that are potentially conditional of the level of education and the wage schedule is
denoted by w(e). Hence the decision problem of the workers is to maximize wages less the cost of
education as shown below.

*+
()

An equilibrium in this economy is a pair {e
*
(), w
*
(e)} where e
*
() determines the level of education as a
function of productivity and w
*
(e) determines the wage as a function of education. In equilibrium, these
functions must satisfy three properties.
(a) No worker wants to change his education choice given the wage schedule w
*
(e).
(b) No firm wants to change its wage schedule given its beliefs about worker types and education
choices e
*
().
(c) Firms have correct beliefs given the education choices.
A separating equilibrium occurs when the low and high-productivity workers choose different levels of
education. A separating equilibrium must satisfy the following conditions.

) (i)

))

(ii a)

))

(ii b)

))

))

(iii a)

))

))

(iii b)
Condition (i) requires low and high productivity workers to choose different education levels, (ii a) and
(ii b) requires that the wages are equal to the marginal products and (iii a) and (iii b) requires that the
choices are individually rational for the consumers. The values of wages given in (ii a) and (ii b) are the
consequence of signaling and competition between firms. Signaling implies workers of different
productivities are paid different wages. If a firm paid a wage above the marginal product, it would make a
loss of each worker employed. If it paid a wage below the marginal product, the other firm would have an
incentive to set its wage incrementally higher to capture all the workers of that productivity level. Hence
the only equilibrium values of wages when signaling occurs are the productivity levels.
In choosing the equilibrium level of education for the low-productivity workers, we note that if they
choose not to act like the high-productivity workers, then there is no point in obtaining education, which
becomes a cost with no benefit. Hence

) = 0. Using this and the fact that wages are equal to

productivities, the level of education for the high-productivity worker can be found from the incentive
compatibility constraints. From (iii a), we get

(iv)
or

)

,

- (v)
From (v), we get the minimum level of education that will ensure that the low-productivity workers
choose not to be educated. From (iii b), we get

(vi)
or

) (vii)

Hence, a separating equilibrium occurs when

) = 0


,

)

,

))

))

so that the low-productivity workers obtain no education, the high-productivity workers have education
between the two limits and both are paid their marginal products.
Signaling allows the high-productivity to distinguish themselves from the low-productivity. However,
signaling need not be socially beneficial as it is costly and does not add to productivity by assumption.
The alternative to signaling is pooling where both types purchase no education and are paid a wage equal
to the average productivity. The low- productivity would prefer this equilibrium as it raises their wage
from

to ()

. For the high-productivity, pooling is preferred if

()

Since

, this inequality will be satisfied if

That is, there are sufficiently many high-productivity workers so that the average wage is close to the high
productivity level, the separating equilibrium is Pareto-dominated by the pooling equilibrium. In this
case, signaling is individually rational, but socially unproductive.
In this case, government intervention can increase efficiency and make everyone better off by restricting
the size of the signal that can be transmitted. This could be done by placing an upper limit on the signal
(education) equal to

,

-, when the pooling equilibrium does not Pareto-dominate the separating

equilibrium. The government could also cross-subsidize wages from the good to bad workers. This can
take the form of a minimum wage for the low-productivity workers in excess of their productivity
financed by wage limits on the high-productivity workers that is below their productivity. A ban on
signaling can be seen as an extreme form of such cross-subsidization as it forces the same wage on all.
When the pooling equilibrium is Pareto-preferred, signals should be eliminated entirely to improve social
welfare. However the basic problem with government intervention is that it does not have a natural
informational advantage over the private agents and could not intervene beyond cross-subsidization.