You are on page 1of 55

Microeconomic Analysis of the Public Sector

ECO 2110A
University of Ottawa

4. Public Goods
[Ch. 4]
Rosen, Wen and Snoddon
McGraw-Hill Ryerson, 5th Canadian edition,

Learning Objectives
1. Describe the characteristics of public goods.
2. Explain why the private provision of public
goods is unlikely to be efficient.
3. Derive the condition for an efficient provision of
public goods.
4. Summarize the procedure of perfect price
discrimination for financing a public good.

4-2

Learning Objectives (cont)


5. Distinguish between public versus private
provision and public versus private production.
6. Describe the factors that determine the right
mix of public and private provision of
excludable goods.
7. Identify circumstances where private
contractors are likely to produce inferior public
services.

4-3

Key Focus
Definition of public goods
Efficient provision of public goods
Efficiency condition
Providing public goods financed by distortionary taxes
Difficulties in achieving efficiency
Free-rider problem
The privatization debate
Public versus public provision
Private versus public production
Public goods and public choice
4

Characteristics of Goods
Excludable vs. Nonexcludable
Excludable preventing anyone from
consuming the good is relatively easy
Nonexcludable preventing anyone from
consuming the good is either very expensive or
impossible

Rival vs. Nonrival


Rival once provided, the additional resource
cost of another person consuming the good is
positive
Nonrival once provided, the additional
resource cost of another person consuming the
5
good is zero

Private and Public Goods

Excludable In Use?

Rival In Use?
Yes

No

Yes

1. Pure Private Goods


Food
Clothing
Highly Congested Toll
Highways

2. Natural Monopolies
Fire Protection
Cable TV
Uncongested Toll Highways

No

3. Common Resources
Fish in the oceans
Environment
Highly Congested Free
Highways

4. Pure Public Goods


National Defence
Research & Knowledge
Uncongested free Highways
Fireworks displays

Fourfold Classification of Goods


1. Private good
can be consumed by only one person at a time and
only by those people who have bought it or own it.
Rival and excludable

2. Public good
can be consumed simultaneously by everyone and
from which no one can be excluded
Non rival and non excludable
Pure public good: no exclusion possible
Scenic area viewed by few people

Impure public good: possibly rival or excludable


Scenic area viewed by large crowds (fewer good viewing areas of
poorer quality)

Fourfold Classification of Goods


3. Common resources
nonexcludable and rival
can be used only once but no one can
be prevented from using what is
available.

4. (Collective good) Natural


monopoly
non-rival to some degree but
excludable.

Examples of Public Goods

Basic research
Programs to fight poverty
Uncongested non-toll roads
Fireworks display
National Defense

4-9

Your Turn: Categorizing roads

A road is which of the four kinds of goods?


The answer depends on whether the road is
congested or not, and whether its a toll road or
not.

Rival in consumption? Only if congested.


Excludable? Only if a toll road.
Four possibilities:
1. uncongested non-toll road: public good
2. uncongested toll road: natural monopoly
3. congested non-toll road: common resource
4. congested toll road: private good
Ch14 -10

10

Noteworthy Aspects of Public Goods

Even though everyone consumes the same quantity of the good,


it need not be valued equally by all
Classification as a public good is not absolute; it depends on
market conditions and the state of technology
Impure public good: rival or excludable
A commodity can satisfy one part of the definition of a public
good but not the other

Some things that are not conventionally thought of as


commodities have public good characteristics
Private goods are not always provided only by the private sector
publicly provided private goods: rival and excludable goods
provided by government

Public provision of a good does not necessarily mean that it is


also produced by the public sector (e.g. garbage collection)

4-11

D1

24

Q1
(a)

24

D1
9

36

Q2
(b)

Price ($/unit)

18

Price ($/unit)

Price ($/unit)

The Market Demand Curve for a Private


Good
24
D = D1 + D2

60

Q = Q1 + Q2
(c)

To construct the market demand curve for a


private good [panel (c)], we add the individual
demand curves [panels (a) and (b)] horizontally.
Ch14 -12

Efficient Provision of Private


Goods
Price

Adam
(DfA)

Eve
(DfA)

Market
(DfA+E)

$11

5+1=6

$9

7+3=10

$7

14

$5

11

18

$3

13

22

$1

15

11

26

The summation of individual quantities demanded at given prices.

13

The Loss in Surplus from a Pay-per-View Fee

Twice as many households would watch the program if its price were zero
instead of $10. The additional economic surplus is the area of the blue
triangle, or $50 million.
Ch14 -14

Pareto Efficiency Private Goods Case


1.
2.
3.
4.
5.
6.
7.

MRSfa = Pf/Pa
Set Pa = $1
MRSfa = Pf
DfA shows MRSfa for Adam
DfE shows MRSfa for Eve
Sf shows MRTfa
Necessary condition for Pareto efficiency:
MRSfaAdam = MRSfaEve = MRTfa
. f= figs and a = apples
15

Price
($/unit)

The Demand Curve for


a Public Good

18
9

D1
12

24

36

Q1

(a)
Price
($/unit)
24

To construct the demand


curve for a public good [panel
(c)], we add the individual
demand curves [panels (a)
and (b)] vertically.

16

D2

8
12

24

36

Q2

(b)
Price
($/unit)
42
D = D1 + D2

25
8
12

24

36

(c)
Ch14 -16

Efficient Provision of a
Public Good
At Q=20 units, total WTP = $4+$6 = $10

17

Three citizens: Private


Good X
Citizen A

Citizen B

Citizen C

Price
($)

Quantity
Demanded

Price
($)

Quantity
Demanded

Price
($)

Quantity
Demanded

10

20

10

Market: (A + B + C)

Price
($)

Quantity
Demanded

10

30

10

20

40

20

40

20

50

30

70

30

60

40

100

40

70

50

130

50

80

60

160

190

18

Three citizens: Public Good


X
Citizen A

Citizen B

Citizen C

Price
($)

Quantity
Demanded

Price
($)

Quantity
Demanded

Price
($)

Quantity
Demanded

10

20

30

10

20

Market: (A + B + C)
Quantity

Willingness to
pay

10

19

10

20

16

40

20

30

13

50

30

40

10

30

60

40

50

40

70

50

60

50

80

60

70

80

19

Pure Public Goods


Two reasons favour government provision of
public goods.
A private business providing such goods
could not collect any payment for costs.
Free-rider will let others pay and consume
anyway.

Economic surplus issue

Since non-rival good means the marginal cost of


serving additional users = zero, it would be
inefficient to charge those users, even if charging
a price were possible.

The only public goods the government should


even consider providing are those whose
benefits exceed their costs.
Ch14 -20

Pareto Efficiency Public Goods Case


1.
2.
3.
4.
5.
6.
7.

MRSfa = Pf/Pa
Set Pa = $1
MRSfa = Pf
DfA shows MRSfa for Adam
DfE shows MRSfa for Eve
Sf shows MRTfa
Necessary condition for Pareto efficiency (public good):
MRSfaAdam + MRSfaEve = MRTfa
Compare to the necessary condition for Pareto efficiency
(private good):
MRSfaAdam = MRSfaEve = MRTfa
21

Efficiency: A Summary
Public goods
MSB (of society from the good) = MSC
MSB = marginal social benefit of all individuals
from the consumption of a public good
MSC = marginal social cost (total cost of
production)

Private goods
MBPaul = MBMary= MC
MB = marginal private benefit from the
consumption of a private good
MC = marginal private cost of production
22

Provision of public goods financed by


distortionary taxation (non lump sum)
Non lump sum taxes (e.g., income taxes) distort the
allocation of resources and create economic inefficiency.
Marginal cost of public funds (MCF) = marginal (economic)
cost of raising an additional dollar of tax revenue
Usually greater than 1.
Also, the provision of a public good could impact
government revenues (MR)
Example: A new lighthouse may stimulate shipping and
trade and, as a result, increase government revenues
(e.g., tariffs).
Hence, we need to consider the net economic impact
(MC-MR) of the tax

23

Provision of public goods financed by


distortionary taxation
Efficiency condition (persons A and B)
MRSA + MRSB = MRT
(i.e., MSB = MSC)
Above efficiency condition is based on financing by
lump-sum taxes (and expenditures by lump-sum
subsidies).
If other (distortionary) taxes are used to finance the
goods, the allocation of resources is no longer
efficient.
MRSPaul + MRSMary = MCF(MC-MR)
MCF = marginal cost of raising an additional dollar of
revenue
24

MCF in different scenarios


The provision of a public good to Mary and Paul is financed
entirely from lump-sum taxes
MRSPaul + MRSMary = MCF(=1) x MC
The provision of a public good to Mary and Paul is financed in
part from lump-sum taxes and revenues from the sale of the
good
MRSPaul + MRSMary = MCF(=1) x (MC-MR)
The provision of a public good to Mary and Paul is financed
entirely from progressive income taxes
MRSPaul + MRSMary = MCF(>1) x MC
The provision of a public good to Mary and Paul is financed in
part from progressive income taxes and revenues from the sale
of the good
MRSPaul + MRSMary = MCF(>1) x (MC-MR)
25

Problems Achieving Efficiency


The Free-Rider
lets others pay and consumes anyway.
Solutions to the free-rider problem
Perfect price discrimination
The seller needs to know each persons demand for
the good
The good cannot be transferred between persons

Policy Perspective: Global Positioning System


Do people free ride?
Evidence that persons contribute about 50% of
their resources to the provision of public goods.
26

The Free-Rider Problem


Laboratory experiments to investigate the
importance of free-rider behaviour
Typical experiment
Typical results
People contribute about 50% of resources to provision of public
good
The more people repeat the game, the less likely they are to
contribute
Cooperation fostered by prior communication
Contribution rates decline when opportunity cost of giving goes
up

Warm-glow giving
4-27

LO5, LO6

The Privatization Debate


Privatization taking services supplied by government
and turning them over to the private sector
Public versus Private Provision
What is the right mix?
Relative wage and materials costs: less expensive sector
preferred on efficiency grounds
Administrative costs: large fixed administrative costs can be
spread over a large group under public sector
Diversity of tastes: larger diversity better handled by private
sector
Quality of information: with poor information cannot make
informed choices
Distributional issues: commodity egalitarianism some
commodities ought to be made available to everyone better
achieved under public sector

4-28

Public Goods
Price

Total Benefit
Maximu
m
Net
Production Cost
Benefit

Optimal Output

Quantity
29

Your Turn: The Optimal Quantity of Parkland

Marginal
cost

200
140
80

Demand
A0

A*

The optimal number of hectares of urban parkland is A*, the quantity


at which the publics willingness to pay (= marginal benefit) for
additional parkland is equal to the marginal cost of parkland.
Ch14 -30

Your Turn: Categorizing roads

A road is which of the four kinds of goods?


The answer depends on whether the road is
congested or not, and whether its a toll road or
not.

Rival in consumption? Only if congested.


Excludable? Only if a toll road.
Four possibilities:
1. uncongested non-toll road: public good
2. uncongested toll road: natural monopoly
3. congested non-toll road: common resource
4. congested toll road: private good
Ch14 -31

31

Paying for Public Goods


Public provision and public production are
different issues, because government can and
often does sub-contract parts of production.
Example:
The military often subcontracts aircraft or
building maintenance to private firms.

If cost collection from individual users is


infeasible, covering the costs of provision
means taxation is unavoidable.
How to design the least cost method of
taxation.
Ch14 -32

Public or Private Provision?


1. Relative wage and materials costs
Production by sector that pays less for inputs
2. Administrative costs
The larger the spreading of costs (AFC), the greater the
advantage (e.g., garbage collection)
3. Diversity of tastes
You want more protection if you have valuables at home
You want better education if you have children
4. Quality of information
Need good information to make informed choices
5. Distributional issues
Should some commodities be made available to everyone
regardless of income? Commodity egalitarianism
33

Distributional Issues
Commodity egalitarianism
James Tobin 1970
notion that some commodities ought to
be made available to everyone
Health care? Education?

34

Private Provision of Public Goods


Governments are not the only potential
providers of public goods.
Charitable donations fund some public goods.
Development of the new technology.
Examples: light house and GPS.

Sale of by-products can finance provision.


Examples: TV and Internet ads.

Core problem: under-provision.


If each individual considers only own benefit
from public good.
Or if price is charged when marginal cost of
supply = 0.
production will be sub-optimal.

Ch14 -35

Public versus Private Production?

Efficiency of private production


Problems in comparing cost differences
Incomplete contracts
Competition to supply good or service
Reputation building
Policy Perspective:
Should airport security be produced publicly or
privately?
Market Environment (power)
A public monopoly that is privatized can
maintain its market power for some time.
36

Preference Revelation Mechanisms

TEve = MRTra (MRSraTotal


MRSraEve)
Eves choice: TEve = MRSraEve
By substitution:
MRTra (MRSraTotal MRSraEve) =
MRSraEve
Add (MRSraTotal MRSraEve) to both
sides:

37

Human Rights as Public Goods


Why is Government Now Involved in
Education and Health?
economic surplus is part of the reason:
lower health care costs in a single payer system.
faster growth if the labour force is well educated.

Equity
equality of opportunity

Universal education and health are basic


human rights.
1948 Universal Declaration of Human Rights.
Ch14 -38

Environmental Public Goods


Canadians also value the quality of the
natural environment in which they live.
Clean air is both non-rivalrous and nonexcludable. It is a classic public good.
Regulation of pollution is an important
function of government.
The choice between different levels of
government often confronts us with
difficult trade-offs.
Ch14 -39

40

Chapter 4 Summary
Public goods are characterized by nonrivalness and
nonexcludability in consumption. Thus, each person consumes
the same amount, but not necessarily the preferred amount, of the
public good.
With lump-sum taxation, efficient provision of public goods
requires that the sum of individuals MRSs equal the MRT, unlike
private goods where each MRS equals the MRT. Equivalently,
the sum of the individuals marginal benefits equals the marginal
cost of production with the efficient provision of a public good.
With distortionary taxation, efficient provision of public goods
requires that the sum of the individuals marginal benefits equal
the marginal cost of financing the provision of an additional unit of
the public good. This is equal to the marginal cost of public funds
times the difference between the marginal cost of producing the
public good and the additional revenue that is generated when an
additional unit of the public good is provided.

4-41

Chapter 4 Summary (cont)


Market mechanisms are unlikely to provide public goods
efficiently, even if they are excludable in consumption.
Casual observation and laboratory studies indicate that
people do not fully exploit free-riding possibilities.
Nonetheless, in certain cases, free riding is likely to be a
significant problem.
Public goods can be provided privately, and private goods can
be provided publicly. The choice between public and private
provision should depend on relative wage and materials
costs, administrative costs, diversity of tastes for the good,
quality of information, and distributional issues.
Even in cases where public provision of a good is selected, a
choice between public and private production must be made.
A key factor in determining whether public or private
production will be more efficient is the market environment.
4-42

Will Prentice and Wilson buy a water


filter?

Prentice and Wilson own adjacent summer cottages. Each must


add chlorine to his water intake valve each week.
The cost of the filter device to serve both houses is $1000.
Wilson earns twice as much as Prentice and is willing to pay up
to $800 toward the cost of a filter whereas Prentice wants to pay
up to $400.
Neither will purchase the filter individually because each
has a reservation price that is below its selling price.
Sharing the cost is the most socially efficient and the
economic surplus is $200.
With a large numbers of people, the free-rider problem
may emerge and it may be difficult to reach an
agreement.

Source: Principles of Microeconomics, Frank et al. 4th Canadian Edition


Ch14 -43

Will the government buy the water filter if


each person pays an equal tax?
The same tax collected from every citizen is called
a head tax.
If the government must rely on a head tax, it must
raise $500 from Prentice and $500 from Wilson to
pay for a filter which costs $1000.
Since $500 is higher than Prentices reservation
price of $400, he will vote against it (wont
participate).
Wilson wont buy the filter alone since his
reservation price of $800 is less that the cost of the
filter ($1000).
Source: Principles of Microeconomics, Frank et al. 4th Canadian Edition
Ch14 -44

Will the government buy the filter if there is a


proportional tax on income?
Suppose Prentice and Wilson ask the government to
help broker the water filter purchase.
A proportional income tax is one under which all
taxpayers pay the same percentage of their
incomes in taxes.
If the government must rely on a proportional
income tax, it must raise $333 from Prentice and
$667 from Wilson (Wilsons income is 2X Prentices
income and the filter costs $1000).
The government would buy the filter, resulting in
additional surpluses of $67 for Prentice and $133 for
Wilson.
Ch14 -45

Exercise
In the jungle, Tarzan and Jane have trained Cheetah to
patrol their clearing and to harvest fruit.
Cheetah
can collect 3 kilos of fruit per hour and
spends
6 hours patrolling
8 hours picking fruit
10 hours sleeping.

a. What are the public and public goods?


b. If Tarzan and Jane are willing to give up 1 hour of patrol
for 2 kilos of fruit, is the allocation of Cheetahs time
efficient?
Should Cheetah patrol more? Less?
46

Exercise
Cheetah
Assume that Cheetahs utility does not enter the social welfare
function; hence, her allocation of labor supply across activities
does not matter.
can collect 3 kilos of fruit per hour and
patrols 6 hrs; picks fruit 8 hrs; sleeps 10 hrs (= 24 hrs).
a. What are the public and public goods?
Patrolling = public; picking fruit (for own consumption) =
private
b. If Tarzan and Jane are willing to give up 1 hour of patrol for 2
kilos of fruit, is the allocation of Cheetahs time efficient?
Should Cheetah patrol more? Less?

MRST (=2)+MRSJ (=2) = 4 MRT (=3) Cheetah should patrol


more.
47

Exercise

Students Moe, Larry and Curly wish to hire a drama coach.


A drama coach cost $20 per hour.
The marginal benefit from each hour of coaching is shown below.
1. Construct each students marginal private benefit from coaching
2. Construct the marginal social benefit from coaching.
3. For how many hours should a coach be hired?

48

1.
2.
3.

Students Moe, Larry and Curly wish to hire a drama coach.


A drama coach cost $20 per hour.
The marginal benefit from each hour of coaching is shown below.
Construct each students marginal private benefit from coaching.
Construct the marginal social benefit from coaching.
For how many hours should a coach be hired?

(Moes MB + Larrys MB + Curlys MB) = MC


1st hr: 12+17+6 = 35 > $20
2nd hr: 10+15+5= 30>$20
3rd hr: 8+13+4 = 25 > $20
4th hour: 6+11+3 = $20
MB = marginal benefit; MC = marginal cost
49

Problem: Does the optimal number of streetlights provided


by the public and private sector differ?

Two groups of 10 persons each benefitting from


streetlights.
Each streetlight cost $5.
Individual demands in each group are
Q1=20-4P
Q2=8-P

1. Find the profit maximizing number of


streetlights?
2. Find the socially optimal number of
streetlights?
50

Profit maximizing number of streetlights


Individual demands in each group
Q1=20-4P and Q2=8-P (individual demands)
Q1=200-40P and Q2=80-10P (Group demands)

Aggregate demand: Q1+Q2=Q; Q=280-50P


Hence 50P=280-Q; P=(280/50)-(Q/50)
or P = 5.6 0.02Q
For profit maximizing quantity (Q), set MR=MC
MR=5.6 2(0.02)Q = 5.6-0.04Q and MC = 5
Solve for Q; Q = 15 streetlights
51

Socially optimal number of streetlights


Individual demands in each group
Q1=20-4P (Individual) P=5-0.25Q1
Q2=8-P (Individual) P=8-Q2
P=5-0.25Q1 (Individual) P=50-2.5Q1 (Group 1)
P=8-Q2 (Individual) P=80-10Q2 (Group 2)
Aggregate (inverse) demand is
P=(50+80)-(2.5+10)Q or P=130-12.5Q
If P=130-12.5Q, MB=130-25Q
where Q = Q1+Q2
Set MB=MC to find socially optimal number of streetlights
MB = 130-25Q = MC 130-25Q=5
Solve for Q; Q= 125/5 = 5 streetlights
52

Socially Optimal Number of Bus Shelters


Given
3 groups of persons benefitting from bus shelters (X)
50 persons per group

Benefits per person in each group


Group 1: 100
Group 2: 200+30X-1.5X2
Group 3: 150+90X-4.5X2
Find the socially optimal number of bus shelters (X)?

53

Socially Optimal Number of Bus Shelters


Total benefits from shelters (X) for each group
Group 1: 100(50) = 5000
Group 2: 50(200+30X-1.5X2)=10000+1500X-75X2
Group 3: 50(150+90X-4.5X2)=7500+4500X-225X2
Total benefits ($) = 22500+6000X-300X2
Cost per bus shelter = $3600
Set MB=MC to find socially optimal quantity of bus
shelters
MB = 6000-600X = MC = 3600
Solve for X; X = 4 bus shelters
54

Microeconomic Analysis of the Public


Sector
ECO 2110A
University of Ottawa

4. Public Goods
[Ch. 4]
Rosen, Wen and Snoddon
McGraw-Hill Ryerson, 5th Canadian edition,

You might also like