Transcript Main problems: Public Goods in General Quasi

Lection 7. Government and Efficiency
MAIN PROBLEMS:
PUBLIC GOODS IN GENERAL
QUASI-PUBLIC GOODS
EXTERNALITIES
PUBLIC GOODS AND EXTERNALITY
SOCIAL COSTS AND BENEFITS
SOCIAL OPTIMUM
EFFICIENCY AND THE ROLE OF GOVERNMENT
The case for government intervention may not look very
good. In the discussions so far, we have learned that (if
we make certain assumptions)
 An efficient allocation of resources is an allocation that
satisfies the rule marginal benefit=marginal cost.
 For each individual, the marginal benefit curve is the
demand curve.
 For each firm, the marginal cost curve is the supply
curve.
Thus, when quantity supplied equals quantity demanded,
we have an efficient allocation of resources.
EXCEPTIONS: THE LIGHTHOUSE 1
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One important category of exceptions comes from the classical economists of the 19th century. Adam
Smith wrote "The third and last duty of the [government] is that and erecting or maintaining those
public institutions and those public works, which, although they may be in the highest degree
advantageous to a great society, are, however, of such a nature, that the profit could not repay the
expense to any individual or small number of individuals, and which it therefore cannot be expected
that any individual or small number of individuals should erect or maintain." In modern economics
these are called "public goods." Smith didn't provide any examples, but John Stuart Mill gave the
example of a lighthouse.
According to Mill, it would be impossible to try to charge seamen according to their use or benefit
from the lighthouse, and might therefore be most convenient for the government to provide the
lighthouse and pay for it out of tax moneys. This is one aspect of a "public good:" for some reason, it is
difficult or impossible to charge those who benefit from it. It is easy to see how this would be difficult
for charge for the lighthouse service. Try to visualize toll booths for the purpose out in the ocean!
Another thing about the lighthouse is that its cost does not depend on the number of ships that use
it. The lighthouse is absolutely indivisible, and the cost of keeping it up is fixed. This is another aspect
of a "public good" in general. The cost of a "public good" is independent of the number of people it
serves.
This is an extreme case of "economies of scale." We recall that indivisibility causes economies of
scale in general, but in this extreme case there is just one possible scale of operation -- one
lighthouse -- and so long as it operates it costs the same, no matter how many ships it warns off the
rocks.
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Here is a picture of the costs and
benefits for the lighthouse.
Because the cost of the lighthouse is
indivisible, the cost curves for the
lighthouse are rather special. Long run
marginal cost is always zero, and long
run average cost is a downward-sloping
hyperbola. In place of the "demand"
curve we have the marginal benefits
curve. Remember, in a competitive
market, demand is identical to marginal
benefit. Since it is impossible to charge
those who benefit from the lighthouse,
the term "demand" is not quite
appropriate here.
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Notice that the marginal cost curve and the marginal benefit curve
intersect at Q, where the marginal benefit curve touches the horizontal
axis. That's because the marginal cost is always zero. This is the efficient
rate of use of the lighthouse' services. When the marginal cost is zero, it is
efficient to use the service to the point where the marginal benefit is also
zero. This corresponds to a price of zero. That is, the lighthouse is used
and priced efficiently when it is provided for free. This can only be true
when the marginal cost of the good is zero, of course.
We draw two conclusions.
Since it is impractical to try to charge the ships for the use of the lighthouse,
there is no good alternative to government provision of lighthouses.
If the government does provide lighthouses without charge, they will in fact be
used at the efficient rate where the marginal benefit equals the marginal
cost -- zero.
PUBLIC GOODS IN GENERAL
We can now define a "public good" in general. Following the example of the
lighthouse, modern economics defines a "public good" as a good that
shares the two key characteristics of the lighthouse:
It is not practically possible to charge for the use of the good
The cost of the good is indivisible, so that its marginal cost is zero
 Most economists would include the traditional governmental services, such
as defense and the maintenance of law and order, in this category. Some
economists find many other examples of public goods in a modern
economy. There is a good deal of controversy on this.
 Economic theory tells us that a public good will not be provided by profitoriented private suppliers, and sure enough, no-commercial radio and TV
are mostly public radio and TV. There are a few radio and TV stations
supported by charitable contributions -- mostly devoted to religious
programming. But no-commercial broadcasting fits the theory of public
goods in this way as well: profit oriented business doesn't supply nocommercial broadcasting.
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QUASIPUBLIC GOODS
However, public goods like the lighthouse really are very special cases. A public good really is at one
end of the specrum. Private goods, the kind we have been studying for most of this course, are at the
other end of the spectrum.
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We could define a private good as a good that has the following two characteristics. These
characteristics are the opposite of the characteristics of a public good:
Beneficiaries can be charged for their use of a private good without difficulty, and if they do not pay they
can be prevented from enjoying any benefit.
The marginal cost of the good is positive and at least as great as the average cost
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The middle ground of the spectrum are the quasi-public goods. A quasipublic good is almost a public
good, but not quite. That is, quasi-public goods share the following two characteristics:
It is difficult or costly to charge the beneficiaries in some or all cases, but it is possible to charge at least
some of them
The marginal cost of the good is less than the average cost (that is, there are economies of scale) but not
zero
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It seems there are many more quasi-public goods than public goods. In saying that private goods are
at one end of the spectrum, we are not saying that private goods are unusual. Probably most goods
are private goods. The food we eat, the clothing we wear, our houses or apartments and furniture and
cars are all examples of private goods. In neoclassical economic theory, certainly, both public goods
and quasi-public goods are exceptional. But quasi-public goods are a less extreme and more common
kind of exception.
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EXTERNALITY
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In the case of "public goods," it is practically impossible
to charge people for the benefits they get from the
"public good," and that creates a problem. Since the
beneficiaries of the public good do not pay for the
benefits they get, a profit-oriented market economy will
not supply the public good, and that is inefficient. That
point can be generalized somewhat. In general, when
there are goods, services, and resources that people
can get without paying for them at a market equilibrium
price, inefficiency will be the result.
The term for this in economics is "externality."
EXTERNAL COSTS AND BENEFITS
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Economists define "externalities" and "external costs and benefits" as
follows: Definitions:
When some people bear costs that they are not paid or compensated for,
these costs are said to be external costs.
When some people get benefits that they do not pay for, these benefits are
said to be external benefits.
In general, if there are either external benefits or external costs, we say that
there are externalities.
The idea is that the decision-maker, who does not pay for the costs nor get
paid for the benefits, doesn't take them into consideration in deciding how
resources shall be allocated. He has no motive to produce benefits that he
doesn't get, nor to cut back on costs that he doesn't pay. The benefits and
costs are "external" to his maximization of his own net benefits.
In general, if there are "external" costs or benefits or both, we say that there
are "externalities," and we can expect markets to be inefficient when there
are "externalities."
SOCIAL COSTS AND BENEFITS
External costs and benefits are the costs and
benefits that decision-makers do not take account
of, so market decisions on the allocation of
resources do not reflect the external costs and
benefits. But, of course, external costs and benefits
are only part of the total costs and benefits of any
decision.
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The costs and benefits that decision-makers do take
account of, because they pay the costs and enjoy
the benefits, are called private costs and benefits.
These are the kinds of costs and benefits we have
discussed in earlier chapters in this series.
In turn
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Social costs are the sum of private and external
costs
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Social benefits are the sum of private and external
benefits.
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Let's sum up this terminology in a table:
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Social costs and benefits are so-called because they
are the total costs and benefits for everybody in
society. Economists do not think of society as an
independent actor that can gain benefits or suffer
costs. Rather, the social costs are the sum total of all
costs to individuals in society, regardless of whether
the costs are paid by the person who decides whether
they will be incurred. Similarly, social benefits are the
sum total of all benefits to individuals in society,
regardless of whether the beneficiaries decide how
much benefit will be produced.
external
private
social
benefits
beneficiary
doesn't pay
beneficiary pays
total of both
costs
loser isn't
compensated
loser is
compensated
total of both
SOCIAL OPTIMUM
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The economist's concept of "optimum
allocation of resources" is a social optimum.
That is, the idea is to maximize the net
benefits for everybody in society. , regardless
of who enjoys the benefits or pays the cost. In
the ideal P-competitive economy, this is no
problem. Everyone maximizes their private
benefit, but since everyone pays for any
benefits they receive, and bears only the
corresponding costs, the result of this
private-benefit maximization is that social net
benefits are maximized.
When there are externalities, however, this is
no longer true. In maximizing their private net
benefits, people will overlook some (external)
costs and benefits, and maximization of
private benefits will no longer lead to
maximization of social net benefits.
Recall the rule for the for a socially optimal
allocation of resources is still the equimarginal
rule, MB=MC. However, we now have two kinds
each of costs and benefits. We will abbreviate
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MSC (marginal social cost)
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MSB (marginal social benefit)
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MPB (marginal private benefit)
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MPC (marginal private cost)
Using these definitions, we can state the rule for a
social optimum, and the problem of externality,
more precisely. The rule for a socially optimal
allocation of resources is
MSB=MSC
and the problem is that rational self-interested
decision-makers operate according to a
different rule
MPB=MPC
So now let's look at some examples -- practically
important ones.
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A FISH STORY
When a fisherman catches a fish and sells it, that
fisherman gets a private benefit -- the revenue from
selling the fish. But there is a cost -- because there
are fewer fish to reproduce, there will be less fish
caught (ceteris paribus) in the next and future years.
This cost is spread out over all the fishermen and
consumers of fish, and thus is "external" to the
individual fisherman's decision how many fish to
take.
The individual fisherman does not take into account the
influence of his fishing on the fish that will be
available to other fishermen in the future -- it he isn't
going to catch them, why should he care? The result
is that he does not limit his catch in such a way as to
conserve the fish population to reproduce, and this
is why fisheries are overexploited.
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As usual, we will express some of these ideas with
diagrams. Starting from an industry marginal cost
(supply) diagram, we will change the diagram to reflect
the difference between private and social cost. As
usual we have the quantity of output on the horizontal
axis. In this case the quantity of output is measured in
tons of fish caught. On the vertical axis we have the
marginal cost per ton of fish caught. Here is the
picture.
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In the diagram, the difference between MPC and MSC
is the market value of fish that might be caught in the
future (discounted to present value) if one less fish
were taken this year. This opportunity cost is the
marginal external cost of fish caught and therefore the
difference between the marginal private cost and the
marginal social cost.
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Now let's put "supply" and
"demand" together. We will add a
marginal benefit curve to the last
diagramm
In the diagram, the marginal benefit,
MB, is also the demand curve for
fish and the marginal private and
marginal social benefit.
Applying the equimarginal principle,
MC=MB, the socially optimal output
is Q1. However, fishermen -balancing marginal private benefit
against marginal private cost, MPC
-- choose Q2. "Too many" fish are
caught, and society as a whole has
overallocated resources to fishing.
Now let's look at an example with
external benefits.
GOVERNMENT POLICY
Regulation
Taxes and Subsidies
Market-based regulation
REGULATION
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Let's consider how regulation would improve the allocation of
resources to fishing. Fishermen would be legally limited in
how much fish they can catch. There are some real
difficulties in making this work. The regulators have to figure
out about how large a catch would be efficient and find ways
to be sure that the fishermen do not evade the regulations
and catch more fish anyway. The objective would be to
reduce the catch of fish and still have the limited quantity of
fish caught in the least costly manner.
All the same, regulation has been the favorite response of
government (perhaps because it is cheap and/or easy to
understand) and as a result we have a good deal of
experience in making regulations work not too badly.
TAXES AND SUBSIDIES
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Taxes on a particular economic activity discourage that activity. Usually, that's
considered a disadvantage, but if the economic activity has external costs, a tax can
be a way of raising the private cost up to the same level as the social cost, and thus
moving the activity back toward its optimal level. Conversely, subsidies could be
useful if the activity has external benefits. The subsidy would decrease the private
cost and bring it into agreement with the social cost, encouraging an efficient
increase in the activity. Thus, fishermen would pay a penalty tax to bring the private
cost of fishing up to the social cost, and public transportation would be subsidized to
bring the cost down and raise ridership toward the optimal level.
Economists have often favored these approaches, because they work more like
markets -- we like the carrot better than the stick, as a rule -- but governments have
not been very committed to, or successful at, putting them into practice. This is
especially true of penalty taxes, which are, after all politically unpopular.
What about the impact on the government deficit? In principle, the penalty taxes
might more or less balance out the subsidies -- perhaps even balance out to zero.
But it's hard to imagine a government with the self-discipline this would require.
Some economists and many citizens would worry that a tax that started out as a way
of discouraging inefficient activity would end up as a government cash cow.
MARKET-BASED REGULATION
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Economists have proposed that market principles could
be put to work by appropriate regulations, and there
have been some trials.
For example, the fish catch could be limited by licenses.
Each license would entitle the holder to catch a limited
number of fish of a certain species.
However, the licenses would be salable, so that largerscale efficient fishermen could buy up licenses from the
smaller fishermen, and fish at an efficient scale.
And at least the little guys would have something -- the
market price of the license -- to apply toward the
retirement fund.
CENTRAL PLANNING
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Public goods, quasipublic goods, and externalities are
the real world of the market system.
These 'problems' are so pervasive that the only hope
for an efficient allocation of resources is for the
government to take control of the allocation of
resources, do the statistical work necessary to
discover the social costs and benefits, solve for the
optimal allocation of resources, and direct the
managers of the economy to realize it.
It's true that this is very difficult -- the Soviet Union
clearly never came anywhere close. But even if the
plan is pretty far off from the optimum, it can't be
much worse than a market economy riddled with
inefficiencies due to externalities and underprovided
public goods.
The deterioration of the Soviet economy in its last
years makes this last point pretty difficult to swallow,
of course, but this is one possible interpretation of
public goods and externalities.
LIBERAL VIEWS
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Public goods, quasipublic goods, and
externalities are fairly common in the real
world.
They are common enough that it is necessary
to take proposals for government intervention
in the economy on a case-by-case basis.
Government action can never be ruled in or
ruled out on principle. Only with attention to
detail and prudent judgment based on the
facts of the case can we hope to approach an
optimal allocation of resources.
That means the government will always have a
full agenda for reform -- and in some cases, as
in deregulation, that will mean undoing the
actions of government in an earlier generation.
This is not evidence of failure but of an alert,
active government aware of changing
circumstances. "