Transcript April 9 - UCSB Economics

Public goods and an
introduction to externalities
Today: Determining what a public good
is; Efficient provision; Public versus
private provision; Defining externalities
Beginning Unit 2
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Last time
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We concluded our “tools” chapters
End of Unit 1
Today
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Begin Unit 2
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Public goods (Chapter 4)
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What is a public good?
Efficient provision
Public versus private provision
An introduction to externalities (Chapter 5)
Public goods
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Public goods are goods that have some
degree of two characteristics
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Nonrival
Nonexcludable
These two characteristics lead to suboptimal
consumption when public goods are privately
purchased

Externalities involved, to be defined later
Definitions

Nonrival good (R/G p. 52)
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“Once it is provided, the
additional resource cost of
another person consuming the
good is zero”
Nonexcludable good (R/G p.
52)
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“To prevent anyone from
consuming the good is either
very expensive or impossible”

Pure public good
(R/G p. 52)
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“A commodity that
is nonrival and
nonexcludable in
consumption”
Categories of goods
Nonexcludable
Nonrival
Low
High
High
Commons good
(oxygen that you
breathe)
Public good
(lighthouses)
Low
Private good
(pens)
Collective good
(copyrighted books)
Categories of goods
Nonexcludable
Nonrival
Low
High
High
Commons good
(oxygen that you
breathe)
Public good
(lighthouses)
Low
Private good
(pens)
Collective good
(copyrighted books)
Covered in Econ 1; uses basic supply/demand theory
Categories of goods
Nonexcludable
Nonrival
Low
High
High
Commons good
(oxygen that you
breathe)
Public good
(lighthouses)
Low
Private good
(pens)
Collective good
(copyrighted books)
Often covered in Econ 1 or Econ 100B
Categories of goods
Nonexcludable
Nonrival
Low
High
High
Commons good
(oxygen that you
breathe)
Public good
(lighthouses)
Low
Private good
(pens)
Collective good
(copyrighted books)
Goods with copyright or patent protection have some level of market power
Other examples of public goods
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Basic research
Programs to fight poverty
Uncongested nontoll roads
Fireworks display
Noteworthy aspects of public goods
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Even though everyone consumes the same
quantity of the good, it need not be valued
equally by all
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Surfers generally value ocean quality more than
people living in Utah
Classification as a public good is not
absolute; it depends on market conditions
and the state of technology
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Impure public goods are “rival and/or excludable
to some extent” (R/G p. 53)
Noteworthy aspects of public goods
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Some things that are not conventionally
thought of as commodities have public good
characteristics
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Restaurant ratings
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Consistent within a city
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Often different standards between cities
Example: It appears harder to get an “A” rating in Los
Angeles County restaurants than in San Diego County
Noteworthy aspects of public goods
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Private goods are not necessarily provided
exclusively by the private sector
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Publicly provided private goods
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Example: Government-provided food for the poor
Public provision of a good does not
necessarily mean that it is also produced by
the public sector

Many publicly-provided services are contracted to
private firms

Example: Defense-related goods
Demand of private goods
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Demand of private goods are summed
horizontally
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Add the quantity demanded for each person at a
given price
Efficient Provision of Private Goods
Price
$11
Adam
(DfA)
5
Eve
(DfA)
1
Market
(DfA+E)
6
$9
7
3
10
$7
9
5
14
$5
11
7
18
$3
13
9
22
$1
15
11
26
$
12
11
10
Sf
9
8
7
6
5
4
3
DfA+E
2
1
DfE
0
0
1
2
3
4
5
6
7
8
DfA
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
Quantity of Pizza
Equilibrium and efficiency, private goods
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Privately-provided goods have optimal levels
produced if the following conditions are met:
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The goods are private
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Competitive markets
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Rival and excludable
No market power exists
Price and quantity are where demand and supply curves
meet
Recall First Welfare Theorem
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MRSfaAdam = MRSfaEve = MRTfa
Public goods
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We will examine pure public goods
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Highly nonrival
Highly nonexcludable
Marginal analysis is used to find the optimal
quantity
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Optimal quantity is where PUBLIC MB equals MC
An example: Fireworks
Units of Fireworks
1
2
3
4
Adam (DfA)
$300
$250
$200
$150
Eve (DfE)
250
200
150
100
Market
(DfA+E)
$550
$450
$350
$250
$
800
750
700
650
600
550
500
450
Sf
400
350
300
250
200
150
DfA+E
DfA
100
50
0
DfE
1
2
3
Quantity of Fireworks
4
Pareto efficiency: Public goods case
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MRSfa = Pf / Pa
Set Pa = $1  MRSfa = Pf / 1  MRSfa = Pf
DfA shows MRSfa for Adam
DfE shows MRSfa for Eve
Sf shows MRTfa
Necessary condition for Pareto efficiency:
MRSfaAdam + MRSfaEve = MRTfa
Another example
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Fireworks show off of a tiny coastal community
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25 people live here
Each person has the same private demand for fireworks
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P = 2 – 0.08 Q
MC for fireworks is 10
Notice that if fireworks were privately purchased,
nobody would buy them (10 > 2)
Fireworks show as a public good
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Since one person’s enjoyment of fireworks
does not take away from the enjoyment from
others, PUBLIC MB is the sum of PRIVATE
MBs
PUBLIC MB is the vertical summation of all
25 PRIVATE MBs

P = 25  (2 – 0.08 Q) = 50 – 2Q
Vertical summation
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Vertical
summation of
25 PRIVATE
MB lines
produces
PUBLIC MB
line

PUBLIC
MB
MC
Vertical
intercept is 50
PRIVATE MB
Marginal analysis
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To find efficient level of fireworks, set PUBLIC
MB = MC
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50 – 2Q = 10
Q = 20
Free rider problem
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When public goods are provided privately,
some people let others buy the good for their
own enjoyment
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These people are known as free riders
Perfect price discrimination can solve the free
rider problem
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Usually cannot be done, since it requires
knowledge of each person’s demand curve for the
public good
Do people free ride?
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Public goods games
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Inefficient results predicted
Experimental economics tests free rider
theories
A public goods game
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You can decide whether or not you want to
contribute to a new flower garden at a local
park
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If you decide Yes, you will lose $200, but every
person in the city you live in will gain $10 in
benefits from the park
If you decide No, you will cause no change to the
outcome of you or other people
A public goods game
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What is each person’s best response, given
the decision of others?
We need to look at each person’s marginal
gain and loss (if any)
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Choose yes  Gain $10, lose $200
Choose no  Gain $0, lose $0
A public goods game
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Which is the better choice?
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Choose no (Gain nothing vs. net loss of $190)
Nash equilibrium has everybody choosing no
Efficient outcome has everybody choosing
yes
Why the difference?
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Each person does not account for others’ benefits
when making their own decision
Experimental economics
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Experiments are conducted approximately as
follows
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A group of people meet in a classroom
Each person is offered money (or the equivalent
of money)
Each person has the opportunity to donate money
to a fund
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There is a “money multiplier”
Money (after multiplied) gets distributed equally to
everyone in the classroom
Public goods experiments
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Typical results of public goods experiments
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People contribute about 50% of resources to provision of
public good
Contributions fall the more often the game is repeated
More cooperation with prior communication
Contribution rates decline when opportunity cost of giving
goes up
“Warm-glow” giving
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Some people may feel good by improving social welfare
Public versus private provision of a good
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Although public goods are often publicly
financed, there is often debate as to whether
or not the public sector should also provide
the good
There are a few criteria that help to determine
provision
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Relative wage and materials costs
Administrative costs
Diversity of tastes
Commodity egalitarianism
Provision criteria
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Relative wage and materials costs
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Public sector workers are often unionized more,
leading to higher costs in the private sector
Administrative costs
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Often lower if service provided by public sector
Provision criteria
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Diversity of tastes
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Private provision often means more options to the
consumer
Distributional issues
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Is there a minimum amount of schooling and
health care that should be provided to everyone?
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Up to personal preference and debate
Public/private provision debate
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Change of provision between public and
private sectors
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Heavily debated in some cases
Some issues
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Uncertainty
Responsibility of fulfilling services
Quality of good or service
Incomplete contracts in some private sector services
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Example: All contingencies for security
Consumer satisfaction within a market
Private provision of national defense
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Example: Substantial amounts of money are
spent on national defense
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9.3% of GDP in 1962 (Cold War era)
3.4% of GDP in 1997
Many goods and services related to national
defense are privately provided
The type of contract could lead to substantial
changes in cost to government
Private provision of national defense
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Big private contracts to provide national
defense involve substantial risk
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Cost of cutting-edge technology is very uncertain
Fixed price contracts leave all the risk on the firm
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Cost-plus contracts often lead to substantial cost
overruns
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Winner’s curse
No incentives to keep costs down
What else can be used?
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Incentive contracts
Incentive contracts
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Incentive contracts incorporate aspects of fixed price
and cost-plus contracts
Department of Defense pays a fixed fee plus a
fraction of production costs
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TC = F + λ C
When 0 < λ < 1…
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There is an economic incentive to the firm to prevent cost
overruns
The firm bears less risk than with fixed price contracts
Special cases
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λ = 0  Fixed price contract
λ = 1 and F = 0  Cost-plus contract
Who decides how much to provide?
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Somebody in government must make
decisions about public goods
More on decision making in Chapter 6

Political economy
Summary: Public goods
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Public goods are nonrival and nonexcludable
in consumption
Demand of public goods uses vertical
summation
Free rider problem predicts suboptimal
quantities purchased
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Mixed evidence from experimental economics
Ongoing debate between public and private
provision of public goods
An introduction to externalities
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Markets are well functioning for most private
goods
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Many buyers and sellers
Little or no market power by anybody
Example: When demand shifts right for a good,
new equilibrium will have higher price and quantity
Some markets do not have good
mechanisms to account for everything in a
market
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Example: Talking on a cell phone in an airplane
Externalities
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Externalities are effects that are not
incorporated into market quantities and prices
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R/G (p.71) define an externality as “an activity of
one entity that affects the welfare of another entity
in a way that is outside the market mechanism”
When markets have externalities, they are
typically not efficient
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This is the topic of Chapter 5
Public good versus externality
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Although public goods are often looked at as
goods with externalities, we study the two
topics separately
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Know which analysis applies when you solve a
problem
Negative externalities
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Some examples of negative externalities
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Air pollution
Water pollution
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Sometimes you do not even think about polluting the
water: Washing a car in your driveway
Noise pollution
Highway congestion
Standing at a concert or sporting event
Positive externalities
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Some externalities are benefits
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Planting flowers in your front lawn
Scientific research
Vaccination
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Prevents others from getting a disease from you
Exercise?
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Yes, if it leads to lower health care insurance premiums
for others
More on the private health care market in Chapter 9
More externalities: Benefit or cost?
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Christmas decorations
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A fan blowing in a warm office building
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Enjoyment or nuisance?
Cooling breeze or blowing your important papers?
Use of perfume or cologne
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Nice smell or allergen?
A simple example with externalities
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Suppose private MC equals quantity
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MPC = Q
Let demand be denoted by P = 100 – Q
Let marginal damage be $10 per unit
A simple example with externalities
MSC = Q + 10
MPC = Q
marginal
damage per
unit of $10
P = 100 – Q

Translate equations and external cost
to our graphical example
A simple example: Private equilibrium
MPC = Q
P = 100 – Q

Inefficient equilibrium w/o controls:
Set Q = 100 – Q  Q = 50 (quantity F)
A simple example: Optimal equilibrium
MSC = Q + 10
P = 100 – Q
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Socially optimal quantity
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Q + 10 = 100 – Q  Q = 45 (quantity E)
An algebraic example: Price
MSC = Q + 10
MPC = Q
Price B = 55
Price C = 50
Recall E = 45
and F = 50
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marginal
damage per
unit of $10
P = 100 – Q
Inefficient equilibrium, P = Q  P = 50
Socially optimal quantity, P = Q + 10  P = 55
Summary: An introduction to externalities
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Externalities can be positive or negative
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Sometimes, an action could lead to positive
externalities for some people and negative
externalities for others
With external damages, an equilibrium occurs
that has too much produced and price too low
(relative to the optimal quantity)