1. Chapter Fifteen Public Goods, Externalities, and Government Behavior

2. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 2 Public Goods Public good: Good or service that has 2 characteristics: nonrivalry in consumption and nonexcludability Nonrivalry in consumption: The situation in which increased consumption of a good by one person does not decrease the amount available for consumption by others –Examples: Clean air, National defense Nonexcludability: The situation in which no one can be excluded from consuming a good Private goods has excludability and rivalry

3. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 3 Public goods Free-rider problem: A problem arising in the case of public goods because those who do not contribute to the costs of providing the public good cannot be excluded from the benefits of the good. –Example: National defense: One can enjoy it even if they do not pay and one person consuming it does not reduce it for others. Hard for a private firm to produce, so must have government do it and fund it with taxes –Data is another example: Department of Commerce and U.S. Weather Service

4. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 4 Public Goods Not all public goods are provided by government, so must find alternative ways to fund –Example: Lighthouses were not government funded, so the lighthouse would charge boats in nearby ports for the benefit of the lighthouse –User fee: A fee charged for the use of a good normally provided by the government –Radio and TV is paid for by advertisers. Impossible to charge users individually.

5. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 5 Public good Voters usually decide whether or not to produce a public good and how much. Use cost-benefit analysis. Cost-benefit analysis: An appraisal of a project based on the costs and benefits derived from it. –Must use marginal cost and marginal benefit. Expand a program (or reduce it) until MC = MB –Hard to measure marginal benefit. Can ask “How much would you pay for police protection?” –Contingent valuation: An estimation of the willingness to pay for a project on the part of consumers who may benefit from the project.

6. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 6 Externalities Externality: The situation in which the costs of producing or the benefits of consuming a good spill over onto those who are not producing or consuming the good. costs –Negative externality: The situation in which costs spill over onto someone not involved in producing or consuming the good. benefits –Positive externality: The situation in which benefits spill over onto someone not involved in producing or consuming the good.

7. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 7 Externalities In the case of negative externalities, a competitive market does not generate the efficient amount of production (surplus) Marginal Private Cost: The marginal cost of production as viewed by the private firm or individual –This is less than the actual marginal cost that is incurred by society Marginal Social Cost: The marginal cost of production as viewed by society as a whole –Sum of marginal private cost + marginal external cost

8. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 8 Figure 15.1: Illustration of a Typical Negative Externality

9. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 9 Positive Externalities Examples of positive externalities: Education and Research Marginal Private Benefit: The marginal benefit from consumption of a good as viewed by a private individual Marginal Social Benefit: The marginal benefit from consumption of a good from the viewpoint of society as a whole –Sum of marginal private benefit and marginal external benefit

10. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 10 Figure 15.2: Illustration of a Typical Positive Externality

11. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 11 Remedies for Externalities Production needs to be influenced by government to lead to a more efficient level of production of goods and services Internalize: The process of providing incentives so that externalities are taken into account internally by firms or consumers Private Remedy: A procedure that eliminates or internalizes externalities without government action other than defining property rights

12. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 12 Remedies Property Rights: Rights over the use, sale, and proceeds from a good or resource –Must decide who is being infringed upon Coase Theorem: States that private negotiations between people will lead to an efficient resolution of externalities regardless of who has the property rights as long as the property rights are defined Transaction costs: The cost of buying or selling in a market, including search, bargaining, and writing contracts –For agreements to be reached, transaction costs must be small

13. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 13 Remedies Might also encounter the free rider problem again. Some may not comply but still get benefits –Government might get involved Command and control: The regulations and restrictions that the government uses to correct market imperfections –Fleet efficiency; Scrubbers in smokestacks –EPA has responsibility for environmental controls –Disadvantage is that it doesn’t provide incentives to find alternatives

14. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 14 Remedies Tax goods with negative externalities –Tax coal Subsidize goods with positive externalities

15. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 15 Figure 15.3: Using Taxes in the Case of a Negative Externality

16. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 16 Figure 15.4: Using Subsidies in the Case of a Positive Externality

17. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 17 Remedies Emission Taxes: A charge made to firms that pollute the environment based on the quantity of pollution they emit –Provide incentive to create alternatives Command and control is used more than taxes because the total amount of pollution can be better controlled –With taxes, can reach new equilibrium where production (and pollution) will incease

18. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 18 Tradable Permits Tradable permit: A governmentally granted license to pollute that can be bought and sold –Creates incentive because a firm can sell the permit if they do not pollute –Create control over a group instead of one firm Ex: Acid rain –Must first define property rights

19. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 19 Balancing costs and benefits To engage in pollution control, the benefits MUST outweigh the cost –If poorer countries increase their incomes, can allocate more to pollution control –Eastern Europe environment was much worse when they were centrally planned economies

20. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 20 Models of Government Behavior Normative Economics: Study of what SHOULD be done Positive Economics: Study of what governments ACTUALLY do Remember, politicians must get re-elected to be politicians Public Choice Models: Models of government behavior that assume that those in government take actions to maximize their own well-being, such as getting re-elected Must run close to what the people want or they won’t get re- elected

21. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 21 Models of Government Behavior Median Voter Theorem: A theorem stating that the median or middle of political preferences will be reflected in government decisions –Convergence of positions: The concentration of the stances of political parties around the center or citizens’ opinions –This is why Democrats and Republicans tend to play towards the “middle” Voting Paradox: A situation where voting patterns will not consistently reflect citizens’ preferences because of multiple issues on which people vote

22. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 22 Voting Paradox RankingAliBettyCamilla FirstABC SecondBCA ThirdCAB

23. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 23 Paradox Arrow Impossibility Theorem: A theorem that says that no democratic voting scheme can avoid a voting paradox –Voting paradox can be a reason for government failure in cases where the government takes on some activity such as correcting a market failure

24. Copyright © by Houghton Mifflin Company, Inc. All rights reserved15 - 24 Special Interest Groups They want policies good for them, not necessarily good for the whole country Can have powerful effects on legislation –However, can waste a lot of time and resources on lobbying Can overcome incentive problems in the government by providing competition –Rewards for doing well, punishments for doing poorly School vouchers