Public goods Today: What is a public good? Efficient provision Public versus private provision

Beginning Unit 2 Last time Today We concluded our “tools” lectures End of Unit 1 Today Begin Unit 2 Public goods (Chapter 4) What is a public good? Efficient provision Public versus private provision

Public goods Public goods are goods that have some degree of two characteristics 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) Nonexcludable good (R/G p. 52) “Once it is provided, the additional resource cost of another person consuming the good is zero” Nonexcludable good (R/G p. 52) “To prevent anyone from consuming the good is either very expensive or impossible” Pure public good (R/G p. 52) “A commodity that is nonrival and nonexcludable in consumption”

(oxygen that you breathe) Categories of goods Nonrival Low High Commons good (oxygen that you breathe) Public good (lighthouses) Private good (pens) Collective good (copyrighted books) Nonexcludable

(oxygen that you breathe) Categories of goods Nonrival Low High Commons good (oxygen that you breathe) Public good (lighthouses) Private good (pens) Collective good (copyrighted books) Nonexcludable Covered in Econ 1; uses basic supply/demand theory

(oxygen that you breathe) Categories of goods Nonrival Low High Commons good (oxygen that you breathe) Public good (lighthouses) Private good (pens) Collective good (copyrighted books) Nonexcludable Often covered in Econ 1 or Econ 100B

(oxygen that you breathe) Categories of goods Nonrival Low High Commons good (oxygen that you breathe) Public good (lighthouses) Private good (pens) Collective good (copyrighted books) Nonexcludable Goods with copyright or patent protection have some level of market power

Other examples of public goods Basic research Programs to fight poverty Uncongested nontoll roads Fireworks displays

Noteworthy aspects of public goods Even though everyone consumes the same quantity of the good, it need not be valued equally by all 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 Impure public goods are “rival and/or excludable to some extent” (R/G p. 53)

Noteworthy aspects of public goods Some things that are not conventionally thought of as commodities have public good characteristics Restaurant ratings Consistent within a city Often different standards between cities Example: It appears easier to get an “A” rating in San Diego County than in Los Angeles County

Noteworthy aspects of public goods Private goods are not necessarily provided exclusively by the private sector Publicly provided private goods 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 Demand of private goods are summed horizontally Add the quantity demanded for each person at a given price

Efficient Provision of Private Goods Price Adam (DfA) Eve (DfA) Market (DfA+E) $11 5 1 6 $9 7 3 10 $7 9 14 $5 11 18 $3 13 22 $1 15 26

DfA+E DfA DfE $ Sf Quantity of Pizza 1st click – Adam’s D curve Sf 1st click – Adam’s D curve 2nd click – Eve’s D curve 3rd click – sum of Adam and Eve at P = 11 4th click – sum of Adam and Eve at P = 9 5t click – sum of Adam and Eve at P = 7 6th click – sum of Adam and Eve at P = 5 7th click – sum of Adam and Eve at P = 3 8th clck – sum of Adam and Eve at P = 1 9th click - Market Demand curve and dashed horizontal lines disappear 10th click – Market Supply curve DfA+E DfA DfE Quantity of Pizza

Equilibrium and efficiency, private goods Privately-provided goods have optimal levels produced if the following conditions are met: The goods are private Rival and excludable Competitive markets No market power exists Price and quantity are where demand and supply curves meet

Public goods We will examine pure public goods Highly nonrival Highly nonexcludable Marginal analysis is used to find the optimal quantity Optimal quantity is where PUBLIC MB equals MC

An example: Fireworks Units of Fireworks 1 2 3 4 Adam (DfA) $300 $250 Units of Fireworks 1 2 3 4 Adam (DfA) $300 $250 $200 $150 Eve (DfE) $100 Market (DfA+E) $550 $450 $350

DfA+E DfA DfE $ Sf Quantity of Fireworks 1st click – Adam’s D curve Sf DfA+E 1st click – Adam’s D curve 2nd click – Eve’s D curve 3rd click – sum of Adam and Eve at Q = 1 4th click – sum of Adam and Eve at Q = 2 5t click – sum of Adam and Eve at Q = 3 6th click – sum of Adam and Eve at Q = 4 7th click - Market Demand curve and dashed vertical lines disappear 8th click – Market Supply curve DfA DfE Quantity of Fireworks

Kinks Some public MB curves have a kink in them Why? Notice that person B starts having a willingness to pay of 0 at a lower quantity than person A See Figures 4.3 and 4.4

Another example Fireworks show off of a tiny coastal community 25 people live here Each person has the same private demand for fireworks 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 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 Public MB = 25  (2 – 0.08 Q) = 50 – 2Q

Vertical summation Vertical summation of 25 PRIVATE MB lines produces PUBLIC MB line Vertical intercept is 50 PUBLIC MB MC PRIVATE MB

Marginal analysis To find efficient level of fireworks, set PUBLIC MB = MC 50 – 2Q = 10 Q = 20

Free rider problem When public goods are provided privately, some people let others buy the good for their own enjoyment These people are known as free riders Perfect price discrimination can solve the free rider problem Usually cannot be done, since it requires knowledge of each person’s demand curve for the public good

Do people free ride? Public goods games Inefficient results predicted Experimental economics tests free rider theories

A public goods game You can decide whether or not you want to contribute to a new flower garden at a local park 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 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) Choose yes  Gain $10, lose $200 Choose no  Gain $0, lose $0

A public goods game Which is the better choice? Choose no (Gain nothing vs. net loss of $190) Nash equilibrium has everybody choosing no Efficient outcome has everybody choosing yes Why the difference? Each person does not account for others’ benefits when making their own decision

Experimental economics Experiments are conducted approximately as follows 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 There is a “money multiplier” Money (after multiplied) gets distributed equally to everyone in the classroom

Public goods experiments Typical results of public goods experiments 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 Some people may feel good by improving social welfare

Public versus private provision of a good 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 Relative wage and materials costs Administrative costs Diversity of tastes Commodity egalitarianism

Provision criteria Relative wage and materials costs Public sector workers are often unionized more, leading to higher costs than in the private sector Administrative costs Often lower if service provided by public sector Public administration is already set up  MC of additional administration is low

Provision criteria Diversity of tastes Distributional issues Private provision often means more options to the consumer Distributional issues Is there a minimum amount of schooling and health care that should be provided to everyone? Up to personal preference and debate

Public/private provision debate Change of provision between public and private sectors Heavily debated in some cases Some issues Uncertainty Responsibility of fulfilling services Quality of good or service Incomplete contracts in some private sector services Example: All contingencies for security contracts Consumer satisfaction within a market

Private provision of national defense Example: Substantial amounts of money are spent on national defense 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 Big private contracts to provide national defense involve substantial risk Cost of cutting-edge technology is very uncertain Fixed price contracts leave all the risk on the firm Winner’s curse Cost-plus contracts often lead to substantial cost overruns No incentives to keep costs down What else can be used? Incentive contracts

Incentive contracts Incentive contracts incorporate aspects of fixed price and cost-plus contracts Department of Defense pays a fixed fee plus a fraction of production costs TC = F + λ C When 0 < λ < 1… There is an economic incentive to the firm to prevent cost overruns The firm bears less risk than with fixed price contracts Special cases λ = 0  Fixed price contract λ = 1 and F = 0  Cost-plus contract

Who decides how much to provide? Somebody in government must make decisions about public goods More on decision making in Chapter 6 Political economy

Summary Public goods are nonrival and nonexcludable in consumption Demand of public goods uses vertical summation Free rider problem predicts suboptimal quantities purchased Mixed evidence from experimental economics Ongoing debate between public and private provision of public goods

Another example Patty and Selma are the only two people that enjoy grass in a Shelbyville park Cost to plant an acre of grass is $70 Patty’s demand for grass is P = 100 – 10Q Selma’s demand for grass is P = 300 – 20Q Assume that grass is a public good in this park

Patty and Selma If Patty and Selma were left to purchasing grass on their own as a private good… Patty: 70 = 100 – 10Q  Q = 3 Selma: 70 = 300 – 20Q  Q = 11.5

Patty and Selma Since grass is a public good, we should let Patty and Selma spend money for grass that they can both use Vertical summation of willingness to pay (WTP) WARNING: Be careful when calculating, since there is a kink When P is 0 for Patty, Q is 10  Patty has WTP of 0 for additional acres above 10 When P is 0 for Selma, Q is 15  Selma has WTP of 0 for additional acres above 15

Vertical summation for Patty and Selma For quantities between 0 and 10, we sum each person’s WTP to determine public marginal benefit for each additional acre Public MB = (100 – 10Q) + (300 – 20Q) Public MB = 400 – 30Q For quantities between 10 and 15, Selma is the only person with a positive WTP Public MB = 300 – 20Q

Calculating the efficient quantity Two steps Plug in MC in both equations Find which answer matches the relevant quantity range Step 1 For Q between 0-10 70 = 400 – 30Q  Q = 11 For Q between 10-15 70 = 300 – 20Q  Q = 11.5 Step 2 Pick the second quantity (10 < 11.5 < 15)

What if MC is 130? Step 1 Step 2 For Q between 0-10 130 = 400 – 30Q  Q = 9 For Q between 10-15 130 = 300 – 20Q  Q = 8.5 Step 2 Pick the first quantity (0 < 9 < 10)

Next week Externalities Read Chapter 5 Positive and negative externalities Graphical analysis Deadweight loss (or excess burden) Bargaining and other private responses Public responses Taxes Subsidies Permits

Have a good weekend