4-1 Session 3 Public Goods

4-2 Public goods defined Goods can be classified according to two attributes: –whether they are excludable –whether they are rival in consumption A good is excludable if the supplier of that good can prevent people who do not pay from consuming it. A good is rival in consumption if the same unit of the good cannot be consumed by more than one person at the same time.

4-3 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 good is zero

4-4 Types of Goods EXCLUDABLE RIVAL YESNO YES NO PRIVATE GOODS PUBLIC GOODS COMMON RESOURCES NATURAL MONOPOLY

4-5 Public goods defined There are four types of goods: Private goods, which are excludable and rival in consumption, like wheat Public goods, which are nonexcludable and nonrival in consumption, like a public sewer system Common resources, which are nonexcludable but rival in consumption, like clean water in a river Artificially scarce goods, which are excludable but nonrival in consumption, like pay-per-view movies on cable TV

4-6 Public goods defined Pure public goods Goods that are perfectly non-rival in consumption and are nonexcludable. Impure public goods Goods that satisfy the two public good conditions (non-rival in consumption and non-excludable) to some extent, but not fully.

4-7 Noteworthy Aspects of Public Goods Even though everyone consumes the same quantity of the good, it need not be valued equally by all –People differ on how they value public goods- +ve or –ve e.g. national defence Classification as a public good is not absolute; it depends on market conditions and the state of technology: publicness is a matter of degree –impure public good e.g. lighthouse can be impure. A commodity can satisfy one part of the definition of a public good but not the other. –Characterisation of a commodity depends on the state of technology and legal arrangements. Streets in certain cities are excludable.

4-8 Noteworthy Aspects of Public Goods Some things that are not conventionally thought of as commodities have public good characteristics. –E.g. honesty, income distribution and information. Private goods are not always provided only by the private sector –publicly provided private goods e.g. medical services and housing. Public provision of a good does not necessarily mean that it is also produced by the public sector –E.g. refuse collection, fire protection services, and libraries.

4-9 Some Other Public Goods Basic research Programs to fight poverty Uncongested non-toll roads Fireworks display

4-10 Efficient Provision of Private Goods Assume a two people society(Adam and Eve) Assume 2 pvt goods, apples and fig leaves. The demand curve for Adam is denoted by D A f The demand curve for Eve is denoted by D E f Each person’s dd curve shows how much they are willing to pay for a particular quantity. To get the mkt dd curve we do a horizontal summation of individual dd curves. If we introduce a market ss curve we come up with an equilibrium in the mkt where SS=DD => efficient provision.

4-11 Efficient Provision of Private Goods PriceAdam (D f A ) Eve (D f E ) Market (D f A+E ) $11516 $97310 $79514 $ $ $

4-12 DfADfA DfEDfE D f A+E SfSf $ Quantity of Pizza 4-12

4-13 Pareto Efficiency – Private Goods Case Utility maximisation: MRS fa = P f /P a Set P a = $1 MRS fa = P f D f A shows MRS fa for Adam D f E shows MRS fa for Eve S f shows MRT fa Necessary condition for Pareto efficiency: MRS fa Adam = MRS fa Eve = MRT fa

4-14 Efficient Provision of Public Goods Assume Adam and Eve enjoy fireworks display. Adam and Eve prefer bigger to smaller shows ceteris paribus To determine efficient provision we compare the marginal benefit and marginal cost. Consumption is nonrival so MB is the sum of what they are willing to pay.

4-15 Efficient Provision of Public Goods Units of Fireworks 1234 Adam (D r A) $300$250$200$150 Eve (D f E ) Market (D f A+E ) $550$450$350$250

4-16 Efficient Provision of Public Goods If the MB>MC efficiency requires that the extra unit should be bought. Efficiency requires that provision of a public good be expanded until the point at which the sum of each person’s marginal valuation on the last unit just equals the marginal cost. In our e.g. to find the group willingness to pay we add the prices that each would be willing to pay per quantity: - vertical summation of the dd curves.

4-17 DrADrA Dr E D r A+E Sr Quantity of Fireworks $ 4-17

4-18 Pareto Efficiency – Public Goods Case MRS fa = P f /P a Set P a = $1 MRS fa = P f D f A shows MRS fa for Adam D f E shows MRS fa for Eve S f shows MRT fa Necessary condition for Pareto efficiency: MRS fa Adam + MRS fa Eve = MRT fa

4-19 Problems Achieving Efficiency The Free-Rider Problem The incentive to let other people pay for a public good while you enjoy the benefits. This causes the market to fail to provide the efficient amount of fireworks. Even if consumption is excludable, mkt provision of a nonrival good is likely to be inefficient

4-20 Free rider problem Solutions to the free-rider problem: Perfect price discrimination –If the entrepreneur knows each person’s dd curve and if it is impossible to transfer the good to another person. Then each person can be charged an individual price based on their willingness to pay. –Individual preferences are difficult to determine so private provision will lead to inefficiency.

4-21 Policy Perspective Global Positioning System – nonrival but yet excludable Becoz the MC of letting another person receive the signal is zero, efficiency requires that every person who values the GPS signal should be allowed to receive it. Prior to 2000 signals were not available to everyone coz of security concerns.(inefficient) Do people free ride?

4-22 Free rider problem and govt Efficiency requires govt provision of public goods. Govt can coerce everybody to pay for public goods. There are instances where people have acted collectively without government coercion in provision of plc gds. The free rider problem becomes an empirical question.

4-23 The Privatization Debate Privatization – taking services supplied by government and turning them over to the private sector Public v Private Provision: What is the right mix? –The mix btwn public and pvt modes of provision has changed substantially –During the 19 th century govt had less responsibility for education,police protection, libraries.

4-24 The Privatization Debate –Currently there appears to be a trend back to the private sector for provision of public goods. What criteria should be used to select the right mix of public and private provision? 1.Relative wage and materials costs –The less expensive sector should be preferred. 2. Administrative costs –Under public provision fixed admin costs are spread over a large group 3. Diversity of tastes Becoz of diversity pvt provision is more efficient

4-25 Distributional Issues Commodity egalitarianism – notion that some commodities ought to be made available to everyone

4-26 Public versus Private Production Efficiency of private production Problems in comparing cost differences Incomplete contracts- gvt cannot specify every contingency in advance Competition to supply good or service – is a way of ensuring efficiency even with incomplete contracts. Reputation building - ensures more contracts Market Environment in which a public or pvt enterprise operates.