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

2. 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

3. 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

4. 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”

5. (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

6. (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

7. (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

8. (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

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

10. 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)

11. 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

12. 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

13. Demand of private goods
Demand of private goods are summed horizontally
Add the quantity demanded for each person at a given price

14. 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

15. DfA+E DfA DfE $ Sf Quantity of Pizza 1st click – Adam’s D curveSf
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

16. 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

17. 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

18. 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

19. DfA+E DfA DfE $ Sf Quantity of Fireworks 1st click – Adam’s D curveSf
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

20. 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

21. 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)

22. 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

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

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

25. 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

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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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)

46. 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)

47. 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

48. Have a good weekend