Microeconomics 1000 Lecture 7 Public Goods

Key points definition of public goods and common resources. private markets fail to provide public goods. some of the important public goods in our economy. the cost–benefit analysis of public goods is both necessary and difficult. people tend to use common resources too much. some of the important common resources in our economy.

Market failures A market economy delivers the efficient allocation of resources (invisible hand, I theorem of welfare economics) However, efficiency is not guaranteed in the presence of Market power Externalities Public goods Asymmetric information

THE DIFFERENT KINDS OF GOODS When thinking about the various goods in the economy, it is useful to group them according to two characteristics: Is the good excludable? Is the good rival?

THE DIFFERENT KINDS OF GOODS Excludability Excludability refers to the property of a good whereby a person can be prevented from using it. Rivalry Rivalry refers to the property of a good whereby one person’s use diminishes other people’s use.

THE DIFFERENT KINDS OF GOODS Four Types of Goods Private Goods Public Goods Common Resources

THE DIFFERENT KINDS OF GOODS Private Goods Are both excludable and rival. Public Goods Are neither excludable nor rival. Common Resources Are rival but not excludable. What about excludable but not rival? (encrypted TV channels, knowledge protected by intellectual property rights…)

Figure 1 Four Types of Goods Rival? Yes No Private Goods • Ice-cream cones Clothing Congested toll roads • Fire protection Cable TV Uncongested toll roads Yes Excludable? Common Resources Public Goods • Fish in the ocean The environment Congested nontoll roads • Lighthouses National defence Uncongested nontoll roads No Copyright © 2004 South-Western

Mixed cases Some goods are subject to congestion effects: they are not rival when consumption is low, but become rival when it is high Examples Toll roads Swimming pools

Some Important Public Goods Knowledge National Defense TV and radio programs (not encrypted) A public good is not a good provided by the government Privately provided public goods Publicly provided private goods

Market failure To see why there is a market failure in the presence of public goods, consider a simple example There are three agents, A, B and C One indivisible good Willingnesses to pay are: vA = 20, vB = 15 and vC = 12 c is the unit production cost

Example If the good was private, the social value of the first unit would be 20, that of the second unit 15, and the social value of the third unit would be 12 Thus, if c = 14 two units of the good should be produced, if c = 25 none But when the good is public, the social value of the first unit is 20+15+12=47 (that of the subsequent units is zero)

Example Suppose the good is public and c = 25 The good should be produced What happens in a market economy? Would a profit maximizing firm supply the good? No, because it cannot sell it at a positive price (the good is not excludable) Would one of the agents supply the good? No, because the private value is at most 20, which is lower than the cost (and the other agents cannot be excluded)

Market failure We conclude that in the presence of public good the market will not guarantee that the good is provided, even when it would be efficient that the good is provided More generally, the provision of public goods in a market economy tends to be inefficiently low

Public goods and externalities One way of looking at the problem is as follows: when one of the agents (say A) supplies the good, because the good is not excludable, he is exerting a positive externality on the others That is, the private provision of public goods is a special case of externalities

Coase-type solution Viewed from this perspective, it appears that the problem of public goods might be addressed as the problem of externality The Coase theorem suggests that bargaining between the parties can be a solution to the problem of public goods In our previous example, the three agents would bargain and agree to have the good produced and to somehow share the burden among them

Transaction costs But we know that the bargaining solution works only if transaction costs are small In the case of public goods, transaction costs (a general term than encompasses any obstacle to finding an agreement among the parties) are large because of the problem of cost sharing Since any group of two agents would have enough incentives to provide the good, each agent would like the other two to pay for the good

The free-rider problem This is known as the problem of free-riding A free-rider is a person who receives the benefit of a good but avoids paying for it.

The Free-Rider Problem Since people cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it. In many cases, the free-rider problem prevents private solutions to the problem of supplying public goods.

Government intervention Solving the Free-Rider Problem The government can decide to provide the public good if the total benefits exceed the costs. The government can make everyone better off by providing the public good and paying for it with tax revenue. Principle #7: Governments can sometimes improve market outcomes.

The Difficult Job of Cost-Benefit Analysis Cost benefit analysis refers to a study that compares the costs and benefits to society of providing a public good. In order to decide whether to provide a public good or not, the total benefits of all those who use the good must be compared to the costs of providing and maintaining the public good.

The Difficult Job of Cost-Benefit Analysis A cost-benefit analysis would be used to estimate the total costs and benefits of the project to society as a whole. It is difficult to do because of the absence of prices needed to estimate social benefits and resource costs. If people share the burden of public good provision according to the benefit that each one obtains, each agent has an incentive to misreport his/her true valuation of the public good. Private information/asymmetry of information

Making public good excludable In some cases, it is possible to address the problem of the underprovision of public goods by making the public good excludable Examples: Intellectual property rights Encrypted TV programs

Intellectual property rights Nobel Prize winner Kenneth Arrow argues that knowledge is a public good: It is non rival (everybody can learn and use, say, Pytagora’s theorem) It tends to be not excludable (however, knowledge can be kept secret) However, IPRs make innovative knowledge excludable

IPRs Cover artistic work (copyrights) and technological knowledge (patents), not basic research Are typically temporary (patent life is 20 years in most countries, the term of copyrights is often 70 years after the death of the author) Create a temporary monopoly over the commercial exploitation of the knowledge

Patents Normally IPRs are alternative to secrecy For example, in order to get a patent the inventor has to disclose the innovative knowledge Other patentability requirements Novelty Non-obviousness (inventive step) Utility

COMMON RESOURCES Common resources, like public goods, are not excludable. They are available free of charge to anyone who wishes to use them. Common resources are rival goods because one person’s use of the common resource reduces other people’s use.

Tragedy of the Commons The Tragedy of the Commons is a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole. Common resources tend to be used excessively when individuals are not charged for their usage. This is similar to a negative externality.

Some Important Common Resources Commons (shared areas of land) Congested roads Fish

Ways out Use prices Property rights

THE IMPORTANCE OF PROPERTY RIGHTS Property rights are the recognition and defense of a person right to own things. The market fails to allocate resources efficiently when property rights are not well-established (i.e. some item of value does not have an owner with the legal authority to control it).

Tragedy of the Anti-Commons The Tragedy of the Anti-Commons is another parable that illustrates why resources get used less than is desirable from the standpoint of society as a whole due to the existence of many property right holders.

Tragedy of Anti-commenos Heller (1998) noted that after the fall of Communism, in many Russian cities cities there were a lot of open air kiosks, but also a lot of empty stores. He argued that after privatisation many different parties had rights over the use of store space, so it was difficult for a retailer to negotiate successfully. Similar to a negative externality.

Summary Goods differ in whether they are excludable and whether they are rival. A good is excludable if it is possible to prevent someone from using it. A good is rival if one person’s enjoyment of the good prevents other people from enjoying the same unit of the good.

Summary Public goods are neither rival nor excludable. Because people are not charged for their use of public goods, they have an incentive to free ride when the good is provided privately. Governments may provide public goods, making quantity decisions based upon cost-benefit analysis.

Summary Common resources are rival but not excludable. Because people are not charged for their use of common resources, they tend to use them excessively.