Public Finance - Introduction Public goods Public Finance - Introduction

Public Finance - Introduction Public goods → basic concept to identify conditions in which public sector may potentially outperform private sector in efficiency terms → areas in which government should operate Useful analytical tool proxy for general interest goods Abbreviations: PG: public good; pg: private good PS: public sector; ps: public sector Public Finance - Introduction

Public Finance - Introduction Definition Pure public good is : Non rival in consumption Non excludable Public Finance - Introduction

Definition – Non rivalry Non rivalry in consumption Once supplied to ind A → MC of supplying to ind B as well is 0 Es. lighthouse for ships (but Coase, 1974) Everybody consumes same quantity → this does not mean that everybody gets same MU E.g. missile defense system. For those who care about security from external threats, MU>0. For a pacifist, MU<0 PG may no longer be so if: Market situations change (e.g. swimming pool: crowding effect) Tecnology changes (es. TV signal can now be coded) Impure PG is rival to a certain extent (es. tourists in front of a view spoil the scenery) Public Finance - Introduction

Definition – Non excludibility Non excludibility (= joint supply) and non rivalry often in fact coincide but are not the same concept Non excludibility is on the supply side, non rivalry on the demand side Non excludibility appears when excluding someone from consumption of a good is too costly Es. exclusion from city roads is (sometimes) too costly, yet rival insofar as there is traffic Non excludibility depends on technology Public Finance - Introduction

Public Finance - Introduction Types of Goods EXCLUDABLE RIVAL YES NO PRIVATE GOODS NATURAL MONOPOLY 1st click - “Private goods” 2nd click - “Public goods” 3rd click - “Common resources” 4th click - “Natural monopoly” COMMON RESOURCES PUBLIC GOODS Public Finance - Introduction

Public Finance - Introduction Some Public Goods Basic research Programs to fight poverty Uncongested non-toll roads Fireworks display Honesty National Defense Public Finance - Introduction

Definition – some remarks Many ‘issues’ usually not regarded as goods have characteristics of PGs (es. trustworthiness) Thurow (1971) → income redistribution is PG If income distribution is more ‘fair’ (‘equalitarian’?) → everybody benefits from living in a society with fewer tensions → Redistribution has non rivalrous characteristics What’s ‘fair’ ? → disagreement on idea of justice in income distribution → Moral value of status quo pg non necessarily produced by ps There are pg that are publicly produced (es. medical services) Nature of the good does not categorically inform about sector of the economy where it is being produced Distribution of a good in PS does not imply that it also be produced in PS PS may purchase service from private firms (es. garbage collection, medical services) Public Finance - Introduction

Public Finance - Introduction Provision of pg Aggregate demand of pg ‘a’ (rival in consumption) is obtained by horizontal sum Given Pa → we observe demand (=marginal willingness to pay) of ind 1 and 2 Public Finance - Introduction

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

Public Finance - Introduction $ 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 Public Finance - Introduction Quantity of Pizza

Pareto Efficiency – Private Goods Case MRSfa = Pf/Pa Set Pa = $1 MRSfa = Pf DfA shows MRSfa for Adam DfE shows MRSfa for Eve Sf shows MRTfa Necessary condition for Pareto efficiency: MRSfaAdam = MRSfaEve = MRTfa Public Finance - Introduction

Efficiency in provision of PG - 1 PG non rivalrous in consumption Efficiency condition (optimal PG quantity) MCPG = MBPG If MCPG=5, and ind1 is willing to pay €2, while ind2 is willing to pay €4, → total MB = €6 MCPG< MBPG → expanding production is efficient Total MB must be considered because both ind1 and ind2 consume PG (non rivalry) (5-2)+(8-5)=3+3=6 Sum wrt i [What i benefit – what she would have paid for], considering price of first unit equal to zero and price of second unit equal to 5. Public Finance - Introduction

Efficient Provision of Public Goods Efficient Provision of Public Goods Units of Fireworks 1 2 3 4 Adam (DrA) $300 $250 $200 $150 Eve (DfE) 250 200 150 100 Market (DfA+E) $550 $450 $350 Public Finance - Introduction

Public Finance - Introduction $ Sr DrA+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 horizontal lines disappear 8th click – Market Supply curve DrA DrE Public Finance - Introduction Quantity of Fireworks

Pareto Efficiency – Public Goods Case MRSfa = Pf/Pa Set Pa = $1 MRSfa = Pf DfA shows MRSfa for Adam DfE shows MRSfa for Eve Sf shows MRTfa Necessary condition for Pareto efficiency: MRSfaAdam + MRSfaEve = MRTfa Public Finance - Introduction

Production of PG and free riding Market does not produce PG in efficient way → ind1 and ind2 have no incentive to reveal their true preferences free riding → underprovision of PG Explainable result given non excludability MC of adding another person to consumption of PG is 0 Efficiency requires MC=P=0 → at P=0 market does not work Should firm know demand functions of ind1 e ind2 → perfect price discrimination → market might work Public Finance - Introduction

Public Finance - Introduction Free riding Traditional view: Free riding causes failure of market supply Hence conclusion that government must intervene Government can somehow “find out” preferences of ind1 and ind2 and use its coercive power to force them to contribute to the financing of PG es: income taxation → used as proxy for marginal willingness to pay under the hypotheses that ind preces be identical (a contradiction of the hypothesis) Free riding is not a phenomenon per se → rather a consequence that ind max U Experimental economics tries to assess generality of free riding In one shot games free riding is below theory’s prediction; in repeated games free riding becomes more pervasive (Isaac et al. 1985) Does indoctrination in rational choice influence ind behavior? → Yezer et al. (1996) find students in economics more altruistic, if anything Public Finance - Introduction

Laboratory Experiments: Do People Free-Ride? How a typical experiment works Typical results People contribute about 50% of resources to provision of public good Contributions fall the more often the game is repeated Cooperation fostered by prior communication Contribution rates decline when opportunity cost of giving goes up “Warm-glow” giving Public Finance - Introduction

Public Finance - Introduction Prisoner’s dilemma Cooperating (do not confess) or defecting (confess)? Nash equilibeium is not PO Public Finance - Introduction

Public and private production Many goods currently produced in PS can be produced in ps → issue of privatizations Which criteria to follow? Relative production costs→ choose the least costly Administrative costs → PS centralizes them → the higher they are the more efficient is to centralize them Preferences → the more heterogenous they are, the larger the advantages of ps Distributive issues→ commodity egalitarism (Tobin, 1970) → PS better (es. education, health care) Problem: who decides cases of commodity egalitarism? Public Finance - Introduction

Revenues from privatizations, UE countries (1990-2000) Source: OECD (2002), Paris. Public Finance - Introduction

Privatizations in UE, % GDP, 1990-2000 Source: OECD (2002), Paris. Public Finance - Introduction

Public vs. Private production Even when a good is held to be supplied in PS → that does not imply it must be also produced in PS Many believe ps to be more efficient Managers in PS less penalized if fail to produce efficiently → often not requested to maximize profits Golden rule of 2 (Mueller, 2003) Output in PS more difficult to measure Market condition is what really counts → competition matters more than public or private nature of the firm Regola aurea del 2: (empirics)Costi spesso pari alla metà Public Finance - Introduction