Notes appear on slides 4, 7, 10, 16, and 35.

10 Public Goods and Common Resources CHAPTER

C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to Distinguish among private goods, public goods, and common resources. 1 Explain the free-rider problem and how public provision can help to overcome that problem. 2 Explain the tragedy of the commons and review the possible solutions to that problem. 3

10.1 CLASSIFYING GOODS AND RESOURCES What is the essential difference between: A city police department and Brink’s security Fish in the Pacific Ocean and fish in a fish farm A live concert and a concert on television These, and all goods and services, can be classified according to whether they are excludable or nonexcludable and rival or nonrival. Tell students that you are going to classify goods (and services) today and you’ll be using this classification to see which goods should be provided by the government versus private firms. Use a grid similar to the one in the text, with “rivalry” along one axis and “excludability” along the other. Explain the definitions of rival goods and excludable goods. Then start naming goods: cable TV, broadcast TV, radio broadcasts, oceans, lakes stocked with fish, cars, air, etc. Make sure to get a meaningful range of goods to fill the areas on your grid. Then ask students which ones need government provision. Use their answers to define public goods, private goods, and common resources.

10.1 CLASSIFYING GOODS AND RESOURCES Excludable A good, service, or resource is excludable if it is possible to prevent a person from enjoying its benefits. Nonexcludable A good, service, or resource is nonexcludable if it is impossible to prevent a person from benefiting from it.

10.1 CLASSIFYING GOODS AND RESOURCES Examples of excludable items are The security services of Brink’s Fish in a fish farm A live concert Examples of nonexcludable items are The services of the city police department Fish in the Pacific Ocean A concert on network television

10.1 CLASSIFYING GOODS AND RESOURCES Rival A good, service, or resource is rival if its use by one person decreases the quantity available to someone else. Nonrival A good, service, or resource is nonrival if its use by one person does not decrease the quantity available to someone else. Students sometimes find it difficult to distinguish between nonrival and rival goods, especially when there is a large supply of a good. Remind students that even McDonald’s hamburgers are rival goods. You eating a burger prevents me from eating the same burger, even though “billions and billions” have been sold!

10.1 CLASSIFYING GOODS AND RESOURCES Examples of rival items are The services of Brink’s security Fish both in ocean and in a fish farm A seat at a live concert Examples of nonrival items are The protection provided by a city police department A concert on network television

10.1 CLASSIFYING GOODS AND RESOURCES A Four-Fold Classification Private Goods Private good A good or service that can be consumed by only one person at a time and only by those people who have bought it or own it. A private good is both rival and excludable. For example, A can of coke.

10.1 CLASSIFYING GOODS AND RESOURCES Public Goods Public good A good or service that can be consumed simultaneously by everyone and no one can be excluded from enjoying its benefits. It is both nonrival and nonexcludable. For example, a flood-control levee. Most texts list a lighthouse as a pure public good. In fact, you might have used it in your lecture. Depending on the circumstances though, some goods, for example a lighthouse, do not always fit into one category. There is evidence from the United Kingdom that in the 18th century, the Crown granted owners the right to build lighthouses via patents. The owners then sent agents to ports and were empowered to collect fees from sailors who had benefited from sailing past the lighthouse. And, when the lighthouse saw a ship whose owner refused to pay, the light196 house would sometimes be turned off(!). You can use this historical story in the discussion of private firms providing public goods.

10.1 CLASSIFYING GOODS AND RESOURCES Common Resources Common resource A resource that can be used only once but no one can be prevented from using what is available. It is both rival and nonexcludable. For example, fish in the Pacific Ocean.

10.1 CLASSIFYING GOODS AND RESOURCES Natural monopoly A good or service that is both nonrival and excludable is produced by a natural monopoly. A natural monopoly is a firm that produces at lower cost than two or more firms can.

10.1 CLASSIFYING GOODS AND RESOURCES Figure 10.1 shows this four-fold classification of goods and services.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM Public goods create a free-rider problem. Free rider A person who enjoys the benefits of a good or service without paying for it. Because of the free-rider problem, the market would provide too small a quantity of a public good. To produce the efficient quantity, government action is required. The Free-Rider Problem

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM The Marginal Benefit of a Public Good The benefit a public good provides is the value of its services. Because security lights in a common parking area are nonrival and nonexcludable, they are a public good. Everyone consumes the same quantity of them. To find the economy-wide value of the security lights, we add together the marginal benefits of everyone who benefits from them.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM Figure 10.2 shows how to find an economy’s MB curve. Lisa’s marginal benefit curve is MBL. Max’s marginal benefit curve is MBM. Spend time on determining the marginal benefit of a public good. The vertical sum of individual marginal benefit curves is not always an easy concept to grasp (especially if your students are used to the horizontal sum for private goods). Remind students that because private goods are rival (each consumer needs to have his or her own unit of the good), we add quantities at each price. Public goods are nonrival (the unit of a good that satisfies the demand for one person is the same unit that also satisfies the demand by another person). So we add prices at each quantity (a vertical sum). Take the time to work through an example using prices and quantities, comparing the different approaches. The MB curve for the economy is the vertical sum of the marginal benefit curves of everyone in the economy—Lisa and Max.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM The Marginal Cost of a Public Good Marginal cost increases as the quantity of a public good produced increases—the principle of increasing marginal cost. So the marginal cost curve of public good slopes upward.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM The Efficient Quantity of a Public Good Resources are used efficiently if marginal benefit equals marginal cost. If marginal benefit exceeds marginal cost, resources can be used more efficiently by increasing the quantity produced. If marginal cost exceeds marginal benefit, resources can be used more efficiently by decreasing the quantity produced.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM Figure 10.3 shows the efficient quantity of a public good—surveillance satellites. 1. If MB exceeds MC, an increase in the quantity will make resource use more efficient. 2. If MC exceeds MB, a decrease in the quantity will make resource use more efficient.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM 3. If MB equals MC, resource use is efficient. 4. The efficient quantity is 200 satellites. 5. Private provision leads to underproduction—in the extreme, to zero production.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM Private Provision: Underproduction No one would have an incentive to buy his or her share of the satellite system—the free-rider problem. So a private firm would not supply satellites. Public Provision: Efficient Production The political process determines the quantity of a public good provided—this quantity might be efficient or inefficient.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM Figure 10.4(a) shows the preferences of two political parties in an election. 1. Doves would like to provide 100 satellites. 2. The Hawks would like to provide 300 satellites.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM Figure 10.4(b) shows an efficient political outcome. 3. The political outcome is 200 satellites because, unless each party proposes 200 satellites, the other party can beat it in the election.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM Principle of Minimum Differentiation Principle of minimum differentiation The tendency for competitors to make themselves identical to appeal to the maximum number of clients or voters.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM Public Provision: Overproduction Bureaucrats translate the choices of politicians into programs and control the day-to-day activities that deliver public goods. The behavior of bureaucrats modifies the political outcome.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM Objective of Bureaucrats The bureau’s goal is to maximize its budget. 1. The efficient quantity is 200 satellites. If the bureau is successful in the pursuit of its goal, the politicians provide 300 satellites. 2. With 300 satellites, marginal cost exceeds marginal benefit.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM 3. With 300 satellites, inefficient overproduction occurs.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM Why don’t the politicians block the bureaucrats? Rational Ignorance Rational choice balances marginal benefit and marginal cost. An implication of rational choice is rational ignorance. The decision not to acquire information because the marginal cost of doing so exceeds the expected marginal benefit.

10.2 PUBLIC GOODS AND FREE-RIDER PROBLEM Why Government Is Large Part of the reason why government is large is Inefficient overprovision of public goods Voters’ rational ignorance Once a bureaucracy gets established, its goal of budget maximization combined with voters’ rational ignorance explains why government takes a large proportion of total income.

The Tragedy of the Commons 10.3 COMMON RESOURCES The Tragedy of the Commons The tragedy of the commons is the absence of incentives to prevent the overuse and depletion of a commonly owned resource. Examples include the Atlantic Ocean cod stocks, South Pacific whales, and the quality of the earth’s atmosphere. The traditional example from which the term derives is the common grazing land surrounding middle-age villages. I ask students why do we have plenty of cows while rhinos are almost extinct. They want to answer that rhinos are exotic or that the rhino’s environment is deteriorating. You can remind students that the buffalo wasn’t exotic and they had plenty of space to roam and still they were almost extinguished. The difference between cows and rhinos (and buffaloes in the 19th century) is that someone owns the cows, that is, someone has the property rights to the cows, but no one owns the rhinos. Because no one has property rights to the rhino, they are a common resource and so there is no benefit to anyone for the rhino to stay alive; they will be hunted to extinction. In South Africa, though, black and white rhinos are growing in number because of “game privatization.” According to Smithsonian magazine (March 2001), private landowners in South Africa are converting their farms to private reserves to breed, raise, and sell rhinos and other endangered species. You can even hunt white rhinos today, but not black ones. Mark Englezakis, a lodge owner quoted in the magazine understands the benefits of property rights: “The cow is mine, it’s worth money, so I’ve got to protect it,” he says. He adds that by giving him the right to sell a rhino and earn the benefits (profits), he’s also willing to raise and protect rhinos. “For wildlife to survive, it has to become a cow,” he adds.

10.3 COMMON RESOURCES Figure 10.6 illustrates the sustainable production of fish. As the number of fishing boats increases, the sustainable quantity of fish caught increases to some maximum and then decreases. Beyond that maximum sustainable catch, there is overfishing.

10.3 COMMON RESOURCES Figure 10.7 shows why overfishing occurs. 1. The average catch per boat, which is the marginal private benefit, MPB, decreases as the number of boats increases. 2. The marginal cost per boat is MC (assumed constant).

10.3 COMMON RESOURCES 3. Equilibrium occurs where marginal private benefit, MPB, equals marginal cost, MC. The equilibrium number of boats fishing is 8,000 and overfishing occurs. Overfishing occurs because no one takes into account the effects of her/his actions on other users of the resource.

The Efficient Use of the Commons 10.3 COMMON RESOURCES The Efficient Use of the Commons The quantity of fish caught by each boat decreases as the number of boats increases. But no one has an incentive to take this fact into account when deciding whether to fish. The efficient use of a common resource requires marginal cost to equal marginal social benefit.

10.3 COMMON RESOURCES Marginal Social Benefit Marginal social benefit is the increase in total fish catch that results from an additional boat. The marginal social benefit is not the average catch per boat, which is the marginal private benefit. Table 10.1 on the next slide shows the calculation of marginal social benefit.

10.3 COMMON RESOURCES Boats Total Catch MSB A 90 B 1 70 C 2 160 50 D 3 90 B 1 70 C 2 160 50 D 3 210 30 E 4 240

10.3 COMMON RESOURCES Efficient Use Figure 10.8 illustrates the efficient use of a common resource. 1. At each number of boats, the marginal social benefit curve, MSB, is below the MPB curve. 2. The resource is used efficiently when MSB equals MC.

Achieving an Efficient Outcome 10.3 COMMON RESOURCES Achieving an Efficient Outcome It is harder to achieve an efficient use of a common resource than to define the conditions under which it occurs. Three methods in use are: Property rights Quotas Individual transferable quotas (ITQs)

10.3 COMMON RESOURCES Property Rights By assigning property rights, common property becomes private property. When someone owns a resource, the owner is confronted with the full consequences of her/his actions in using that resources. The social benefits become the private benefits.

10.3 COMMON RESOURCES In Figure 10.8, the marginal social benefit curve, MSB, becomes the marginal private benefit curve. The resource is used efficiently because the owner of the resource is best off when MSB equals MC.

10.3 COMMON RESOURCES Quotas By setting a production quota at the efficient quantity, a common resource might remain in common use but be used efficiently. Figure 10.9(a) shows this situation. It is hard to make a quota work.

10.3 COMMON RESOURCES Individual Transferable Quotas An individual transferable quota (ITQ) is a production limit that is assigned to an individual who is free to transfer the quota to someone else. A market emerges in ITQs. If the efficient quantity of ITQs is assigned, the market price of a quota confronts resource users with a marginal cost that equals MSB at the efficient quantity.

10.3 COMMON RESOURCES Figure 10.9(b) shows the situation with an efficient number of ITQs. Marginal cost rises from MC0 to MC1. Users of the resource make marginal private benefit, MPB, equal to marginal private cost, MC1, and the outcome is efficient.

A Free-Rider Problem in YOUR Life Copying illegally and sharing MP3 files create a free-rider problem. What’s the solution to this free-rider problem? Have government provide all the music? Tax all purchases of MP3 players and use the revenue to compensate all artists and recording companies? The best solution is to uphold property rights, so recording companies can pursue illegal file sharers and hit them with large penalties.