Market Failure and the Role of Government: Public Goods AP Microeconomics Mr. Bordelon

Characteristics of Goods

Private Goods Excludable. Suppliers of the good can prevent people who don’t pay from consuming it. Rival in consumption. Same unit of the good can not be consumed by more than one person at a time. Example. A car dealership sells a car to Tom at a price of $20,000. Tom gets the car because he is willing and able to pay that price. The seller does not sell a car to Becky because Becky considers that price to be out of her budget. The car is excludable. This means that the seller does not have to provide a car to Becky or the rest of the people in town who are unwilling and unable to pay the going price. Once Tom has purchased the car, the car is his. In other words, he has consumed this unit of that good and thus prevents Huck from buying it off of the car lot. Of course Tom could give Huck a ride, or sell the used car to Huck, but once he sells it to Huck it now belongs to Huck. Tom cannot sell it to Huck and also sell it to Becky.

Public Goods Non-excludable. Anyone can consume it. Non-rival in consumption. Good can be consumed by more than one person at the same time. Example. Cities have fire departments that protect all homes in the city and can’t exclude anyone on the basis of payment. And more than one person can consume the fire protection at the same time. If a fire breaks out at Margaret’s house, the fire department rushes to put it out. This prevents the fire from spreading to Melanie’s store, so both people are consuming the same unit of fire protection.

Artificially Scarce Goods Excludable. Non-rival in consumption. Example. A college economics lecture is excludable because only students who have paid tuition can enroll in the course and attend the lecture. However it is non-rival because many people can consume the same unit of the good at the same time. Other examples are pay-per-view movies or sporting events.

Common Resources Non-excludable. Non-rival in consumption. Example. The stock of salmon in the Pacific Ocean has historically been a common resource. If a person had a boat, they could harvest salmon from the ocean, or even scoop the fish from the bank of a river as the salmon headed upstream. This made the salmon non-excludable. However once a salmon is caught, it cannot be caught by a second person, which makes it rival.

Markets Supply Only Private Goods Efficiently Markets are efficient except in the case of market power, externalities or other instances of market failure. Markets can only supply goods and services efficiently if the goods are excludable and rival in consumption—private goods. Free rider. Goods that are non-excludable suffer from this. Individuals have no incentive to pay for their own consumption and instead will take a free ride on anyone who does pay.

Markets Supply Only Private Goods Efficiently With public goods, the non-exclusive nature of the goods and the free-rider problem will prevent an efficient quantity from being produced in a market. So much so that zero units may be produced (or not, as it were).

Markets Supply Only Private Goods Efficiently Artificially scarce goods face a similar problem with respect to free- riders. Example. Pay-per-view of $10 per game. Because this is greater than zero, fewer consumers will purchase the game and the number of units consumed will be less than the efficient quantity. The efficient quantity would be zero assuming this was not pay-per-view. More than one person can consume this good despite the $10 excludable price tag.

Markets Supply Only Private Goods Efficiently Private goods don’t have this problem. Firms can charge a price and thus have an incentive to produce them. Goods are rival, consumers have an incentive to pay a positive price for them. If firms have an incentive to offer a good at a price above zero and there are enough consumers willing to pay that price a market will emerge for the good.

Providing Public Goods There are really only a small number of ways in which a good is supplied: by private firms or by the government. Private firms won’t supply public goods, so that leaves voluntary contributions or the government. Research for disease prevention is a public good that requires a lot of money to provide. Some of those funds are donated by citizens and corporations, but the government must provide the rest. Example. National defense is a public good that could not survive on voluntary donations so the government provides all of it. Government provides public goods by collecting taxes from the population.

How Much of the Public Good Should be Provided? Streetlights along a city street are a public good. How many lights should be provided in the city? Suppose that Bob and Sandy are the only residents and that they truthfully tell the government how much they would be willing to pay for each streetlight. This willingness to pay (WTP) is also each resident’s marginal private benefit (MPB) to having the next light installed. What is the first streetlight worth to this town? Bob: $10 Sandy: $18 Total marginal private benefit (MPB): $28

How Much of the Public Good Should be Provided? Streetlights Bob’s MPB Sandy’s MPB MSB = MPBB + MPBA 1 $10 $18 $28 2 8 15 23 3 6 12 18 4 9 13 5 How many should be installed? The answer lies with the MSC of the lights. If each light cost the town $12, the first four will be installed because MSB > MSC, but the fifth would not because it is inefficient. Even assuming Bob or Sandy was a free rider, the results would be the same because it was a public good.

How Much of the Public Good Should be Provided? Let’s look it from a graph perspective. This curve represents Ted’s MPB. As you can see, the benefit decreases with each additional street cleaning. Notice that the MPB decreases with each additional street cleaning.

How Much of the Public Good Should be Provided? Alice has a similar MPB curve, declining according to her own personal benefit.

How Much of the Public Good Should be Provided? Putting both Ted and Alice together, we can create the marginal social benefit curve (total benefit to both). Here, we have a MSC of $6, meaning it costs $6 per street cleaning. How much would we produce?

How Much of the Public Good Should be Provided? We would produce 5, where the MSB > MSC. Once we go past 5, it actually costs society more to produce, effectively a loss of $4 per street cleaning when producing 6.

Common Resources AP Examples: Fish, oceans, clean air, clean water, biodiversity. The biggest problem with common resources is overuse. Because they are non-excludable and rival in consumption, competitors will overuse the resource. Want a good website to illustrate this: http://www.bunnygame.org

Common Resources We live in Florida and we get most of our fresh water from the aquifer. If I drill a well for my own personal use, it’s non-excludable…others can consume this water. For every gallon I use, however, it’s one that someone else can not use…it’s rival. My consumption of water drops the aquifer, making it more costly for others to get their water. My MPC of the next gallon of water is lower than the MSC. The socially optimal quantity of water is less than the market quantity of water. This tells us that a common resource will be overused. If rainfall is insufficient to recharge the aquifer, we will exhaust it.

Common Resources Graphing it out, we see this problem of overuse. MSC will eventually cross the supply curve, and exhaust the resource. Anytime the QOPT of a common resource is less than the QMKT, then the common resource will be over used.

Efficient Use and Maintenance of a Common Resource These solutions should look familiar (think negative externalities): Tax or otherwise regulate the use of the common resource. Create a system of tradable licenses for the right to use the common resource. Make the common resource excludable and assign property rights to some individuals.

Artificially Scarce Goods Pay-per-view movies are artificially scarce because they are excludable but non-rival. The cable company can exclude me from watching the movie if you don’t pay the price, and if you watch the movie it doesn’t deny another household from also watching the movie. The marginal cost of providing the movie to one more household is zero. The efficient quantity would be the quantity where the demand curve intersects the horizontal axis and the price would be zero. Of course there is no way the firm can profit if the price is zero, so the firm sets a price of maybe $5 and excludes some of the potential customers. If the price is $5, fewer movies will be ordered than the efficient number. This is why this good is called “artificially scarce”.