© 2007 Thomson South-Western

Boston Harbor 1987 This was taken just before the harbor cleanup was about to begin

© 2007 Thomson South-Western Boston Harbor Today After a 4.5 billion dollar investment Boston Harbor went from being the “dirtiest harbor in America” to “a Great American Jewel” offering some of the cleanest urban beaches in America

© 2007 Thomson South-Western Deer Island Treatment Plant To clean the harbor 3.8 billion was spent on the Deer Island Treatment Plant The treatment plant has two characteristics which make it particularly problematic: Non-excludable Non-rival Goods with both these characteristics are known as Public Goods

© 2007 Thomson South-Western EXCLUDABILITY Excludability - refers to the property of a good whereby a person can be prevented from using itExcludability - refers to the property of a good whereby a person can be prevented from using it –Deer Island Treatment Plant-can someone be prevented from benefiting from the clean harbor? –Examples: excludable: tacos, dial-up internet serviceexcludable: tacos, dial-up internet service not excludable: FM radio signals, national defensenot excludable: FM radio signals, national defense

© 2007 Thomson South-Western Rivalry in consumption refers to the property of a good whereby one person’s use diminishes other people’s use.Rivalry in consumption refers to the property of a good whereby one person’s use diminishes other people’s use. –Deer Island Treatment Plant-benefits that result from the treatment plant do not depend on how many others also benefit –Examples: rival: tacosrival: tacos not rival: An MP3 file of the latest hit songnot rival: An MP3 file of the latest hit song RIVALRY

© 2007 Thomson South-Western THE DIFFERENT KINDS OF GOODS Rival in consumption? YesNo Excludable? Yes Private Goods Coffee/Tea Clothing Collective Good (club goods) Fire Protection Cable TV No Common Resources Fish in the ocean Clean water Public Goods National Defense Sewer systems

© 2007 Thomson South-Western Public Goods? Free meals at a soup kitchen?Free meals at a soup kitchen? –Non rival? No!No! –Non excludable? No!No! Library?Library? –Non rival? No!No! –Non excludable? No!No!

© 2007 Thomson South-Western Public Goods? Street lighting?Street lighting? –Non rival? Yes!Yes! –Non excludable? Yes!Yes!

© 2007 Thomson South-Western Why can’t market efficiently provide public goods? Public goods are difficult for private markets to provide because of the free-rider problem.Public goods are difficult for private markets to provide because of the free-rider problem. A free-rider is a person who receives the benefit of a good but avoids paying for it.A free-rider is a person who receives the benefit of a good but avoids paying for it.

© 2007 Thomson South-Western The Free-Rider Problem If good is not excludable, people have an incentive to be free riders, because firms cannot prevent non-payers from consuming the good.If good is not excludable, people have an incentive to be free riders, because firms cannot prevent non-payers from consuming the good. The free-rider problem prevents private markets from supplying efficient amounts of public goodsThe free-rider problem prevents private markets from supplying efficient amounts of public goods

© 2007 Thomson South-Western Fireworks Display Smalltown, USA, enjoys fireworks on the Fourth of July.Smalltown, USA, enjoys fireworks on the Fourth of July. Value to each of the town’s 500 residents: $10Value to each of the town’s 500 residents: $10 Ellen’s cost of the fireworks display: $1000Ellen’s cost of the fireworks display: $1000 Benefit > CostBenefit > Cost Socially Efficient outcome: Have a fireworks display on the Fourth of July.Socially Efficient outcome: Have a fireworks display on the Fourth of July. But, Private Outcome ≠ Social Outcome, why?But, Private Outcome ≠ Social Outcome, why?

© 2007 Thomson South-Western Solving the Free Rider Problem Government Provision:Government Provision: The government can decide to provide the public good if the total benefits exceed the costs.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.The government can make everyone better off by providing the public good and paying for it with tax revenue. Problem: Measuring the benefit is usually difficultProblem: Measuring the benefit is usually difficult To determine which public goods to provide and how much of them to provide, the government conducts Cost/Benefit AnalysesTo determine which public goods to provide and how much of them to provide, the government conducts Cost/Benefit Analyses

© 2007 Thomson South-Western Cost-Benefit Analysis Technique for decision making in the public sectorTechnique for decision making in the public sector Compare:Compare: the benefit of providing incremental units of public goodsthe benefit of providing incremental units of public goods with the costs of providing these additional unitswith the costs of providing these additional units The comparison is based on marginalsThe comparison is based on marginals (rational decisions are made at the margin!)

© 2007 Thomson South-Western

The Difficult Job of Cost-Benefit Analysis It is difficult to do because of the absence of prices needed to estimate social benefits and resource costs.It is difficult to do because of the absence of prices needed to estimate social benefits and resource costs. Without accurate prices, it is difficult to assess value good would provide to the publicWithout accurate prices, it is difficult to assess value good would provide to the public

© 2007 Thomson South-Western Ex/Building a Bridge in Virginia What type of a good is a bridge?What type of a good is a bridge? Excludable?Excludable? Yes, could put a toll on a bridgeYes, could put a toll on a bridge Rival?Rival? No, unless it is congestedNo, unless it is congested Would consider this to be a collective good (or a club good)Would consider this to be a collective good (or a club good)

© 2007 Thomson South-Western What is the market failure? This good is excludable  can charge to use the good, so free markets will provide some of these goods (ex/Cable TV)This good is excludable  can charge to use the good, so free markets will provide some of these goods (ex/Cable TV) BUT this good is non-rival, meaning that many people can enjoy the good without diminishing other people’s enjoyment of the goodBUT this good is non-rival, meaning that many people can enjoy the good without diminishing other people’s enjoyment of the good Because the marginal cost of allowing an extra user to benefit from the good is very small (often 0), the free market will under-provide these goodsBecause the marginal cost of allowing an extra user to benefit from the good is very small (often 0), the free market will under-provide these goods

© 2007 Thomson South-Western Building a Bridge in Virginia Case 1: Annual cost of maintaining the bridge = $40,000 Benefits? Area under demand curve (willingness to pay for bridge) ½ (1) (100,000) = $50,000 Socially Efficient to build bridge? Yes, consumer surplus > annual cost Question: Should the bridge be built?

© 2007 Thomson South-Western Building a Bridge in Virginia Question: Should the bridge be built? Would the private market provide this bridge? Only if total revenue they could raise would be greater than 40,000 In this case maximum possible revenue is $25,000 so would not build the bridge even though it is socially efficient

© 2007 Thomson South-Western Building a Bridge in Virginia Question: Should the bridge be built? Case 2: Annual cost of the bridge = $20,000 Would the private market provide this bridge? Socially Efficient to build bridge? Yes, consumer surplus > annual cost Yes, maximum possible revenue is $25,000 so would build the bridge, but since marginal cost of provision is 0 (or very small) this private provider will charge a toll above the optimum, leading to an outcome that is not efficient

© 2007 Thomson South-Western Providing the right amount of a public good Though there are no prices on these goods, people still have an underlying willingness to pay which should help us determine optimal provision of a good.Though there are no prices on these goods, people still have an underlying willingness to pay which should help us determine optimal provision of a good.

© 2007 Thomson South-Western Example – Demand for Streetlights in Privet Drive Note: Willingness to Pay represents marginal benefits, not total, i.e. how much willing to pay for 2 nd lamp, etc. Question: How do we aggregate individual demand curves to arrive at market demand? Answer: Remember that streetlights are public goods, which means they are non-rival, so benefits accrue simultaneously to everyone. Only one quantity can be produced, and everyone will get that quantity. So we sum the demand curves vertically rather than horizontally as we did with private goods.

© 2007 Thomson South-Western Example – Demand for Streetlights in Privet Drive Draw the Market Demand for streetlights

© 2007 Thomson South-Western Example – Demand for Streetlights in Privet Drive Marginal Benefit of a Public Good is the sum of the marginal benefits of all individuals that consume the good. If the marginal cost of providing the street lamp is $40, how many should we provide? 3 Street Lights – point where society’s MB = MC

© 2007 Thomson South-Western Example – Demand for Streetlights in Privet Drive Problem: How could we get people to be honest about what they are truly willing to pay? If we ask people directly and their payment is based on their answer, then they have an incentive to under- report their willingness to pay (free-rider problem)

© 2007 Thomson South-Western Does Voting Solve the Problem? In the U.S. and other democratic counties we determine output of public goods through political system  Voting Voting can be imperfect as too. Why? Voting will result in no streetlamp. But would it have been socially efficient to have streetlamps? YES! Problem is that voting does not take into account the intensity of people’s preferences, so many socially valuable public goods will not be provided through this system.

© 2007 Thomson South-Western Does Voting Solve the Problem? Another problem with voting is that once a program is voted on, it is usually “one size fits all” i.e. everyone receives the same level of services. Solutions? Many small jurisdictions with powers of taxation. In our country one of the primary functions of local governments is the provision of public schools. Business Improvement District (BID) is an organization that is granted power to levy supplemental surcharge on businesses in a local area. The organization then uses revenues to provide supplemental public services in a community, like street clean-up, graffiti removal, and sidewalk repair, it organizes street fairs, and constructs attractive signs, etc.

© 2007 Thomson South-Western COMMON RESOURCES Common resources, like public goods, are not excludableCommon resources, like public goods, are not excludable They are available free of charge to anyone who wishes to use them They are available free of charge to anyone who wishes to use them Little incentive for firms to provide Little incentive for firms to provide Role for govt: ensuring that they are provided Role for govt: ensuring that they are provided

© 2007 Thomson South-Western COMMON RESOURCES Common resources are rival goods because one person’s use of the common resource reduces other people’s use.Common resources are rival goods because one person’s use of the common resource reduces other people’s use. Role for govt: ensuring they are not overusedRole for govt: ensuring they are not overused

© 2007 Thomson South-Western 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.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.Common resources tend to be used excessively when individuals are not charged for their usage. This is similar to a negative externality.This is similar to a negative externality.

© 2007 Thomson South-Western The Tragedy of the Commons Setting: A medieval town, where sheep graze on common land.Setting: A medieval town, where sheep graze on common land. As the population grows, the number of sheep grows.As the population grows, the number of sheep grows. The amount of land is fixed, the grass begins to disappear from overgrazing.The amount of land is fixed, the grass begins to disappear from overgrazing. The private incentives (using the land for free) outweigh the social incentives (using it carefully).The private incentives (using the land for free) outweigh the social incentives (using it carefully). Result: People can no longer raise sheep.Result: People can no longer raise sheep.

© 2007 Thomson South-Western The Tragedy of the Commons The tragedy is due to an externality: Allowing one’s flock to graze on the common land reduces its quality for other families.The tragedy is due to an externality: Allowing one’s flock to graze on the common land reduces its quality for other families. People neglect this external cost, resulting in overuse of the land.People neglect this external cost, resulting in overuse of the land.

© 2007 Thomson South-Western A C T I V E L E A R N I N G 2 : Policy options for common resources What could the townspeople (or their government) have done to prevent the tragedy?What could the townspeople (or their government) have done to prevent the tragedy? Try to think of two or three options.Try to think of two or three options.

© 2007 Thomson South-Western A C T I V E L E A R N I N G 2 : Answers Impose a corrective tax on the use of the land to “internalize the externality”Impose a corrective tax on the use of the land to “internalize the externality” Regulate use of the land (the “command-and- control” approach)Regulate use of the land (the “command-and- control” approach) Auction off permits allowing use of the landAuction off permits allowing use of the land Divide the land, sell lots to individual families Each family will have incentive not to overgraze its own land.Divide the land, sell lots to individual families Each family will have incentive not to overgraze its own land.

© 2007 Thomson South-Western Policy Options to Prevent Overconsumption of Common Resources Regulate use of the resourceRegulate use of the resource Impose a corrective tax to internalize the externalityImpose a corrective tax to internalize the externality Example: hunting & fishing licenses, entrance fees for congested national parksExample: hunting & fishing licenses, entrance fees for congested national parks Auction off permits allowing use of the resourceAuction off permits allowing use of the resource Example: spectrum auctions by the U.S. Federal Communications CommissionExample: spectrum auctions by the U.S. Federal Communications Commission If the resource is land, convert to a private good by dividing and selling parcels to individualsIf the resource is land, convert to a private good by dividing and selling parcels to individuals