Public goods and an introduction to externalities Today: Determining what a public good is; Efficient provision; Public versus private provision; Defining externalities

Beginning Unit 2 Last time  We concluded our “tools” chapters  End of Unit 1 Today  Begin Unit 2 Public goods (Chapter 4)  What is a public good?  Efficient provision  Public versus private provision An introduction to externalities (Chapter 5)

Public goods Public goods are goods that have some degree of two characteristics  Nonrival  Nonexcludable These two characteristics lead to suboptimal consumption when public goods are privately purchased  Externalities involved, to be defined later

Definitions Nonrival good (R/G p. 52)  “Once it is provided, the additional resource cost of another person consuming the good is zero” Nonexcludable good (R/G p. 52)  “To prevent anyone from consuming the good is either very expensive or impossible” Pure public good (R/G p. 52)  “A commodity that is nonrival and nonexcludable in consumption”

Categories of goods LowHigh Commons good (oxygen that you breathe) Public good (lighthouses) LowPrivate good (pens) Collective good (copyrighted books) Nonexcludable Nonrival

Categories of goods LowHigh Commons good (oxygen that you breathe) Public good (lighthouses) LowPrivate good (pens) Collective good (copyrighted books) Nonexcludable Nonrival Covered in Econ 1; uses basic supply/demand theory

Categories of goods LowHigh Commons good (oxygen that you breathe) Public good (lighthouses) LowPrivate good (pens) Collective good (copyrighted books) Nonexcludable Nonrival Often covered in Econ 1 or Econ 100B

Categories of goods LowHigh Commons good (oxygen that you breathe) Public good (lighthouses) LowPrivate good (pens) Collective good (copyrighted books) Nonexcludable Nonrival Goods with copyright or patent protection have some level of market power

Other examples of public goods Basic research Programs to fight poverty Uncongested nontoll roads Fireworks display

Noteworthy aspects of public goods Even though everyone consumes the same quantity of the good, it need not be valued equally by all  Surfers generally value ocean quality more than people living in Utah Classification as a public good is not absolute; it depends on market conditions and the state of technology  Impure public goods are “rival and/or excludable to some extent” (R/G p. 53)

Noteworthy aspects of public goods Some things that are not conventionally thought of as commodities have public good characteristics  Restaurant ratings Consistent within a city  Often different standards between cities  Example: It appears harder to get an “A” rating in Los Angeles County restaurants than in San Diego County

Noteworthy aspects of public goods Private goods are not necessarily provided exclusively by the private sector  Publicly provided private goods Example: Government-provided food for the poor Public provision of a good does not necessarily mean that it is also produced by the public sector  Many publicly-provided services are contracted to private firms Example: Defense-related goods

Demand of private goods Demand of private goods are summed horizontally  Add the quantity demanded for each person at a given price

Efficient Provision of Private Goods PriceAdam (D f A ) Eve (D f A ) Market (D f A+E ) $11516 $97310 $79514 $ $ $

DfADfA DfEDfE D f A+E SfSf $ Quantity of Pizza

Equilibrium and efficiency, private goods Privately-provided goods have optimal levels produced if the following conditions are met:  The goods are private Rival and excludable  Competitive markets No market power exists Price and quantity are where demand and supply curves meet Recall First Welfare Theorem  MRS fa Adam = MRS fa Eve = MRT fa

Public goods We will examine pure public goods  Highly nonrival  Highly nonexcludable Marginal analysis is used to find the optimal quantity  Optimal quantity is where PUBLIC MB equals MC

An example: Fireworks Units of Fireworks 1234 Adam (D f A )$300$250$200$150 Eve (D f E ) Market (D f A+E ) $550$450$350$250

DfADfA DfEDfE D f A+E SfSf Quantity of Fireworks $

Pareto efficiency: Public goods case MRS fa = P f / P a Set P a = $1  MRS fa = P f / 1  MRS fa = P f D f A shows MRS fa for Adam D f E shows MRS fa for Eve S f shows MRT fa Necessary condition for Pareto efficiency: MRS fa Adam + MRS fa Eve = MRT fa

Another example Fireworks show off of a tiny coastal community  25 people live here  Each person has the same private demand for fireworks P = 2 – 0.08 Q  MC for fireworks is 10 Notice that if fireworks were privately purchased, nobody would buy them (10 > 2)

Fireworks show as a public good Since one person’s enjoyment of fireworks does not take away from the enjoyment from others, PUBLIC MB is the sum of PRIVATE MBs PUBLIC MB is the vertical summation of all 25 PRIVATE MBs  P = 25  (2 – 0.08 Q) = 50 – 2Q

Vertical summation Vertical summation of 25 PRIVATE MB lines produces PUBLIC MB line  Vertical intercept is 50 MC PUBLIC MB PRIVATE MB

Marginal analysis To find efficient level of fireworks, set PUBLIC MB = MC  50 – 2Q = 10  Q = 20

Free rider problem When public goods are provided privately, some people let others buy the good for their own enjoyment  These people are known as free riders Perfect price discrimination can solve the free rider problem  Usually cannot be done, since it requires knowledge of each person’s demand curve for the public good

Do people free ride? Public goods games  Inefficient results predicted Experimental economics tests free rider theories

A public goods game You can decide whether or not you want to contribute to a new flower garden at a local park  If you decide Yes, you will lose $200, but every person in the city you live in will gain $10 in benefits from the park  If you decide No, you will cause no change to the outcome of you or other people

A public goods game What is each person’s best response, given the decision of others? We need to look at each person’s marginal gain and loss (if any)  Choose yes  Gain $10, lose $200  Choose no  Gain $0, lose $0

A public goods game Which is the better choice?  Choose no (Gain nothing vs. net loss of $190) Nash equilibrium has everybody choosing no Efficient outcome has everybody choosing yes Why the difference?  Each person does not account for others’ benefits when making their own decision

Experimental economics Experiments are conducted approximately as follows  A group of people meet in a classroom  Each person is offered money (or the equivalent of money)  Each person has the opportunity to donate money to a fund There is a “money multiplier” Money (after multiplied) gets distributed equally to everyone in the classroom

Public goods experiments Typical results of public goods experiments  People contribute about 50% of resources to provision of public good  Contributions fall the more often the game is repeated  More cooperation with prior communication  Contribution rates decline when opportunity cost of giving goes up “Warm-glow” giving  Some people may feel good by improving social welfare

Public versus private provision of a good Although public goods are often publicly financed, there is often debate as to whether or not the public sector should also provide the good There are a few criteria that help to determine provision  Relative wage and materials costs  Administrative costs  Diversity of tastes  Commodity egalitarianism

Provision criteria Relative wage and materials costs  Public sector workers are often unionized more, leading to higher costs in the private sector Administrative costs  Often lower if service provided by public sector

Provision criteria Diversity of tastes  Private provision often means more options to the consumer Distributional issues  Is there a minimum amount of schooling and health care that should be provided to everyone? Up to personal preference and debate

Public/private provision debate Change of provision between public and private sectors  Heavily debated in some cases  Some issues Uncertainty Responsibility of fulfilling services Quality of good or service Incomplete contracts in some private sector services  Example: All contingencies for security Consumer satisfaction within a market

Private provision of national defense Example: Substantial amounts of money are spent on national defense  9.3% of GDP in 1962 (Cold War era)  3.4% of GDP in 1997 Many goods and services related to national defense are privately provided The type of contract could lead to substantial changes in cost to government

Private provision of national defense Big private contracts to provide national defense involve substantial risk  Cost of cutting-edge technology is very uncertain  Fixed price contracts leave all the risk on the firm Winner’s curse  Cost-plus contracts often lead to substantial cost overruns No incentives to keep costs down  What else can be used? Incentive contracts

Incentive contracts incorporate aspects of fixed price and cost-plus contracts Department of Defense pays a fixed fee plus a fraction of production costs  TC = F + λ C  When 0 < λ < 1… There is an economic incentive to the firm to prevent cost overruns The firm bears less risk than with fixed price contracts  Special cases λ = 0  Fixed price contract λ = 1 and F = 0  Cost-plus contract

Who decides how much to provide? Somebody in government must make decisions about public goods More on decision making in Chapter 6  Political economy

Summary: Public goods Public goods are nonrival and nonexcludable in consumption Demand of public goods uses vertical summation Free rider problem predicts suboptimal quantities purchased  Mixed evidence from experimental economics Ongoing debate between public and private provision of public goods

An introduction to externalities Markets are well functioning for most private goods  Many buyers and sellers  Little or no market power by anybody  Example: When demand shifts right for a good, new equilibrium will have higher price and quantity Some markets do not have good mechanisms to account for everything in a market  Example: Talking on a cell phone in an airplane

Externalities Externalities are effects that are not incorporated into market quantities and prices  R/G (p.71) define an externality as “an activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism” When markets have externalities, they are typically not efficient  This is the topic of Chapter 5

Public good versus externality Although public goods are often looked at as goods with externalities, we study the two topics separately  Know which analysis applies when you solve a problem

Negative externalities Some examples of negative externalities  Air pollution  Water pollution Sometimes you do not even think about polluting the water: Washing a car in your driveway  Noise pollution  Highway congestion  Standing at a concert or sporting event

Positive externalities Some externalities are benefits  Planting flowers in your front lawn  Scientific research  Vaccination Prevents others from getting a disease from you  Exercise? Yes, if it leads to lower health care insurance premiums for others More on the private health care market in Chapter 9

More externalities: Benefit or cost? Christmas decorations  Enjoyment or nuisance? A fan blowing in a warm office building  Cooling breeze or blowing your important papers? Use of perfume or cologne  Nice smell or allergen?

A simple example with externalities Suppose private MC equals quantity  MPC = Q Let demand be denoted by P = 100 – Q Let marginal damage be $10 per unit

A simple example with externalities Translate equations and external cost to our graphical example marginal damage per unit of $10 P = 100 – Q MPC = Q MSC = Q + 10

A simple example: Private equilibrium Inefficient equilibrium w/o controls: Set Q = 100 – Q  Q = 50 (quantity F) MPC = Q P = 100 – Q

A simple example: Optimal equilibrium Socially optimal quantity  Q + 10 = 100 – Q  Q = 45 (quantity E) P = 100 – Q MSC = Q + 10

An algebraic example: Price Inefficient equilibrium, P = Q  P = 50 Socially optimal quantity, P = Q + 10  P = 55 marginal damage per unit of $10 P = 100 – Q MPC = Q MSC = Q + 10 Price C = 50 Price B = 55 Recall E = 45 and F = 50

Summary: An introduction to externalities Externalities can be positive or negative  Sometimes, an action could lead to positive externalities for some people and negative externalities for others With external damages, an equilibrium occurs that has too much produced and price too low (relative to the optimal quantity)