PUBLIC GOODS A good that is available for everyone toconsume A good that is available for everyone to consume, regardless of who pays and who doesn’t. Examples: National Defense,National Defense, Law Enforcement,Law Enforcement, Space Exploration,Space Exploration, Preservation of Endangered Species,Preservation of Endangered Species, Protection of the Earth’s Ozone Layer,Protection of the Earth’s Ozone Layer, City Streets and HighwaysCity Streets and Highways A good that is available for everyone toconsume A good that is available for everyone to consume, regardless of who pays and who doesn’t. Examples: National Defense,National Defense, Law Enforcement,Law Enforcement, Space Exploration,Space Exploration, Preservation of Endangered Species,Preservation of Endangered Species, Protection of the Earth’s Ozone Layer,Protection of the Earth’s Ozone Layer, City Streets and HighwaysCity Streets and Highways

Workplace spilloversWorkplace spillovers A college degree generates spillover benefits for the graduate’s fellow workers. A college degree generates spillover benefits for the graduate’s fellow workers. Civic spilloversCivic spillovers A person with a college education is likely to vote more intelligently, so there are spillover benefits for the graduate’s fellow citizens. A person with a college education is likely to vote more intelligently, so there are spillover benefits for the graduate’s fellow citizens. Workplace spilloversWorkplace spillovers A college degree generates spillover benefits for the graduate’s fellow workers. A college degree generates spillover benefits for the graduate’s fellow workers. Civic spilloversCivic spillovers A person with a college education is likely to vote more intelligently, so there are spillover benefits for the graduate’s fellow citizens. A person with a college education is likely to vote more intelligently, so there are spillover benefits for the graduate’s fellow citizens. SPILLOVER BENEFITS

COLLEGE DEGREE MARKET In this market: A college degree has a constant cost of $40,000,A college degree has a constant cost of $40,000, Given the market demand, a market equilibrium occurs at point i: a quantity of 8,000 degrees,Given the market demand, a market equilibrium occurs at point i: a quantity of 8,000 degrees, Heidi is willing to pay $30,000 for a degree, point d.Heidi is willing to pay $30,000 for a degree, point d. Heidi doesn’t get a degree in this market.Heidi doesn’t get a degree in this market. In this market: A college degree has a constant cost of $40,000,A college degree has a constant cost of $40,000, Given the market demand, a market equilibrium occurs at point i: a quantity of 8,000 degrees,Given the market demand, a market equilibrium occurs at point i: a quantity of 8,000 degrees, Heidi is willing to pay $30,000 for a degree, point d.Heidi is willing to pay $30,000 for a degree, point d. Heidi doesn’t get a degree in this market.Heidi doesn’t get a degree in this market.

Price $ Supply Demand i d $40,000 $30,000 8,00010,000 Number of college degrees per year

SPILLOVER BENEFITS OF COLLEGE DEGREES Spillover benefit for a college degree is $15,000: amount taxpayers willing to pay, recognizing workplace and civic externalities that come with a degree;Spillover benefit for a college degree is $15,000: amount taxpayers willing to pay, recognizing workplace and civic externalities that come with a degree; If taxpayers give Heidi $11,000 to cover part of college cost, Heidi pays $29,000 ($40,000 tuition - $11,000), instead of $30,000;If taxpayers give Heidi $11,000 to cover part of college cost, Heidi pays $29,000 ($40,000 tuition - $11,000), instead of $30,000; Since citizens’ spillover benefit is $15,000, both Heidi and citizens could gain by this arrangement.Since citizens’ spillover benefit is $15,000, both Heidi and citizens could gain by this arrangement. Spillover benefit for a college degree is $15,000: amount taxpayers willing to pay, recognizing workplace and civic externalities that come with a degree;Spillover benefit for a college degree is $15,000: amount taxpayers willing to pay, recognizing workplace and civic externalities that come with a degree; If taxpayers give Heidi $11,000 to cover part of college cost, Heidi pays $29,000 ($40,000 tuition - $11,000), instead of $30,000;If taxpayers give Heidi $11,000 to cover part of college cost, Heidi pays $29,000 ($40,000 tuition - $11,000), instead of $30,000; Since citizens’ spillover benefit is $15,000, both Heidi and citizens could gain by this arrangement.Since citizens’ spillover benefit is $15,000, both Heidi and citizens could gain by this arrangement.

SUBSIDIES TO GUIDE THE MARKET The government can use tuition subsidies to increase the equilibrium number of college degrees; The government can use tuition subsidies to increase the equilibrium number of college degrees; An education subsidy internalizes the externality. An education subsidy internalizes the externality. Local governments provide 100% subsidy for primary and secondary education;Local governments provide 100% subsidy for primary and secondary education; State and local governments charge students at public colleges and universities a fraction of the education cost;State and local governments charge students at public colleges and universities a fraction of the education cost; Many firms use government subsidies to support on-the- job training and education;Many firms use government subsidies to support on-the- job training and education; Government subsidizes basic research at universities and other non-profit organizationsGovernment subsidizes basic research at universities and other non-profit organizations The government can use tuition subsidies to increase the equilibrium number of college degrees; The government can use tuition subsidies to increase the equilibrium number of college degrees; An education subsidy internalizes the externality. An education subsidy internalizes the externality. Local governments provide 100% subsidy for primary and secondary education;Local governments provide 100% subsidy for primary and secondary education; State and local governments charge students at public colleges and universities a fraction of the education cost;State and local governments charge students at public colleges and universities a fraction of the education cost; Many firms use government subsidies to support on-the- job training and education;Many firms use government subsidies to support on-the- job training and education; Government subsidizes basic research at universities and other non-profit organizationsGovernment subsidizes basic research at universities and other non-profit organizations

THREE REASONS FOR GOVERNMENT INEFFICIENCY Inadequate Information,Inadequate Information, Inflexible Tax Systems,Inflexible Tax Systems, Special-interest GroupsSpecial-interest Groups Inadequate Information,Inadequate Information, Inflexible Tax Systems,Inflexible Tax Systems, Special-interest GroupsSpecial-interest Groups

INADEQUATE INFORMATION It is often difficult to estimate the benefits because people have a strong incentive to either understate or overstate their personal benefits: It is often difficult to estimate the benefits because people have a strong incentive to either understate or overstate their personal benefits: One might overstate benefits to make it more likely that the government will provide the public good;One might overstate benefits to make it more likely that the government will provide the public good; Another might understate benefits to avoid paying a large tax for the public good.Another might understate benefits to avoid paying a large tax for the public good. It is often difficult to estimate the benefits because people have a strong incentive to either understate or overstate their personal benefits: It is often difficult to estimate the benefits because people have a strong incentive to either understate or overstate their personal benefits: One might overstate benefits to make it more likely that the government will provide the public good;One might overstate benefits to make it more likely that the government will provide the public good; Another might understate benefits to avoid paying a large tax for the public good.Another might understate benefits to avoid paying a large tax for the public good.

INFLEXIBLE TAX SYSTEMS Most tax systems are not flexible enough to allow close matching of the taxes they pay with the benefits they receive. Most tax systems are not flexible enough to allow close matching of the taxes they pay with the benefits they receive. The result is that voters will reject some efficient public projects and approve some inefficient ones. The result is that voters will reject some efficient public projects and approve some inefficient ones. Most tax systems are not flexible enough to allow close matching of the taxes they pay with the benefits they receive. Most tax systems are not flexible enough to allow close matching of the taxes they pay with the benefits they receive. The result is that voters will reject some efficient public projects and approve some inefficient ones. The result is that voters will reject some efficient public projects and approve some inefficient ones.

SPECIAL INTEREST GROUPS If a few people reap large benefits from a project but many bear small costs, the project may be approved, even if the total cost exceeds the total benefit. Example: a dam which benefits a few farmers, but financed by a million taxpayers; Farmers have a strong incentive to spend time and money to convince policy makers to build the dam; If tax is only $1 per capita, few taxpayers will make their feelings known to policy makers; If politicians listen to people who express their feelings and back them up with money, the inefficient project will be approved. If a few people reap large benefits from a project but many bear small costs, the project may be approved, even if the total cost exceeds the total benefit. Example: a dam which benefits a few farmers, but financed by a million taxpayers; Farmers have a strong incentive to spend time and money to convince policy makers to build the dam; If tax is only $1 per capita, few taxpayers will make their feelings known to policy makers; If politicians listen to people who express their feelings and back them up with money, the inefficient project will be approved.

FREE-RIDING EXPERIMENT Free-riding experiments suggest that (some) people contribute some money (to a public good), but less than the amount that would maximize the benefit per person. Free-riding experiments suggest that (some) people contribute some money (to a public good), but less than the amount that would maximize the benefit per person.

OVERCOMING THE FREE-RIDER PROBLEM Successful public-good organizations use a number of techniques to encourage people to contribute to them: Successful public-good organizations use a number of techniques to encourage people to contribute to them: Give contributors private goods,Give contributors private goods, Arrange matching contributions,Arrange matching contributions, Appeal to people’s sense of civic or moral responsibility.Appeal to people’s sense of civic or moral responsibility. Successful public-good organizations use a number of techniques to encourage people to contribute to them: Successful public-good organizations use a number of techniques to encourage people to contribute to them: Give contributors private goods,Give contributors private goods, Arrange matching contributions,Arrange matching contributions, Appeal to people’s sense of civic or moral responsibility.Appeal to people’s sense of civic or moral responsibility.

Using elasticity to determine the amount of tax shifting Taxes are “shifted” if consumers and producers share in the burden of the tax.Taxes are “shifted” if consumers and producers share in the burden of the tax. The tax burden is the cost of the tax (to producers and consumers).The tax burden is the cost of the tax (to producers and consumers).

Using elasticity to determine the amount of tax shifting Producers argue that they pay the tax because the government collects it from them. Consumers argue that they pay the tax because it is “built in” to the price of cigarettes. Producers argue that they pay the tax because the government collects it from them. Consumers argue that they pay the tax because it is “built in” to the price of cigarettes. Who actually pays the tax? Consider a tax on cigarettes.

Price of Cigarette s ($ per pack) Packs of Cigarettes per week (millions) SUPPLY with TAX INITIAL SUPPLY 0 Supply curve with tax TAX Assume a tax of $1 is imposed. TAX

Price of Cigarette s ($ per pack) Packs of Cigarettes per week (millions) SUPPLY with TAX INITIAL SUPPLY 0 Equilibrium with tax TAX = $1 DEMAND Price paid by consumers (after tax): $2.90 per pack Price received by producers (after tax): $1.90 per pack Consumers’ burden: $2.90 -$2.00 = $.90 per pack Total: $.90 x 9 million = $8.1 million Producers’ burden: $2.00 -$1.90 = $.10 per pack Total: $.10 x 9 million = $0.9 million

Price of Cigarette s ($ per pack) Packs of Cigarettes per week (millions) SUPPLY with TAX INITIAL SUPPLY 0 Elasticity and the tax burden DEMAND A B C Price elasticity of demand (A to B): | % | / | 45%| = Price elasticity of supply (A to C): | % | / | - 5% | = % - 5% % INELASTIC: Consumers are not very responsive to the increase in the price they pay. ELASTIC: Producers are very responsive to the decrease in the price they receive.

Elasticity and the tax burden Price elasticity of demand is smaller than price elasticity of supply.Price elasticity of demand is smaller than price elasticity of supply. –Consumers bear more of the tax burden. If price elasticity of supply were smaller than price elasticity of demand, then producers would bear more of the tax burden.If price elasticity of supply were smaller than price elasticity of demand, then producers would bear more of the tax burden. –Examples: luxury goods (yachts, diamonds) Price elasticity of demand is smaller than price elasticity of supply.Price elasticity of demand is smaller than price elasticity of supply. –Consumers bear more of the tax burden. If price elasticity of supply were smaller than price elasticity of demand, then producers would bear more of the tax burden.If price elasticity of supply were smaller than price elasticity of demand, then producers would bear more of the tax burden. –Examples: luxury goods (yachts, diamonds)

Elasticity and the tax burden Government gets the difference between the amount that consumers pay and the amount that producers receive (the tax).Government gets the difference between the amount that consumers pay and the amount that producers receive (the tax). –Total tax revenue equals the tax times the number of units sold after the tax is imposed. –In this example: tax revenue = $1 x 9 million packs = $9 million. The tax prevents some potentially profitable trades.The tax prevents some potentially profitable trades. –A market with a tax is inefficient. Government gets the difference between the amount that consumers pay and the amount that producers receive (the tax).Government gets the difference between the amount that consumers pay and the amount that producers receive (the tax). –Total tax revenue equals the tax times the number of units sold after the tax is imposed. –In this example: tax revenue = $1 x 9 million packs = $9 million. The tax prevents some potentially profitable trades.The tax prevents some potentially profitable trades. –A market with a tax is inefficient.

Price of Cigarette s ($ per pack) Packs of Cigarettes per week (millions) SUPPLY with TAX INITIAL SUPPLY 0 A tax creates inefficiency in a perfectly competitive market DEMAND B C With the tax, only 9 million packs are traded There are potentially beneficial trades that could still be made if the tax were removed (up to 11 million packs).

A tax can improve efficiency in a market with negative spillovers not confined to the individual or organization that decides how much of the good to produce or consume. not confined to the individual or organization that decides how much of the good to produce or consume. Negative spillovers occur when the costs associated with a good are

Spillovers are also called “externalities” This reflects the fact that they affect people who are “external to” or “outside of” the market in question. Negative externalities (“external costs”) occur when a market transaction imposes a cost on third parties.Negative externalities (“external costs”) occur when a market transaction imposes a cost on third parties. Positive externalities (“external benefits”) occur when a market transaction provides a benefit for third parties.Positive externalities (“external benefits”) occur when a market transaction provides a benefit for third parties. This reflects the fact that they affect people who are “external to” or “outside of” the market in question. Negative externalities (“external costs”) occur when a market transaction imposes a cost on third parties.Negative externalities (“external costs”) occur when a market transaction imposes a cost on third parties. Positive externalities (“external benefits”) occur when a market transaction provides a benefit for third parties.Positive externalities (“external benefits”) occur when a market transaction provides a benefit for third parties.

Why do negative spillovers cause market failure? Sellers usually don’t consider the spillover when deciding whether or not to make the transaction. This causes a discrepancy between private marginal cost and social marginal cost. Sellers usually don’t consider the spillover when deciding whether or not to make the transaction. This causes a discrepancy between private marginal cost and social marginal cost.

Graphical analysis of a negative spillover DEMAND = private MB SUPPLY = private MC Q1Q1 P1P1 SOCIAL MC = private MC + external cost External Cost Price ($ per ton) Raw Timber (tons per month) Q* P* = social MB (because there’s no external benefit) Equilibrium in unregulated market: (Q 1, P 1 ) Social Optimum (Q*, P*) External Cost