PPA 723: Managerial Economics Lecture 17: Public Goods The Maxwell School, Syracuse University Professor John Yinger

Managerial Economics, Lecture 17: Public Goods Outline  Definitions  Common Resources  Public Goods

Managerial Economics, Lecture 17: Public Goods Market Failure  Market power (e.g. monopoly) is a market failure that may call for government intervention.  Today we start a section on public goods and externalities, which lead to another kind of market failure that may call for government intervention—even in competitive markets.  We will look at both positive analysis (how do people behave with public goods and externalities) and normative analysis (the case for government intervention).

Managerial Economics, Lecture 17: Public Goods Definitions  The topics in this section involve situations in which people interact with each other.  Externality = a case in which one person’s actions inadvertently affect other people.  Common Property = a case in which many people consume a common resource.  Public Good = a good that by its very nature provides benefits to more than one person.

Managerial Economics, Lecture 17: Public Goods Schedule  Today we look at common property and public goods.  Then we have two lectures and a case on externalities.

Managerial Economics, Lecture 17: Public Goods Private Goods  Private goods are characterized by:  Rivalry: only one person can consume the good (it is depletable).  Exclusion: others can be prevented from consuming the good.  Private goods may also involve externalities.

Managerial Economics, Lecture 17: Public Goods Common Property  Common property is defined as a resource to which everyone has free access.  Examples of common property include  Fisheries  Public grazing lands  Common pools (petroleum, water…)  The internet  Many roads

Managerial Economics, Lecture 17: Public Goods Public Goods  Public goods are commodities or services, such as national defense, for which consumption by one person doesn’t preclude consumption by others.  In other words, public goods lack rivalry.  The nonrivalry in a public good may have a limit; that is, the good may eventually become “congested.”

Managerial Economics, Lecture 17: Public Goods Club Good  A club good is a public good with exclusion.  Examples include a tennis club or a concert:  Security guards can keep people who don’t have tickets from entering a concert hall  The marginal cost of adding one more person is zero, as long as the hall is not filled (i.e. there is not congestion.)

Managerial Economics, Lecture 17: Public Goods Relationships Among Concepts  A common property involves a type of externality, namely, the impact of users on the common property.  A public good is one characterized by “non- rivalry,” in the sense that it can be provided to more than one person without raising its cost. But many public goods, like common property, are characterized by “non- excludability.”  A public good is often said to have a positive externality: because of non-rivalry, providing it to one person provides benefits to others.

Managerial Economics, Lecture 17: Public Goods Table Rivalry and Exclusion Note: Externalities may exist in the rivalry/exclusion cell and arise by definition in the other three cells.

Managerial Economics, Lecture 17: Public Goods The Tragedy of the Commons  Common property is a resource to which everyone has free access.  Because access is free, people do not consider their impact on the resource when they use it— that is, the social cost they impose.  As a result, people over-use the common property, lowering the benefits to society.

Managerial Economics, Lecture 17: Public Goods Government Policy for Common Property  To avoid over-use, governments sometimes limit usage or place a fee on usage.  In the case of fishing, for example, some fishing areas are placed off-limits or allowable catches of certain types of fish are limited.  On highways, usage may be controlled with tolls.  We return to these policies when we analyze externalities more generally.

Managerial Economics, Lecture 17: Public Goods The Demand for Public Goods  In the case of a private good, the market demand curve is the horizontal sum of individual demand curves.  In the case of a public good, the market demand curve is the vertical sum of the individual demand curves: each additional unit goes to everyone simultaneously.  In both cases the market demand curve is the marginal social benefit curve.

Managerial Economics, Lecture 17: Public Goods The Demand for a Public Good Price of guard service, $ per hour Guards per hour Supply,MC e p e s D 1 D D 2 D = Marginal Social Benefit Curve

Managerial Economics, Lecture 17: Public Goods Markets for Public Goods  Private markets for public goods exist only if nonpurchasers can be excluded from consuming them.  Without the possibility of exclusion, people can be free riders, that is, they can receive the good without paying.  A market obviously cannot operate if consumers can choose not to pay!

Managerial Economics, Lecture 17: Public Goods Exclusive Public Goods  Private markets can exist for exclusive (or excludable) public goods  But these markets tend to produce too little of the good because of non-rivalry  Microsoft’s marginal cost for one more unit is virtually zero  It’s price is much higher!

Managerial Economics, Lecture 17: Public Goods Providing Public Goods  To ensure that a nonexclusive public good is provided, the government, unlike a private firm, can levy taxes and then  Produce it  Pay private firms to produce it  If the government does not provide it, all the consumer surplus associated with the good is lost.

Managerial Economics, Lecture 17: Public Goods Providing Public Goods, 2  A government often has difficulty determining the benefits from a public good.  People may not to reveal their willingness to pay (= benefits) if they think their preferences might be linked to their taxes.  A government learns these benefits through  Surveys  Citizens’ votes

Managerial Economics, Lecture 17: Public Goods Voting  One simple way to think about voting is to recognize that the outcome will always depend on the preferences of the median voter.  The median voter is defined as the voter in the middle of the distribution of voter preferences for the public good.

Managerial Economics, Lecture 17: Public Goods Example  Traffic signal costs $300 to install.  There are 3 voters, who will share the cost.  Each person votes for the signal only if he or she thinks the signal is worth at least $100 (= the tax each person will pay).  There are 3 cases (corners) in the table.  In each case, Hayley is median voter, so her views determine the outcome.

Managerial Economics, Lecture 17: Public Goods

Voting and Efficiency  It is efficient to provide public good if the aggregate benefit (that is, the sum of the benefits to all households) is greater than the cost.  This is about allocative efficiency.  Majority voting may not lead to efficiency;  Voting gives each person equal weight;  An efficiency calculation gives each dollar of willingness to pay equal weight.

Managerial Economics, Lecture 17: Public Goods The Tiebout Hypothesis  Local public goods and services are characterized by congestion.  A famous article by Charles Tiebout in 1956 argued that voters reveal their preferences for local public goods and services through their choice of a community.  Picking a community is like buying a shirt, he said, so if there are many communities, the outcome should be equally efficient.

Managerial Economics, Lecture 17: Public Goods The Tiebout Literature  Subsequent analysis has revealed that having many local governments with different levels of service is more efficient than having a single local government.  But a system with many local governments is perfectly efficient only under extreme assumptions, and policies to promote efficiency may still be needed.  And this system is unlikely to be equitable.

Managerial Economics, Lecture 17: Public Goods The Tiebout Literature, 2  For example, local communities will be perfectly homogeneous only under extreme assumptions (such as completely flexible jurisdiction boundaries).  But if communities are heterogeneous, the median voter may not pick the efficient level of local public services.