Public Finance (MPA405) Dr. Khurrum S. Mughal

Lecture 7: Public Goods Public Finance

Demand For a Pure Public Good Demand for a Pure Private Good is derived by adding quantities at each price. Demand for a Pure Public Good is derived by adding how much people will be willing to pay at each quantity. 3

Price per Loaf of Bread (Dollars) Loaves of Bread Purchased per Week Demand For a Private Good E S = MC = AC D C = MB C D B = MB A D A = MB A D =  Q D 4

Security Guards per Week Demand For A Pure Public Good Z 1 Z 2 Z 3 Z4Z Marginal Benefit (Dollars) D A = MB A D B = MB B D C = MB C D A =  MB A 5

Efficient Output of a Pure Public Good The socially optimal level of the public good requires that we set the Marginal Social Benefit of that good equal to its Marginal Social Cost. MSB = MSC   Lindahl Pricing: Everyone in a group cooperates and pays their marginal benefit.  We can demonstrate this issue mathematically, numerically (using a table), and graphically. 6

Mathematically Recall from Figure “Demand for Pure Public Goods” that the marginal social benefit for a pure public good is the sum of the individual marginal benefits. That is: MSB =  MB. Efficient output is therefore: MSB =  MB = MSC.

Numerically –Suppose we have three people who are discussing the issue of hiring security guards. Note that each person places a different value on the levels of security. 8

Number of Security Guards per Week 1234 MB A $300$250$200$150 MB B $250$200$150$100 MB C $200$150$100$50  MB $750$600$450$300 If the cost of security guards is $450 per week, then no individual will hire even one guard, even though to group one is worth $750. The group should hire three. If they pay their marginal benefit, then three guards are hired. Person A pays $600 ($200 per guard), person B pays $450 ($150 per guard) and person C pay $300 ($100 per guard). A Numerical Example 9

Efficient Output for a Pure Public Good Security Guards per Week E Marginal Benefit (Dollars) MB A MB B MB C D A =  MB A = MSB MC = AC = MSB 10

The Peace Dividend National Defense is the classic pure public good. Defense spending as a percentage of GDP –Fell from above 8 percent during the Vietnam era to just above 5 percent in the late 1970s; –Grew during the Reagan defense buildup of the 1980s; –Fell below 5 percent with the demise of the Soviet Union. 11

Public Policy Perspective: Defense Purchases as a Percentage of GDP, 1966– Year Percentage of GDP 12

Lindahl Equilibrium The amount each person contributes, t i, depends on their individual desires for the public good. The sum of the contributions equals the total cost of the public good. –  t i Q* = MC(Q*) = AC(Q*) –  t i = MC = AC All individuals agree to pay their share. 13

Freeriding –Freeriding occurs when people are not honest in stating their Marginal Benefit because if they understate it, they can get a slightly reduced level of the public good while paying nothing for it. 14

Freeriding is easier with Anonymity: If everyone knows who contributes, there can be powerful social stigmas applied to shirkers. Large numbers of people: It’s easier to determine the shirkers in a small group and the punishment is more profound when people close to you shun you. 15

Illustrating Voluntary Contributions to a Public Good: The Gulf War Under the premise that defeating Iraq in the Gulf War was a public good to be consumed by the industrialized economies and Arab nations, each nation was expected to contribute. The U.S. and UK contributed the bulk of the fighting forces. Saudi Arabia, Kuwait, the UAE, Japan, and Germany voluntarily paid $54 billion of the estimated $61 billion cost. 16