Public Good Public Choice Public Finance course 8 th week 7-Apr-’06Qafqaz University, BakuInstructor: Elchin Rashidov

John L. Mikesell. Fiscal Administration 4/e Chapter 1: Fundamental Principles of Public Finance Material to read: Main textbook: Public Goods and Public Choice, uploaded to group website Supplementary material:

Why we need the government? Set common rules of behavior Set common rules of behavior Protect citizens from external threats Protect citizens from external threats Pool resources for the common good Pool resources for the common good Address and correct market failures Address and correct market failures 3 economic values: 3 economic values: stabilization and growth (prevention of unemployment, inflation…) stabilization and growth (prevention of unemployment, inflation…) distribution of wealth in the society distribution of wealth in the society allocation: provision of public/collective goods - private sector alone is not enough allocation: provision of public/collective goods - private sector alone is not enough

1. Non-exhaustion/non-rivalry: Once a good/service is provided for one consumer, the cost of supplying it to another is zero: Marginal cost = 0 2. Non-exclusion: Once a good is provided for one consumer all other consumers can use it — cost allocation is impossible. Private goods don’t have appropriability problems: additional product/service is an extra cost that will be charged by the seller; it is possible to separate payers from non-payers. Public goods: public fireworks, lighthouse, invention, software… In the real world there may be no such thing as an absolutely non-rival or non-excludable good. Appropriability: 2 market failures

Free rider: A consumer who uses a benefit of collective action in which he/she refuses to participate. Individuals have an incentive to “free-ride” with public goods; since they cannot be excluded from use of the good, they will let someone else purchase the good and will still receive benefits from it. Individuals have an incentive to “free-ride” with public goods; since they cannot be excluded from use of the good, they will let someone else purchase the good and will still receive benefits from it. Because of the “free-rider” problem, people are not willing to reveal their true demand for a public good, so there will be little/no market for these goods, and they will be underproduced. Because of the “free-rider” problem, people are not willing to reveal their true demand for a public good, so there will be little/no market for these goods, and they will be underproduced. Diner’s dilemma (tragedy of commons): individuals tend to consume less efficiently & more when the cost is shared – creates another problem for public good provision. free rider problem

Exhaustion / Rivalry Alternate Use Joint Use Private Goods Toll Goods ExclusionFeasible Food, clothing, TV Toll bridges, movies Common-Pool Resources Public Goods Not feasible Aquifers, fishing grounds National defense, system of justice, disease control National defense, system of justice, disease control The Elements of Nonappropriability Classic division of goods in economy

privatization 1. Transfer to private sector gov’t owned businesses with no significant market failure 2. Transfer to private sector gov’t owned businesses w/ natural monopoly power (telecommunications, electricity…) 3. Contracted out publicly financed services to private businesses

benefits of privatization Smaller govt. (philosophical matter) Smaller govt. (philosophical matter) Operating efficiency + client service: in contrast with the political-bureaucratic public sector, private sector is more concerned with cost-efficiency + customer demand as a matter of survival Operating efficiency + client service: in contrast with the political-bureaucratic public sector, private sector is more concerned with cost-efficiency + customer demand as a matter of survival Cash: sale of govt.-operated enterprises bring revenue, and the enterprise can be taxed in future Cash: sale of govt.-operated enterprises bring revenue, and the enterprise can be taxed in future

Govt. & private production & provision 1. Govt. provision – govt. production 2. Govt. provision – private production 3. Private provision – govt. production 4. Private provision – private production

Externality: Effect of market transaction imposed on a “third party” (neither producer nor consumer of the transaction good). Positive: Third party receives benefits from transaction (vaccinations)—Hidden benefits: undersupply of good. Negative: Third party incurs costs from transaction (factory pollution emissions)— Hidden costs: oversupply of good.

Criteria for undertaking govt. action Pareto: Is it possible to make at least one better-off without making someone worse-off? Pareto: Is it possible to make at least one better-off without making someone worse-off? Kaldor: Can the gainers compensate the losers? Kaldor: Can the gainers compensate the losers? Cost-benefit: Do benefits to society exceed costs? Cost-benefit: Do benefits to society exceed costs? Majority rule (democracy): Do more members of society benefit than lose? Majority rule (democracy): Do more members of society benefit than lose? Rawlsian fairness: Is the least well-off person as well-off as possible? Rawlsian fairness: Is the least well-off person as well-off as possible? Superfairness: Is each group prefers its own share? Is there an envy? Superfairness: Is each group prefers its own share? Is there an envy? Oligarchic (elite rule): Do those who control society benefit? Oligarchic (elite rule): Do those who control society benefit? Social justice (re-distributive): Do worse off members of society benefit? Social justice (re-distributive): Do worse off members of society benefit?

Public choice Building social decisions from individual preferences Building social decisions from individual preferences Easy when median voter principle is applicable Easy when median voter principle is applicable Difficult w/ independent irrelevant alternatives Difficult w/ independent irrelevant alternatives Voting paradox – when everyone’s preferences cannot be combined to generate a unique community choice Voting paradox – when everyone’s preferences cannot be combined to generate a unique community choice Arrow’s impossibility theorem –there is no general way to combine the individual preferences w/o running into some kind of irrationality or unfairness Arrow’s impossibility theorem –there is no general way to combine the individual preferences w/o running into some kind of irrationality or unfairness Government failure Government failure

Coase Theorem When parties can bargain w/o cost and to their mutual advantage, the resulting outcome will be efficient, regardless how the property rights are specified. 1. Property rights are well defined; 2. People act rationally 3. Transaction costs are minimal Only if all three of these apply will individual bargaining solve the problem of externalities.

Individual Individual Benefit Cost Share Individual Gain A 8,000 8,000 4,000 4,000 B 6,000 6,000 4,000 4,000 2,000 2,000 C 4,000 4,000 0 D 9,000 9,000 4,000 4,000 5,000 5,000 E 3,000 3,000 4,000 4,000 -1,000 -1,000 Total30,00020,000 Total benefit = $30,000; Total cost = $20,000 Total benefit exceeds total cost Individual cost (evenly distributed) is $4,000 ( $20,000/5 ) All individuals benefit from the project differently Three gains. One is tie. One loses.

Individual Individual Benefit Cost Share Individual Gain A 5,000 5,000 4,000 4,000 1,000 1,000 B 6,000 6,000 4,000 4,000 2,000 2,000 C 5,000 5,000 4,000 4,000 1,000 1,000 D 2,000 2,000 4,000 4,000 -2,000 -2,000 E 1,000 1,000 4,000 4,000 -3,000 -3,000 Total19,00020,000 Total benefit = $19,000; Total cost = $20,000 Total cost exceeds total benefit (Benefit = $19,000 Cost = $20,000) 3 benefit from the project. 2 lose. If everyone voted strictly on self interest, based on majority rule project would go forward, even though costs > benefits (democracy of 2 wolves & 1 sheep).

Individua l Individua l Benefit Cost Share Cost Share Individua l Gain Individual Share of Total Benefits Benefit-Based Cost Share A 3,000 3,000 2,500 2, % 15% 1,875 1,875 B 5,000 5,000 2,500 2,500 25% 25% 3,125 3,125 C 8,000 8,000 2,500 2,500 5,500 5,500 40% 40% 5,000 5,000 D 3,000 3,000 2,500 2, % 15% 1,875 1,875 E 1,000 1,000 2,500 2,500 -1,500 -1,500 5% 5% Total20,00012, % 100%12,500 Total benefit exceeds total cost (Benefit = $20,000 Cost = $12,500) 4 individuals gains from the project. 1 loses. Costs can be re-distributed proportional to benefits (i.e., one receiving x% of benefit, should pay x% of the cost). Then everyone gains.

For example, for Individual A: For example, for Individual A: 0.15 x 12,500 = 1,875