1. Microeconomics 1000
Lecture 7 Public Goods

2. Key points definition of public goods and common resources.
private markets fail to provide public goods.
some of the important public goods in our economy.
the cost–benefit analysis of public goods is both necessary and difficult.
people tend to use common resources too much.
some of the important common resources in our economy.

3. Market failures
A market economy delivers the efficient allocation of resources (invisible hand, I theorem of welfare economics)
However, efficiency is not guaranteed in the presence of
Market power
Externalities
Public goods
Asymmetric information

4. THE DIFFERENT KINDS OF GOODS
When thinking about the various goods in the economy, it is useful to group them according to two characteristics:
Is the good excludable?
Is the good rival?

5. THE DIFFERENT KINDS OF GOODS
Excludability
Excludability refers to the property of a good whereby a person can be prevented from using it.
Rivalry
Rivalry refers to the property of a good whereby one person’s use diminishes other people’s use.

6. THE DIFFERENT KINDS OF GOODS
Four Types of Goods
Private Goods
Public Goods
Common Resources

7. THE DIFFERENT KINDS OF GOODS
Private Goods
Are both excludable and rival.
Public Goods
Are neither excludable nor rival.
Common Resources
Are rival but not excludable.
What about excludable but not rival?
(encrypted TV channels, knowledge protected by intellectual property rights…)

8. Figure 1 Four Types of Goods
Rival?
Yes No
Private Goods •
Ice-cream cones
Clothing
Congested toll roads •
Fire protection
Cable TV
Uncongested toll roads
Yes
Excludable?
Common Resources
Public Goods •
Fish in the ocean
The environment
Congested nontoll roads •
Lighthouses
National defence
Uncongested nontoll roads No
Copyright © South-Western

9. Mixed cases
Some goods are subject to congestion effects: they are not rival when consumption is low, but become rival when it is high
Examples
Toll roads
Swimming pools

10. Some Important Public Goods
Knowledge
National Defense
TV and radio programs (not encrypted)
A public good is not a good provided by the government
Privately provided public goods
Publicly provided private goods

11. Market failure
To see why there is a market failure in the presence of public goods, consider a simple example
There are three agents, A, B and C
One indivisible good
Willingnesses to pay are: vA = 20, vB = 15 and vC = 12
c is the unit production cost

12. Example
If the good was private, the social value of the first unit would be 20, that of the second unit 15, and the social value of the third unit would be 12
Thus, if c = 14 two units of the good should be produced, if c = 25 none
But when the good is public, the social value of the first unit is =47 (that of the subsequent units is zero)

13. Example Suppose the good is public and c = 25
The good should be produced
What happens in a market economy?
Would a profit maximizing firm supply the good? No, because it cannot sell it at a positive price (the good is not excludable)
Would one of the agents supply the good? No, because the private value is at most 20, which is lower than the cost (and the other agents cannot be excluded)

14. Market failure
We conclude that in the presence of public good the market will not guarantee that the good is provided, even when it would be efficient that the good is provided
More generally, the provision of public goods in a market economy tends to be inefficiently low

15. Public goods and externalities
One way of looking at the problem is as follows: when one of the agents (say A) supplies the good, because the good is not excludable, he is exerting a positive externality on the others
That is, the private provision of public goods is a special case of externalities

16. Coase-type solution
Viewed from this perspective, it appears that the problem of public goods might be addressed as the problem of externality
The Coase theorem suggests that bargaining between the parties can be a solution to the problem of public goods
In our previous example, the three agents would bargain and agree to have the good produced and to somehow share the burden among them

17. Transaction costs
But we know that the bargaining solution works only if transaction costs are small
In the case of public goods, transaction costs (a general term than encompasses any obstacle to finding an agreement among the parties) are large because of the problem of cost sharing
Since any group of two agents would have enough incentives to provide the good, each agent would like the other two to pay for the good

18. The free-rider problem
This is known as the problem of free-riding
A free-rider is a person who receives the benefit of a good but avoids paying for it.

19. The Free-Rider Problem
Since people cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it.
In many cases, the free-rider problem prevents private solutions to the problem of supplying public goods.

20. Government intervention
Solving the Free-Rider Problem
The government can decide to provide the public good if the total benefits exceed the costs.
The government can make everyone better off by providing the public good and paying for it with tax revenue.
Principle #7: Governments can sometimes improve market outcomes.

21. The Difficult Job of Cost-Benefit Analysis
Cost benefit analysis refers to a study that compares the costs and benefits to society of providing a public good.
In order to decide whether to provide a public good or not, the total benefits of all those who use the good must be compared to the costs of providing and maintaining the public good.

22. The Difficult Job of Cost-Benefit Analysis
A cost-benefit analysis would be used to estimate the total costs and benefits of the project to society as a whole.
It is difficult to do because of the absence of prices needed to estimate social benefits and resource costs.
If people share the burden of public good provision according to the benefit that each one obtains, each agent has an incentive to misreport his/her true valuation of the public good.
Private information/asymmetry of information

23. Making public good excludable
In some cases, it is possible to address the problem of the underprovision of public goods by making the public good excludable
Examples:
Intellectual property rights
Encrypted TV programs

24. Intellectual property rights
Nobel Prize winner Kenneth Arrow argues that knowledge is a public good:
It is non rival (everybody can learn and use, say, Pytagora’s theorem)
It tends to be not excludable (however, knowledge can be kept secret)
However, IPRs make innovative knowledge excludable

25. IPRs
Cover artistic work (copyrights) and technological knowledge (patents), not basic research
Are typically temporary (patent life is 20 years in most countries, the term of copyrights is often 70 years after the death of the author)
Create a temporary monopoly over the commercial exploitation of the knowledge

26. Patents Normally IPRs are alternative to secrecy
For example, in order to get a patent the inventor has to disclose the innovative knowledge
Other patentability requirements
Novelty
Non-obviousness (inventive step)
Utility

27. COMMON RESOURCES
Common resources, like public goods, are not excludable. They are available free of charge to anyone who wishes to use them.
Common resources are rival goods because one person’s use of the common resource reduces other people’s use.

28. Tragedy of the Commons
The Tragedy of the Commons is a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole.
Common resources tend to be used excessively when individuals are not charged for their usage.
This is similar to a negative externality.

29. Some Important Common Resources
Commons (shared areas of land)
Congested roads
Fish

30. Ways out
Use prices
Property rights

31. THE IMPORTANCE OF PROPERTY RIGHTS
Property rights are the recognition and defense of a person right to own things.
The market fails to allocate resources efficiently when property rights are not well-established (i.e. some item of value does not have an owner with the legal authority to control it).

32. Tragedy of the Anti-Commons
The Tragedy of the Anti-Commons is another parable that illustrates why resources get used less than is desirable from the standpoint of society as a whole due to the existence of many property right holders.

33. Tragedy of Anti-commenos
Heller (1998) noted that after the fall of Communism, in many Russian cities cities there were a lot of open air kiosks, but also a lot of empty stores.
He argued that after privatisation many different parties had rights over the use of store space, so it was difficult for a retailer to negotiate successfully.
Similar to a negative externality.

34. Summary
Goods differ in whether they are excludable and whether they are rival.
A good is excludable if it is possible to prevent someone from using it.
A good is rival if one person’s enjoyment of the good prevents other people from enjoying the same unit of the good.

35. Summary Public goods are neither rival nor excludable.
Because people are not charged for their use of public goods, they have an incentive to free ride when the good is provided privately.
Governments may provide public goods, making quantity decisions based upon cost-benefit analysis.

36. Summary Common resources are rival but not excludable.
Because people are not charged for their use of common resources, they tend to use them excessively.