1. Copyright © 2002 by Thomson Learning, Inc. Chapter 4 Public Goods Copyright © 2002 Thomson Learning, Inc. Thomson Learning is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any meansgraphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systemswithout the written permission of the publisher. Printed in the United States of America ISBN 0-03-033652-X

2. Copyright © 2002 by Thomson Learning, Inc. Public Goods are goods for which exclusion is impossible. One example is National Defense: A military that defends its citizenry from invasion does so for the entire public. Public Goods

3. Copyright © 2002 by Thomson Learning, Inc. Characteristics of Public Goods Nonexclusion: The inability of a seller to prevent people from consuming a good when they do not pay for it. Nonrivalry: The characteristic that if one person consumes a good, another persons pleasure is not diminished nor is another person prevented from consuming it.

4. Copyright © 2002 by Thomson Learning, Inc. Pure Public Goods and Pure Private Goods Pure Public Good: There is no ability to exclude and there is no rivalry for the benefits. Pure Private Good: There is a clear ability to exclude and there is rivalry for the benefits.

5. Copyright © 2002 by Thomson Learning, Inc. Marginal Costs for Provision of Public Goods The marginal cost of allowing another person to benefit from a pure public good is zero while the marginal cost of a greater level of public good is positive.

6. Copyright © 2002 by Thomson Learning, Inc. Figure 4.1 Marginal Costs of Consuming and Producing a Pure Public Good-Figure A Cost (Dollars) Number of Consumers 0 200 Marginal Cost of Allowing an Additional Person to Consume a Given Quantity of Pure Public Good 1

7. Copyright © 2002 by Thomson Learning, Inc. Marginal Cost of Producing a Pure Public Good Figure 4.1 Marginal Costs of Consuming and Producing a Pure Public Good--Figure B Units of a Pure Public Good per Year Cost (Dollars) MC = AC 200 0

8. Copyright © 2002 by Thomson Learning, Inc. Example Bread versus Heat Bread – Clearly a pure private good because there is the ability to exclude and there is rivalry. Heat – Clearly a pure public good because there is no ability to exclude and there is no rivalry.

9. Copyright © 2002 by Thomson Learning, Inc. Price Excludable Public Goods vs Congestible Public Goods Provision of Private Good and Public Goods: Markets and Government

10. Copyright © 2002 by Thomson Learning, Inc. Price Excludable Public Goods Excludability but no rivalry Another type of good is a price- excludable public good: no rivalry but exclusion is easy. Examples: Country Clubs, Cable TV

11. Copyright © 2002 by Thomson Learning, Inc. Congestible Public Goods Rivalry but no excludability There are public goods where, after a point, the enjoyment received by the consumer is diminished by crowding or congestion. These are called Congestible Public Goods. Examples: roads and parks

12. Copyright © 2002 by Thomson Learning, Inc. Marginal Cost per User Figure 4.2 A Congestible Public Good Number of Consumers per Hour 01 Marginal Cost

13. Copyright © 2002 by Thomson Learning, Inc. Table 4.1a Alternate Means of Producing, Distributing, and Financing Goods and Services

14. Copyright © 2002 by Thomson Learning, Inc. Table 4.1b Alternate Means of Producing, Distributing, and Financing Goods and Services

15. Copyright © 2002 by Thomson Learning, Inc. A B C H Excludability Rivalry 0 1 1 Figure 4.3 Classifying Goods According to the Degree of Rivalry and Excludability of Benefits from Their Use

16. Copyright © 2002 by Thomson Learning, Inc. 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.

17. Copyright © 2002 by Thomson Learning, Inc. Price per Loaf of Bread (Dollars) Loaves of Bread Purchased per Week Figure 4.4 Demand For a Private Good 7 6 5 4 3 2 1 012345910687 E S = MC = AC D C = MB C D B = MB A D A = MB A D = Q D

18. Copyright © 2002 by Thomson Learning, Inc. Security Guards per Week Figure 4.5 Demand For A Pure Public Good Z 1 Z 2 Z 3 Z4Z4 100 200 300 400 500 600 700 800 Marginal Benefit (Dollars) 0 12345 D A = MB A D B = MB B D C = MB C D A = MB A

19. Copyright © 2002 by Thomson Learning, Inc. Figure 4.6 Efficient Output for a Pure Public Good Security Guards per Week E 100 200 300 400 500 600 700 800 Marginal Benefit (Dollars) 0 12345 MB A MB B MB C D A = MB A = MSB MC = AC = MSB

20. Copyright © 2002 by Thomson Learning, Inc. 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.

21. Copyright © 2002 by Thomson Learning, Inc. Mathematically Recall from Figure 4.5 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.

22. Copyright © 2002 by Thomson Learning, Inc. 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.

23. Copyright © 2002 by Thomson Learning, Inc. 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

24. Copyright © 2002 by Thomson Learning, Inc. 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.

25. Copyright © 2002 by Thomson Learning, Inc. Public Policy Perspective: Defense Purchases as a Percentage of GDP, 1966–1999 1966 11 10 9 8 7 6 5 197119761981198719991993 Year Percentage of GDP

26. Copyright © 2002 by Thomson Learning, Inc. 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.

27. Copyright © 2002 by Thomson Learning, Inc. 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.

28. Copyright © 2002 by Thomson Learning, Inc. Freeriding is easier with Anonymity: If everyone knows who contributes, there can be powerful social stigmas applied to shirkers. Large numbers of people: Its easier to determine the shirkers in a small group and the punishment is more profound when people close to you shun you.

29. Copyright © 2002 by Thomson Learning, Inc. 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.