1. Chapter 3: Public Goods and Political Economy 3 - 1 Chapter 3 Public Goods and Political Economy Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. Chapter 3: Public Goods and Political Economy 3 - 2 Introduction Political economy The concept of a public good The behavior of the government

3. Chapter 3: Public Goods and Political Economy 3 - 3 The Concept of a Public Good Competitive markets generally work well, but there is a kind of good that markets cannot be expected to handle well: PUBLIC GOODS A public good has 2 properties: 2. Non-excludability 1. Non-rivalry 1. Rivalry A private good has 2 properties: 2. Excludability

4. Chapter 3: Public Goods and Political Economy 3 - 4 Non-excludability Non-Excludability, Free-Riders and Compulsory Taxation Free Rider Compulsory Taxation “I can’t be excluded from using the public good.” “So I don’t have to pay for that public good.” Solution?

5. Chapter 3: Public Goods and Political Economy 3 - 5 After the government raises the money for a public good through taxes, who should produce it? Who Should Produce a Public Good? Private Firms?Government? Both?

6. Chapter 3: Public Goods and Political Economy 3 - 6 3 families on an island The Island Wall – assumptions Should a defensive wall (a public good) be built to protect the island from pirates? Merchant ships sell private goods to the families Pirates sometimes raid the island

7. Chapter 3: Public Goods and Political Economy 3 - 7 The Island Wall – graph MB M MB L MB H Wall Thickness (ft) $900 - $800 - $700 - $600 - $500 - $400 - $300 - $200 - $100 - I I I I I I I 2 4 6 8 10 12 14 Figure 3.1 MC Individually, none of the families would build a wall on their own: MB < MC The MB curves are in a ratio of: 3:2:1

8. Chapter 3: Public Goods and Political Economy 3 - 8 The Island Wall – graph MB M MB L MB H Wall Thickness (ft) $900 - $800 - $700 - $600 - $500 - $400 - $300 - $200 - $100 - I I I I I I I 2 4 6 8 10 12 14 Figure 3.1 MC Summing their marginal benefits, this public good should be built.  MB > MC But how thick?  MB 10 feet thick is the socially optimal or efficient thickness of the wall!!

9. Chapter 3: Public Goods and Political Economy 3 - 9 At the efficient, socially optimal quantity of a public good,  MB = MC Efficiency At the efficient, socially optimal quantity of a private good, MB = MC

10. Chapter 3: Public Goods and Political Economy 3 - 10 How does a community collectively make decisions concerning a public good? Political Economy How do you choose the socially optimal quantity? Each family, individually, would not build the wall, but if they get together and collectively decide what to do, they would build the wall. So… how much will each family be willing to pay towards the construction of the wall?

11. Chapter 3: Public Goods and Political Economy 3 - 11 Cost-Share and Efficiency Unanimous choice of the efficient quantity of the public good depends upon: Cost-share is the price each family must pay per unit of the public good Cooperation Each family agreeing to cost-share in the same ratio as their MBs Each family being honest about their MB curves

12. Chapter 3: Public Goods and Political Economy 3 - 12 A Unanimity Rule Unanimity rule – all families agree in advance to build a certain thickness of a wall if all families support it. Pros All families enjoy a net benefit from the public good, and cost-share ratios will be equal to their MB ratios Cons A family may be dishonest about their MB and hold out for a lower cost-share, preventing the efficient outcome

13. Chapter 3: Public Goods and Political Economy 3 - 13 Majority Rule Voting and the Median Voter Majority rule voting – if two of the three families vote for a certain thickness of a wall, then that thickness will be built. Median voter – the family with the middle ranking or preference of wall thickness Outcome With majority voting, when cost-shares have been assigned, the outcome will be what the median voter prefers, but it may not be the efficient outcome

14. Chapter 3: Public Goods and Political Economy 3 - 14 Majority Rule Voting: Single and Double-Peaked Preferences D thin thick int. L thin int. thick ChoiceHM Firstthickint. Secondint.thin Thirdthinthick Table 3.1 H, M, and L vote between: H, M, and D vote between: Thick and Intermediate Intermediate and Thin Outcome: Thick and Thin Thick and Intermediate Intermediate Thin

15. Chapter 3: Public Goods and Political Economy 3 - 15 Majority Rule Voting: Single and Double-Peaked Preferences Wall thickness (ft)Thin Intermediate Thick Choice 1 st 2 nd 3 rd H D M, L Figure 3.2 Pair-wise voting can lead to cycling with no clear, stable outcome. Outcome

16. Chapter 3: Public Goods and Political Economy 3 - 16 Government and Optimal Taxation When there are many families, often a government is established. How do you tax to provide the efficient quantity of public goods? Proportional Taxation Regressive Taxation Progressive Taxation What about practical obstacles?

17. Chapter 3: Public Goods and Political Economy 3 - 17 The Behavior of Government Decisions about public goods are made by a legislature, not by citizens directly. Election between candidates DOVE and HAWK 0% 10% 20% 30% 40% Figure 3.3 Dovish VotersHawkish Voters

18. Chapter 3: Public Goods and Political Economy 3 - 18 Lobbying, Special Interests, Campaigns, Bureaucracies, and Corruption Lobbying Special interests Campaigns Bureaucracies The interaction between special interests and government bureaucracies creates prospects for corruption. Potential Issue Logrolling

19. Chapter 3: Public Goods and Political Economy 3 - 19 Public Choice, Government Failure, and Constitutions Public choice economists argue that these legislators need to be restrained by a...... constitution … government failure. Public choice school of economists believes that legislators, executives, and bureaucrats are biased towards expanding the government beyond what is best for the public and there may be a…

20. Chapter 3: Public Goods and Political Economy 3 - 20 Summary The concept of a public good The behavior of the government Political economy

21. Chapter 3: Public Goods and Political Economy 3 - 21 Preview of Chapter 4: Cost-Benefit Analysis Cost-benefit analysis Building a factory Benefits from improving the safety of a highway Mistakes to avoid Benefits from building a highway Reducing global warming Paying for a costly medical treatment Intervening militarily