1. successfully Chapter 17: Public Goods and Common Resources. Two situations where the private market alone will not provide a good solution. So what do we do?

2. 17 Public Goods and Common Resources

3. After studying this chapter you will be able to  Distinguish between:  private goods  public goods  and common resources  Explore the free-rider problem and other problems that arise when a good or service has “public good” properties.  Explore the link between the tragedy of the commons and its possible solutions Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

4. RE: Public Goods: Why don’t we let private firms produce weather forecasting, national defence, or police services and sell their products in the market? RE: Access to Common Goods What can be done to prevent the extinction of fish species in the Atlantic Ocean resulting from overfishing? These are the two big questions explored in this chapter. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

5. What Is a Public Good? What is the essential difference between:  A city police department and Brink’s security?  Fish in the Atlantic Ocean and fish in a fish farm?  A live concert and a concert on television? All goods and services can be classified according to whether they are excludable or nonexcludable and rival or nonrival. Classifying Goods and Resources Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

6. Excludable: A good is excludable if only the people who pay for it are able to enjoy (or control) its benefits. Examples: Brink’s security services, Aquaculture’s Farm fish, and a Coldplay concert. Nonexcludable: A good is nonexcludable if it is impossible (or extremely costly) to prevent anyone from benefiting from it. Examples: The services of the police, fish in the Pacific Ocean, and a concert on network television are examples. Classifying Goods and Resources Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

7. Rival: A good is rival if one person’s use of it decreases the quantity available for someone else. Example: A Brink’s truck can’t deliver cash to two banks at the same time. A fish can be consumed only once. Nonrival: A good is nonrival if one person’s use of it does not decrease the quantity available for someone else. Example: The services of the police and a concert on network television are nonrival. Classifying Goods and Resources Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

8. A Four-Fold Classification Private Goods: A private good is both rival and excludable. Example: A can of Soda Water and a fish on Aquaculture’s Farm are private goods. Public goods: A public good is both nonrival and nonexcludable. A public good can be consumed simultaneously by everyone, and no one can be excluded from its benefits. Example: National defence is an example of a public good. Classifying Goods and Resources Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

9. Common Resources: is rival and nonexcludable. A unit of a common resource can be used only once no one can be prevented from using what is available. Example: Ocean fish are a common resource. They are rival because a fish taken by one person isn’t available for anyone else. They are nonexcludable because it is difficult to prevent people from catching them. (Somalia, Ghana) Classifying Goods and Resources Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

10. Natural Monopoly Goods: excludable and nonrival or rival A special case of natural monopoly arises when the good or service can be produced at zero marginal cost. (Economies of Scale mean one producer) If such a good is also excludable, whether it is rival or nonrival, it is produced by a natural monopoly. The Internet and cable television are examples, because the technology allows excludability. One pays for access, and in some cases, bandwidth and traffic. Classifying Goods and Resources Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

11. Figure 17.1 shows this four-fold classification of goods and services. Classifying Goods and Resources Copyright © 2013 Pearson Canada Inc., Toronto, Ontario Technology and regulations will determine The market structure for Excludable goods Access for use Benefits

12. The Free-Rider Problem A free rider enjoys the benefits of a good or service without paying for it. Because no one can be excluded from the benefits of a public good, everyone has an incentive to free ride. Public goods create a free-rider problem—the absence of an incentive for people to pay for what they consume. Also, since cost it consume is free (cost to produce is not) consumption will go beyond where Marg Benefit = Marg. Cost. (Dead weight loss here) Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

13. The value of a private good is the maximum amount that a person is willing to pay for one more unit of it. Private Good Market Demand is horizontal sum of individual demand curves. The value of a public good is the maximum amount that all the people are willing to pay for one more unit of it. Public Good “market demand” is the vertical sum of individual demand curves. To calculate the value placed on a public good, we use the concepts of total benefit and marginal benefit. Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

14. Marginal Social Benefit of a Public Good Marginal benefit is the increase in total benefit that results from a one-unit increase in the quantity of a good. The marginal benefit of a public good diminishes with the quantity of the good provided. (Principle of Diminishing Marginal Benefit) Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

15. Public Goods Figure 17.2 shows that the marginal social benefit of a public good is the sum of marginal benefits of everyone at each quantity of the good provided. Part (a) shows Lisa’s marginal benefit. Part (b) shows Max’s marginal benefit. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

16. Public Goods The economy’s marginal social benefit of a public good is the sum of the marginal benefits of all individuals at each quantity of the good provided. The economy’s marginal social benefit curve for a public good is the vertical sum of all individual marginal benefit curves. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

17. The Marginal Social Cost of a Public Good The marginal social cost of a public good is determined in the same way as that of a private good. The Efficient Quantity of a Public Good The efficient quantity of a public good is the quantity that at which marginal social benefit equals marginal social cost. Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

18. With more than 2 satellites, MSC exceeds MSB. Resources can be used more efficiently if fewer satellites are provided. So the quantity at which MSB = MSC, resources are used efficiently. Private production would produce 0 satellites. Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario Key here is that MSB is vertical sum of individual demand curves.

19. Inefficient Private Provision If a private firm tried to produce and sell a public good, almost no one would buy it. The free-rider problem results in too little of the good being produced in the context of a private market. Dead weigh loss from under production. Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

20. Efficient Public Provision Because the government can tax all the consumers of the public good and force everyone to pay for its provision, public provision overcomes the free-rider problem. If two political parties compete, each is driven to propose the efficient quantity of a public good. A party that proposes either too much or too little can be beaten by one that proposes the efficient amount because more people vote for an increase in net benefit…If voters are informed and rational (not always the case) Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

21. Public Goods Figure 17.4 illustrates the efficient political outcome. Two parties, Blues and Greens, agree on everything except the number of satellites. If Blues propose 1 satellite and Greens propose 3, voters are equally unhappy and the election is too close to call. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

22. If Blues increase the number of satellites to 2, it will win the election if Greens propose 3. If Greens decrease the number of satellites to 2, it will win the election if Blues propose 1. Both parties propose 2 satellites and each party gets 50 percent of the votes. Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario Hotelling Principle at work here. (explore vendors on a beach scenario)

23. Principle of Minimum Differentiation: Hotelling Principle The attempt by politicians to appeal to a majority of voters leads them to the same policies—an example of the principle of minimum differentiation. The principle of minimum differentiation is the tendency for competitors to make themselves similar so as to appeal to the maximum number of clients (voters). (The same principle applies to competing firms such as Tim Hortons and Starbucks). Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

24. Inefficient Public Overprovision If competition between two political parties is to deliver the efficient quantity of a public good, bureaucrats must cooperate and help achieve this outcome. Objective of Bureaucrats Bureaucrats want to maximize their department’s budget. A bigger budget increases their status and power. Bureaucrats might try to persuade politicians to provide more than the efficient quantity. Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

25. Rational Ignorance: The decision by a voter not to acquire information about a policy or provision of a public good, because the cost of doing so exceeds the expected benefit. For voters who consume but don’t produce a public good, it is rational to be ignorant about the costs and benefit. For voters who produce a public good, it is rational to be well informed, to maximize profits.. When the rationality of uninformed voters and special interest groups is taken into account, the political equilibrium results in overprovision of a public good because of the costs of organizing difuse opposition to over production. Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

26. Public Goods Figure 17.5 shows bureaucratic overprovision. If rationally ignorant voters enable the bureaucrats to achieve their goal of maximizing their budget, … public good might be overprovided and … and a deadweight loss created. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

27. Two Types of Political Equilibrium The two types of political equilibrium—efficient provision and inefficient overprovision of public goods correspond to two theories of government:  Social interest theory predicts that political equilibrium achieves efficiency because well-informed voters refuse to support inefficient policies.  Game theory and proportional representation  Public choice theory predicts that government delivers an inefficient allocation of resources—that government failure parallels market failure. Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

28. Why Government Is Large and Growing Among many, two possible reasons are  Voter preferences: Government grows because the voters’ demand for some public goods is income elastic.  Inefficient overprovision: Tendency toward “overprovision”. This might explain the size of government but not its growth rate, then again it might is growth is toward a set target size of government. Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

29. Voters and Interest Groups Lobby/Jockey for Position If government grows too large relative to the value voters place on public goods, there might be a voter backlash that leads politicians to propose smaller government. Privatization is one way of coping with overgrown government and is based on distinguishing between public provision and public production of public goods. Two core points here: First, there is no simple market solution to how much public good should be produced. Second, which ever side of the market (producers or consumers) is most organized will get the most benefits. Public Goods Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

30. Overgrazing the pastures around villages in Middle-age England and overfishing the cod stocks of the North Atlantic Ocean during the recent past are tragedies of the commons. The tragedy of the commons: the absence of incentives to prevent the overuse and depletion of a commonly owned resource. Examples include the Atlantic Ocean cod stocks, South Pacific whales, and the quality of the earth’s atmosphere. The traditional example from which the term derives is the common grazing land surrounding middle-age villages. Common Resources Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

31. Common Resources Sustainable Use of a Renewable Resource Renewable resource is one that replenishes itself by birth and growth of new members of the population. Sustainable catch is the quantity of fish that can be caught year after year without depleting the stock. If the stock is small, the quantity of new fish born is small, so the sustainable catch is small. If the stock is large, many fish are born but they must to complete for food … so only a small number survive to reproduce and grow large enough for fishers to catch. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

32. Figure 17.6 illustrates the sustainable catch. As the stock of fish increases, the sustainable catch increases. Beyond that number, more fish compete for food and the sustainable catch falls. If the catch exceeds the sustainable catch, the fish stock diminishes. (This is not illustrated with this figure.) Common Resources Copyright © 2013 Pearson Canada Inc., Toronto, Ontario The Curve is what nature will do, if left alone.

33. Common Resources The Overuse of a Common Resource Figure 17.7 shows why overfishing occurs. The supply is the marginal private cost curve, MC. The demand is the marginal social benefit curve, MSB. Market equilibrium occurs at 800,000 tonnes per year and $10 a kilogram. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario Since nobody owns the fish, there is no “cost” assigned to the fish themselves as an input into the production process

34. Common Resources The marginal social cost curve is MSC. The efficient quantity is 300,000 tonnes per year. At the market equilibrium, there is overfishing and a deadweight loss arises. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario MSC includes a cost for the fish, and the cost of sustaining the fish stocks.

35. Common Resources Achieving an Efficient Outcome An efficient outcome occurs MSB = MSC. This is harder to achieve than to define The three main methods used to approach the efficient use of a common resource are  Property rights  Production quotas  Individual transferable quotas (ITQs). Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

36. Common Resources Property Rights By converting the common resource to private property, fishers face the full social cost of their actions. The marginal social cost curve becomes the supply curve and the resource is used efficiently. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

37. Common Resources Production Quotas: Cod fisheries & Lobster Catch By setting a production quota at the efficient quantity, the resource might be used efficiently. Figure 17.9 shows the profit on the marginal tonne of fish. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario P > MC (15 > 5) so a fisher who cheats will increase his profit. There is an incentive to overfish.

38. Common Resources Quota Solutions raise the question of who gets the Quotas, and can they sell them. Individual Transferable Quotas (ITQ) An individual transferable quota (ITQ) is a production limit that is assigned to an individual who is free to transfer (sell) the quota to someone else. A market in ITQs emerges, and the market price of an ITQ confronts resource users with a marginal cost equal to MC + price of ITQ. Incentive for efficiency as well If the efficient quantity of ITQs is assigned, with MC + price of ITQ equal to MSB, the quantity produced is efficient. (Incentive to cheat is still present) Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

39. Common Resources Figure 17.10 shows the situation with an efficient number of ITQs. The market price of an ITQ increases the marginal social cost to MC + price of ITQ. Users of the resource make MSB equal MC + price of ITQ, and the outcome is efficient. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario