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Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 1 of 28

Public Goods 7
7.1 Optimal Provision of Public Goods
7.2 Private Provision of Public Goods
7.3 Public Provision of Public Goods
7.4 Conclusion

PREPARED BY

Dan Sacks

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 2 of 28
CHAPTER 7 ■ PUBLIC GOODS
7
Public Goods: Trash Collection

Why don’t people pay to have their neighbor’s trash


collected?
• No one wants to pay, but everyone wants someone
else to pay.
• Private trash collection, financed by a voluntary fee
paid by neighborhood residents, faces the classic free
rider problem.
• Goods that suffer from this free rider problem are
known in economics as public goods.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 3 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.1
Public Goods: A taxonomy

• Pure public goods: Goods that are perfectly non-rival


in consumption and are non-excludable.
• Non-rival in consumption: One individual’s
consumption of a good does not affect another’s
opportunity to consume the good.
• Non-excludable: Individuals cannot deny each other
the opportunity to consume a good.
• Impure public goods: Goods that satisfy the two public
good conditions (non-rival in consumption and non-
excludable) to some extent, but not fully.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 4 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.1
Defining Pure and Impure Public Goods

Is the good rival in consumption?


Yes No
Yes Private good Impure public good
Is the good (ice cream) (Cable TV)
excludable?
No Impure public good Public good
(crowded sidewalk) (defense)

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 5 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.1
Optimal Provision of Public Goods

How much of the public good should society provide?


• Markets will not provide the correct amount.
• To answer this question, start by reconsidering the
market for a private good, ice cream cones.
• Ben and Jerry have different tastes for ice cream (ic),
relative to the other good (c). How does the market
aggregate their preferences?

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 6 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.1
Horizontal Summation in the Private Goods Market

• Ben and Jerry demand different quantities of the good


at each price.
• The optimality condition for the consumption of
private goods is written as:
𝐵
𝑀𝑈𝑖𝑐 𝐵 𝐽 𝑃𝑖𝑐
𝐵 = 𝑀𝑅𝑆𝑖𝑐,𝑐 = 𝑀𝑅𝑆 𝑖𝑐,𝑐 = 𝑃
𝑀𝑈𝑐 𝑐

• Equilibrium on the supply side requires 𝑀𝐶𝑖𝑐 = 𝑃𝑖𝑐 .


Therefore in equilibrium, 𝑀𝑅𝑆 = 𝑀𝐶.
• 𝑀𝐶, marginal cost of production, equals marginal
benefit, 𝑀𝑅𝑆 𝐵 or 𝑀𝑅𝑆 𝐽 .

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 7 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.1
Horizontal Summation in the Private Goods Market
Ben’s Marginal Jerry’s Marginal Market
Benefit Benefit
Price Price Price
of ice of ice of ice
cream cream cream
cone cone cone

S = SMC

$2 DB $2 DJ $2 E

DB&J = SMB

0 2 Quantity 0 1 Quantity 0 3 Quantity


of cones of cones of cones

• To find social demand curve, add quantity at each


price—sum horizontally.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 8 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.1
Optimal Provision of Public Goods

• With public goods, such as missiles (m), Ben’s


consumption doesn’t reduce Jerry’s.
• Therefore the social-efficiency maximizing quantity
solves
𝐵 + 𝑀𝑅𝑆 𝐽
𝑀𝑅𝑆𝑚,𝑐 𝑚,𝑐 = 𝑀𝐶

• Social efficiency is maximized when the marginal cost


is set equal to the sum of the MRSs, rather than being
set equal to each individual’s MRS.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 9 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.1
Vertical Summation in the Public Goods Market
Price of Ben’s marginal benefit
missiles
$2
1
DB
0 1 5 Quantity of missiles
Price of
missiles Jerry’s marginal benefit
$4

2
DJ
0 1 5 Quantity of missiles
Price of
missiles
$6
Social marginal benefit and cost
S = SMC

DB&J = SMB
0 1 5 Quantity of missiles
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 10 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.2
Private Provision of Public Goods: Private-Sector
Under-Provision

The market does not produce the efficient amount of


public goods, because of the free rider problem.
• Free rider problem: When an investment has a
personal cost but a common benefit, individuals will
underinvest.
• Since Ben’s consumption of missiles also benefits Jerry,
Jerry may not want to pay (or vice versa).

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 11 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.2
APPLICATION: The Free Rider Problem in Practice

The free rider problem is one of the most powerful


concepts in all of economics.
• Radio and television programming:
o WNYC has an estimated listening audience of
about 1 million people, but only 7.5% of their
listeners support the station.
o The United Kingdom uses a non-market solution:
The BBC charges an annual licensing fee to anyone
who owns and operates a TV!

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 12 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.2
APPLICATION: The Free Rider Problem in Practice

• File sharing:
o 85% of users of a file sharing program download
files only from others.
o The file-sharing software Kazaa gives download
priority to users according to their ratings, thus
discouraging free riders.
• Bicycle shares:
o Users were expected to return each bike riding.
o Within four days, not a single bicycle was left.
o Literal example of a “free ride.”

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 13 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.2
Can Private Providers Overcome the Free Rider
Problem?

• The free rider problem does not lead to a complete


absence of private provision of public goods.
• Plenty of private-sector TV programming
• The private sector can in some cases combat the free
rider problem to provide public goods by charging user
fees that are proportional to their valuation of the
public good.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 14 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.2
APPLICATION: Business Improvement Districts

Clean, safe sidewalks are public goods.


• Cities attempt to provide them through street repair
and police work, financed with tax revenue.
• But New York City’s Times Square in the 1980s was a
failure:
“Dirty, dangerous, decrepit, and increasingly derelict”
• In 1992, a group of private firms formed a “Business
Improvement District” to improve the area
themselves.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 15 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.2
APPLICATION: Business Improvement Districts

How did this BID work?


• A (BID) is a legal entity that privately provides local
services and funds these services with fees charged to
local businesses.
• How do BIDs overcome free rider problem?
• NYC law allows BIDs to levy fees on non-paying
members, as long as 60% of members contribute.
• Resounding success:
• Crime has dropped significantly.
• The area is cleaner and more attractive.
• Business and tourism are booming.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 16 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.2
APPLICATION: Business Improvement Districts

Resounding success:
• Crime has dropped significantly.
• The area is cleaner and more attractive.
• Business and tourism are booming.
• Success of BIDs depends on the legal underpinnings:
Can members charge fees to encourage payment?

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 17 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.2
When Is Private Provision Likely to Overcome
the Free Rider Problem?

Markets can (mostly) overcome the free rider problem


when some Individuals care more than others.
• Suppose Ben cares much more about fireworks than
Jerry.
• Then Ben will want to buy a lot of fireworks for himself
(𝑀𝑅𝑆 𝐵 = 𝑀𝐶𝑓 ).
• And the efficiency loss is not too great (𝑀𝑅𝑆 𝐵𝐸𝑁 ≈
𝑀𝑅𝑆 𝐵 + 𝑀𝑅𝑆 𝐽 ).

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 18 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.2
Altruism and social capital.

Private markets provide public goods when people are


altruistic.
• Altruistic: When individuals value the benefits and
costs to others in making their consumption choices.
• Many laboratory experiments provide evidence for
altruism and show that people contribute to public
goods.
• How altruistic people are is measured by social capital.
• Social capital: The value of altruistic and communal
behavior in society.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 19 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.2
Warm Glow

People might simply feel good about contributing to


public goods or charity.
• Warm glow model: A model of the public goods
provision in which individuals care about both the
total amount of the public good and their particular
contributions as well.
• Different from altruism because people don’t care
about just the amount of the public good.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 20 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.3
Public Provision of Public Goods

Despite private provision, there is a role for government


provision of public goods:
• Under private provision, not everyone contributes to
the good, even though everyone benefits.
• Government provision potentially solves the problem
of non-contributors.
• Nonetheless, there are several challenges to
government provision.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 21 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.3
Private Responses to Public Provision: The Problem
of Crowd-Out

• Crowd-out: As the government provides more of a


public good, the private sector will provide less.
• Warm glow: If people care about contributions per se,
they may continue to contribute even when the
government contributes.
• Evidence on crowd-out: Mixed.
o No evidence for full crowd-out
o No consensus on the size of this important
individual response to government intervention

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 22 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.3
EVIDENCE: Measuring Crowd-Out

The evidence on crowd-out is mixed.


• Kingman (1989) looked at how contributions varied as
local governments contributed different amounts to
public radio.
• The study found that $1 increase in government
funding for public radio, private contributions fell by
13.5¢.
• Bias: Areas with high government contribution could
be high income, or have a high taste for radio.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 23 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.3
EVIDENCE: Measuring Crowd-Out

Laboratory evidence seems more convincing.


• In another study, individuals tokens to a public good.
o A 2-token tax on every player was then contributed
to the public good.
o Without warm glow effects, players should have
reduced their contributions by 2 tokens.
o However, each player cut his or her contributions
by only 1.43 tokens.
• Unclear how well this result generalizes outside of the
lab, however.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 24 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.3
Measuring the Costs and Benefits of Public Goods

Optimal public good provision requires knowing the MRS


for each person. How to measure this?
• Consider the case of a highway. Cost include wages
and materials.
• What if, without this highway project, half of the
workers on the project would be unemployed?
• How can the government take into account that it
is not only paying wages but also providing a new
job opportunity for these workers?

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 25 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.3
Measuring the Costs and Benefits of Public Goods

The benefits of highway construction are also difficult to


measure.
• What is the value of the time saved for commuters
due to reduced traffic jams?
• And what is the value to society of the reduced
number of deaths if the highway is improved?

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 26 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.3
How Can We Measure Preferences for the Public
Good?

Three challenges in measuring preferences for public


goods.
1. Preference revelation: People may not want to reveal
their true valuation because the government might
charge them more for the good if they say that they
value it highly.
2. Preference knowledge: People may not know what
their valuation is.
3. Preference aggregation: How can the government
combine the preferences of millions of citizens?

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 27 of 28
CHAPTER 7 ■ PUBLIC GOODS
7.4
Conclusion

• A major function of governments at all levels is the


provision of public goods.
• Sometimes, the private sector can provide public
goods, but usually not the optimal amount.
• Government intervention can potentially increase
efficiency.
• Success of intervention depends on:
o Ability of government to measure costs and
benefits
o Ability to implement optimal plan

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