Demand, Supply and Market Equilibrium

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

CHAPTER 4

Public GoodsPublic Goods

4-2

Characteristics of Goods

Excludable v Nonexcludable Excludable – preventing anyone from consuming the

good is relatively easy Nonexcludable – preventing anyone from consuming the

good is either very expensive or impossible

Rival v Nonrival Rival – once provided, the additional resource cost of

another person consuming the good is positive Nonrival – once provided, the additional resource cost of

another person consuming the good is zero

4-3

Types of Goods

EXCLUDABLE

RIVALYES NO

YES

NO

PRIVATE

GOODS

PUBLIC

GOODS

COMMON

RESOURCES

NATURALMONOPOLY

4-4

Noteworthy Aspects of Public Goods

Even though everyone consumes the same quantity of the good, it need not be valued equally by all

Examples?

4-5

Noteworthy Aspects of Public Goods

Classification as a public good is not absolute; it depends on market conditions and the state of technology

Consider a lighthouse – pure public good Jamming device preventing ships from obtaining the

lighthouse signal unless special receiver purchased (excludable)

A scenic view, as congestion rises, nonrivalness criterion no longer satisfied impure public good: is to some extent rival or

excludable

4-6

Noteworthy Aspects of Public Goods

A commodity can satisfy one part of the definition of a public good but not the other

Main roads in rush house: nonexcludability holds but consumption is rival. Everyone is trying to get ahead

Exclusion is possible if there are only a few access roads

4-7

Noteworthy Aspects of Public Goods

Some things that are not conventionally thought of as commodities have public good characteristics

Honesty – transactions costs Fairly distributed income Information dissemination

4-8

Noteworthy Aspects of Public Goods

Private goods are not necessarily provided exclusively by the private sector publicly provided private goods Medical services Housing

4-9

Noteworthy Aspects of Public Goods

Public provision of a good does not necessarily mean that it is also produced by the public sector

Government can contract out to private firms for the provision of certain public goods

Garbage collection Fire protection

4-10

Some Other Public Goods

Basic research Programs to fight poverty Uncongested nontoll roads Fireworks display

4-11

Efficient Provision of Private Goods

Horizontal summation for finding the market curve Price Adam

(DfA)

Eve (Df

A)Market (Df

A+E)$11 5 1 6

$9 7 3 10

$7 9 5 14

$5 11 7 18

$3 13 9 22

$1 15 11 26

4-12

0

1

2

3

4

5

6

7

8

9

10

11

12

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

DfA

DfE

DfA+E

Sf

$

Quantity of Pizza

4-13

Pareto Efficiency – Private Goods Case

MRSfa = Pf/Pa (from IC and Budget line) Set Pa = $1 MRSfa = Pf

Price of figs measures the rate at which Adam is willing to substitute figs for apples

DfA shows MRSfa for Adam

Adams demand curve for figs shows the maximum price per fig leaf that he would pay at each level of fig leaf consumption

DfE shows MRSfa for Eve

4-14

Pareto Efficiency – Private Goods Case

Supply (Sf) shows MRTfa

MRTfa = MCf/ MCa Let MCa =1, so MRTfa = MCf

Therefore in pure competition Pf = MCf (Pareto Efficient) Necessary condition for Pareto efficiency:

MRSfaAdam = MRSfa

Eve = MRTfa

4-15

Efficient Provision of Public Goods

Are fireworks a public good or private good? Nonrival? Nonexcludable?

Units of Fireworks

1 2 3 4

Adam (DrA) $300 $250 $200 $150

Eve (DfE) 250 200 150 100

Market(Df

A+E)$550 $450 $350 $250

4-16

Once again, prices are being interpreted in terms of MRS as Adam’s willingness to pay for rockets is his MRS

From production standpoint, price represents the MRT

4-17

The MB of the fourth unit is the sum of what Adam and Eve are willing to pay, which is $250

The MC of the fourth unit is the cost of the last unit

If the MB>MC then it should be produced “Provision of public goods should be

expanded until the point at which the sum of each person’s marginal valuation of the last unit just equals the MC”

4-18

Market Demand for Public Goods

Public goods must be consumed in equal amounts, no matter how differently Adam and Eve value each unit

Market demand is the sum of willingness to pay by each consumer for a given quantity

So, instead of horizontal summation, it is vertical summation

4-19

050100

150200250300350400

450500550600650

700750800

1 2 3 4

DrA

DrE

DrA+E

Sr

Quantity of Fireworks

$

4-20

Pareto Efficiency – Public Goods Case

MRSfa = Pf/Pa

Set Pa = $1 MRSfa = Pf

DfA shows MRSfa for Adam

DfE shows MRSfa for Eve

Sf shows MRTfa

Necessary condition for Pareto efficiency: MRSfa

Adam + MRSfaEve = MRTfa

4-21

Private Good: MRS (Adam)= MRS(Eve) = MRT Public Good MRS (Adam) + MRS(Eve) = MRT Since everyone consumes the same amount of

public good, its efficient provision requires that the total valuation they place on the last unit provided (sum of MRS) equal the incremental cost to society of providing it (MRT)

4-22

Problems Achieving Efficiency

No incentive to lie about how much you value a private good!

The Free-Rider Problem

Someone who lets other people pay while enjoying the benefits himself

Excludable consumption, but nonrival

Eg. Fireworks display cannot be seen w/o purchasing a ticket. Anyone willing to pay more than 0 can buy ticket. What should you charge?

4-23

Solutions to the free-rider problem Perfect price discrimination

A nonrival excludable commodity can be provided privately in case of perfect information

Policy Perspective: Global Positioning System (US military initially did not want civilians to benefit from GPS)

Do people free ride?

4-24

Laboratory Experiments and Free-Riding

How a typical experiment works Typical results

People contribute about 50% of resources to provision of public good

Contributions fall the more often the game is repeated Cooperation fostered by prior communication Contribution rates decline when opportunity cost of

giving goes up

“Warm-glow” feeling of satisfaction from giving giving

4-25

The Privatization Debate

Privatization – taking services supplied by government and turning them over to the private sector

Public v Private Provision: What is the right mix? Relative wage and materials costs Administrative costs Diversity of tastes

4-26

Public versus Private Production

Efficiency of private production Problems in comparing cost differences Incomplete Contracts Competition to supply good or service Reputation building Policy Perspective: Should airport security be

produced publicly or privately? Market Environment

4-27

Distributional Issues

Commodity egalitarianism – notion that some commodities ought to be made available to everyone

4-28

Appendix: Preference Revelation Mechanisms

∆TEve = MRTra – (MRSraTotal – MRSra

Eve)

Eve’s choice: ∆TEve = MRSraEve

By substitution: MRTra – (MRSra

Total – MRSraEve) = MRSra

Eve

Add (MRSraTotal – MRSra

Eve) to both sides:

MRTra = MRSraTotal