Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS 1 PUBLIC GOODS

Assoc. Prof. Y.Kuştepeli ECN 242 PUBLIC ECONOMICS 1

PUBLIC GOODS

ECN 242 PUBLIC ECONOMICS 2Assoc. Prof. Y.Kuştepeli

A pure public good is nonrival and nonexcludable in consumption; once the good is provided, the additional resource cost of another person consuming the good is zero.

A private good is rival in consumption.


Properties of public goods:

1. Though everyone consumes the same quantity of the good, this consumption need not be valued equally by all. People might differ over whether the value of certain public goods is positive or negative. Ex: national defense, security.

2. Classification as a public good depends on the market conditions and the state of technology. Ex: reading room in library, when crowded it’s a private good. It’s useful to think of publicness as a matter of degree. A pure public good satisfies the definition exactly. Consumption of an impure public good is to some extent rival or excludable.


3. The consumption of a good is nonexcludable when it is either very expensive or impossible to prevent anyone from consuming it who is not willing to pay for it.

Nonexcludability or nonrivalness do not have to go together. Just like nonrivalness, nonexcludability is not an absolute either. It depends on the state of technology and on legal arrangements. Ex: streets in rush hours, lighthouse.

4. A number of things that are not conventionally thought of as commodities have public good characteristics. Ex: income distribution is a public good. If income is distributed “fairly”, each person gains satisfaction from living in a good society, and no one can be excluded from having that satisfaction, ex, morality.


5. Private goods are not necessarily provided exclusively by the private sector. There are many publicly provided private goods, rival commodities that are provided by governments. Ex: medical services, education.

Public goods can be provided privately. The label “public” or “private” does not by itself tell us anything about which sector provides the item.

6. Public provision of a good does not necessarily mean that it is also produced by the public sector. Ex: Garbage collection.


Efficient provision of public goods:

Dm = D1 + D2 (horizontal summation)

At equilibrium (at point E) MRS1 = MRS2 =MRT

This is the necessary condition for Pareto efficiency. As long as the market is competitive and it functions properly, the fundamental theorem of welfare economics guarantees that this condition holds. This is the case with private goods.

Efficient provision of a public good requires that the sum of each person’s marginal valuation on the last unit just equal to the marginal cost. (MV=MC)


The public good must be consumed in equal amounts. To find the group willingness to pay for a public good, we add the prices that each would be willing to pay for a given quantity. For a public good the group willingness to pay is found by vertical summation of the individual demand curves.

With a private good everyone has the same MRS but people can consume different quantities. Therefore, demands are summed horizontally over the differing quantities. For public goods, everyone consumes the same quantity, but people may have different MRSs. Vertical summation is required to find the group willingness to pay.

From the production point of view, price still represents the MRT. So, equilibrium condition is: MRS1 + MRS2 = MRT

Because everybody must consume the same amount of the public good, its efficient provision requires the total valuation they place on the last unit provided (sum of MRSs) equal the incremental cost to society of providing it (-MRT)


Under a reasonably general set of conditions, a decentralized market system will provide private goods efficiently. When a private good is exchanged in a competitive market, an individual has no incentive to lie about how much he/she values it.

The efficient provision of public goods depends on the revealence of the peoples’ true preferences. People may have incentives to hide their true preferences. This incentive to let other people pay while you enjoy the benefits is known as the free rider problem.

The market may fall short of providing the efficient amount of the public good. No automatic tendency exists for markets to reach the efficient allocation. Even if consumption is excludable, market provision of a public good is likely to be inefficient.


The problem can be solved by perfect price discrimination; everyone who put positive value on the public good would attend an efficient outcome. However, two conditions must hold:

1) each person’s demand curve for the public good must be known. 2) it must be (is) difficult or impossible to transfer the good from one to another. If 1) holds, there would be no problem in determining the optimum provision in the first place.

The free rider problem necessarily leads to inefficient levels of nonexcludable public goods; therefore efficiency requires government provision of such goods. The government can somehow find out everyone’s true preferences, and then using its coercive power , force everybody to pay for public goods. If all this is possible, the government can avoid the free rider problem and ensure that public goods are optimally provided.


Privatization means taking services that are supplied by the government and turning them over the private sector for provision and/or production.

In some cases the service provided by publicly provided goods (ex: protection) can be obtained privately. Over time, the mix between public and private modes of provision has changed substantially.

There appears to be a trend back to the private sector for provision of what we have come to consider publicly provided goods and services.


What is the right mix of public and private provision?

If what ultimately matters to people is the level of output, the following criteria can be used to select the amount of each input:

1) Relative wage and materials cost: these costs may be different for public and private sectors.

2) Administrative cost: under public provision any fixed administrative cost can be spread over a large group of people

3) Diversity of tastes: to the extent that, such diversity is present, private provision is more efficient.

4) Distributional issues: the community’s notions of fairness may require that some commodities be made available to everybody. An idea sometimes referred as to commodity egalitarianism.


Public vs. Private production:

Even when it is agreed that certain items should be provided by the public sector, there is disagreement over whether they should be produced publicly or privately. Part of the controversy stems from fundamental differences regarding the extent to which government should intervene in the economy. Part is due to differences of opinions about the relative cost of public and private provision. Public sector managers have little incentive to monitor the activities of their enterprises carefully.

Opponents of privatization respond that the cost savings of private production are overstated. The quality of the service provided in two modes may be different, making the comparison difficult this brings us to the central argument of opponents of private production. Private contractors produce inferior products.


A possible response to this is the government can simply write a contract with the private provider, completely specifying the quality of the service government wants but this may be impossible in advance.

The market environment in which public or private enterprise operates is also important. Privately owned monopoly may produce very inefficient results from society’s standpoints, while a publicly owned operation that has a lot of competition may produce quite efficiently. Lack of effective competition is important.


National defense:

If any commodity is a candidate for public provision it is national defense. Its consumption is highly nonrival, it cannot be provided by the private market.

Many of capital goods demanded by military are routine but an important component of capital spending requires the use of advanced and specialized technologies. Often only a few firms are capable of producing a given kind of hardware. The costs associated with such production are likely to be uncertain.


Because there are only a few suppliers, the market for military hardware is not competitive. Several different types of contracts are possible:

1) A fixed price contract: stipulates the firm will complete the project in return for a fixed price. The firm bears all the consequences if costs are higher than expected. To the extent the firm is averse to risk, it will require a higher return as compensation for accepting all of this risk – a risk premium.

2) A cost plus contract: requires a fixed fee plus all additional costs incurred by the firm in completing the project. The firm bears no risk, but neither does it have any incentives to keep costs down. Hence, there is a well documented tendency for cost over-runs.

3) An incentive contract: lies between the extremes of fixed price and cost plus. The contracting firm receives a fixed fee plus some fraction of the costs of the project.


TC = F + λC TC: total costs; F: Fee; λ: share of production costs borne by gov.; C: cost of production. With fixed price, λ=0 With cost plus λ=1 As λ increases from 0 to 1, incentives to contain

costs decrease, so risk Premium embodied in F also falls.


This is a kind of principal-agent problem.

A principal government wants an agent (firm) to perform a task. The agent operates in an environment of uncertainty, so if the job is not well-done (if C is too high) the principal cannot know for sure if it is the agents fault. This problem is for the principal to structure the agents incentives so the principal’s expected net gain is as high as possible.

In this model solving the Principal-Agent (P-A) problem amounts to finding the cost minimizing value of λ.


λ* depends on how averse to risk the firm is (slope of F) and the rate at which costs fall as the firm has to bear a higher proportion of the costs (slope of λC)

An important issue not considered here is the firms innovative activity during the R&D phase of the Project. The gov. can pay a monetary award for each good idea of the firm to provide incentives for R&D.

One way to ensure maximal effort during R&D phase of Project may be to use a cost-plus contract during the production phase. This will create a price for innovation by guaranteeing that firms which produce ideas good enough to be adopted by the government will be rewarded with economic profits during production phase.


Education:

Why does the government involve itself so extensively in education, rather than leave its provision to the market?

Markets do not provide goods efficiently when those goods are public goods. They give rise to externalities or they are provided monopolistically. Education is primarily a private good improving students’ welfare by enhancing their ability to earn a living and to deal with life.

But there are public good characteristics of education as well. Schools can be a powerful force for socialization. Education provides an avenue for political indoctrination that makes citizens more accepting of their governments, thus contributing to political stability.


Welfare economics suggest that equity must also be considered, arguments can be made for public education. Because, access to education is an important source of social mobility, it is an important good to be made available to all citizens.

If education gives rise to public goods government may wish to subsidize it. 8 years of education are free & compulsory in many countries. This cannot be rationalized on efficiency grounds. What is so special about education?

What ever the rational, such a system does not necessarily induce everyone to consume more schooling than they would have in a private market.


The existence of public education leads to a large increase in the opportunity cost of private education reducing the consumption of education.

To the extent that the amount of the education offered through public schools can be supplemented by private lessons. It is less likely that public schooling would lead to reduction in the quantity of education consumed.

One cannot take for granted that the government provision of free education or any other good leads to an increase in its consumption.

Do higher expenditures lead to better education? This cannot be predicted by looking at data on their purchased inputs.

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Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS 1 PUBLIC GOODS