PE Unit 2- Rationale for government intervention

What is a public good?

A public good is a good whose benefits are available to all individuals simultaneously, without reducing the amount available to others. Public goods arise when consumption is nonrival (one person’s consumption does not reduce the availability for others) and often nonexcludable (it is difficult or impossible to prevent people from benefiting from the good). Examples include national defense, street lighting, weather forecasting, and environmental protection.

Pure public goods exhibit perfect nonrivalry and nonexcludability. Examples include:

• National defense

• Street lighting

• Air purification

• Weather forecasting services

How do public goods differ from private goods?

Public goods differ from private goods in their consumption characteristics:

• Private goods are rival and excludable—consumption by one person reduces the amount for others, and access can be restricted.

• Public goods are nonrival and often nonexcludable—everyone can consume the same quantity, and preventing access is difficult or undesirable.
  

What are the main characteristics of public goods?

Public goods possess two foundational characteristics: nonrivalry and nonexcludability.

• Nonrivalry means that consumption by one individual does not reduce the amount available for others. A streetlight illuminates the road whether one or many people pass under it.

• Nonexcludability means individuals cannot be prevented from using the good, even if they do not pay for it.
  explicitly identifies nonrivalry as the defining feature of social goods and emphasizes that exclusion "cannot or should not be applied" to such goods, making market-based provision impossible

  Because of nonexcludability, individuals cannot be charged for their usage. This causes the free rider problem, where individuals hide their true preferences hoping others will pay.

  The free rider problem is a market failure where individuals benefit from a good or service without paying for it, because they cannot be excluded from the service

What is meant by the efficient allocation of public goods?

Efficient allocation of public goods refers to choosing a level of public good provision where society’s total marginal benefit equals the marginal cost of providing the good.

Because public goods are non rival and non excludable, their efficient allocation cannot be determined through market prices. Instead, efficiency requires aggregating individuals’ marginal valuations vertically and comparing them to the cost of supplying one more unit.

It explains that for social goods, the market cannot allocate resources efficiently; therefore, collective decision-making must be used to determine efficient levels of provision.

It also emphasizes the need for a separate efficiency rule because individual consumption is simultaneous and not priced by the market.

What is the Samuelson Condition for efficient public good allocation?

The Samuelson Condition states that a public good is provided efficiently when:

Sum of individual marginal benefits (MRS)=Marginal cost of provision (MC)

Because everyone consumes the same quantity of the public good, we add individual marginal willingness-to-pay vertically.
Musgrave uses the same principle, stating that the determination of output requires a “procedure for allocating resources” where individuals express preferences collectively to match benefits with costs

This condition contrasts with private goods, where each consumer chooses quantity independently.

How does the free rider problem affect efficient allocation?

The free rider problem prevents individuals from revealing their true willingness to pay for public goods.
Since everyone benefits regardless of contribution, people understate preferences to avoid paying, leading to underprovision.
Musgrave notes that individuals “will act as free riders” and not demand social goods voluntarily, causing the market mechanism to fail in determining efficient provision levels

What is the role of Pareto efficiency in public goods allocation?

Pareto efficiency requires making someone better off without worsening others’ welfare. For public goods, this requires balancing total social benefits and production costs. If the marginal social benefit exceeds marginal cost, the good is under-provided; if it is lower, the good is over-provided.

What is market failure?

Market failure occurs when markets fail to allocate resources efficiently, causing socially undesirable outcomes. This happens when private incentives do not align with social well-being. Public goods, externalities, lack of property rights, imperfect information, and monopolies are major causes.

causes of market failure

-Externalities arise when actions impose costs or benefits on third parties. Markets ignore these spillovers, leading to overproduction (negative externalities) or underproduction (positive externalities). Government intervention through taxes, subsidies, or regulation becomes necessary.

-Individuals understate their true valuation for public goods to reduce their tax burden. Because markets depend on truthful preferences to signal demand, insufficient information leads to inefficient outcomes. This necessitates collective decision-making mechanisms.

-Public goods violate the exclusion principle. Because people can consume benefits without paying, private firms cannot profitably supply them. This results in free-riding, under-provision, and inefficient allocation. Governments intervene to correct this failure through taxation and public provision.

how does public good lead to market failure?

1. the free rider problem- a free rider is someone who enjoys the benefit of a good without contributing to its cost.

2. private firms cannot profitably provide these goods as they cannot enforce payment the result is underproduction or no production of the goods by private markets.

3. efficiency condition not met- for efficient provision, the sum of individuals marginal benefits must equal the MC of providing the public good. In reality this is hard to achieve due to strategic behaviour and misreporting. sum of all individual’s marginal benefit= marginal cost of provision.

how can the free rider problem be solved?

• true willingness to pay.

• free rider issue can be resolved by using taxes to fund public goods.

• determine provision voting especially for local public goods.

What is the difference between provision and production of public goods?

Provision refers to the decision-making, financing, and responsibility for supplying a public good.

Production refers to the actual creation or delivery of the good. Governments may finance a public good while private firms produce it, meaning provision and production need not be performed by the same entity.

Pure public goods vs Impure public goods (quasi goods)

Pure public goods are perfectly non-rivalrous (one person's use doesn't stop another's) and non-excludable (can't stop anyone from using), like national defense, while impure public goods fail at least one of these criteria, often introducing rivalry (congestion) or excludability (tolls, subscriptions) while retaining public benefits, like toll roads or parks with entry fees. Essentially, impure goods are a mix, sometimes called "quasi-public goods," blending private and public traits, unlike the strict ideal of pure public goods. 

Pure Public Goods

• Definition: Strictly non-rivalrous and non-excludable.

• Non-Rivalry: One person's consumption doesn't reduce availability for others (e.g., a lighthouse beam).

• Non-Excludability: Impossible or too costly to prevent non-payers from using it (e.g., clean air).

• Examples: National Defense, streetlights, tornado sirens. 

Impure Public Goods (Quasi-Public Goods)

• Definition: Partially meet public good criteria but have some rivalry or excludability.

• Rivalry: Can become rival when crowded (e.g., traffic on a highway, congestion in a park).

• Excludability: Access can often be restricted (e.g., toll roads, subscription TV channels, paid parks).

• Examples: Public parks (can get crowded), cable TV (excludable by subscription), toll bridges/roads (excludable by toll, rival during congestion). 

Key Difference

• Purity: Pure goods perfectly embody both public characteristics; impure goods compromise one or both to some degree, making them more like private

What is Lindahl pricing?

Lindahl pricing is a method where each individual pays a price equal to their marginal benefit from the public good. Everyone pays different tax shares but receives the same quantity. When individual contributions equal production cost, the public good is efficiently provided.

Why do individuals pay different prices for a public good?

Because everyone values the public good differently, efficiency requires that each person pays according to their own marginal willingness to pay. This ensures fairness and efficient allocation, although it is difficult to achieve in practice due to preference revelation issues.

What is a tax price?

A tax price is the amount of private goods an individual gives up (through taxes) to obtain one more unit of a public good. It represents the personal “price” of public goods in terms of sacrificed private consumption.

What is vertical summation? Why is vertical summation used for public goods?

Vertical summation is a method of adding individuals’ marginal willingness to pay at each quantity of a public good. Since everyone consumes the same amount, we add valuations (prices), not quantities. This creates the total social demand curve. Public goods provide a common quantity to all individuals. To measure total benefit, we add the marginal benefits of all consumers at that same quantity level. This is crucial for determining the efficient level of provision.

merit goods vs private goods vs public goods

Private goods are rival (one person's use stops another's) and excludable (can charge for them, e.g., a burger); public goods are non-rival and non-excludable (e.g., national defense); while merit goods are socially desirable goods (like education/healthcare) that could be private but governments provide them due to market failure, aiming for broader consumption beyond just ability to pay, even though they're often excludable and rival. 

Here's a breakdown:

Private Goods (e.g., Food, Clothes)

• Rivalrous: If you eat a pizza, no one else can have that same slice.

• Excludable: The seller can prevent you from having the pizza if you don't pay.

• Market Provision: Typically provided efficiently by the private sector for profit. 

Public Goods (e.g., Streetlights, Lighthouses)

• Non-Rivalrous: One person using a streetlight doesn't diminish the light for others.

• Non-Excludable: Impossible to stop someone from benefiting from streetlights.

• Market Failure: Suffers from the "free-rider problem" (people use it without paying), so the government usually provides them, funded by taxes. 

Merit Goods (e.g., Education, Healthcare)

• Socially Desirable: Society deems them important for well-being (positive externalities).

• Under-consumed: People might under-consume them in a free market due to short-sightedness or cost.

• Excludable & Rival (Usually): A school seat or hospital bed can be restricted and used by only one person.

• Government Intervention: Provided or subsidized by the government (through vouchers, free services) to ensure access, even if you can't fully pay, to maximize societal benefit. 

ordinary vs compensated demand curve

The ordinary demand curve (Marshallian) shows total demand change with price, mixing both substitution and income effects, while the compensated demand curve (Hicksian) isolates just the substitution effect by adjusting income to keep utility constant, meaning it's always steeper (more elastic) than the ordinary curve for normal goods, showing only pure price impact. 

Ordinary Demand Curve (Marshallian)

• Definition: Shows how quantity demanded changes with price, reflecting both the substitution effect (relative price changes) and the income effect (purchasing power changes).

• Income Effect: Included; as price rises, real income falls, reducing demand (for normal goods).

• Elasticity: More elastic (flatter) than the compensated curve because it includes the income effect.

• Derived From: Maximizing utility given prices and wealth. 

Compensated Demand Curve (Hicksian)

• Definition: Shows how quantity demanded changes with price, only due to the substitution effect, by hypothetically adjusting income to keep the consumer at the same utility level (same indifference curve).

• Income Effect: Excluded; income is "compensated" to offset real income changes.

• Elasticity: Less elastic (steeper) than the ordinary curve because it removes the income effect.

• Derived From: Minimizing expenditure to achieve a constant utility level. 

Key Difference in Slopes

• For normal goods, the ordinary curve is flatter than the compensated curve.

• For inferior goods, the income effect works in the opposite direction, making the ordinary curve steeper or even upward-sloping (Giffen goods), while the compensated curve remains downward sloping. 

google diagram

What is an externality?

An externality exists when an economic activity imposes benefits or costs on others who are not directly involved in the transaction. Because markets do not account for these external effects, private decisions lead to inefficient outcomes.

Types of externalities

-Positive externalities occur when others enjoy benefits from someone’s actions, such as vaccination or education. Since private benefits are lower than social benefits, markets under-provide such goods. Governments may use subsidies to increase output to the optimal level.

-Negative externalities occur when actions impose costs on third parties, such as pollution. Private firms over-produce these goods because they do not bear the full cost. Governments correct this through taxes, fines, or regulation.

Positive externalities benefit third parties (e.g., vaccinations reducing spread), while negative externalities harm them (e.g., pollution from factories). The key difference is that positive ones create uncompensated social benefits, whereas negative ones create uncompensated social costs, leading to market inefficiencies where too little of beneficial activities and too much of harmful ones occur from society's viewpoint.

Positive Externalities (Benefits)

• Definition: An economic activity creates unintended benefits for people not involved in the transaction, who don't pay for them.

• Impact: Increases overall social welfare and efficiency, but the market produces less than the socially optimal amount.

• Examples:

  • Education: A more educated populace leads to innovation and lower crime, benefiting everyone.

  • Vaccinations: Protects the vaccinated individual and reduces disease transmission to others.

  • Home Gardening: Beautifies neighborhoods, potentially raising property values for neighbors.

Negative Externalities (Costs)

• Definition: An economic activity imposes unintended costs on third parties not part of the transaction, for which they aren't compensated.

• Impact: Decreases social welfare, leading to market failure where the market produces more than the socially optimal amount.

• Examples:

  • Pollution: A factory's emissions harm the health and environment of nearby residents.

  • Noise: A barking dog deprives neighbors of sleep.

  • Traffic Congestion: An extra car on the road slows down everyone else.

Summary Table

Feature	Positive Externality	Negative Externality
Effect	Unintended benefits	Unintended costs/harms
Third Party	Receives benefits	Bears costs
Market Outcome	Underproduction (too little)	Overproduction (too much)
Solution	Subsidies, government provision	Taxes, regulations (e.g., carbon tax)

GRAPH IN NOTEBOOK

Measures for externalities

GRAPH IN NOTEBOOK

1. Pigouvian Taxes and Subsidies (Corrective Taxes/Subsidies)

• Principle: Proposed by economist Arthur Pigou, the idea is to implement a tax on activities generating negative externalities and provide a subsidy for activities generating positive externalities.

• Negative Externality (Tax): A Pigouvian tax is set equal to the Marginal External Cost (MEC) at the socially optimal quantity. This shifts the private cost curve (MPC) up to the social cost curve (MSC), reducing production to the efficient level (QSocial).

  • Formula: Pigouvian Tax = MEC at Q Social

  • Examples: Carbon taxes, pollution taxes, and taxes on cigarettes/alcohol.

• Positive Externality (Subsidy): A Pigouvian subsidy is set equal to the Marginal External Benefit (MEB) at the socially optimal quantity. This shifts the private benefit curve MPB up to the social benefit curve MSB, increasing consumption/production to the efficient level.

  • Examples: Subsidies for education, public health (vaccines), and renewable energy.

2. Tradable Pollution Permits (Cap-and-Trade)

   • Principle: The government first sets a limit (cap) on the total amount of the negative externality (e.g., total CO2 emissions). It then issues permits to pollute up to that limit.

   • Mechanism: Firms are allowed to trade these permits. Firms with high pollution-reduction costs will buy permits, while firms with low reduction costs will sell permits and invest in cleaner technology.

   • Advantage: This system guarantees the target level of reduction is met (the cap) while ensuring that the reduction is achieved by the firms that can do so at the lowest cost, promoting cost-effectiveness and efficiency.

3. Command-and-Control Regulations (Direct Regulation)

   These measures directly regulate behavior by making certain activities either required or forbidden.

   • Emission Standards: Legally limiting the maximum amount of a pollutant a firm can discharge.

   • Technology Mandates: Requiring firms to install specific anti-pollution equipment or use particular production processes (e.g., catalytic converters on cars).

   • Outright Bans: Prohibiting the production or consumption of certain harmful goods or chemicals (e.g., banning DDT or certain industrial toxins).

   • Critique: Economists often criticize this approach because it is inflexible (applies the same standard to all, regardless of cost) and provides no incentive for firms to reduce the externality beyond the legal limit.

4. Private Solutions

In certain cases, the market failure can be resolved without government intervention through private negotiation or social mechanisms.

A. The Coase Theorem

• Statement: If property rights are clearly defined and transaction costs are zero (or very low), private parties can bargain and negotiate a mutually beneficial solution to the externality problem, leading to the socially efficient outcome, regardless of which party is initially granted the property rights.

• Example: A factory polluting a river and a fishing lodge. If the fishing lodge has the right to clean water, the factory will pay them to pollute (if the profit from polluting > damage to the lodge). If the factory has the right to pollute, the lodge will pay the factory to stop (if the damage to the lodge > cost to the factory of reducing pollution). In both cases, the efficient outcome (stop/continue polluting) is reached.

• Limitation: This theorem is rarely applicable to large-scale externalities (like global warming) due to high transaction costs and the free-rider problem when many people are involved.

B. Social Norms and Moral Codes

• Principle: Society encourages activities with positive externalities and discourages those with negative ones through social pressure and ethical frameworks.

• Examples: Encouraging recycling, discouraging littering, and voluntary charitable donations for public goods (like parks or community services).

private cost vs social cost

A private cost is the cost borne directly by an individual or firm involved in an activity, such as production expenses or personal consumption costs. Markets account only for private costs.

Social cost equals private cost + external cost. It includes all costs suffered by society, including pollution, congestion, or health hazards. When private cost is less than social cost, markets over-produce the good.

Utilitarian vs rawlsian social welfare functions

Utilitarian and Rawlsian social welfare functions (SWFs) offer different ways to judge societal well-being: Utilitarianism sums all individual utilities to maximize total happiness, ignoring distribution, while Rawlsian (or Maximin) focuses solely on the least advantaged person, maximizing their welfare, often leading to greater redistribution and equality. The core difference is utilitarianism's summation (total utility) versus Rawlsian's focus on the minimum (worst-off), stemming from Rawls's "veil of ignorance" principle. 

Utilitarian Social Welfare Function (SWF) 

• Goal: Maximize the total or average utility (happiness/satisfaction) across society.

• Method: Sums up all individuals' utilities:

  W=U1+U2+....

• Key Idea: Any gain in utility for one person can compensate for a loss for another, even if it increases inequality.

• Example: A policy that makes one person extremely rich and a thousand people slightly poorer might be considered good if the total happiness increase is large enough. 

Rawlsian Social Welfare Function (SWF) 

• Goal: Maximize the utility of the worst-off individual (the "maximin" principle).

• Method: The welfare of society is determined by the minimum utility level: W=min(U1,U2,...,Un)

• Key Idea: Derived from the "veil of ignorance," where you design society without knowing your own future position; you'd want to ensure even the worst off are protected.

• Example: Prioritizes policies that lift up the poor, even if it means sacrificing some potential overall societal gain, to reduce extreme hardship and inequality. 

Key Differences Summarized

• Focus: Utilitarianism = Total Welfare; Rawlsian = Worst-Off Welfare.

• Distribution: Utilitarianism indifferent to inequality; Rawlsian emphasizes equality/fairness for the vulnerable.

• Policy: Utilitarianism might favor growth; Rawlsian favors redistribution. 

What is product mix efficiency?

Product mix efficiency means producing the right combination of goods that consumers want, using resources optimally to meet demand and maximize overall welfare, balancing production costs (production efficiency) with consumer preferences (allocative/exchange efficiency). It ensures resources aren't wasted on unwanted products, leading to profitability, streamlined operations, and aligning the firm's output with market desires, often measured by shifting towards more profitable offerings. 

How it Works in Practice

• Balancing Offerings: A company creates a product mix that satisfies varied customer needs while using shared resources (like machinery, ingredients) efficiently, reducing costs.

• Resource Alignment: Instead of producing many low-demand items, resources are shifted to high-demand, high-profit products, improving financial returns and operations.

• Example: A bank expanding from traditional loans to new services (like securitization) shows a positive product mix effect, indicating profitable reallocation.

• Goal: Achieve Pareto efficiency, where no one can be made better off (more satisfied consumers) without making someone else worse off (higher costs or less product).