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.
Musgrave explains that public or social goods are “goods the benefits of which are available in a nonrival fashion, such that A's partaking does not interfere with B's”

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.
  Musgrave defines private goods as those where consumption by A is rival to B, while public goods provide nonrival benefits that cannot be effectively excluded from others

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.

Why can provision be public even if production is private?

Government may choose to outsource production to private firms to take advantage of efficiency, technology, or lower costs while still retaining responsibility for financing and ensuring universal access. This allows the state to benefit from private sector efficiency without giving up control. local governments often handle provision Local governments are closer to the people and can better identify community preferences. They can tailor public goods to local needs and improve satisfaction and efficiency.

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.

How does vertical summation differ from horizontal summation?

Horizontal summation is used for private goods: quantities are added at each price. Vertical summation is used for public goods: prices (willingness to pay) are added at each quantity.

What does the vertical demand curve show?

Google the diagram, It shows society's total marginal benefit from each level of the public good. Comparing this with marginal cost determines whether more or less of the public good should be produced.

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.

What is a private 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.

What is a social cost?

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.

What is a private benefit?

Private benefit refers to the direct benefit enjoyed by an individual consumer or producer. It reflects personal satisfaction or profit and is the basis for private decision-making.

What is a social benefit?

Social benefit equals private benefit + external benefit. It includes spillover gains to society, such as herd immunity or technological innovation. When social benefit exceeds private benefit, markets under-produce the good.