Lecture 4 - Public Goods and Market Failure

Public Goods vs. Private Goods
Public Goods:

• Non-Rival Consumption: One person's use of a public good does not limit another's ability to use it. This means that the consumption of the good by one individual does not diminish the availability of that good for others.

  • Example: National defense is a classic example. When a country invests in national defense, the security it provides does not prevent others from also benefiting from that security.

• Non-Excludability: It is not feasible to exclude individuals from accessing the benefits of a public good without incurring high costs.

  • Example: Street lighting serves everyone in an area. Once installed, it is not possible to prevent individuals from benefiting from the light it provides without significant expenditure, such as cutting off the light or erecting barriers, which is impractical.

Private Goods:

• Rival Consumption: One person's consumption reduces the quantity available for others. This means that if one individual consumes a unit of the good, that unit is no longer available for another individual to consume.

  • Example: An iPhone is a private good because if one person buys it, that specific device is not available for someone else.

• Excludability: Access to private goods can be restricted to those who pay for them. Because of this, producers can ensure that they receive compensation for their goods.

Problems Related to Public Goods

• Free Rider Problem: Individuals often avoid contributing to the provision of public goods because they know they can benefit from them without having to pay.

  • Impact: This leads to an undersupply of public goods as individuals think, "If the good is going to be provided anyway, why should I pay?" As a result, the incentive to contribute diminishes, leading to fewer resources allocated to the public good's provision.

Market Failure and Public Provision

• Market Failure: This occurs when markets fail to efficiently provide public goods, necessitating public measures to intervene and ensure these goods are available. Market failures can arise due to the free rider problem and the inability of private markets to sustain the production of goods that offer collective benefits.

• When Pricing is Possible: In circumstances where non-rival goods can be priced, it may result in underconsumption as individuals may not see the value of paying for something they can use freely.

• When Pricing is Not Possible: Because of non-exclusion, public goods often experience undersupply, leading to significant free-rider issues which result in public goods rarely being adequately provided by traditional market mechanisms.

Methods of Rationing Public Goods

1. User Charges

   • Advantages: This method allows those who benefit directly from the good to pay for it, thereby aligning costs with consumption.

   • Disadvantages: It can lead to underconsumption, particularly if charges are perceived as too high, and it might introduce transaction costs that can make it cumbersome to implement.

2. Uniform Provision

   • Advantages: This strategy reduces transaction costs associated with the allocation of public goods since the same service is provided uniformly to all users.

   • Disadvantages: Uniform provision can result in some individuals underconsuming while others may overconsume based solely on the equality of access.

3. Queuing

   • Advantages: This method does not prioritize access based on wealth, which can create a more equitable system for distributing public goods.

   • Disadvantages: It may allocate resources to those who can afford the time to wait rather than to those who are in immediate need.

Conditions for Efficient Provision of Public Goods

• Optimal Supply Level: Pure public goods are efficiently supplied when the marginal social benefit equals the marginal social cost.

  • Additionally, efficiency can be achieved when the cumulative marginal rates of substitution for all individuals equate to the marginal rate of transformation from private goods into public goods. This requires careful consideration of societal preferences in allocation.

Calculation Example for Efficiency
Given demand functions:
p1 = 10 - \frac{1}{10}G p2 = 20 - \frac{1}{10}G

• Optimal Public Good Level with Marginal Cost = $25:

  • To find the optimal level of public goods, sum the willingness to pay and set it equal to the marginal cost:
    p1 + p2 = 25

  • Result: G=25.

• Optimal Public Good Level with Marginal Cost = $5:

  • Result: G=125.

• Optimal Public Good Level with Marginal Cost = $40:

  • Result: G=0.

• Reporting Demand Functions:

  • Honesty in Reporting: The accuracy of reported demand can depend on the potential consequences of announcement.

  • If the government uses reported data to determine provision but individuals do not incur costs for their usage, they may understate the benefits to avoid future liabilities, leading to skewed resource allocation.

Collective Demand Functions

• Aggregate demand curves illustrate the total willingness to pay for public goods by all consumers in a given market, showcasing both the value and the quantity that individuals collectively seek from public goods.

Deadweight Loss from Undersupply

• The absence of adequate provision for public goods leads to a deadweight loss, which can be quantified by analyzing the discrepancy between what individuals are willing to pay versus the actual quantity available. This economic inefficiency illustrates the broader ramifications of underinvestment in public goods.

Conclusion

• Understanding public goods, their efficient calculation, and the implications of market failures in their provision is critical for effective policy-making.

• It is advisable to delve deeper into related materials, especially those discussing externalities and market behavior, to enhance comprehension of these concepts and their real-world applications.