Public Goods and Externalities Notes

Public Goods

• Externalities: Costs and benefits that affect third parties not involved in a transaction.
  • Positive Externality: Creates benefits for non-participating third parties; externalities can cause problems.

The Role of Government

• Why does the government provide certain goods/services like law enforcement, national defense, and public schools?
• Why not let private firms produce everything based on demand?

Public Choices

• A public choice is a decision made by elected or appointed officials in the public sector with consequences for many people or an entire society.
• Examples include decisions about government spending, taxes, subsidies, transfer payments, regulations, and international trade.

Types of Goods

• Private Goods: Individuals weigh costs and benefits; resources are used efficiently.
• Public Goods: Everyone benefits, but no one has an incentive to pay.
• Common Resources: No one owns them, so no one has an incentive to conserve.

Classifying Goods

• Goods and services can be classified based on two characteristics:
  • Excludable: Whether it's possible to prevent someone from enjoying the benefits if they don't pay.
  • Rival: Whether one person's use diminishes the quantity available for others.

Excludability

• Excludable Good: Requires payment to enjoy the benefits (e.g., sandwich, Uber ride).
• Non-Excludable Good: Impossible (or extremely costly) to prevent someone from benefiting, even without payment (e.g., police services, lobsters in the ocean).

Rivalry

• Rival Good: One person's use reduces the quantity available for others (e.g., a seat on a bus, a slice of pizza).
• Non-Rival Good: One person's use does not decrease the quantity available for others (e.g., police, concert in the park).

Goods Classification Matrix

• Private Good: Rival and excludable (e.g., loaf of bread, coffee).
• Public Good: Non-rival and non-excludable (e.g., national defense).
• Common Resource: Rival and non-excludable (e.g., fish in the ocean).

Classification Table

Situations Requiring Public Choices

• Public Goods: Underproduction
• Common Resources: Overuse
• Natural Monopoly: Monopoly Prices

Public Goods as a Positive Externality

• Public goods are a positive externality because two parties engage in a transaction, but others benefit without paying.

The Free-Rider Problem

• A free rider enjoys the benefits of a good/service without paying.
• Since no one can be excluded from a public good's benefits, no one has an incentive to pay.

Value of Public Goods

• The value of a private good is the maximum amount a person is willing to pay for one more unit.
• The value of a public good is the maximum amount all people are willing to pay for one more unit.

Marginal Social Benefit (MSB) of Public Goods

• The marginal benefit of a public good is the vertical sum of the marginal benefits of all individuals at each quantity.
• MSB = \sum MB_i

Efficient Quantity of a Public Good

• Efficient quantity occurs where Marginal Social Benefit (MSB) equals Marginal Social Cost (MSC). However, private production results in less or zero production.
• Q_e: MSB = MSC

Inefficient Equilibrium

• Private Production with Inefficient Equilibrium
• Quantity QPP
• Price Ppp/Cpp
• There will be Deadweight Loss

Insufficient Private Provisioning

• If a private firm tried to sell a public good (e.g., defense), almost no one would buy it due to the free-rider problem.
• Too little of the good is produced by a private firm.

Government Provisioning

• The government can tax everyone to provide the public good, overcoming the free-rider problem.

Voting and Efficient Outcomes

• If two political parties compete, each will propose an efficient quantity of a public good.
• A party proposing too much or too little loses to the one proposing the efficient amount.

Limits of Government Action

• Government action should be limited to situations with widespread agreement on the need for intervention.

Inefficient Public Overprovisioning

• Bureaucrats: Benefit from Overproduction
  • Bureaucrats maximize their department’s budget, size, and power, leading them to produce more than necessary or efficient.
• Special Interests: Benefit from Overproduction
  • Special interests benefit from spending on projects and influence voters/politicians to produce more than necessary.

Rational Ignorance

• Voters have a widely dispersed interest, making it rational to be ignorant about the costs, benefits, and details of public goods.
• Special interests have a concentrated interest, making it rational to be well-informed.
• The political equilibrium results in overproduction of a public good.
• Equilibrium: Overproduction: Qi
• Marginal Social Cost (MSC) > Marginal Social Benefit (MSB)
• Deadweight Loss

Eisenhower's Farewell Address

• Dwight D. Eisenhower (1952-1960) warned against the "military-industrial complex" and the potential for misplaced power.

Mixed Goods with External Benefits

• Mixed Goods: Have both private and external benefits (e.g., healthcare, education).
  • Private Benefits: Received by the consumer.
  • External Benefits: Received by someone else.

Market Underproduction

• The market underproduces a mixed good that generates external benefits.
• Government action is a solution:
  • Buyers pay the market price.
  • Taxpayers pay the balance of the marginal social cost.

Government Actions for Mixed Goods

• Financing the action, letting the private market produce.
• Producing the good, letting the private market finance.
• Financing and producing the good or service.

Examples:

• Financing: Solar Power, Electric Cars, School Vouchers
• Public Production: Amtrak, USPS
• Financing & Production: National Defense, K-12 Schools

Efficiency Considerations

• Nonrival and nonexcludable goods/services may be public goods, BUT not all goods/services with external benefits should be produced by the government.
• Is the private market producing the good/service?
• Is there a widespread consensus that the government should produce the good/service?
• Public Provisioning of goods and services is inefficient.
• How much should be produced?
• How do you discourage bureaucratic waste and abuse?
• How can you stop special interests from creating overproduction?

Public Goods Summary

• Non-rival and non-excludable goods can result in under provisioning in the private market due to the Free Rider Problem.
• Solution: Tax everyone who benefits and produce a higher output.
• Government can:
  • Finance (tax) & produce the good. ISSUE: Government Over Provisioning.
  • Finance (tax) to pay private market to provision (mixed goods). ISSUE: Government Inefficiency.