Principles of Microeconomics - Public Goods and Tax Policies

Public Goods and Tax Policies (Chapter 14)

The Government, Public Goods, and Tax Policies

• The government can increase efficiency by:
  • Regulating industries to overcome market failures (e.g., curbing negative externalities, monopolies).
  • Providing critical public goods and services (e.g., delineating and enforcing property rights, national defense).

Public Goods

• A public good is nonrival and nonexcludable.
  • Nonrival good: Consumption by one person does not diminish its availability to others.
  • Non-excludable good: Difficult or costly to exclude non-payers from consuming.
    • Examples: Fresh air, fireworks displays, street lighting, national defense.
  • A pure public good is, to a high degree, both nonrival and nonexcludable.

Goods Classification

• Classification of goods based on excludability and rivalry:
  • Rival and Excludable: Private Goods (e.g., ice cream).
  • Rival and Non-Excludable: Common Resources (e.g., tuna in the ocean).
  • Non-Rival and Excludable: Collective Goods (e.g., cable TV, Wi-Fi).
  • Non-Rival and Non-Excludable: Public Goods (e.g., national defense, asteroid deflection).

Market for Public Goods

• Public goods are not provided in sufficient quantities by the market due to:
  • The free-rider problem: Non-payers cannot easily be excluded from consuming.
    • Difficult for private firms to cover costs and make a profit.
• How much of a public good should be provided?
  • Cost-Benefit Principle: Provide it up to the point where Marginal Benefit (MB) equals Marginal Cost (MC) (difficult to implement).
    • Costs are calculated as for private goods.
    • Benefits are hard to estimate in practice.
  • Demand for Public Good differs from Demand for Private Good.

The Optimal Quantity of a Public Good

• The optimal quantity is where the demand curve (marginal benefit) intersects the marginal cost curve.

Private Good Demand

• Horizontal Summation of Individual Demand Curves
  • All buyers face the same price and each choose the quantity they want.
• Example:
  • Individual 1's demand (D1):
  • Individual 2's demand (D2):
  • Total Market Demand (D) = D1 + D2

Public Good Demand

• Vertical Summation of Individual Demand Curves
  • All buyers are provided with the same quantity, although they might value it differently.
• Example:
  • Individual 1's demand (D1):
  • Individual 2's demand (D2):
  • Total Market Demand (D) = D1 + D2

Who Provides Public Goods?

• Two alternative means:
  • Government Provision
  • Private Provision

Private Provision of Public Goods

• Examples of private provision (which doesn’t rely on markets):
  • Funding by donation: Volunteer action and funding. Non-profit NGOs, e.g., National Public Radio (NPR), Public Broadcasting Services (PBS), American Alliance for Museums, the Getty Foundation, the Central Park Conservancy (NY–land preservation) etc.
  • Sale of by-products: e.g., Air broadcasting T.V., financed by the sale of advertisement; National parks selling branded merchandise, etc.
  • Private contracting: Gated communities and homeowners’ associations.

Government Provision of Public Goods

• The government provides public goods through various means, funded by taxes.

Who Should Pay for Government Provision of Public Goods?

• Benefit principle: Those who benefit from public spending should bear the cost.
  • e.g., those who benefit from a road should pay for that road’s upkeep.
  • Practical considerations make it impossible to rely on this approach exclusively.
    • Main issue: ability to pay.
    • Potential option: Progressive Tax System, we all pay but according to our ability to pay.

Sharing a Water Well - An Example

• Imagine sharing a water well with a neighbor. A new device costs $1,000$. You both value it, but you earn twice as much.
  • You're willing to pay $800$, neighbor's reservation price is $400$.
  • Individually, neither will buy it (not willing to pay $1,000$).
  • Efficient to share: Total Value = 800 + 400 = $1,200. Cooperative Surplus = $$200 = (1,200 - $1,000)$.</li> <li>Will efficient solution be obtained? Depends on transaction costs. Unlikely for large groups.</li></ul></li> </ul> <h4 id="governmentinvolvementinthewaterwellexample">Government Involvement in the Water Well Example</h4> <ul> <li>Would you accept government providing the device based on:<ul> <li><strong>Equal Tax Rule (Head Tax)</strong>: Tax of$$500$ each. Neighbor's reservation price is too low ($$400$). No.</li> <li><strong>Proportional Income Tax</strong>: Tax under which all taxpayers pay the same proportion of their incomes in taxes. Yes.<ul> <li>You earn twice as much, so pay twice as much.</li> <li>You earn$$66,700$ a year, neighbor earns $$33,350$a year. A proportional tax to cover the device will charge you both 1<li>You pay$$667$, neighbor $$333$. You both are better off!</li></ul></li></ul></li> </ul> <h4 id="takeaway">Takeaway</h4> <ul> <li>Wealthy individuals tend to assign higher reservation prices for public goods than low-income people.</li> <li>A head tax would result in society getting smaller amounts of public goods than it wants.</li> <li>A proportional taxation or a progressive taxation [a tax under which the proportion of income paid in taxes rises as income rises] are more effective at achieving efficient outcomes!</li> </ul> <h4 id="thegovernmentandincentives">The Government and Incentives</h4> <ul> <li>The government can help increase efficiency…</li> <li>But government intervention is not a "free lunch."</li> </ul> <h4 id="governmentinterventionisnotafreelunch">Government Intervention is Not a Free Lunch</h4> <ul> <li>It is costly to maintain a bureaucracy.</li> <li>Taxes necessary to finance public goods can create deadweight losses.</li> <li>Major incentive problems get in the way of efficiency enhancing policies: People who act in their own self-interest in market situations do not stop doing so once they step into public office!</li> </ul> <h4 id="structuralincentiveproblemsharingarestaurantbill">Structural Incentive Problem: Sharing a Restaurant Bill</h4> <ul> <li>Nate and 9 friends share a restaurant bill.</li> <li>Dessert time: Nate only orders dessert when he shares the bill, due to the reduced cost to 10$$3$ surplus from pudding ($$4 - $1$) and$$2.40$ from mousse ($$3 - $0.6$). He chooses pudding.</li> <li>Nate's friends follow same logic the total restaurant bill higher than it would otherwise be…Nate ends up paying the full$$10$ and losing $$6 = ($10 - $4)$.</li> <li>Pumpkin Bread Pudding<ul> <li>Menu Price$$10$
    *Reservation Price $$4$</li></ul></li> <li>Chocolate Mousse<ul> <li>Menu Price$$6$
    *Reservation Price $$3$</li></ul></li> </ul> <h4 id="incentiveproblematthegovernmentlevelporkbarrelspending">Incentive Problem at the Government Level: Pork Barrel Spending</h4> <ul> <li><strong>Pork barrel spending</strong>: Inefficient projects supported by a legislator because the benefits to their district exceed the costs to their district.<ul> <li>Ex. Project creates$$100$ million in benefits to a specific district with total costs of $$150$million.</li> <li>Inefficient to go for this project.</li> <li>But, if the district has only 1$$1.5$ million; $$98.5$$ million surplus for the district. Its representative will propose this bill.
  • Legislators from other districts support this bill because of logrolling (exchanging favors).

Rent-Seeking

• Rent-seeking: Groups or individuals spending resources to use the government to redistribute wealth in their favor.
  • Example: Lobbying government to get tariff exemptions.
• Rent-seeking produces inefficient outcomes because:
  • It diverts resources from productive activities to redistributive ones.
• Rent-seeking is costly to curb because:
  • Public officials enjoy donations from rent-seekers (for political or personal gain).
  • Groups hurt by such outcomes (e.g., consumers) often fail to organize due to high transaction costs.