Chapters 20 Public Goods Externalities Government 1

Chapters 20: Public Goods, Externalities, & Government 1

Tragedy of the Commons Commuters in West Seattle have to get downtown to work. Suppose they can either get there by driving alone in their car via the West Seattle bridge or by taking the monorail. Travel on the monorail always takes 30 minutes regardless of how many people ride. The bridge, on the other hand, begins to get congested if more than three thousand cars travel at a time. Assume that each commuter values their time at $ 12. 00 per hour. Number of cars on the bridge (in thousands) Average commute time along the bridge Total commute time via the bridge (in thousands of minutes) Marginal time cost of one more car taking the bridge Monetary cost to individuals of taking the bridge Net Monetary benefit of individuals taking the bridge instead of the monorail 1 15 min 15 15 $ 3. 00 2 15 min 30 15 $ 3. 00 3 15 min 45 15 $ 3. 00 4 17. 5 min 70 25 $ 3. 50 $ 2. 50 5 20 min 100 30 $ 4. 00 $ 2. 00 6 22. 5 min 135 35 $ 4. 50 $ 1. 50 7 25 min 175 40 $ 5. 00 $ 1. 00 8 27. 5 min 220 45 $ 5. 50 $ 0. 50 9 30 min 270 50 $ 6. 00 $ 0. 00 10 32. 5 min 325 55 $ 6. 50 $ -0. 50 11 35 min 385 60 $ 7. 00 $ -1. 00 2

Analysis of Common Property Problem • How much would West Seattle be willing to pay to build a monorail that would get them downtown in 30 minutes? • Given that the monorail does exist: Left to their own devices, how many commuters travel the bridge and how many commuters take the monorail? • What is the socially efficient number of commuters on the bridge and the monorail? • How much would Seattle need to subsidize monorail riders to achieve the socially efficient ridership? 3

Externalities • An externality is when the production or consumption of a good has an impact (may be positive or negative) on others in the market – There are, in theory, eight possible types of externalities: 1. 2. 3. 4. 5. 6. 7. 8. • Positive, consumer-consumer Positive, producer-producer Positive, producer-consumer Positive, consumer-producer Negative, consumer-consumer Negative, producer-producer Negative, producer-consumer Negative, consumer-producer Positional externalities - externalities that arise when rewards or sanctions are determined not by absolute position (e. g. performance), but by one’s position in society 4

Coase Theorem • Externalities exist because property rights are not assigned for all goods • Coase Theorem states that when the parties affected by externalities can negotiate costlessly with one another, an efficient outcome results no matter how the law assigns responsibility for damages – Law often doesn’t assign responsibility – Affected parties can never negotiate completely costlessly; sometimes the costs of negotiation are quite high 5

Interventions to Deal with Externalities • Taxation of negative externalities • Subsidization of positive externalities • Assignment of property rights 6

Intervention to Deal with Negative Externalities: Fixing the Tragedy of the Commons Cost of Taking Bridge MC AC $6 Tax/Toll $4 C* # of cars 7

Intervention to Deal with Negative Externalities: Fixing the Tragedy of the Commons from Benefit Side Net Benefit of Using Bridge $2. 00 0 Average Benefit C* Marginal Benefit 8

Alternative Intervention to Deal with Negative Externality • Two neighbors live across the street from each other. The neighbor on the east side of the street wants to build a second story onto his house. The on the west side doesn’t want the morning sunrise to be blocked. The city has given the East Side neighbor the permit for the addition. East Side Neighbor Builds Gains to East Side Neighbor $1, 000 Damage to West $1, 400 Side Neighbor • • How much would the West Side neighbor be willing to pay her neighbor not to build the addition? How much would the West Side neighbor be willing to pay if she had to pay a lawyer $250 to negotiate the agreement? 9

Intervention to Deal with Negative Externalities Social MC Individual MC PE TAX P 0 Demand (MV) QE Q 0 10

Intervention to Deal with Positive Externalities Price MC SUBSIDY Individual Marginal Benefit Social Marginal Benefit Quantity 11

When Is The Market Less Likely to Be Efficient • When markets are less competitive • In the case of externalities – May be positive or negative – May occur on production or consumption side • In the case of public goods • In the case of asymmetric/poor information 12

Public Goods • Public goods are those goods that, to a greater or lesser degree, possess two key traits, nondiminishability and nonexcludability (a special case of externalities) – A nondiminishable good is one for which one persons consumption of a good has no effect on the amount of it available to others (MC = 0) – A nonexcludability good is one for which it is not possible to prevent consumers (paying or nonpaying) from consuming that good • Two types of public goods – Pure public good is one that has a high degree of nondimishability and nonexcludability (e. g. national defense) – Collective good is has a high degree of nondiminishability, but may have excludible properties (e. g. roads) • Public goods may be provided by either the government or the private sector 13

Optimal Quantity of Public Goods • Aggregate willingness to pay curve (like the aggregate demand curve) is the vertical sum of individual’s willingness to pay curves • Optimal quantity of a public good is the quantity, Q*, corresponding to the intersection of aggregate willingness to pay and marginal cost curves with the proviso that the total cost of producing Q* does not exceed the total amount that the public would be willing to pay • The fact that the optimal quantity of public goods may differ from person to person suggests “Tiebout” sorting associated with local provision of public goods 14

Public Goods: Graphical Example MC Aggregate Willingness to Pay Curve A* = 13 A* = 8 A* = 5 Q*=10 15

Provision of Public Goods • Funding by donation – Suffers from free rider problem • Sale of by-products - e. g. commercial TV • Creating excludability techniques - cable TV • Legal/private contracts - e. g. condo/home association 16

Public Goods: Numeric Example • A town has 100 people with identical preferences for a fireworks display. • Each person has a willingness to pay P=40 -. 2 Q • How much would the town be willing to pay for 100 shells at their fireworks display? • The aggregate willingness to pay is P = 4000 - 20 Q • The town is willing to pay $2000 or $20 each. 17

Government Interventions to Try to Create Efficient Resource Allocation • Control over pricing – e. g. The setting of rates for natural monopolies • Information, licensure, certifications, etc. – e. g. FDA, FAA • Regulations governing production techniques – e. g. mandating smokestack scrubbers • Taxation/subsidies – e. g. cigarette tax • Creation of “new” markets – e. g. pollution credit markets 18

Another Key Role for Government: Income Redistribution • As a society we may care not only about efficiency (pretty much everything we’ve been talking about), but also equity – The two may be linked if utility functions are interdependent (my utility depends on your utility) • Rawlsian pre-birth lottery - thought experiment on what constitutes a just distribution of income – What should the distribution of income (& rewards for work/talent) look like for those behind the veil of ignorance? • Risk aversion suggests that social safety net acts as pre-birth insurance policy • Methods of Redistribution – Welfare programs – Negative income tax – Jobs programs 19

Public Choice • Major way we make policy is through majority voting, where the median voter (the voter whose ideal outcome lies above the ideal outcomes of half the voters) determines the outcome • But there are some unpalatable properties of majority voting, including – Intransitivity • With more than 2 choices, the least preferable choice may be selected if the voters are split between the most preferred choices • Majority voting may sometimes imply so the order of the votes may be very important • Allows for agenda manipulation (we see this all the time in politics) – Lack of consideration of strength of preference 20

And the Winner Is…The Loser • A city has the choice between four mayoral candidates: Tara, Sarah, Wendy and Amy was recently added to the ballot when her corporate fraud conviction was overturned on a technicality • When asked, 74% of the citizens list Amy as their last choice out of the four candidates. However, in deciding between the candidates A, B, and C they are evenly split. • When they vote, the final tally will be: Tara 24. 67% Sarah 24. 67% Wendy 24. 67% Amy 26% • Amy Wins! 21

And the Winner Is…Who Knows? • Three people are voting on three alternatives. The orders of their preferred choices are listed below. Meghan Cory Jon Johnson 1 2 3 Duritz 2 3 1 Zavala 3 1 2 • This group prefers Johnson over Duritz and Zavala over Johnson, but prefers Duritz over Zavala. If these elections are run sequentially, then the order in which they are done will determine the outcome. 22

We’re All Winners! Johnson Duritz Zavala Congratulations Mayor Zavala! Zavala Duritz Johnson Er…Congratulations Mayor Duritz! Duritz Zavala Johnson Wait…Congratulations Mayor Johnson! Johnson 23