7-Apr-’06
Public Finance course
8th week
Public Good
Public Choice
Qafqaz University, Baku
Instructor: Elchin Rashidov
Material to read:
Main textbook:
John L. Mikesell. Fiscal Administration 4/e
Chapter 1: Fundamental Principles of Public Finance
Supplementary material:
Public Goods and Public Choice, uploaded to group
website
Why we need the government?





Set common rules of behavior
Protect citizens from external threats
Pool resources for the common good
Address and correct market failures
3 economic values:



stabilization and growth (prevention of unemployment,
inflation…)
distribution of wealth in the society
allocation: provision of public/collective goods - private
sector alone is not enough
Appropriability: 2 market failures
1. Non-exhaustion/non-rivalry: Once a good/service is
provided for one consumer, the cost of supplying it to
another is zero: Marginal cost = 0
2. Non-exclusion: Once a good is provided for one
consumer all other consumers can use it — cost
allocation is impossible.
Private goods don’t have appropriability problems:
additional product/service is an extra cost that will be
charged by the seller; it is possible to separate payers
from non-payers.
Public goods: public fireworks, lighthouse, invention,
software… In the real world there may be no such thing
as an absolutely non-rival or non-excludable good.
free rider problem
Free rider: A consumer who uses a benefit of collective
action in which he/she refuses to participate.


Individuals have an incentive to “free-ride” with public
goods; since they cannot be excluded from use of the good,
they will let someone else purchase the good and will still
receive benefits from it.
Because of the “free-rider” problem, people are not willing to
reveal their true demand for a public good, so there will be
little/no market for these goods, and they will be
underproduced.
Diner’s dilemma (tragedy of commons): individuals tend to
consume less efficiently & more when the cost is shared –
creates another problem for public good provision.
Classic division of goods in economy
The Elements of Nonappropriability
Exhaustion / Rivalry
Feasible
Alternate Use
Joint Use
Private Goods
Toll Goods
Food, clothing, TV
Toll bridges, movies
Common-Pool
Resources
Public Goods
Aquifers, fishing
grounds
National defense,
system of justice,
disease control
Exclusion
Not
feasible
privatization
1.
2.
3.
Transfer to private sector gov’t owned
businesses with no significant market failure
Transfer to private sector gov’t owned
businesses w/ natural monopoly power
(telecommunications, electricity…)
Contracted out publicly financed services to
private businesses
benefits of privatization

Smaller govt. (philosophical matter)

Operating efficiency + client service: in contrast
with the political-bureaucratic public sector, private
sector is more concerned with cost-efficiency +
customer demand as a matter of survival

Cash: sale of govt.-operated enterprises bring
revenue, and the enterprise can be taxed in future
Govt. & private production & provision
1.
Govt. provision – govt. production
2.
Govt. provision – private production
3.
Private provision – govt. production
4.
Private provision – private production
Externality: Effect of market transaction
imposed on a “third party” (neither producer
nor consumer of the transaction good).
Positive: Third party receives benefits from
transaction (vaccinations)—Hidden benefits:
undersupply of good.
Negative: Third party incurs costs from
transaction (factory pollution emissions)—
Hidden costs: oversupply of good.
Criteria for undertaking govt. action








Pareto: Is it possible to make at least one better-off without
making someone worse-off?
Kaldor: Can the gainers compensate the losers?
Cost-benefit: Do benefits to society exceed costs?
Majority rule (democracy): Do more members of society
benefit than lose?
Rawlsian fairness: Is the least well-off person as well-off as
possible?
Superfairness: Is each group prefers its own share? Is there an
envy?
Oligarchic (elite rule): Do those who control society benefit?
Social justice (re-distributive): Do worse off members of
society benefit?
Public choice



Building social decisions from individual
preferences
Easy when median voter principle is applicable
Difficult w/ independent irrelevant alternatives



Voting paradox – when everyone’s preferences cannot
be combined to generate a unique community choice
Arrow’s impossibility theorem –there is no general
way to combine the individual preferences w/o running
into some kind of irrationality or unfairness
Government failure
Coase Theorem
When parties can bargain w/o cost and to their
mutual advantage, the resulting outcome will be
efficient, regardless how the property rights are
specified.
1. Property rights are well defined;
2. People act rationally
3. Transaction costs are minimal
Only if all three of these apply will individual
bargaining solve the problem of externalities.
Individual Individual Benefit Cost Share
Individual Gain
A
8,000
4,000
4,000
B
6,000
4,000
2,000
C
4,000
4,000
0
D
9,000
4,000
5,000
E
3,000
4,000
-1,000
30,000
20,000
Total
Total benefit = $30,000; Total cost = $20,000
Total benefit exceeds total cost
Individual cost (evenly distributed) is $4,000 ( $20,000/5 )
All individuals benefit from the project differently
Three gains. One is tie. One loses.
Individual Individual Benefit Cost Share
Individual Gain
A
5,000
4,000
1,000
B
6,000
4,000
2,000
C
5,000
4,000
1,000
D
2,000
4,000
-2,000
E
1,000
4,000
-3,000
19,000
20,000
Total
Total benefit = $19,000; Total cost = $20,000
Total cost exceeds total benefit (Benefit = $19,000 Cost = $20,000)
3 benefit from the project. 2 lose.
If everyone voted strictly on self interest, based on majority rule project would
go forward, even though costs > benefits (democracy of 2 wolves & 1 sheep) .
Individua Individua Cost
l
l Benefit Share
Individua Individual Share Benefit-Based
l Gain
of Total Benefits Cost Share
A
3,000
2,500
500
15%
1,875
B
5,000
2,500
2,500
25%
3,125
C
8,000
2,500
5,500
40%
5,000
D
3,000
2,500
500
15%
1,875
E
1,000
2,500
-1,500
5%
625
20,000
12,500
100%
12,500
Total
Total benefit exceeds total cost (Benefit = $20,000 Cost = $12,500)
4 individuals gains from the project. 1 loses.
Costs can be re-distributed proportional to benefits (i.e., one
receiving x% of benefit, should pay x% of the cost). Then everyone
gains.
Individual Benefit
Individual Share of Total Benefit 
Total Benefit
For example, for Individual A:
3,000
 0.15 (or 15%)
20,000
Benefit-Based Cost Share  Individual Share of Total Benefit  Total Cost
For example, for Individual A: 0.15 x 12,500 = 1,875