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
$ 3.00
2
15 min
30
15
$ 3.00
$ 3.00
3
15 min
45
15
$ 3.00
$ 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 one 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
P0
Demand (MV)
QE
Q0
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-.2Q
• How much would the town be willing to pay for 100
shells at their fireworks display?
• The aggregate willingness to pay is P = 4000 - 20Q
• 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 A B,B C,C A 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. 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
Johnson
Duritz
Zavala
Congratulations Mayor Zavala!
Zavala
Zavala
Zavala
Duritz
Johnson
Er…Congratulations Mayor Duritz!
Duritz
Duritz
Duritz
Zavala
Johnson
Wait…Congratulations Mayor Johnson!
Johnson
23