Public Goods

Chapter 22
Slides by Pamela L. Hall
Western Washington University
2005, Southwestern

Introduction

Previous chapters generally considered only private

goods
Commodities consumed individually by consumers
One consumers consumption of such a commodity precludes other
consumers consumption

This chapter considers nonrival commodities

One consumers consumption of a commodity does not
preclude other consumers consumption
Called public goods

Goods where there is no congestion

For example, one consumers satisfaction from breathing clean air
does not rival (compete with) other consumers gaining pleasure
from also breathing the air

Introduction

We define public and private goods in terms of their rivalry and

exclusive characteristics
We investigate exclusive but nonrival commodities and condition
for renting instead of selling nonrival commodities
We address free-rider problem associated with public goods in a
game-theory framework
Develop Pareto-efficient conditions for allocating public goods
We discuss how to obtain Pareto-efficient allocation when
markets can be developed to establish prices for public goods
(called Lindahl prices)
We discuss Clarke tax
Provides a second-best Pareto-efficient mechanism for allocating public
goods

Introduction
Aim

in chapter is to understand
distinguishing characteristics between
private and public goods

Why a free market (decentralized control) will

not result in a Pareto-efficient allocation of
public goods
Leaves applied economists with task of developing
various mechanisms for determining optimal
allocation of resources to production of public
goods
4

Rivalry and Exclusive-Good

Characteristics

Public good: nonrival commodity

One consumers consumption does not reduce amount available to other consumers
Exists when marginal cost of another consumers consuming commodity is zero

Private good: rival commodity

Depletable or diminishable commodity

Each additional unit consumed by one consumer results in less of commodity
available for other consumers

For a rival commodity, congestion is so severe only one consumer can consume
commodity
Both public and private goods are further classified based on their exclusiveness

Exclusive commodity
Other consumers can be excluded from consuming the commodity
Nonexclusive commodity
Either it is illegal to exclude other consumers from consuming the commodity or cost of
exclusion is prohibitive

Rivalry and Exclusive-Good

Characteristics

Pure private goods are distinguished from private

goods by their exclusiveness
Private goods are all rival commodities
Pure private goods have additional criterion of being
exclusive

Similarly, public goods are all nonrival commodities

Pure public goods are also nonexclusive
If consumption of a nonexclusive commodity also does
not deplete commodity for other consumers (a
nondepletable commodity)
Commodity is a pure public good
6

Rivalry and Exclusive-Good

Characteristics

Pure public goods are a specific type of externality that

affects all consumers in an economy
If one consumer is to consume a certain amount of a pure public
good
Then all consumers will consume that same level

Examples of commodities possessing characteristics of rivalry and

exclusiveness are provided in Table 22.1

An exclusive commodity, such as food, with high

congestion costs associated with rivalry is a pure private
good
Cost of an additional unit of commodity is nonzero
In a free-market economy, such pure private commodities are generally
provided by firms

Table 22.1 Rivalry and

Exclusiveness in Commodities

Rivalry and Exclusive-Good

Characteristics

Table 22.1 also shows that a private good, such as fire protection, can
also be a nonexclusive commodity

In contrast, public goods with zero congestion costs are nonrival

An additional consumer does not add any additional cost for providing commodities
For exclusive public goods, consumers can be excluded unless, for
example, they pay an entrance price (subscription fee, toll, or ticket)

And marginal cost of an additional subscriber is zero

Exclusion can also be based on some nonprice criteria

Such as gender, race, national origin, or social status

However, in U.S. such criteria are generally illegal

In free markets, public goods can be privately produced by firms (such as

movie theaters)

Or publicly produced by government agencies (such as toll roads and bridges)

Nonexclusive pure public goods (such as street lights) are generally provided solely
by government agencies

Rivalry and Exclusive-Good

Characteristics

Distinctions among rival, nonrival, exclusive, and nonexclusive commodities

are in terms of degree to which a commodity falls in one category or another

For example, fire and police protection could be considered pure public goods
for a community

If protection is at a level where marginal cost of an additional consumer is near zero

As number of consumers increases with an associated increase in marginal cost

Fire and police protection would then become more rival commodities

Increased highway congestion at some point will raise marginal cost of highway
commuting

Increases degree of rivalry on roads (Labor Day Weekend)

Finally, consumer preferences for a public commodity are not always
positive

Bad public commodities (called public bads) also exist

Examples are environmental degradation (including air and water pollution), global
warming, and species extinction

10

Nonrival but Exclusive

Commodities (Public Goods)

Nonrival characteristics of certain

commodities allow

Public libraries to share books and electronic

media
Video outlets to share (for some rental fee)
videos and electronic games
Equipment rental firms to rent a variety of items
from backhoes to party supplies

11

Nonrival but Exclusive

Commodities (Public Goods)

Consider case of a firm offering commodity

assuming no sharing exists
Let p(q) be inverse demand function with
associated constant marginal and average cost of c
Firms profit-maximizing problem is
If consumers rent commodity instead of purchasing
it
Level of consumption, y, will be greater than level of
production
For example, more videos will be watched than produced
12

Nonrival but Exclusive

Commodities (Public Goods)

Let be number of times each commodity is shared by a

consumer
Level of consumption is y = q
Assuming all commodities are only rented, rental price
would be p(y)
Along with some positive transactions cost, ct, of renting versus
owning commodity

Purchasing a commodity reduces transaction costs involved with renting

Major reason why many households purchase rather than rent lawn mowers

Marginal consumers, with zero consumer surplus, would be willing to

pay p(y) to rent commodity minus this transactions cost, p(y) - c t

13

Nonrival but Exclusive

Commodities (Public Goods)

Further assuming that there are of these marginal

consumers sharing one commodity
Per-unit price firm receives is times p(y) - ct

[p(y) ct] = [p(q) ct]

Firms profit-maximizing problem for renting commodity is

14

Nonrival but Exclusive

Commodities (Public Goods)

Comparing this profit-maximizing problem for producing and

then renting output versus maximizing problem associated
with producing and then selling output
Only difference is in marginal costs
Marginal cost for selling commodity is c
Marginal cost associated with producing commodity for renting is [(c/) +
ct]

Profits will be higher for renting if marginal cost for production associated with
renting is lower than marginal cost for selling
c/ + ct < c
Illustrated in Figure 22.1

Assume demand for renting is same as for purchasing

Both can be represented by same demand curve
For profit maximization, firm will equate MR to MC

15

Figure 22.1 Renting versus

selling a product

16

Nonrival but Exclusive

Commodities (Public Goods)

Marginal cost for renting is lower than

marginal cost for selling

Firm will set a rental price of pR*and y* of

commodity will be consumed
If firm sold product, price and quantity sold would be

p* and q*
If marginal cost for renting is less than marginal cost
for selling

Profits from renting [(c/) + ct], are higher than for selling,
(c)

17

Nonrival but Exclusive

Commodities (Public Goods)

The more a product is characterized as nonrival

The higher will be the number of times each product is shared with
consumers,
As increases, marginal cost of renting falls relative to selling

Enhances profitability of renting versus selling product

As approaches infinity, condition for renting instead of selling

commodity is ct < c
Firm will then rent commodity instead of selling it
When marginal cost of production is greater than consumers transactions
costs of renting instead of owning

For example, transactions cost for newly released videos is relatively low compared
with marginal cost
Consumers generally will rent new releases
In contrast, marginal selling cost of used videos (salvage value) is relatively low
Consumers may instead purchase video rather than rent it

18

Free-Rider Problem

Nondepletable and nonexclusive characteristics of a

pure public good (such as PBS)
Result in each consumers purchase of commodity providing
utility
Not only directly to this consumer but also to all other consumers

If consumers only consider their own utility in

purchasing commodity and not effects such purchases
have on all other consumers
Externalities are present
Consumers have an incentive to let other consumers purchase public
good and receive utility from it without any cost

Called free-rider problem

19

Free-Rider Problem

A free rider is a consumer who cannot be excluded from receiving benefits of

a nondepletable commodity

But is unwilling to pay his portion of cost (a non-PBS member viewing a PBS
program)

By not cooperating and paying his portion of cost associated with public good,
free rider gains

Another form of Prisoners Dilemma game

As an illustration, assume two roommates with public good of a clean kitchen

(Table 22.2)

If they cooperate and both agree to share in cleaning, their payoffs are 50 each
Payoffs could be in monetary units or some other measurement

However, by not cooperating, becoming a free rider, and letting the other roommate
clean

Free rider can increase her payoff from 50 to 120

Nash-equilibrium result is both attempting to be free riders (not cooperating)

Results in a dirty kitchen

20

Table 22.2 Free-Rider Problem for a

Clean Kitchen as the Public Good

21

Free-Rider Problem

Generally, in case of a small number of

agents with limited or no transaction costs

Coase Theorem applies and this externality

problem is resolved

However as number of agents increases, a

Coasian solution is generally not possible

With a large number of agents, it is generally

easy to be a free rider

22

Pareto-Efficient Conditions for

Pure Public Goods

Efficient allocation of a pure public good

Sum of each agents willingness-to-pay is equal to cost of
public good

Recall that a Pareto-efficient allocation condition for

consumer 1 considering purchasing commodities x1
and y is

MRPT denotes marginal rate of product transformation

MRS is marginal rate of substitution
23

Pareto-Efficient Conditions for

Pure Public Goods

Letting x1 and y be a private good and a pure public good,

respectively
MRS1(x1 for y) is how much consumer 1 is willing to sacrifice of the private
good, x1, for one more unit of pure public good, y

MRS1(x1 for y) is consumer 1s maximum willingness-to-pay, or reservation price,

for pure public good

However, condition does not consider externalities associated with

pure public good
With these externalities, societys maximum willingness-to-pay (MRSS) is
higher

Given that pure public good y provides same positive benefits to other consumers

MRPT(x1 for y) = MRS1(x1 for y) < MRSS(x1 for y)

Level of pure public good provided in a perfectly competitive market

is below socially efficient solution

24

Pareto-Efficient Conditions for

Pure Public Goods

Can develop Pareto-efficient condition for a pure public

good supplanting inefficient condition, MRPT = MRS1
By considering a two-consumer economy with purchasing decisions
of x1 and y

Let y be amount of pure public good and x1 and x2 be

amounts of private good associated with consumers 1 and
2, respectively
There is no subscript on y

Both consumers consume same amount of y, and y is nondepletable

However, they may consume different amounts of private commodity

So x1 + x2 = Q
Where Q is total amount of commodity produced

25

Pareto-Efficient Conditions for

Pure Public Goods

Will describe technological possibilities of this

economy by production possibilities frontier, f(Q, y)
=0
Welfare-maximization problem is
Where U1 and U2 are utility functions for consumers 1 and 2,
respectively
is some social-welfare function

Forming the Lagrangian

26

Pareto-Efficient Conditions for

Pure Public Goods

F.O.C.s are

Q/x1 = Q/x2 = 1, given Q = x1 + x2

27

Pareto-Efficient Conditions for

Pure Public Goods

Solving for Lagrangian multiplier and equating

yields

The last equality establishes

28

Pareto-Efficient Conditions for

Pure Public Goods

Marginal gain in welfare associated with additional

consumption of commodity Q by a consumer must
be equal for all consumers
If this is not the case, it would be possible to reallocate Q
among consumers in a way that increases social welfare

Cross-multiplying first equality yields

29

Pareto-Efficient Conditions for

Pure Public Goods

First term is consumer 1s MRS1(x1 for y)

Second is consumer 2s MRS2(x2 for y)

Term on right-hand side is MRPT(Q for y) between

public and private good
Thus, condition for Pareto efficiency is
MRS1 + MRS2 = MRPT

30

Pareto-Efficient Conditions for

Pure Public Goods

Instead of perfectly competitive condition, MRS1 = MRS2 = = MRSn =

MRPT for n consumers

Pareto-efficient condition is

Sum of willingness-to-pay (MRSS) equated to cost (MRPT) results in a

Pareto-efficient allocation of pure public good
An example is if a home theater system costs $5000 and 100 sorority
sisters are each willing to pay $50

Individually, no one sister would purchase the system

But collectively Pareto-efficient response would be to purchase it

MRSS is sum of individual consumers MRS

Accounts for benefits all consumers receive from pure public good
Equate MRSS to MRPT to determine Pareto-efficient level of resource allocation

Individual consumers MRS(xj for y) are each consumers reservation

price

31

Pareto-Efficient Conditions for

Pure Public Goods

Can relate concept of MRS(xj for y) as a consumers

reservation price for y to market price for y, py
By letting price of Q be a numeraire, so pQ = 1
For utility maximization consumer sets MRS(xj for y)
= py/pQ
For pQ = 1, a consumers reservation price is equal to
market price, MRS(xj for y) = py
Thus, for a pure public good, summing reservation prices yields
total per-unit price society is willing to pay for pure public good y

Equating total per-unit price to cost of supplying one more unit,

MRPT(Q for y), yields a Pareto-efficient allocation

32

Pareto-Efficient Conditions for

Pure Public Goods

Consumers paying their reservation price per unit for

pure public good is one Pareto-efficient outcome
Yields a marked distinction for efficiency between private
and pure public goods

For a private good, all consumers consume different

amounts of commodity but pay same market price
For a pure public good all consumers consume same
amount of commodity (say, national defense) but pay
different prices
Illustrated in Figures 22.2 and 22.3
33

Figure 22.2 Horizontal summation of the

demand curves for a private good

34

Pareto-Efficient Conditions for

Pure Public Goods

Market demand curve for a private good is horizontal

summation of individual consumers demand curves for private
good
Treating reservation price, MRS(y for xj), as price of private
good Q, Pareto-efficient allocation is for both consumers to
pay the same price
MRS1(y for x1) = MRS2(y for x2) = MRPT(y for Q)
From Figure 22.2, at this price, 10 and 8 units of Q are
demanded by consumers 1 and 2, respectively
Yields a total market demand of 18
Individual demand curves are based on preference orderings of consumers

Represented by indifference curves

35

Pareto-Efficient Conditions for

Pure Public Goods

For a public commodity, each consumer consumes same amount

of commodity but at a different price
Derive market demand curve by vertically summing individual
consumers demand curves
Shown in Figure 22.3
Consumer 1s MRS1(x1 for y) is 4 and consumer 2s MRS2(x2 for y) is 1

Pareto-efficient allocation is where

MRS1(x1 for y) + MRS2(x2 for y) = MRPT(Q for y)
If price of Q is numeraire, pQ = 1, then ratio py/pQ = 4 = MRS1(x1
for y) and py/pQ = 1 = MRS2(x2 for y)
Consumer 1 pays $4 per unit for pure public good and consumer 2 pays $1
But they each consume the same amount

36

Figure 22.3 Vertical summation of the

demand curves for a pure public good

37

Pareto-Efficient Conditions for

Pure Public Goods

One solution for inefficiency of perfectly competitive markets in providing for

pure public goods

Establish another market that will account for externalities associated with public
goods

Offered such a solution in Chapter 21

Market for permits could be established to yield a second-best Pareto-efficient

allocation

Solution may or may not be feasible, depending on nature of inefficiency

A market solution works well when a commodity can be segmented

Proportion of property rights for commodity can be transferred from public to a private
agent

Market-permit system is one case where this market solution can be

feasible

Permits transfer a proportion of a common property commodity to a private

agent

However, it is not as attractive for correcting public-goods allocation problem

38

Pareto-Efficient Conditions for

Pure Public Goods

Nonrival and nonexclusive characteristics of a pure public

good prevent segmenting of commodity
For example, an individual household cannot purchase a
proportion of national defense

To establish such a market (a Lindahl market) for a pure

public good
Each consumer would have to voluntarily reveal and pay their
reservation price (their Lindahl price) per unit for a pure public
good
Summing reservation prices and equating sum to MRPT would determine
efficient allocation of pure public good
Such markets generally are not feasible

Mainly as a consequence of free-rider problem

39

Pareto-Efficient Conditions for

Pure Public Goods

Consumers dominant strategy

Understate their preferences (by discounting their Lindahl prices) and rely on other
consumers to pay a larger share for pure public goods

Nonexclusive characteristic of pure public goods fosters this free-rider strategy

One solution to free-rider problem

For government to impose a per-unit tax on each consumer equivalent to their

respective Lindahl prices

However, unlike reservation prices for private goods, Lindahl prices are not revealed in
market

Consumers cannot adjust their level of consumption unilaterally

Destroys possibility of a market for pure public goods

Government agency has no feasible mechanism for determining each consumers
willingness-to-pay

To impose such a tax government agency must perfectly price discriminate

among consumers

Such systems are difficult to achieve

40

Pareto-Efficient Conditions for

Pure Public Goods

Even if it were feasible to determine consumers Lindahl prices

and perfectly price discriminate
Consumers may object to paying differentially per unit for pure public
goods

May be more inclined to support funding for pure public goods based on
ability to pay rather than willingness-to-pay

Many public health and housing agencies base fees and rents
on ability to pay
In general, pure public goods are financed by taxes based on
income and wealth
As opposed to decentralized control for allocation of private goods
Some type of centralized control is required for public-goods allocations

Determination of types, amounts, and funding for pure public goods may then be
based on some mechanism design

41

Pareto-Efficient Conditions for

Pure Public Goods

In general, such mechanism designs attempt

to determine intensities of individual and
group desires

And formulate a mechanism composed of

policies and rules for group choice and actions
Clarke tax is one such mechanism
Under some rather restrictive conditions, tax provides
incentives for consumers to reveal their true
preferences for a social choice

42

Clarke Tax

Eliciting truthful preferences for pure public goods

can mitigate misallocation of governments taxing,
spending, and regulatory authorities
By overcoming free-rider problem
Proponents of Clarke tax mechanism claim, based
on a second-bid auction, tax mechanism will not
completely cure free-rider problem by yielding a
Pareto-efficient allocation
But has potential to treat the symptoms

43

Clarke Tax

As an illustration, consider a group of consumers jointly

deciding on purchase of a pure public good
If purchased, every consumer will pay a predetermined amount for
purchasing the good

An example is an appliance such as a microwave oven in a dormitory

Let cj be this predetermined amount for consumer j

Summing over all consumers equals cost of pure public good

Consumers will then state how much they are willing to pay

Difference between consumer js willingness-to-pay, WTP j, and

predetermined amount is net benefit, NB j
NBj = WTPj - cj
If sum of net benefits over all consumers is positive
Then pure public good should be purchased

44

Clarke Tax

Problem is designing a mechanism that provides an incentive for

consumers to reveal their true net benefit

Instead of revealing an exaggerated figure in an attempt to influence this social

choice

However, an exaggeration is only of concern if it affects social choice

For example, say consumer j attempted to be a free rider by stating a
value of zero

Yielding a net benefit of -cj

If sum of net benefits over all consumers is still positive

Free rider does not influence social choice, so it is of no concern

Only consumers whose exaggeration will affect social choice are of

concern

Such consumers are called pivotal consumers

Their net benefit determines whether sum of net benefits is positive or negative

In the extreme, all consumers could be pivotal consumers or none could be pivotal

45

Clarke Tax

It is possible that any one consumer could be pivotal

Ensuring that all potential pivotal consumers have the right incentives
corresponds to ensuring that all consumers reveal their true preferences

When a social choice is changed by a pivotal consumer

Adversely affects other consumers
For example, if other consumers have positive net benefits for
a pure public good and pivotal consumers negative net benefit
resulted in not purchasing good
All other consumers are made worse off
A measure for how much other consumers, in aggregate, are
worse off
Sum of net benefits excluding pivotal consumer, say, consumer 1

46

Clarke Tax

If other consumers have negative net benefits for pure

public good and pivotal consumers positive net benefit
resulted in purchasing commodity
All other consumers are again made worse off
Measure for how much other consumers, in aggregate, are worse off is
the negative of the sum of net benefits excluding pivotal consumer, say,
consumer 1

Analogous to imposing a Pigouvian tax on negative

externalities, pivotal consumer is taxed by amount he or she
harms other consumers, 1
Called a Clarke tax

Which is paid by all pivotal consumers

Results in these consumers having incentive to reveal their true
preferences for pure public good

47

Clarke Tax

Clarke tax mechanism is a second-bid, sealed bid auction for a pure

public good

A pivotal consumers tax is equal to second-highest valuation

Sum of all other consumers net benefits

Benefits from tax revenue cannot be distributed to other consumers in such a manner
that it influences other consumers net benefit for pure public good

Consumers facing a higher tax rate relative to others may not respond
well to tax-discriminating nature of Clarke tax
One problem with Clarke tax is that it is not necessarily Pareto efficient

Predetermined payment may result in some cases where a group of

consumers has negative net benefits for pure public good

Even when sum of net benefits is positive

Purchasing pure public good will harm these consumers

Not result in a Pareto improvement
Some type of compensation principle would be required to justify social-welfare
benefits of a Clarke tax

48