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Public goods

Lecture 4 Tom Holden Intermediate Microeconomics Semester 2

http://micro2.tholden.org/

ECO 2051 Intermediate Microeconomics

Externalities exercise from lecture 3.2 (1/3)


It takes 45 minutes to go around town on an uncongested road. The road through town can get congested. It then takes minutes 100 to travel the direct route. Assume 6000 commuters need to travel from one side of town to the other. With no tolls how many will travel through town?
The two journeys must take the same time for people to be prepared to 20+ travel along either road. I.e. 45 = 100 , so 4480 go the direct route, and 1520 people go around.
20+

How many minutes will be spent travelling?


45 6000 = 270000 minutes, or 4500 hours.
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Externalities exercise from lecture 3.2 (2/2)


Suppose a social planner determines the allocation of routes. How many people will go a) through town b) around town?
Social planner minimises total travelling time, which is 20 + + 6000 45 100 FOC: 0 = 100 + 100 45, so 2240 people go through town and 3760 people go around.
20 2

How many person-minutes would be spent travelling?


2240
20+2240 100

+ 3760 45 = 219824 minutes.

ECO 2051 Intermediate Microeconomics

Externalities exercise from lecture 3.3 (3/3)


If each commuter values their time at x per minute what level should a toll on the road through town be set at to minimise commuting time?
Equating the costs of the two roads we have that in equilibrium: 45 = 20+ + where is the toll. We want = 2240 for efficiency, hence = 100
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Are commuters better off? By how much?


Before a consumer would always pay 45 (effectively), since they were indifferent between the two roads. But they are still indifferent between the two roads, and the one around still costs 45, so they are no better off if the planner keeps the toll. But the planner raises 50176 pounds in revenue, which can be redistributed, making everyone better off by the equivalent of about 8.36 minutes.
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Motivating questions
What are public goods? How do they relate to externalities? When is a public good provided optimally? How can we find out peoples preferences for public good provision?

ECO 2051 Intermediate Microeconomics

Reading
Varian, Chapter 36 Morgan Katz and Rosen, Chapter 18
Less good on this topic.

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Introduction
With externalities we saw how two parties could trade to a Pareto optimal solution. However when there is more than one party experiencing the externality it is necessary for agreement to be reached on the value of the externality. This is particularly true in the case of non-depletable externalities, when all parties experience the externality equally. In this case the externality problem becomes a public good problem.

ECO 2051 Intermediate Microeconomics

The definition of Public Goods


A pure public good has two features. It is: Non-rival in consumption
All individuals who consume the good, consume the same amount although they may value it differently. In this case, how much should be provided?
Easy once you know peoples valuations, but how do we find them out?

Non-excludable
If I buy a public good, I cannot stop you from consuming it as well.
This generates a free-rider problem, individuals do not need to pay, therefore they do not reveal how much they value the good.

ECO 2051 Intermediate Microeconomics

Pareto efficient provision: to provide or not to provide (1/4)


Two flatmates called 1 and 2 are deciding whether to buy a TV for the living room.
Their initial wealths are 1 and 2 respectively. Their contribution to the TV are 1 and 2 respectively. Their private consumptions are 1 and 2 respectively.
Thus 1 = 1 1 and 2 = 2 2 .

They both consume units of the public good, the TV (either = 0 or = 1). They have utility functions given by 1 1 , and 2 2 , respectively.

The cost of the television is , so the television is provided if 1 + 2 > .

ECO 2051 Intermediate Microeconomics

Pareto efficient provision: to provide or not to provide (2/4)


We can define 1 and 2 to be the most that the respective flatmates are prepared to contribute in order to obtain the television.
These are reservation prices. When 1 = 1 , the first flatmate must be just indifferent between having the TV and paying 1 and not having the TV and paying nothing.
I.e. 1 1 1 , 1 = 1 1 , 0 .

Likewise, when 2 = 2:
2 2 2 , 1 = 2 2 , 0 .

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Pareto efficient provision: to provide or not to provide (3/4)


Providing the TV is a weak Pareto improvement if:
1 1 1 , 1 1 1 , 0 and 2 2 2 , 1 2 2 , 0 .

But from the definition of the reservation wage this means providing the TV is a weak Pareto improvement if:
1 1 1 , 1 1 1 1 , 1 and 2 2 2 , 1 2 2 2 , 1 .

So as utility is increasing in both arguments:


1 1 1 1 , i.e. 1 1 and 1 2 2 2 , i.e. 2 2 .

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Pareto efficient provision: to provide or not to provide (4/4)


So a necessary condition for providing the TV being efficient is that each individual is contributing less than his reservation price. A sufficient condition for it to be efficient to provide the TV is that 1 + 2 , since if this holds we can find 1 1 and 2 2 such that 1 + 2 = , and under these payments each individual must be at least as well off as without the TV.

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Free riding
Suppose each person has a wealth of 500 and values the TV at 100. Suppose also that the TV costs 150. It is Pareto optimal to buy the television. but each individual has an incentive to free ride. Look at the game below. Does either player have a dominant strategy?
Individual A Buy
Individual B Buy Dont Buy 25, 25 100, -50

Dont Buy
-50, 100 0, 0
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Public goods: Continuous choice case (1/2)


Everything is as before except the decision is on how much money to spend on the TV.
The cost of the television is , where is its quality.

When utility functions are increasing, the following condition is sufficient for Pareto efficiency:
Given consumer 2s level of utility, consumer 1 is as well-off as possible.
Why do we not need an equivalent condition with the roles of the two individuals reversed?

Thus we just need to choose 1 , 2 and , to maximise 1 1 , subject to the constraints that:
2 2 , = ( is some fixed utility level), and: 1 + 2 + = 1 + 2 (the budget constraint).

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Public goods: Continuous choice case


Choose 1 , 2 and , to maximise 1 1 , subject to the constraints that 2 2 , = and 1 + 2 + = 1 + 2 . Lagrangian:
= 1 1 , + 2 2 , 1 + 2 + 1 + 2

FOCs:
FOC 1 : 0 = FOC FOC
1 , hence = 1 . 1 1 2: 0 = 2 , so = 1 1 . 2 2 2 1 1 : 0 = 1 + 2 , thus:

= .

Hence: 1 + 2 = .
1 1 2 2

I.e. MRS1 + MRS2 = MC

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Interpretation of the solution (1/2)


MC is the opportunity cost of spending money on the public good MRS measures the willingness to pay for an extra unit of the public good.
We can think of this as the goods marginal benefit (MB).

Thus the solution can be written as MB1 + MB2 = MC. So, the optimality condition is that the marginal social benefit is equal to the marginal social cost.

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Interpretation of the solution (2/2) Diagram


MRS1 + MRS2
MC

MRS
MRS2

Efficient provision of a public good: The sum of the MRS must equal the marginal cost. Private good: consumers would set their own MB equal to the marginal cost, i.e. MRS1 = MRS2 = MC.

MRS1

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The intuition for optimality


Approach: look at situations where this condition is not met and show that they can be improved upon.
Say MC = 1, MRS1 = 1
4

and MRS2 = 1 2.

MRS is how much of the private good would be required to compensate for 1 less unit of the public good. If the public good is reduced by 1 unit this will cost 1, it takes only 3 to compensate both individuals for the loss.
So its optimal to reduce the amount of the public good thats provided.

Alternatively, if MRS1 = 2 3 and MRS2 = 1 2 then the total marginal benefit of an extra unit of public good is worth more than it costs.
So its optimal to increase the amount of the public good thats provided.
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Examples (1/2)
A town has one private good (bottles of beer) and one public good (size of the town skating rink in square metres). Beer costs 1, and the skating rink costs 5 per square metre. There are 500 citizens all with an income of at least 5000. All citizens have the same quasi-linear utility function.
, =
64 .

How do we find the Pareto optimal size of the skating rink?


(Should get = 80.)

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Examples (2/2)
Suppose in the fishery/factory example from lecture 3.2, there were two fisheries. As before, the steel firm has total cost , . The first fishery one has total cost 1 , . The second fishery has total cost 2 , .

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Free riding in the continuum case


Assume = 1. Given individual 2 contributes some fixed level 2 units of public good, individual 1 will maximize 1 1 1 , 1 + 2 subject to the constraint that 1 0.

With an interior solution, the FOC says: 0 =


Likewise, MRS2 = 1.
So MRS1 + MRS2 > MC = 1. I.e. the public good is under supplied.

1 1

1 ,

i.e. MRS1 = 1.

When the constraint binds, 1 +


1

< 0, so MRS1 < 1, but we must


1

still have MRS2 = 1, so there is still too little of the public good unless MRS1 = 0, which only happens when = 0.

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Solutions: Public intervention


The government may subsidise private firms to provide the good. The government may just provide the good itself. Has to decide how much (if any) of the good ought to be provided. Raises the question of preference revelation.

Strong incentive to lie on a survey.


E.g. pretend not to care about the good, in order to escape paying for it.

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Voting on public goods (1/3)


Suppose that a majority-rule vote is held on whether to install traffic signals at several street corners. Assume:
3 individuals. Each signal costs 300 to install, which is split equally between the three individuals. Individuals will thus only vote for a signal if they think the signal is worth at least 100.

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Voting on public goods (2/3)


Value to Each Voter, Signal Location
Corner A Corner B Corner C

Hayley
50 50 50

Nancy
100 75 100

Chris
150 250 110

Value to Society,
300 375 260

Outcome of Vote
YES NO YES

Will the signal be installed?

For which corners is the outcome efficient?


Problem with yes-no votes: the vote indicates only whether the public good is worth more or less than a certain amount.

But in fact the intensity of preferences matters too.


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Voting on public goods (3/3)


We saw in lecture 3.1 that voting may lead to intransitive social preferences. Imagine there are three voters A, B and C, and three levels of public good, X, Y, and Z.
A 1st preference 2nd preference 3rd preference X Y Z Y Z X B Z X Y C

In the aggregate, it appears X is preferred to Y, Y is preferred to Z and Z is preferred to X. Standard Condorcet paradox. But if X, Y and Z are different levels of public good provision, is it really plausible that people would have all of these preferences?

Single-peaked preferences
Collective intransitivity is avoided if all preferences are single peaked. This rules out all or nothing preferences such as those held by person C (assuming X, Y and Z are ordered as we would expect).

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With single-peaked preferences


Suppose preferences are instead as given below: Voter Cs preferences are now single-peaked. In this case Y>Z, Z>X and Y>X, no issues of collective rationality.

A 1st preference 2nd preference 3rd preference X Y Z Y Z X

B Z Y X

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Do single-peaked preferences really help?


Honest voting on expenditure with single-peaked preferences leads to choosing the amount preferred by the median-voter.
Imagine there was a pro-spending and an anti-spending political party, and think about where the parties would like the indifferent voter to be.

That half the population want more expenditure and half want less does not mean it is an efficient outcome.
Maybe the half that want more all want a large amount more, whereas the other lot only want a little less.

And in any case, there is no reason people should vote honestly.


With most voting mechanisms individuals have an incentive to misrepresent their preferences.
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Demand revelation mechanisms


There are problems with voting as we already know (Arrow etc.). Just asking people their valuation will encourage them:
To overvalue if their payment doesnt vary in their reported valuation, and, To undervalue if their payment does vary in their reported valuation, and they believe the good will be provided anyway.

The Vickrey-Clarke-Groves mechanism is a general solution to this problem, at least when individual preferences are quasi-linear.

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The Vickrey-Clarke-Groves mechanism (1/3)


Suppose we want to choose between a suite of different alternatives 1 , 2 , , .
For example, these could be different levels of public good provision.

Or they could be allocations of students to rooms.


Or they could be allocations of a single object to one person out of (as in an auction).

Assume that person values outcome at .

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The Vickrey-Clarke-Groves mechanism (2/3)


Step 1:
Ask all individuals to report their valuations of each alternative (i.e. 1 , 2 , , ).

Step 2:
Find the alternative 1 , , that maximises

Step 3:
Charge individual a fee of:
1 ,,

max

> 0.

AKA: Clarke tax If an individual has no effect on (they are not pivotal) this will be zero.

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The Vickrey-Clarke-Groves mechanism (3/3)


Why should people report truthfully?
Suppose agent reports as their valuation function. Then the chosen will maximise:

. +

And agent s value from participating is: max .


1 ,,

They cannot affect the final term, so they would like to choose their report such that the thing the social planner maximises corresponds with the first two terms.
But setting will do this!

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Example
Person A
B C

Cost share 100


100 100

Value 50
50 250

Net value -50


-50 150

Fee 0
0 100

TV costs 300 which will be split equally.


It is Pareto optimal to provide in this case.

Individuals A and B are not pivotal.


To become pivotal individual A would need to exaggerate net cost to -100. This would save 50, but he would need to pay a fee of 100 so its not worth doing.

Individual C is pivotal and pays a fee.


To save on the fee, theyd need to become not pivotal by understating their valuation. But in this case, theyd lose their net valuation of 150 and only save 100.

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Problems with the VCG mechanism


It only works with quasi-linear preferences, otherwise payment of the fee would change individuals demands. Although the allocation of public goods is optimal the overall picture is not, because the fees are all deadweight losses. In large (infinite) populations the revenues can be returned without affecting incentives.

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Another VCG example


Voter Option F Option G

1 2 3 Total

60 10 20 90

20 80 0 100

What fees do the three voters pay under the VCG mechanism? Demonstrate that they are incentive compatible.

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Summary
We answered two key questions in this topic:
What is the optimal allocation of public goods?
Important to see the difference between the conditions for public and private goods.

How can preferences be discovered so that optimality can be delivered?


Voting aspects are closely related to our lecture on welfare. Important to understand the VCG Mechanism.

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