Public Goods

EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Overview

Overview

Public good:

Examples:

A good that must be provided in

the same amount to all the
affected consumers

Facilities provided by
the government
National defense

Pareto Improvement to
Provide the Public Good
Consider

Budget constraints
Let
w1 , w2 Each persons

Two persons: Person 1, Person 2

initial wealth
g1 , g 2 Each persons
contribution to the TV
x1 , x2 Each persons
private consumption

They decide whether or not to

purchase a TV.
TV is a public good.
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Public Goods

EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Budget constraints

Budget constraints

Budget constraints for

persons 1 and 2:

where

x1 + g1 = w1
x2 + g 2 = w2

g1 + g 2 c
c costs of the TV

They can acquire the TV if

together they pay the cost c .
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Utility function

Utility function

Each persons utility function will

depend on:

Utility functions for persons

1 and 2:

his private consumption

the availability of the public
good

where
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Public Goods

0
G=
1

u1 (x1, G )
u 2 ( x2 , G )

No TV
TV is available
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EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Reservation price

Reservation price

Reservation price:

If each person

The maximum amount of money

that each person is willing to
pay to have the TV available

pays ri and gets TV

xi = wi ri
does not get TV

xi = wi

Reservation price

Reservation price

Each person is indifferent between

{paying ri + TV available}
and
{not having TV}

u1 (w1 r1 ,1) = u1 (w1 ,0 )

u2 (w2 r2 ,1) = u2 (w2 ,0)

These equations define ri for
each person.

if
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Public Goods

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EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Pareto improvement

Pareto improvement

Two possible allocations:

2) An allocation where the public

good (TV) is provided:

1) An allocation where the public

good (TV) is not provided:

(w1, w2 ,0)

where

Each person spends his wealth

only on his private consumption.

(x1, x2 ,1)

x1= w1 g1
x 2 = w2 g 2

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Condition for
Pareto improvement

Pareto improvement
Each persons private
consumption is determined by
his wealth left after making
contribution to the public good.

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Public Goods

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It will be a Pareto improvement to

provide the TV if
both persons are better off
having the TV provided than not
having it provided:
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EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Condition for
Pareto improvement

u1 (w1,0) < u1 (x1,1)

u2 (w2 ,0 ) < u2 ( x2 ,1)

Condition for
Pareto improvement
(1)

By the definition of reservation

prices, the LHS of (1) and (2) are:

(2)

u1 (w1 r1,1) = u1 (w1,0 )

u2 (w2 r2 ,1) = u2 (w2 ,0)

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Condition for
Pareto improvement

Condition for
Pareto improvement

By the budget constraint, the RHS

of (1) and (2) are:

(1) and (2) then become:

u1 (x1 ,1) = u1 (w1 g1,1)

u1 (w1 r1,1) < u1 (w1 g1 ,1)

(3)

u2 (w2 r2 ,1) < u2 (w2 g 2 ,1) (4)

u2 (x2 ,1) = u2 (w2 g 2 ,1)

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Public Goods

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EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Condition for
Pareto improvement

Condition for
Pareto improvement

Since x i ui , (3) and (4)

imply that:

or

w1 r1 < w1 g1
w2 r2 < w2 g 2

r1 > g1
r2 > g 2

(5)
(6)

Each persons contribution to

the TV is less than his
willingness to pay for the TV.
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Condition for
Pareto improvement

Condition for
Pareto improvement

This is a necessary condition

for providing the TV to be a
Pareto improvement.

If (5) and (6) are satisfied, then:

r1 + r2 > g1 + g 2 = c

(7)

The total willingness to pay is

greater than the cost of the
TV.
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Public Goods

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EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Condition for
Pareto improvement

Note

This is a sufficient condition

for providing the TV to be a
Pareto improvement.

1) The sufficient condition only

depend on (r1 , r2 ) and c .

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Note

Note

2) The sufficient condition will

depend on (w1 , w2 ) because
(r1, r2 ) depends on (w1, w2 ) .

It is possible that:

r1 + r2 > c for some (w1 , w2 )

Public good is provided.

r1 + r2 < c for other (w1 , w2 )

Public good is not provided.
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Public Goods

If r1 + r2 > c :
there will always exist a
payment scheme ( g1 , g 2 ) such
that both are better off having
the public good.

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EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Private Provision
of the Public Good

Note
In general
Whether or not the public good
should be provided will depend on:

Having the public good provided

will be a Pareto improvement if

r1 + r2 > c

the distribution of wealth

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Private Provision
of the Public Good
For the public good:

Private Provision
of the Public Good

Each person may not have an

incentive to reveal his true
willingness to pay.
Each person has an incentive to
pay as little as possible toward
the provision of the public good.
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Public Goods

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People are attempting to free

ride on each other.
Each person hopes that the
other person will purchase
the public good.

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EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Free Riding

Free Riding

Free riding game

Let

Two players: Player A

Player B
Two strategies: Buy TV
Dont buy TV

Each persons wealth

= 500

Each persons value

for the TV

= 100

Cost of the TV

= 150

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Free Riding

Free Riding

Suppose:

Each person cannot exclude the

other person from watching the
TV.
Each person will decide
independently whether or not to
buy the TV.
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Public Goods

Payoff matrix
A

Buy

Buy

Dont buy

50,50

50,100

Dont buy 100, 50

0,0
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EC 221 Intermediate Microeconomics

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Free Riding

Free Riding
Difference:

Dominant strategy equilibrium:

Prisoners dilemma game

The strategy that maximizes
the sum of the players
payoffs is for both to make
the same choice.

(Dont buy, Dont buy)

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Free Riding

Free Riding

Free riding game

The strategy that maximizes
the sum of the players
payoffs is for only one to buy
the TV.
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Public Goods

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Pareto improvement:
If A buys the TV and B makes a
payment between 50 and 100,
both will be made better off.

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EC 221 Intermediate Microeconomics

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Pareto Efficient Level

of the Public Good
Consider:

Pareto efficiency condition

Two persons have to decide how

much of the public good to
provide.

private consumption

g1 , g 2 Each persons
contribution to
the public good

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Pareto efficiency condition

Pareto efficiency condition

Constraint:

Quality of
the public good
c(G ) Cost for the public
good of quality G

(x1 + g1 ) + (x2 + g 2 ) = w1 + w2
x1 + x2 + c(C ) = w1 + w2

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Public Goods

Let
x1 , x2 Each persons

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EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Pareto efficiency condition

Pareto efficiency condition

The total amount of the their

private consumption and the
public good is equal to the total
amount of their wealth.

Pareto efficient allocation:

An allocation where one person
is as well-off as possible given
the other persons utility level
Lets fix Person 2s utility at u 2 .

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Pareto efficiency condition

Pareto efficiency condition

Person 1s problem:
max u1 (x1 , G )

Condition for Pareto

efficiency:

x1 , x2 ,G

s.t. u2 (x2 , G ) = u2
x1 + x2 + c(G ) = w1 + w2
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Public Goods

MRS1 + MRS 2 = MC (G )

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EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Pareto efficiency condition

Interpretation for
Pareto efficiency condition

The sum of the two persons

MRS between the private good
and the public good equals the
marginal cost of providing an
extra unit of the public good.

Consider:
MRS marginal willingness
to pay for an extra unit
of the public good

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Interpretation for
Pareto efficiency condition

Interpretation for
Pareto efficiency condition

Discrete public good

Different levels of
public good

If MRS1 + MRS 2 > MC (G )

The public good is provided.

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Public Goods

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If MRS1 + MRS 2 > MC (G )

It is appropriate to provide
more of the public good.
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EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Efficient amount
of the public good

Efficient amount
of the public good

Sum MRS1 and MRS 2 vertically.

G Efficient amount of the

public good

The ( MRS1 + MRS 2 ) curve

The two persons must consume

the same amount of the public
good.

Condition for Pareto efficiency:

MRS1 + MRS 2 = MC
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Efficient amount of the

public good (Varian: Figure 36.1)

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Free Riding Problem

Let
w1 , w2 Each persons wealth
x1 , x2 Each persons
private consumption
g1 , g 2 Each persons
contribution to
the public good

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Public Goods

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EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Free Riding Problem

Free Riding Problem

Cost of providing the public good:

c(G ) = G

MC (G ) =

Total amount of the public good

provided:

G = g1 + g 2

dc
=1
dG

Person i s utility function:

ui (xi , G )

= g1 + g 2

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Free Riding Problem

Free Riding Problem

Person 1s problem:

Person 2s problem:

Person 1 has to choose x1 and g1 ,

guessing that g 2 = g 2

Person 2 has to choose x2 and g 2 ,

guessing that g1 = g1

max u1 ( x1, g1 + g 2 )
x1 , g1

max u2 ( x2 , g1 + g 2 )
x2 , g 2

s.t. x2 + g 2 = w2

s.t. x1 + g1 = w1
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Public Goods

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EC 221 Intermediate Microeconomics

Saree Worawisutsarakul

Free Riding Problem

Free Riding Problem

Optimal condition:

There is one extra constraint on

each persons contribution:

MRS1 = 1
MRS 2 = 1

g1 0 , g 2 0

If each person purchases both

goods, then the MRS between
the public good and the private
good should be 1 for each person.

Each person can only increase

contribution, or make no
contribution at all.

Free riding

Free riding

Example:

Denote:

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Person 2 is free riding Person 1s

contribution to the public good.

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Public Goods

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ei Person i s endowment

ei = wi + g j

ji

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EC 221 Intermediate Microeconomics

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Person 1s optimal choice

Person 1

(Varian: Figure 36.2 A)

Person 1s contribution:

g1 = G

Person 1s optimal choice is where:

MRS1 = 1

His indifference curve is

tangent to his budget line.
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Person 2

Person 2

Person 2s endowment:

Person 2s optimal choice is to

e2 = w2 + G

Since Person 2 can only increase

the public good:
His budget line is the bold line.
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Public Goods

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free ride on Person 1s

contribution;
consume at his endowment.

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EC 221 Intermediate Microeconomics

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Person 2s optimal choice

Free riding

(Varian: Figure 36.2 B)

In general
Efficient
Equilibrium
amount of the < amount of the
public good
public good

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Public Goods

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