4.

Public Goods

SO FAR
We have seen that the role of government in promoting
efficiency is to intervene in the pricing mechanism of
goods that create externalities.
Now we will investigate a class of goods where it is usually
more efficient for the government to supply instead of
the private sector.
Public Goods:=(Law and Order, defence, refuse collection,
roads, education, public health,)

Outline
1.
2.
3.
4.

Definition and Description

Free-riding
Optimal Provision:
Problems of Preference Revelation

Definition
A Public Good has 2 properties:
(1) If it has been provided to one consumer it is
difficult/impossible to stop another from enjoying it too.
Non-Excludable
(2) The amount of the good I enjoy has no affect on the
amount you enjoy.

Non-rival

Example: TV Signals

NON-EXCLUDABLE

EXCLUDABLE

NON-RIVAL

RIVAL

TERESTRIAL

BASIC CABLE

Pure Public Good

Impure Public Good

SATELLITE

Pay-per-View

Impure Public Good

Pure Private Good

CONSEQUENCES
Non-excludable:
Very difficult for the private sector to provide it and
make a profit.
(Basic Research, Information, R&D)
Non-rivalry:
Do not want to exclude people as it is inefficient
(The marginal cost of them getting the good is zero and
they get positive benefit.)

The Free Rider Problem

The fundamental problem of all public goods is Id rather
someone else paid for the public goods I consumed.
This is called the free-rider problem.

Prisoners Dilemma in Action

Imagine it costs 4 to provide a
clean street outside my house.
Either I or my neighbour can pay
for it.
We both value clean streets at 3.
If one of us pays 4 we are both
better off.

He Pays

He
Doesnt
Pay

I Pay

I Dont
Pay

Prisoners Dilemma in Action

Imagine it costs 4 to provide a
clean street outside my house.
Either I or my neighbour can pay
for it.
We both value clean streets at 3.
If one of us pays 4 we are both
better off.

He Pays

He
Doesnt
Pay

I Pay

(-1,-1)

(-1,3)

I Dont
Pay

(3,-1)

(0,0)

Prisoners Dilemma in Action

Imagine it costs 4 to provide a
clean street outside my house.
Either I or my neighbour can pay
for it.
We both value clean streets at 3.
If one of us pays 4 we are both
better off.

He Pays

He
Doesnt
Pay

I Pay

(-1,-1)

(-1,3)

I Dont
Pay

(3,-1)

(0,0)

Other Examples of Free Rider Problems

In the USA people pay voluntary subscriptions for the
public broadcasting service less than 10% do so. (In the
UK it is mandatory to pay the TV licence fee.)
The town of Cambridge distributed 350 bikes around the
town for people to use free of charge. (You had to return
the bike to a special stand after using it.) Within 4 days
they had all gone.

When can private provision of public goods

work
You often find shops forming groups to improve the
environment they act in. e.g. Oxford Street Traders
Association.
Also rich neighbourhoods sometimes pay for security
patrols, (e.g. Bishops Avenue, Hampstead)
Why does this work?
People are not all the same some people value the
public good a lot.
Altruism
People feel good if they contribute to the public good
(warm glow)

User Fees for Excludable Public Goods and

for Publicly Provided Private Goods
Some public goods are excludable roads, bridges etc.
Some goods (education, water) have large cost of
supplying additional individuals are often publicly
provided.
Price/Fee

Demand/Users Value

# of users

User Fees for Excludable Public Goods and

for Publicly Provided Private Goods
How does welfare get maximized?
The best possible is to allow everyone to travel and to somehow pay for the
bridge.

Price/Fee

Demand/Users Value

# of users

User Fees for Excludable Public Goods and

for Publicly Provided Private Goods
Welfare =

Price/Fee

Cost of the Bridge

Demand/Users Value

# of users

User Fees for Excludable Public Goods and

for Publicly Provided Private Goods
If you charge a fee to recoup the cost of the bridge welfare goes down.

Price/Fee

Demand/Users Value
COST
OF
BRIDGE
FEE

# of users

User Fees for Excludable Public Goods and

for Publicly Provided Private Goods
If you charge a fee to recoup the cost of the bridge welfare goes down.

Price/Fee

LOST
VALUE

Demand/Users Value
COST
OF
BRIDGE
FEE

# of users

Impure Public Goods

Anything with a positive consumption externality.
Congested goods: Roads
Club Goods: Excludable with congestion = Museum
Local Public Goods: Parks, libraries etc.

Efficient Provision of Public Goods

How much Public Goods should the Government provide?
Marginal Benefit of the Public Good
MC of the PG

Marginal Benefit
Non-Excludable
Marginal Benefit =
Marginal Benefit1 + Marginal Benefit2 +
+ Marginal BenefitN
= Marginal Benefiti

How do we know whether we have the

socially optimal quantity of public goods?
Marginal Benefit from the public good
= MU(pg)
Marginal Cost of Providing one more unit of Public Good
= MC(pg)

How do we know whether we have the

socially optimal quantity of public goods?
Marginal Benefit from the public good
= MU(pg)
Marginal Cost of Providing one more unit of Public Good
= MC(pg)
Marginal Benefit from the Private good
= MUi
Marginal Cost of Providing one more unit of Private Good
= MC

Right Mix if

MB(public good)
MC(public good)

MB(private good)
MC(private good)

Equivalently

MU(pg)
MC(pg)

MUi
MC

Equivalently

MU(pg)
MC(pg)

MUi
MC

Equivalently

MU(pg)
MC(pg)

MUi
MC

Equivalently

MU(pg)
MUi

MC(pg)
MC

Equivalently

MRS = MRT
This is called the Samuelson Condition after Paul Samuelson who first
noticed it applied.

Mechanisms for Efficiently Providing the

Public Good

How do you get to provide people with the right quantity

of the public good if:
1. When it is provided at zero MC people will tend to
overstate their desire for it.

2. When it is provided at positive MC people will tend to

understate their desire for it hoping to free ride.

Mechanisms for Efficiently Providing the

Public Good

How do you get to provide people the right quantity of the public good
if:
1.

When it is provided at zero MC people will tend to overstate their

desire for it.

2.

When it is provided at positive MC people will tend to understate

their desire for it hoping to free ride.

We want to find Incentive Compatible Mechanisms

i.e. provision schemes where it is in everyones interest to correctly
report how much they value the good.

Example 1: Vickrey Auctions

Assumptions:
One unit of a good to be sold.
People have independent and private values: v1 ,v2 ,,vn .
(This rules out situations where your value is affected by
what others know.)

Example 1: Vickrey Auctions

Assumptions:
One unit of a good to be sold.
People have independent and private values. (v1 ,v2 ,,vn)
Rules:
Bids are submitted and the highest bid gets the object.
The winner pays the amount bid by the second highest
bidder.
Optimal strategy = Bid how much you value the object.
(i.e. truthfully reveal your value)

Example 1: Vickrey Auctions

Analysis:
The highest bid from everyone else is B.
My value is v*.
If I submit a bid b > B => I win and pay B (I get v*-B)
If I submit a bid b < B => I lose and I get zero.
Case 1: B>v*
In this case winning (and bidding above B) will lose me
money bidding v* is optimal here.

Example 1: Vickrey Auctions

Case 1: B > v*
In this case winning (and bidding above B) will lose me
money bidding v* is optimal here.
Case 2: B < v*
In this case my payoff from winning (v* - B) is positive.
This is also independent of what I bid.
If I bid b=v* I will be sure I always win the auction in this
case.
WHATEVER THE OTHERS DO BIDDING v* IS BEST!
(Note: this is not true if my value depends upon what you
know.)

Clark-Groves Mechanism
This is a process that will get individuals to truthfully to
reveal their preferences for the public good.
Step 1 : Individuals report their value for the bridge vi
Note : they dont have to report the truth vi vi*

Clark-Groves Mechanism
This is a process that will get individuals to truthfully to
reveal their preferences for the public good.
Step 1 : Individuals report their value for the bridge vi
Step 2 : Add up the reported values.

Clark-Groves Mechanism
This is a process that will get individuals to truthfully to
reveal their preferences for the public good.
Step 1 : Individuals report their value for the bridge vi
Step 2 : Add up the reported values.
Step 3 : If Sum of Reports Cost of Bridge >0 then build the
bridge.

Clark-Groves Mechanism
This is a process that will get individuals to truthfully to
reveal their preferences for the public good.
Step 1 : Individuals report their value for the bridge vi
Step 2 : Add up the reported values.
Step 3 : If Sum of Reports Cost of Bridge >0 Build Bridge
If Sum of Reports Cost of Bridge <0 Dont Build

Clark-Groves Mechanism
Step 1 : Individuals report their value for the bridge vi
Step 2 : Add up the reported values.
Step 3 : If Sum of Reports Cost of Bridge >0 Build Bridge
If Sum of Reports Cost of Bridge <0 Dont Build
Step 4 : If the individuals value was decisive, i.e.
Sum of Others Reports < Cost of Bridge < Sum of all Reports

Clark-Groves Mechanism
Step 1 : Individuals report their value for the bridge vi
Step 2 : Add up the reported values.
Step 3 : If Sum of Reports Cost of Bridge >0 Build Bridge
If Sum of Reports Cost of Bridge <0 Dont Build
Step 4 : If the individuals value was decisive, i.e.
Sum of Others Reports < Cost of Bridge < Sum of all Reports
Charge the individual = Cost of Bridge Sum of others reports

Clark-Groves Mechanism
Optimal to tell the truth.
Let U be the sum of the others reports and let v be my value.
If U>Cost:
I dont care what I say so reporting truthfully is fine.

Clark-Groves Mechanism
Optimal to tell the truth.
If U+v > Cost > U:
Then any report u such that U+u>Cost (or u>Cost-U) will get
me utility
v (Cost U) >0 . (independent of report!)
But any report u < Cost U will get me utility
To ensure I get this positive utility should then report
truthfully.

=0.

Clark-Groves Mechanism
Properties:
(1) Optimal to tell the truth
(2) Voter only pays when decisive.
(3) Payments < benefits received
(4) As population grows less of a problem with excess revenue.