Part 2: A Framework for the Analysis of Public

Expenditure Part 1 discussed WHEN to have government

intervention.

Part 2 discusses HOW government can intervene.

Chapter 4: Public GoodsChapter 5: ExternalitiesChapter 6: Income RedistributionChapter 7: Cost-Benefit Analysis

Part 2: A Framework for the Analysis of Public

Expenditure

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Chapter 4: Public Goods

Public Goods – no one wants to pay for them, but everyone benefits from them.

How does the government decide WHICH public goods are provided and HOW MUCH IS provided?

Should the private market be used to provide or produce government commodities?

Chapter 4: Public Goods

What is a Public Good?Efficient Provision of Public Goods

The Efficiency ConditionsPublic Goods and Distortionary TaxationPrivate Provision of Public GoodsFree-RidersPrivatization

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Theory - What is a Public Good?

A PURE PUBLIC GOOD has two features:

1) Nonrival – once provided, another person can consume it at no additional cost

2) Nonexcludable – once provided, it is impossible or highly expensive to prevent anyone from consuming it

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Pure Public Good ExamplesNational Defense is a good example of a pure

public good:

1) Nonrival – all Canadians benefit

2) Nonexcludable – it’s impossible to prevent a Canadian from benefitting

Other examples: Conventional Radio, A Beautiful View, A Canada-Wide Sunglass dome designed to block harmful sun rays (Canadome)

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What is a Private Good?

A PRIAVATE GOOD has two features:

1) Rival – once consumed, another person cannot consume it

2) Excludable – others can be prevented from consuming it

Food (ie: pizza or sushi) is a good example of a private good. Once I eat it, it’s gone and you’re left hungry.

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Pure Public Good Issues

6 Issues arise out of Pure Public Goods:6 Issues arise out of Pure Public Goods:

1)1)Different ValuesDifferent Values

2)2)Public Goods Aren’t AbsolutePublic Goods Aren’t Absolute

3)NONRIVAL ≠ NONEXCLUDABLE

4)Unconventional Public Good

5)Private Provision

6)Private Production

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-National defense protects everyone equally. Paranoid people love it and peace activists hate it.

-The Canadome is popular among people concerned with cancer and unpopular with people wanting tans. It affects everyone, however

1) WHILE EVERYONE CONSUMES 1) WHILE EVERYONE CONSUMES THE SAME AMOUNT, PEOPLE MAY THE SAME AMOUNT, PEOPLE MAY

VALUE IT DIFFERENTLYVALUE IT DIFFERENTLY

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2) PUBLIC GOODS ARE NOT ABSOLUTE

-technology and the market can affect a public good. A free TV station becomes private if you need a decoder. A view becomes rival if too many people crowd.

-An IMPURE PUBLIC GOOD is to some extent rival or to some extent excludable

-most public goods are impure, but analysis of pure public goods still gives valuable results for impure public goods

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3) NONRIVAL ≠ NONEXCLUDABLE

-National parks are excludable if they have gates, but practically nonrival as they are so big

-My office hours are nonexcludable, as everyone is welcome, but rival if too many people are waiting in line

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4) VARIOUS THINGS HAVE SIMILARITIES WITH PUBLIC GOODS

-Inspiration can be nonrival and nonexcludable (such as coming from a sunset)

-Fear is nonrival, as one person being afraid doesn’t prevent others. Fear is also nonexcludable, as its hard to prevent.

-Income distribution or honesty are public goods as everyone benefits

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5) THE PUBLIC SECTOR CAN PROVIDE PRIVATE GOODS

-Medical services, housing, licenses, and utilities can all be provided by the government and/or private sector

-The label public or private doesn’t indicate what sector provides the item

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6) PUBLIC PROVISION ≠> PUBLIC PRODUCTION

-Some public services are contracted out to private contractors

-For example, the City of Edmonton contracts out much of its snow removal business

-it provides the public service through private contractors

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Efficient Provision of Private Goods

-To cover efficient provision of public goods, we first look at efficient provision of private goods

-Consider Maka and Susan’s individual demands for video games

-At a market price, we add up Maka and Susan’s quantity demanded for video games to find market demand

-This results in a HORIZONTAL SUMMATION

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2

Maka Susan Market demand

40

100

Q Q Q

P P P

@ P=$40, QM+QS=QD

2+5=7

5 7

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2

Maka Susan Market

40

100

Q Q Q

P P P

When market supply intersects market demand, we find equilibrium price and individual demand.

5 7

S

Q*=51.5

3.5

@ P*=$65, QM+QS=Q*

1.5+3.5=5

65

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Efficient Provision of Private Goods

-From microeconomic theory, we know that a consumer maximizes utility where MRSxy=Px/Py

-If we normalize Py to $1, this simplifies to MRSxy=Px

-Since price is found on the demand curve, Maka’s (Susan’s) demand expresses Maka’s (Susan’s) MRS at each level of consumption

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Efficient Provision of Private Goods

-From microeconomic theory, the supply curve comes from MC

-MRTxy=MCx/MCy, but since Py=MCy and Py=$1, MRTxy=MCx

-therefore the supply curve represents MRTxy

Then, at equilibrium, Supply=Demand, andPersonBxy

PersonAxyxy MRSMRSMRT

Pareto Efficiency Condition

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Efficient Provision of PUBLIC GOODS

-Consider Maka and Susan’s individual demands for a public good: radio shows

-Radio shows are nonrival and nonexcludable; one person’s consumption doesn’t affect the other

-The key difference in a public good is that BOTH can consume a purchased good; it is not used up

-This results in a VERTICAL SUMMATION to calculate willingness to pay

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2

Maka Susan

Market demand

4

10

Q Q Q

P P P

Maka is willing to pay $4 each for 2 radio shows, and Susan is willing to pay $7 each, therefore the

market is willing to pay $11 each

7

2

11

2

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2

Maka Susan

Market demand

4

10

Q Q Q

P P P

The market Supply gives an equilibrium quantity of 3. Here price paid in the market ($6) is the sum of Maka’s payment ($2) and Susan’s payment ($4).

7

32

11

33

S

64

2

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Efficient Provision of Public Goods

-Once again, if we normalize our other good to $1, demand (willingness to pay) represents MRS for each person.

-The sum of both people’s willingness to pay (market demand), is therefore the sum of individual MRS.

-The supply curve still represents MC and therefore MRT, so we have:

PersonBxy

PersonAxyxy MRSMRSMRT

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Efficient Provision of Public Goods

-Furthermore, again since Py=$1,PersonBPersonA MBMBMC

-Intuitively, public goods should therefore be provided until the point where the marginal cost of the good is equal to the sum of marginal benefits

-The private good equation can also be rewritten as

PersonBPersonA MBMBMC

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THEORY - Distortionary Taxes and Public Goods

If Publi c Goods are funded by distortionary taxation, we have two additional effects :

1) We have to consider the cos t of raising an addi tional dollar through a distorti onary tax, or marginal cost of public funds (MCF). Gross cos t then becomes:

MCMCF

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Distortionary Taxes and Public Goods2) The public good may encourage economic activity,

which translates into new taxes, captured by:

MRMCF *-Therefore, optimal provision of a public

good then occurs when:

PersonBPersonA MBMBMRMCMCF )(

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Distortionary Taxes and Public GoodsNote that if MR is positive (the public good benefits

the economy), benefit becomes

PersonBPersonA MBMBMRMCF *

Alternately, if MR is negative (the public good, though it may benefit people, hurts the economy (such as a free themepark hurting private themeparks),cost becomes: )( MRMCMCF

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Public Goods ConclusionIn short, public goods are always best provided where

Total Marginal Benefit = Marginal Cost

Providing a public good through distortionary taxes may increase or decrease its provision when compared to lump-sum taxation funding

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Theory - Private Provision of Public GoodsIf a public good is provided privately, its efficiency depend on how people represent their willingness to pay

-For private goods, people have no incentive to misrepresent their willingness to pay

-if the price is $10, and that lies in their willingness to pay, they will pay the $10, consume the good and be happy

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Private Provision of Public Goods-For public goods, people have an incentive to misrepresent their willingness to pay

-if the price is $10, a person could hope someone else pays the price, then they get to enjoy it (they are a FREE RIDER)

-for example, at an alligator reserve, people can pay money to throw meat into the water and watch the alligators go, and often wait for someone else to buy and throw the meat

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Private Provision of Public Goods-If the public good can be made excludable (ie: entrance fee), it is still provided inefficiently, as the MC of an additional consumer is

zero, therefore P>MC

-The one way to avoid the free rider problem is through PERFECT PRICE DISCRIMINATION – everyone pays their willingness to pay

-this requires full information, therefore private provision is often doomed to be inefficient

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The Free Rider ProblemTHE FREE RIDER PROBLEM comes from the incentive to let others pay while you enjoy the benefits

-Yet empirically, people do band together to raise funds for public goods such as libraries

-Studies have shown that although people may be willing to contribute some towards public goods, this contribution generally falls short

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The Free Rider Problem ExampleMany people are willing to help construct homes for low income families.

People go to great lengths to help construct these homes, and one low income family is very happy.

-But the project never continues until a city reaches zero homelessness

-Similarly, private provision of public goods only goes so far

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Privatization of Government FunctionsGovernment functions (both public and private commodities) can be provided privately IF THEY ARE EXCLUDABLE:

Privatization has 2 LEVELS:

1) Private Provision – private firms provide the good or service

2) Private Production – private firms produce the good or service, which can then be provided by the government

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Private Provision DebateMany government functions can be and are provided privately IF THEY ARE EXCLUDABLE:

Home/private schooling vs. public schooling

Police force vs. Private security

Private swimming pool vs. Public lake

-To debate the merits of private provision of government functions, a variety of issues need be examined:

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Private Provision Debate1) Input costs

-Do private firms or the government pay lower input costs (wages, materials, etc) for the good or service?

-Are there unions or unique suppliers involved?

2) Administrative Costs-Typically, government can reduce administration costs through size and economies of scale

-This is not always the case

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Provision Debate3) Diversity of Tastes

-If people have a variety of tastes (quality, quantity, environmental footprint, etc), private provision allows for variety

4) Quality of Information-If individuals are poorly informed about the quality of the good, government provision may be best

-sofa selection is a lot easier than healthcare selection

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Provision Debate5) Distributional Issues

-Does fairness imply that some goods and services should be available to EVERYONE, (COMMODITY EGALITARIANISM (Tobin, 1970))

-This argument is often made for healthcare

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Public Production Debate

The argument about who should PRODUCE public goods often hinges on two concepts:

Cost vs. Quality

-private companies often have lower costs due to a focus on profit and lack of unions

-private companies often produce inferior products (as in US health insurance refusing coverage or charging high premiums)

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Production Debate

Some argue that quality can be maintained through good contracts

-Some contracts are straightforward: cut the park lawn once a week

-Some contracts are near impossible: treat this yet-to-be-discovered disease with the following yet-to-be-discovered drugs

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Production Debate

Market structure also needs to be considered:

-If the government has a monopoly, is lack of competition causing inefficiency?

-If privatization creates a monopoly or oligopoly, will market power cause inefficiency?

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Case Study: Alberta Liquor Privatization

West (1997) studied the 1993 privatization of Alberta liquor stores and learned the following:

-the number of liquor stores rose from 258 to 604, and although selection and individual stores fell, overall selection increased

-liquor prices rose between 8.5% and 10% (compared to 5% inflation)

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Case Study: Alberta Liquor Privatization

-Liquor store employment tripled as wages fell by up to 50% (the union was replaced)

-There was no evidence of increased alcohol consumption or alcohol-related crimes

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Case Study: Alberta Liquor PrivatizationWas privatization good?

More stores vs. poorer selection

Liquor Price Increases

More employment vs. Lower wages

If this privatization is so complex, what does that say about privatizing healthcare, utilities or schools?

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Chapter 4 Summary Public goods are nonrival and nonexcludable With lump-sum taxation:

Public Goods are efficiently provided where ∑MRS=MRT or ∑MB=MC (Private goods are efficiently provided where MRSA = MRSB = MRT)

With distortionary taxes, the marginal cost of public funds (MCF) and the tax revenue effect of the public good must be taken into account Efficient provision still occurs where

Total Benefit = Total cost

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Chapter 4 Summary It is unlikely that markets would provide public goods efficiently, even if they are excludable Free-riding limits private provision of public goods Privatization entails private provision or production of a government function 5 issues were raised in the debate between public or private provision Two issues with public production are efficiency and quality