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Econ606 Chapter 05 2020
- 1. CHAPTER 5 Public Goods, Public Choice, and Government Failure
- 2. 5-2 Public Goods Public Choice Theory Government Failure 5-2
- 3. 5-3 Demand-side Market Failures • Demand-side market failures: When it is not possible to charge consumers for the product. • Some can enjoy benefits without paying. • Firms not willing to produce since they cannot cover the costs. • It will lead to under-production of products, create a deadweight-loss, and result in loss of efficiency. LO5.1
- 4. 5-4 Private Goods • Private goods are often produced in the market by (for-profit) firms. • Rivalry: Once one person buys and consumes a product, it is no longer available for another person. • Excludability : Sellers can keep persons who do not pay for a product from obtaining its benefits. LO5.1
- 5. 5-5 Public Goods • Public goods are goods often provided by government. • Non-rivalry: One person’s consumption of a good does not preclude consumption of the same good by others. • Non-excludability : Cannot exclude individuals from the benefit of the good. • Examples: National defense, NPR & PBS, Park & Beach • Free-rider Problem LO5.1
- 6. 5-6 Free-Rider Problem • Free-rider problem: The inability of potential providers of goods to obtain payment from those who benefit due to non-excludability. • Because of free-rider problem, the public goods are usually not provided by (for-profit) firms even though products are desirable for the economy. LO5.1
- 7. 5-7 $9 7 5 3 1 0 P Q 1 2 3 4 5 $6 5 4 3 2 1 0 P Q 1 2 3 4 5 $6 5 4 3 2 1 0 P Q 1 2 3 4 5 Demand for a Public Good: Two Individuals (1) Quantity of Public Good (2) Garcia’s Willingness to Pay (Price) (3) Johnson’s Willingness to Pay (Price) (4) Collective Willingness to Pay (Price) 1 $4 + $5 = $9 2 3 + 4 = 7 3 2 + 3 = 5 4 1 + 2 = 3 5 0 + 1 = 1 LO5.1 D1 (a) Garcia D2 (b) Johnson DC SOptimal quantity Collective willingness to pay (c) Collective demand and supply Johnson’s willingness to pay Garcia’s willingness to pay
- 8. 5-8 Cost-Benefit Analysis • The government needs to apply the cost-benefit analysis to determine quantities of public goods it provides, because the market system fails to determine the optimal quantity of production. • Cost: Resources diverted from private good production = Value of Private goods that will not be produced. • Benefit: Extra satisfaction from the output of more public goods. LO5.1
- 9. 5-9 Cost-Benefit Analysis for a National Highway Construction Project (in Billions) (1) Plan (2) Total Cost of Project (3) Marginal Cost (4) Total Benefit (5) Marginal Benefit (6) Net Benefit (4) – (2) No new construction $ 0 $ 50 90 100 380 $ 0 $200 150 120 110 $ 0 A: Widen existing highways 50 200 150 B: New 2-lane highways 140 350 210 C: New 4-lane highways 240 470 230 D: New 6-lane highways 620 580 -40 LO5.1
- 10. 5-10 Quasi-Public Goods • Quasi-public goods could be provided through the market system. • Often with non-rivalry and excludability • Because of positive externalities the government provides them. • Examples: education, streets, museums. LO5.1
- 11. 5-11 The Reallocation Process • Since it costs the government to produce public goods, the government must have means to finance its production. • Taxes individuals and businesses • Voluntary fee & donation • Problems: The government cannot charge each users at his/her value of public goods. • Users of public goods can be different from payers of public goods. • Users value differently the public goods and are willing to pay different amount of taxes. • Some people want more, others want less public goods. LO5.1
- 12. 5-12 Public Choice Theory Public choice theory is the economic analysis of government decision making, politics, and elections. • Voting and Efficient provision of public goods • Government failures LO5.2
- 13. 5-13 Inefficient Majority Voting • Majority vote may not result in efficient allocation of public goods. • Inefficient “No” vote: Underproduction of a specific public good means underallocation of resources. • Inefficient “Yes” vote: Overproduction of a specific public good results in overallocation of resources. • Problems of voting as means to determine provision of public goods. • Interest groups. • Logrolling. LO5.2
- 15. 5-15 Paradox of Voting • The paradox of voting is a situation in which society may not be able to rank its preferences consistently through paired-choice majority voting. • Outcome may depend on order in which votes were taken. LO5.2
- 16. 5-16 Paradox of Voting Example LO5.2 Public Good Preferences Garcia Johnson Lee National Defense 1st choice 3rd choice 2nd choice Road 2nd choice 1st choice 3rd choice Weather warning system 3rd choice 2nd choice 1st choice Election Voting Outcomes: Winner 1. National defense vs. road National defense (preferred by Garcia and Lee) 2. Road vs. weather warning system Road (preferred by Garcia and Johnson) 3. National defense vs. weather warning system Weather warning system (preferred by Johnson and Lee)
- 17. 5-17 Median-Voter Model • The median-voter model suggests the median voter is likely to determine the outcome of the election. • The median voter is the voter holding the middle position on an issue. • At any point, people may be dissatisfied with the median preference. • People may “vote with their feet.” • Median preferences can change over time. LO5.2
- 18. 5-18 Government Failure Government failure refers to inefficient outcomes caused by government: • Voting problems • Principal-agent problem • Special-interest effect • Collective-action problem • Earmarks • Rent seeking behavior LO5.3
- 19. 5-19 Other issues in Public Choice • Limited and Bundled Choice • Only two or three choices for candidates for election. • Bureaucracy and inefficiency. • Public agencies less efficient than private businesses because of no test of profit and loss. • Government employees often gain political clout and bureaucrats justify their continued employment. • Inefficient Regulation and Intervention • Political corruption • Markets and government are both imperfect: Difficult to assign a good or service to either the public sector or the private sector.LO5.3
- 20. 5-20 Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University It includes copy-righted materials from ©2021 McGraw Hill Education. All rights reserved. No reproduction or further distribution without the prior written consent of McGraw Hill Education.
Editor's Notes
- This chapter discusses how government’s power to coerce can be economically beneficial; difficulties associated with managing and directing the government; and government failure and why it happens. The Last Word provides examples of government failure in the news.
- Learning Objectives LO5.1 Describe free riding and public goods, and illustrate why private firms cannot normally produce public goods. LO5.2 Explain the difficulties of conveying economic preferences through majority voting. LO5.3 Define government failure and explain its causes.
- Demand-side market failures occur because there are situations when it is impossible to charge all consumers, or any consumers, the price that they are willing to pay. A public fireworks display is an example where people don’t have to pay to enjoy the display. Private firms would be unwilling to produce outdoor displays as it would be impossible to raise enough revenue to cover production costs. Firm can’t prevent people from watching the fireworks if they didn’t pay.
- Private goods are produced through the market because they have rivalry (one’s use of a good makes it unavailable for others) and come in units small enough to be afforded by individual buyers. Private goods are subject to excludability, the idea that those unable and unwilling to pay do not have access to the benefits of the product. Since the goods have rivalry and excludability, private firms can produce and sell the goods for a profit.
- The demand curve of public goods may underreport how much consumers are willing and able to pay. Public or social goods would not be produced through the market because they possess the characteristics of nonrivalry and nonexcludability. Nonrivalry means that when one consumes the good this does not preclude another from consuming the good. Nonexcludability means that no one can be prevented from enjoying the benefits of a public good.
- With nonrivalry and nonexcludability, public goods suffer from the free-rider problem. The free-rider problem means that many people can benefit from the goods without paying, making it unprofitable for firms to produce these goods since they have no way to ensure that only paying consumers will enjoy the good. As a result, government often provides these goods. Examples of public goods include national defense, public music concerts, and outdoor fireworks displays.
- The demand for a public good is somewhat unusual. Suppose Garcia and Johnson are the only two people in society and their marginal willingness to pay for a public good, national defense, is as shown in the columns of the table. Notice that the schedules in this table are price-quantity schedules reflecting demand. To find the demand for a public good we add the prices each individual is willing to pay to find the collective willingness-to-pay for each quantity. Shown here is the individual’s willingness-to-pay curves D1 and D2 for Garcia and Johnson. The collective demand curve for a public good is found by summing vertically the individual willingness-to-pay curves, D1 and D2, for Garcia and Johnson. The supply curve of the public good is upward sloping, reflecting rising marginal costs. The optimal amount of the public good is 3 units, determined by the intersection of Dc and S. At that output, the marginal benefit (reflected in the collective demand curve Dc) equals marginal cost (reflected in the supply curve S).
- Government can use a cost-benefit analysis, which is a practical way to decide whether to produce a good and how much to produce. Government might use this method in determining whether or not to build a new highway.
- This table shows that the total annual benefit (column 4) exceeds the total annual cost (column 2) for plans A, B, and C, indicating that some highway construction is economically justifiable. We see this directly in column 6, where total costs (column 2) are subtracted from total annual benefits (column 4). Net benefits are positive for plans A, B, and C. Plan D is not economically justifiable because net benefits are negative, but the question of optimal size or scope for this project remains. By comparing the marginal cost (the change in total cost) and the marginal benefit (the change in total benefit), we can determine the answer. The guideline is well known to you from previous discussions: Increase an activity, project, or output as long as the marginal benefit (column 5) exceeds the marginal cost (column 3). Stop the activity at, or as close as possible to, the point at which the marginal benefit equals the marginal cost. Do not undertake a project for which marginal cost exceeds marginal benefit. In this case, plan C (building new four-lane highways) is the best plan. Plans A and B are too modest; the marginal benefits exceed the marginal costs, and there is a better option. Plan D’s marginal cost ($380 billion) exceeds the marginal benefit ($110 billion) and therefore cannot be justified; it overallocates resources to the project.
- Quasi‑public goods are those that have large positive externalities or spillover benefits where benefits accrue to some third party external to the market transaction, so government will sponsor their provision. Otherwise, if they were produced in the private market they would be underproduced.
- The government taxes individuals and businesses, which reduces their incomes and reduces demand for private goods, but increases the production of public goods when government spends that tax revenue.
- Studying market failure helps us understand how regulating markets may help improve the allocation of resources. And, studying government failure can help us understand how changes in the way government functions might help it to operate more efficiently. Incentives may lead political representatives to pursue policies that go against the preferences of the people, and the majority voting system we use can make it difficult to know voter preferences.
- The democratic process is imperfect. Public choice theory demonstrates that majority voting can produce inefficiencies and inconsistencies. In the marketplace, consumers can find and purchase a good that they have a strong preference for, even if it is unpopular with the majority of consumers, and consumers can choose not buy a good that they do not have a preference for even if it is a very popular product. But that is not the case with public goods. Because majority voting fails to incorporate the strength of the preferences of the individual voter, it may produce economically inefficient outcomes. People who share a common preference for a public good may form an interest group and use advertisements, mailings, etc. to convince others of their view. Logrolling is the trading of votes to secure a desired outcome and can either increase or decrease economic efficiency.
- Majority voting can produce inefficient decisions. In the left graph, we find majority voting leads to the rejection of a public good that would entail a greater total benefit than total cost. On the right, majority voting results in acceptance of a public good that has a higher total cost than total benefit.
- Different sequences of majority votes can lead to different outcomes, many of which may fail to reflect the voters underlying preferences. As a result, government may find it difficult to provide the “correct” public goods when relying on majority voting. Not to imply that there is a better procedure; it is better than having a dictator.
- This table illustrates three voters in the community who have three public goods to vote for. The top part of the table lists the preferences for the three voters, and the lower part shows the outcomes of the elections decided through majority vote. The outcomes of the elections appear irrational by the time the third election is held, but this is really just due to the order in which the votes are taken.
- There is a tendency for public choices and election outcomes to match most closely with the median view. Since information about the median position is imperfect and can change over time, there is much room for politicians to misjudge the true median position.
- Government failure refers to economically inefficient outcomes caused by shortcomings in the public sector. One cause of failure is voting problems. The principal-agent problem refers to conflicts that arise when tasks are delegated by one group of people (principal) to another group of people (agents). Efficient public decision making is often impaired by the special-interest effect: any outcome of the political process whereby a small number of people obtain a government program or policy that gives them large gains at the expense of a much greater number of persons who individually suffer small losses. Smaller groups can achieve political victories due to the collective action problem; that is, larger groups are more difficult to organize and motivate than smaller groups. Earmarks are narrow, specifically designed expenditures placed within broad legislation. Rent-seeking is the appeal to government for special benefits at taxpayers’ expense.
- Public agencies are generally less efficient than private businesses. The market system imposes a very obvious test of performance on private firms: the test of profit and loss. But there is no clear-cut test like this for public agencies. Economists assert that government employees often gain political clout to block attempts to eliminate their agencies. Also, critics point out that government bureaucrats tend to justify their continued employment by looking for a new problem to solve. Several forms of government regulation and intervention have been known to generate outcomes that are less beneficial than intended. A government agency has suffered from regulatory capture when the industry can control its government regulator. The classic example is that of railroad regulation during the 19th and 20th centuries. One potential solution is for the government to engage in deregulation by intentionally removing most or all of the regulations governing an industry. Researchers have found that low and negative rates of return are the norm for government investments. Political corruption is the unlawful misdirection of governmental resources or actions that occurs when governmental officials abuse their entrusted powers for personal gain. Political corruption comes in two basic forms. One, a government official must be bribed to do what he or she should be doing as part of his or her job. Two, a government official demands a bribe to do something that he or she is not legally entitled to do. The public sector is subject to deficiencies in fulfilling its economic function. Because markets and governments are both imperfect, it is sometimes difficult to determine whether a particular activity can be performed with greater success in the private sector or in the public sector.