ECO318 Public Finance Course Notes The Provision of Public Goods

1. Partial Equilibrium Analysis

If we accept the argument for the provision of public goods by government, the next question that arises is how many such goods should be provided i.e. what is the socially optimal mix of public and private goods or what is the optimal allocation of inputs between the public and private sectors. A related question concerns the desirable distribution of taxes needed to finance the public goods supplied. The distribution of taxes is a particular problem because of the nature of public goods. Remember that people who do not pay cannot be excluded from the consumption of public goods AND that once the public goods are supplied individuals are not able to reject them whether they wish to consume them or not. We are here in the world of welfare economics and Pareto optimality. The basic approach starts with the idea that the optimal allocation of resources requires that the marginal utility obtained by society as a whole from public goods should equal the marginal utility from private goods. This follows because in order to obtain an extra unit of public goods people must pay additional taxation (that is, give up some of their consumption of private goods). Hence, if the marginal utility (MU) from public goods were less than that from private goods, it would mean that the population as a whole could be made better off by reducing both taxation and the quantity of public goods supplied. The question of who pays is then answered in the same way at an individual level - each person should pay tax according to the marginal benefit, which s/he obtains from the provision of public goods. This is known as the Benefit Principle of Taxation. Let us now look at the attempts to apply it. We shall continue to take private goods provided through the market as the norm. Then we can say that IF markets worked efficiently (atomistic competition, costless information and all that), then people would express their preferences among goods and services by the prices they were prepared to pay for them. That is, prices would reflect marginal rates of substitution (MRS) and IF resources were optimally allocated, the marginal rates of substitution between each pair of goods would be equal, the marginal rates of transformation (MRT) between each pair of goods would be equal and MRSs would equal MRTs. That is, we would have the optimal pricing rule of P = MC. The amount of each good supplied and the price paid could be shown using a normal private goods diagram (Figure1; see also Brown and Jackson, (1990) p.63 in which individual demand curves are added horizontally. Each individual would pay the same price for the good, but consumers would consume different amounts of it.

Price

C Ss A Pe E X

O G

B H J D

Quantity of Private Good

Figure 1: Partial Equilibrium Model of the Provision of Private Goods In this diagram, AB and CD are the demand curves for a private good of A and B respectively. The horizontal addition of these curves gives the joint demand curve for the private good, CEF. The market solution for price and output is given where the joint demand curve cuts the supply curve at X (market price of Pe and output of OJ). We assume that both A and B pay the market price. We can then discover how much of the total supply will be consumed by each of A and B. By looking at A's and B's individual demand curves, we discover that at a price of Pe, A consumes OG and B consumes OH. OG + OH = OJ. Obviously, this solution is not available for public goods since individuals cannot consume different amounts of them. Samuelson provided a theoretical partial equilibrium solution in which one adds the individual demand curves vertically rather than horizontally (see Figure 2; also in Brown and Jackson, 1990, p.64). Then the intersection of the supply curve and the total demand curve would determine the output, which would be consumed by everyone. Price

F Ss C pt Pb A Pa O X E

J B

Figure 2: Partial Equilibrium Model of the Provision of Public Goods Here, adding the two individual demand curves vertically, gives us a joint demand curve, DEF. This intersects the supply curve at F, establishing the equilibrium output (OJ) and the total cost of supplying OB, OPt. Because this is a public good, both A and B consume the same quantity (OJ). Now we can use the individual demand curves to discover how much each person should contribute towards the total cost of supplying OJ. We discover that A is willing to pay only Pa for OJ of the public good, whereas B is prepared to pay Pb. OPa + OPb = OPt. This provides a theoretical basis for taxation that is in line with the Benefit Principle of Taxation: each person is taxed according to the benefit obtained from the last unit of the public good provided. Connolly and Munro (1999) provide versions of these diagrams on pages 60 and 61. In figures 4.2 and 4.3 demand curves are added horizontally for private goods (4.2) and vertically for public goods (4.3). Figure 4.4 presents the solution for public goods. Figure 4.5 (p. 63) presents a special case in which the total amount that A and B are willing to contribute for the supply of the desired output does not cover the cost of producing that level of output. Another problem is that the demand curves in the public good case are only 'pseudo-demand' curves. Since the good is not sold in the market, we have no basis for determining their position or slope. With private goods, demand schedules can be drawn up from information as to how much people do actually pay for different quantities of a good. In the case of public goods, this information cannot exist. Thus we have a practical problem. We do not know the individual demand curves and so we cannot calculate total demand and cannot determine how much of the public good should be provided. Is there a practical solution? Could we simply ask people? 'Good evening, madam, can you please tell me how much you would be

prepared to contribute towards the provision of: 1 Trident missile? 2 Trident missiles? 3 Trident missiles? ...' With developments in information technology, this has become technically possible to do relatively cheaply for a large population: telephone XXXXX if you are prepared to pay x; YYYYY if you are prepared to pay y and so on. One could, thus, quite easily imagine people voting for the provision of public goods. Nevertheless, a problem would remain. Where large numbers of people were involved, it would be rational for each person to understate what s/he was willing to pay. That is, it would be rational for each person to try to act as a free rider. Why? What do large numbers have to do with it? Connolly and Munro (1999) define free riding on p. 63 and provide an example of a two-person game in which the dominant strategy for each person is to attempt to free ride. The net result is that the good is not produced at all. They then raise the question of whether free riding is always a problem in practice. They conclude: " experimental evidence suggests that, despite the fact free riding is a dominant strategy, consumers will often be influenced by considerations of fairness and will offer to share the cost to ensure that the public good is provided." (p. 65). Box 4.2 on the same page provides some details of these experiments. On pages 67 and 68, the textbook sets out a more formal explanation of the problem of trying to persuade people to reveal their true preferences in relation to the provision of public goods. This is done in the form of a three-person game (see Box 4.3 on page 68). At this point, it would be worthwhile reading the explanation in Brown and Jackson (1990, pp. 67-8) of the derivation of a demand curve for a public good from a set of indifference curves and of the different contributions of Musgrave, Hicks, Bowen, Samuelson and Buchanan. You should pay particular attention as you do so to the underlying assumptions and you should bear in mind the problem of how one could obtain information to enable the construction of a set of indifference curves for public goods.

2. Alternative Approaches
2.1 Lindahl's Model of the Provision of Social Goods This model asks the question in a different way - what percentage of the total cost of the provision of a public good would an individual be prepared to pay for each different amount provided. In a simple case with only two people, one person's demand curve would act as a form of supply curve for the other person, indicating how much of the good would be available for each contribution s/he was willing to make. The model has the same theoretical advantage as our first attempt - it solves in one go both how much of the good should be provided and how much each person should pay towards the cost of provision. It has one additional advantage - it allows a consideration of the gains to be had from providing false information and introduces the possibility of using strategy. However, it also provides no practical solution because the free rider problem remains. If each person deliberately understates the amount s/he will willingly contribute, the public good will be under-supplied. This can be seen in Figure 3 (see also Brown and Jackson, 1990, p.76).

L=1

Ob B
XX

Xx

A OA B X
Quantity of Publi Goods

In this diagram, we measure the proportion of tax paid by A up the left side from OA and the proportion paid by B down the right hand side from OB. The division of the cost is determined by the intersection of the two demand curves. Thus, if both people declare their true preferences, OAX of the public good is supplied, A pays OAH/L while B pays OBH/L. However, a glance at the dotted lines in the graph shows that A may be tempted to understate his valuation of the public good in the hope of reducing his/her share of the cost of provision; but that if B were to follow suit, the net result would be that each would pay the same share as if they had declared their true preferences. The only result, in this case, would be that less of the public good would be provided than they would prefer. Of course, in a two-person community, A and B would quickly realize this and both would declare their true preferences. Nonetheless, the free rider problem would remain in a large community. 2.2 Samuelson's General Equilibrium Model This involves two goods (a private good and a public good) and two people. The production possibilities frontier (PPF) for production of the two goods is given, as are the tastes of the consumers. The model is shown in Brown and Jackson, 1990, p. 70. Figure 4 below shows the top two diagrams correctly but you will need to consult Brown and Jackson (or your class notes) for the bottom diagram, as I cannot succeed in drawing it correctly here. The steps that the figure attempts to illustrate are: (a) choose a given level of utility for individual B (i.e. choose which indifference curve B is on in the middle diagram) (b) superimpose this on the PPF in the bottom diagram and subtract it vertically from the PPF. At the two points where B's indifference curve cuts the PPF, A and B will be consuming the same amount of the public good (that is, each of them will be consuming all of the public good that is available) but B will be consuming all of the private good which is produced. Between these points, both A and B will be consuming some of the private good; (c) from this information, draw a line showing the amounts of public and private goods available to

A. Impose this on the upper diagram, showing A's indifference map, and find where this line is tangent to one of A's indifference curves. This point provides the solution for the provision of the two goods. There will be a different solution for each different assumption regarding B's level of utility i.e. for each assumption regarding the distribution of income between A and B. It is possible then to add other diagrams to show the determination of that distribution of income that will maximise social welfare. However, this assumes that social welfare functions exist and can be known. In any case, the whole apparatus (elegant though it is) does not say anything about the pricing of public goods and, even more important, also does not overcome the free rider problem. Musgrave and Musgrave (1989) provide an alternative explanation and set of diagrams. They also discuss the distribution/allocation issue: that is, the question of whether it is possible to separate the 'proper' distribution of income from the allocation of resources. Samuelson argued that we can't know the distribution of income without knowing the pricing rule being used and hence allocation and distribution need to be determined simultaneously. This, remember, is what the Benefit Principle is all about. Musgrave, on the other hand, argued that the distribution of income is a distinct policy issue, which can be treated separately.

Quantity of Private Good for A A1

A2

PG1

PG3

PG2

Quantity of Private Good for B B3 B2 B1

PG3

Public Good

Total Private Good

B2 O PG1 PG2 PG3

Figure 4: Samuelson's General Equilibrium Model of the Provision of Public Goods

3. Variations on a Theme
3.1 A Bargaining Solution Musgrave and Musgrave (1989) provides an interesting bargaining solution that could apply to the provision of public goods in a small community. This starts with one person (A) acting as a free rider while B pays for all of the public good provided. A, however, would like more of the good to be provided as long as the price to him/her were low enough. This is a variation on the Lindahl model but still does not overcome the basic problem that we have no adequate way of obtaining information regarding individual preferences. It would also have no application for a large community. 3.2 The Tiebout Model Tiebout's model concerns the provision of local public goods. The theoretical solution here is that if there were a sufficiently large number of local communities and each offered a different menu of expenditures on public goods, then each individual could reveal her/his preferences regarding the amount and type of public goods by the choice made as to where s/he would live (that is, people 'vote with their feet'). This would promote an efficient allocation of resources in the public sector. But I don't need to spell out the restrictive assumptions required here, do I? If you can't work out the problems associated with this model, see Brown and Jackson. But have a try at working them out for yourself first. 4. The Ability to Pay Principle of Taxation The major theoretical alternative to the Benefit Principle is the Ability to Pay approach to taxation. It is based on the notion that tax payments should reflect 'equality of sacrifice' and since it is assumed that income, like all normal commodities, provides diminishing marginal utility, the amount of tax paid by individuals should depend on their income level. Note the following: (a) This approach completely separates the question of how much should be spent on public goods from the question of who should pay for them. (b) There are three distinct interpretations possible of the phrase 'equality of sacrifice' - equal absolute sacrifice, equal proportional sacrifice, and equal marginal sacrifice. (c) The approach necessarily assumes that all individuals have identical preferences. (d) The principle does not necessarily prescribe progressive rates of tax, unless one chooses the equal marginal sacrifice interpretation of equality of sacrifice. John Stuart Mill proposed the ability to pay principle but then advocated proportional taxation. However, with the first two interpretations of equality of sacrifice, it would be possible to justify either regressive or progressive taxation, depending on the nature of the utility function assumed. 5. The Provision of Mixed Goods It is possible to develop a Pigovian social costs and benefits approach to determine the desirable level of subsidies/taxes in cases where social costs and benefits differ from private costs and benefits (figures 5 and 6). In the case where social benefits > private benefits, one simply draws an additional demand curve to represent the demand for external benefits and adds this vertically to the market demand curve. Then a subsidy is justified to ensure that the good is provided in the socially desirable quantities. For the social costs > private costs case one acts in the same way on the supply curve. You should, however, recall Coase's criticism of the Pigovian approach and the argument that it may be possible to internalise the externalities by a precise definition of property rights.

Price

Price

D2

S2

D1 P3 P1 P2 O S Q1 Q2

S P2 P1 P3 S1 D1 D2 O Q2 Q1 D

Figure 5

Mixed Goods with Social Benefits

Figure 6

Mixed Goods with Social Costs

In Figure 5, D1 is the demand curve, taking only private benefits into account. D2 Takes social benefits into account also. The market solution without considering social benefits is OP1 OQ1. To ensure the desired output, the price should be OP3, with output of OQ2. At output OQ2, the market price without government intervention would be only OP2. Therefore, a government subsidy of P2P3 is required. In Figure 6, S1 is the supply curve, taking account only of private costs. S2 takes social costs into account. The market solution without considering social costs is an output of OQ1 at a price of OP1. The desired solution, however, is OQ2 at a price of OP2, but producers are willing to supply OQ2 at a price of OP3. Therefore, a tax on producers of P2P3 is required. 6. Some Additional Points (a) Most public goods benefit only limited areas and urban administration and taxing areas may not match the benefit areas of major projects. (b) Goods that appear to be non-rival in consumption become rival when there is congestion because the quality of the service falls. Thus, empty roads are public goods but congested roads are not. (c) Needs can be met in a variety of ways involving different combinations of public and private goods. For example, the need of greater protection of property might be met through the private provision of more locks and alarms or through the public provision of stronger police forces. (d) We have assumed throughout that the existence of public goods requires that government provide these goods. This view derives from the notion that laws are needed to enforce the collection of taxation. Note that in theory public goods could be provided collectively by voluntary groups. That is why economists who are strongly opposed to government intervention in the market economy (for example, Buchanan) refer to public goods as collective goods rather than public goods. Buchanan and other writers have also developed the theory of clubs. This is an attempt to provide a private market solution to the problem of the provision of public goods. However, it only works when the good is excludable in some way, so that a price can be charged. The basic idea is that people will pay to become members of a club to share in the benefits of a good that is non-rival in consumption. They will do this in order to make sure that over-crowding does not arise and, thus, that the good remains non-rival in consumption. Given the costs of supplying the good, the more members there are, the lower will be the cost of membership; but as the membership increases beyond

(e)

a certain number, rivalry begins to set in and the benefits of membership decline. The aim is to optimise the club membership. This will occur when the marginal cost of allowing in an extra member (more competition for the use of the facilities) are just equal to the marginal benefits of doing so (lower membership fees). Connolly and Munro (1999) have a brief discussion of the theory of clubs on p. 66. The theory clearly only applies to a limited number of public goods. Connolly and Munro (1999) also mention the possibility of the private provision of a public good when it is in joint supply with a private good. The private good can be charged for and part of the profits of this can be used to contribute towards the cost of the public good. Two examples are provided in the book. The first is the rental of sun loungers (private good) on a public beach (public good). People will only wish to hire the sun loungers if the beach is clean and safe, and so it is in the interests of the supplier of sun loungers to keep the beach in good condition. The second relates to trade unions, which supply their members with two types of services. One type of service is non-excludable, encouraging free riders. The other type of service is excludable, allowing only those who pay union dues to receive the full range of services offered by the union. What are the types of services that fall into these two categories? If you can't work this out, read p. 67 of Connolly and Munro.

7. The Clarke Tax

References Bain K and P Howells (1987), Government and the Economy chs 1-3 Brown C V and P M Jackson (1990, 4th edn), Public Sector Economics ch 3 Coase R (1960), `The problem of social cost', Journal of Law and Economics. reprinted in Breit and Hochmann (eds), Readings in Microeconomics Connolly S and A Munro (1999), Economics of the Public Sector, London: Prentice Hall Europe Musgrave and Musgrave ch 4 Peston M, Public Goods and the Public Sector Samuelson P (1954), `The pure theory of public expenditure', Review of Economics and Statistics Samuelson P (1955), `A diagrammatic exposition of a theory of public expenditure', Review of Economics and Statistics