Chapter13

Public goods and their financing

13.1 Four different types of goods

- The standard textbook definitions of public goods and private goods are anchored in the
notion that goods and services differ in terms of two basic properties, rivalry and
excludability.
- Rivalry – the extent to which consumption of a good or service by one person diminishes
its availability for others.
n Non-rilvary is sometimes expressed to mean goods which can be made available to
additional users at zero (or close to zero) cost.
n A good need not be reproduced for each new consumer.
- Excludability – the extent to which non-payers can be excluded from consuming a good
or service.
-
Classification of goods and services
Non-rivalrous Rivalrous
Non-excludable Public good Common good or resource
- National defence - Fish in ocean
- Street signs - The atmosphere
- Free-to-air TV
Excludable Collective good Private good
- Pay TV - Cheeseburger
- Uncrowded toll road - Massage

Private goods
- Private goods – goods and services that are both excludable and rivalrous in
consumption.

Common goods
- Common goods – goods and services (or resources) that are rivalrous in consumption
and are non-excludable.

Collective goods
- Collective goods – goods and services that are non-rivalrous and excludable.
- Sometimes provided by government, sometimes by private companies.
- When it is possible to exclude non-payers, the good is one of the natural monopoly
goods.

Public goods
- Public goods – goods or services that are both non-rivalrous and non-excludable.
- Goods often fall between the extremes of rivalry and excludability.
- Goods that are completely rivalrous and which present no possibility of exclusion are
 referred to as pure public goods.
- Goods for which one person’s consumption creates a one-to-one reduction in the good’s
availability for others and are easily excludable are referred to as pure private goods.
- The term “quasi public good” is used to describe goods that display elements of non-
rivalry and non-excludability.

Rethinking the public good/private good divide

- With privatization and globalization provides great opportunities, the removal of what
was once considered a public good to the market has prompted a rethink of what should
be part of the public domain and provided collectively.
- Some argue that society’s common are collective interest include
Ø Physical assets such as clean water and wildlife
Ø Public institutions such as libraries and schools
Ø Social communities such as voluntarism and the internet
Ø Norms and cultural traditions
- Whilst classification based on the properties of rivalry and excludability is helpful,
whether a good is produced by the government or the market and how its provision is
financed can also be a result of deliberate policy choice or collective human action.
Ø E.g. education when assessed in terms of its basic properties, is both rivalrous and
excludable. However, most societies have made a deliberate choice to collectively
provide education, preventing exclusion and providing it in such large quantities
that there is no competition among users.
Ø E.g. by issuing exclusive licenses to fish or harvest forests, these goods are moved
out of the public domain.
- Society can also choose to make non-rivalrous goods more private.
Ø E.g. government allows some types of knowledge to be made exclusive with
patents, whilst open source softwares are kept in the public domain.
- Whether goods are best provided publicly or left to the market is determined by both
their basic properties and their socially-determined status.

13.2 Government provision of public goods

- Two reasons why government provision of public goods is necessary,
Ø Given the inability to exclude non-payers, private companies would have obvious
difficulty recovering their cost of production.
o People might be willing to pay enough to cover cost of producing the good, but
since its non-excludable, the company cannot effectively charge for it. Knowing
this, many people will choose not to contribute knowing they cannot be
prevented from enjoying its benefits once it has been provided. Free-rider
problem.
l Free-rider problem – the incentive that arises to not contribute to the
provision of a good or service in situations in which individuals are able to
 enjoy the benefits of a good or service without contributing to its cost.
Ø If the marginal cost of serving additional users is zero once the good has been
produced (property of non-rivalry), then charging for the good would be inefficient,
even if there were some practical way to do so.
- However, just because it is a public good, it doesn’t mean the government ought to
provide it.
Ø The only public goods the government should consider providing are those whose
benefits exceed their costs.
o The cost of a public good is the sum of all explicit and implicit costs incurred to
provide it.
o The benefit is measured by asking how much people would be willing to pay
for it.
l Similar to measuring benefit of a private good, except the whilst benefit
of additional unit of private good is the highest sum any individual buyer
would be willing to pay for it, whilst for public good it is the sum of the
reservation prices of all people who value that reduction.
Ø Government provision of that good makes sense only if there is no other less costly
way of providing it.
Ø As the cost-benefit principle states, if the benefit of a public good does not exceed
its cost, we are better off without it.

Paying for public goods

- Not everyone benefits equally from the provision of a public good.
- Given a distribution of willingness to pay, it may seem the most equitable method of
financing a given public good would be to tax people in proportion to their willingness to
pay for the good.
Ø In practice, government lack the information needed to tax people in proportion to
their willingness to pay for specific public goods.
- E.g. voluntary contribution, payoff is maximized when no on contribute anything.
Ø Every dollar contributed yields a private return less than this.
Ø All self-interested people will contribute nothing, and will all earn the endowment.
Ø Similarity between this and prisoner’s dilemma.
o Whilst dominant strategy is to contribute nothing, an outcome where
everyone contributes would make everyone better off.
Ø In repeated public goods experiments, contributions fall over time.
- E.g. A and B want a water filter, cost is $1000, A is willing to pay $400 and B $800.
Ø If they share the purchase, it would be socially efficient with total economic surplus
of $200 higher than if they did not buy the filter.
Ø However, joint purchase and sharing of facilities is often more easily proposed than
accomplished.
o Communication costs could be prohibitive when discussing joint purchases.
o With a large number of people, the free-rider problem also emerges.
o Reaching agreement on a fair sharing of the total expense may be difficult.
- If the government follows a “non-discrimination” rule that prohibits charging any citizen
 more for a public good than it charges anyone else. Head tax.
Ø Head tax – a tax that collects the same amount from every tax payer.
Ø Public goods can only be provided if a majority of citizens approve of them.
Ø With the example above, head tax will each both A and B $500, and because it’s
more than what A is willing to pay, there will be no filter.
o This applies whenever taxpayers place significantly different valuations on
public goods.
o Any equal-tax rule under these circumstances will almost invariably rule out
the provision of many worthwhile public goods.
Ø A head tax is an example of a regressive tax.
o Regressive tax – a tax under which the proportion of income paid in taxes
declines as income rises.
Ø Equal contributions are often a poor way to pay for public goods, and are also often
a poor way to share expenses within the household.
- Proportional income tax – a tax under which all tax payers pay the same proportion of
their incomes in taxes.
Ø Under the proportional tax on income, A will contribute $333 and B will contribute
$667.
Ø Hence benefit exceeds both party’s share of its cost.
- Public goods are different from individually consumed private goods in that,
Ø Different individuals are free to consume whatever quantity and quality of most
private goods they choose to buy, but goods that are jointly consumed, once
provided, are available in the same quantity and quality for all persons.
Ø People’s willingness to pay for public goods is generally an increasing function of
income.
Ø Virtually all industrialized nations have tax systems that are at least mildly
progressive.
o Progressive tax – a tax in which the proportion of income paid in taxes rises as
income rises.
Ø This method of taxing have been criticized as being unfair to the wealthy, who are
forced to pay more than others for public goods that all consume in common.
o However, exclusive reliance on head taxes or proportional taxes would curtail
the provision of public goods and services that are of greatest value to high-
income families.
Ø Failure to reply on progressive taxation would result in under-provision of such
public goods and services.

Local, state, federal or global?

- The benefits of some public goods, such as streetlights are clearly local, and hence are
best provided and funded by local governments since generally government will be more
responsive the shorter the distance between office holders and voters.
- Another adv of giving as much authority to local governments as possible is that
different communities often have markedly different preferences about how much to
spend on public goods and what kinds of public goods to provide.
 Ø People can shop for a community whose voters’ preferences coincide with their
own.
Ø Those who like high levels of public goods and services can band together and
authorize high taxes to pay for them.
- One reason for federal government is economies of scale in defence.
Ø For a country to survive politically, it must be able to deter aggression by hostile
governments.
Ø Large, well-equipped armies and navies cost a lot of money and countries without
sufficient population simply cannot afford them.
- The problem of pollution is difficult to solve when various sources of pollution are not
subject to regulatory control by a single government.
Ø E.g. pollution from VIC experienced in NSW.
- Examples of global public goods include,
Ø Discharge of greenhouse gases
Ø High seas and space
Ø International financial stability
Ø Communicable disease eradication
Ø International passport system.
o Providing these goods poses a special challenge as there is no equivalent to
the institution of the state, and the global community has far more diverse
interests and preferences than any other national public.
- The choice between different levels of government confronts us with difficult trade-offs.
Ø Ceding the power of taxation to federal government entail compromises for voters
in individual states.
Ø Loss of political autonomy is an even less attractive option.
Ø Nationals are reluctant to cede any of their sovereign powers to a higher authority,
but failure to take such steps may entail unacceptable environment costs in the
long run.
- Hence, externalities that transcend local boundaries provide an additional rationale for
national and international agreements.

13.3 The optimal quantity of a public good

The demand curve for a public good
- To calculate the socially optimal quantity of any good, we must first construct the market
demand for that good.
- For a private good, we add horizontally, i.e. quantity.
- However, process for constructing a market demand curve for a public good differs in
that all buyers necessarily consume the same quantity, although each may differ in terms
of willingness to pay for additional units of the good.
Ø Hence the curve entails vertical summation of demand curves, i.e. adding the prices
individuals are willing to pay for an additional unit of the good.
- Marginal cost curve is upward-sloping, demand curve downward sloping.
Ø At equilibrium is the optimal quantity of parklands.
o Any quantity less, the benefit of additional parkland exceeds its cost, which
means total economic surplus can be made larger by expanding the amount of
parkland.
- The optimal quantity is one at which the public’s willingness to pay for additional
parkland is equal to the marginal cost of parkland.

13.4 Private provision of public goods

- Advantages of government providing public goods,
Ø Once a tax collection agency has been established to finance a single public good, it
can be expanded at relatively low cost to generate revenue for additional public
good.
Ø Government has the power to tax, and it can summarily assign responsibility for the
recovery of costs of a public good without endless haggling over who bears what
share of the burden.
Ø In the case of pure public goods such as natural defence, the government may be
the only feasible provider.
- Disadvantages of exclusive reliance on government,
Ø The government’s one-size-fits-all approach invariably requires many people to pay
fo public goods they don’t want, while others end up having to do without public
goods they want desperately.
o E.g. discussion of drug education in public schools
Ø Mandatory taxation strikes many people as coercive, even if they approve of the
particular public goods being provided.
- Hence governments are not the exclusive providers of public goods in any society and
many social institutions have evolved to encourage the provision of public goods outside
the government sector.

Funding by donation
- Australians donate to private charities, many of which provide public goods to their
communities.
- Fundraising events such as raffles and lotteries.
- Volunteer time in activities such as panting trees and manning soup kitchens.
Ø When you paint your house, you are enhancing the quality of life in your
neighbourhood and hence you are voluntarily providing a public good to your
neighbours.
Development of new means to exclude non-payers
- New electronic technology makes it possible to exclude non-payers from many goods
that in the past could not be thus restricted.
Ø Broadcast tv stations now have the ability to scramble their signals
Ø Technological developments can bring some goods into the excludable domain.
Ø However, technological developments can make goods less excludable, the
problem of software and music copying providing a case in point.

Private contracting
- The demand for gated private communities, where private homeowners’ associations
wall off contiguous properties and provide various services to residents, has become a
worldwide trend.
Ø Many of these associations provide security services, communal space and schools,
and in other ways function much like ordinary local governments.
Ø Often bill homeowners for those services directly – rules imposed are even more
restrictive than those imposed by local governments.

Sale of by-products
- Many public goods are financed by the sale of rights or services that are generated as by-
products of the public good.
- Radio and tv programming is a public good that is paid for in many cases by the sale of
advertising messages.

- However, private provision often entails problems of its own.

- E.g. 2 TV programs, one which will win a higher percentage of the viewing audience, but
the other has a higher collective willingness to pay to see that program.
Ø If the time slot is financed by another company,
o That company will choose one with higher percentage of viewing audience.
Ø Reliance on advertising and other indirect mechanisms for financing public goods
provides no assurance that the goods chosen will maximize economic surplus.
Ø One way to avoid the inefficiency that arises when advertisers choose programming
is to employ pay-per-view methods of paying for television programming.
o Allows viewers to register not just which programs they prefer but also the
strength of their preferences as measured by how much they are willing to pay.
- However, pay TV is less efficient than free-to-air TV.
Ø Charging each household a fee for viewing discourages some households from
tuning in.
o Pay TV is monopoly, so MR is half of demand curve.
Ø Economic surplus is area under demand curve.
Ø Since the marginal social cost of serving an additional household is exactly zero,
limiting the audience in this way is inefficient.
 Ø In general, charging a positive price for a good whose marginal cost is zero will
result in a loss in surplus.
o The size of the loss when price is set above marginal cost depends on the price
elasticity of demand.
- The mix between private and public provision of public goods and services differs
substantially from society to society.
Ø Differences depend on the nature of available technologies for delivering and
paying for public goods, and also on people’s individual and collective preferences.
- Private for-profit companies can also become providers when new technologies such as
pay tv convert public goods into collective goods.

13.5 Sources of inefficiency in the political process

- Expenditures on public goods, tax policy and laws regulating the behaviour of firms and
individuals are determined in large part by the votes.
- Inefficiencies often arise in the public sphere, not because of incompetent or ignorant
legislators but because of structural incentive problems.

Pork barrel legislation

- Bill-splitting makes the restaurant bill higher
Ø If you’re splitting the bill, you’d order an item simply because when split it’ll be
lower than your reservation price.
Ø However, if everyone does the same, all will suffer economic loss.
Ø But you’d still order because otherwise you’d make even a bigger loss.
Ø When faced with the externalities associated with bill-splitting, diners did not
hesitate to overorder.
- Similar incentive problems occur in the legislative process in the form of pork barreling.
Ø Pork barreling – enacting legislation and regulations whose total costs are more
than the total benefit it creates, but that is favoured by a legislator because his or
her constituents benefit from the expenditure by more than their share of the
resulting extra taxes.
o Enacting of legislation and adoption of programs that benefit local areas but
 are of questionable value from a national perspective.
o One legislator must support other legislator’s home electorate’s projects
because if he does not, they will not support his. This is known as logrolling.
l Logrolling – the practice whereby legislators support one another’s
legislative proposals.
- One example of pork barreling is the ongoing assistance to the QLD sugar industry.

Rent seeking
- A related source of inefficiency in the public sphere also occurs because gains from
government projects are often concentrated in the hands of a few beneficiaries, while
the costs are spread among many.
- This means beneficiaries often have a powerful incentive to organize and lobby in favour
of public projects.
Ø Individual taxpayer however have little at stake in any give public project and
therefore have little incentive to incur the cost of mobilizing themselves in
opposition.
- Citizens often don’t vote against legislators who support such schemes because of the
problem of ignorance.
Ø Many voters have no idea that a price support scheme for sugar even exist.
- Other sources of inefficiency arise even in the case of projects whose benefits exceed
their costs.
Ø Groups seeking to influence tax reform or environment policy may all invest
resources, time and effort in promoting their interest. Rent seeking.
o Rent seeking – the socially unproductive efforts of people or firms to win a
prize.
o Tend to be inefficient for the same reason that investments by contestants in
other positional arms races are efficient.
o 20% of government expenditure is spent by firms and individuals trying to
influence government expenditure in the US.
o People may spent $50 to bid for $20.
- From society’s perspective, rent seeking is highly wasteful.
Ø Government can discourage such waste by selecting contractors not according to
the amount they spend lobbying but on the basis of the price they promise to
charge for their services.

Starve the government

- Many government expenditures are wasteful.
Ø Logrolling often results in pork barrel programs that would not satisfy the cost-
benefit test.
Ø Government employees may not always face strong incentives to get the most for
what they spend.
- Private contractors often deliver comparable services at substantially lower costs than
their public counterparts.
- Many critics have urged major cutbacks in the volume of public goods and services.
 Reason being that if we let the government spend more money, they’ll be more waste.
Ø However, public goods are valuable and there is a growing movement to include
more, not less, goods in the public domain.
- Many public services deliver good value for our money.
- While starving the government may reduce one kind of waste it may increase another by
curtailing public services whose benefit exceeds their cost.

13.6 What should we tax?

- Primary purpose of tax system is to generate the revenue needed to fund public goods
and other government expenditures, but taxes also have many other intended or
unintended consequences.
Ø Taxes alter relative costs and benefits of engaging in different activities.
Ø Affect the distribution of real purchasing power in the economy.
Ø A desirable tax system raises the needed revenue while at the same time, having
the most beneficial, or least deleterious side effects.
- When governments run deficits to pay for public goods, they borrow in the same capital
market as private corporations. Crowding out.
Ø Crowding out – the extent to which government borrowing leads to higher interest
rates, causing private firms to cancel planned investment projects.
Ø When the government fails to raise enough revenue from taxes to cover the
amount it spends on public goods and services, it thus diverts funds from
investments that would have helped the economy to grow.
- Taxes on goods will hold production and consumption below socially optimal levels in a
market with no externalities.
Ø Income taxes also create deadweight losses, as some people might decide to work
fewer hours.
Ø People focus on the deadweight cost caused by taxes. However,
o If a tax in a market did produce a loss in surplus for participants in that market,
it might nonetheless be justified if it led to an even larger gain in surplus from
the public expenditures it financed.
l DWL can be minimized by concentrating taxes on goods with highly elastic
supply or demand curves.
o Taxes need not cause any loss in surplus at all.
l When the production of a good generates negative externalities, the
socially optimal quantity of the good would be less than the market
equilibrium. With tax, the equilibrium quantity would shrink.
l The direct effect of the tax is not only to reduce total economic surplus
but actually to augment it.
l Taxes like these can raise needed revenue while at the same time
contributing to a cleaner environment.