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Berkeley ENVECON C101 - Chapter 7 Public Goods

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-1-1Chapter 7Public GoodsContents: General OverviewHeterogeneity, Non-rivalry, and Market FailureNon-excludability and Market FailureOptimal Provision with Homogeneous IndividualsPrivate Market Outcome for a Non-excludable Public GoodsMechanisms for Providing the Socially Optimal Level of Public GoodsThe Specification of Congestion Costs in Public Goods ModelsGeneral OverviewPublic goods are goods or services that can be consumed by several individualssimultaneously without diminishing the value of consumption to any one of theindividuals. This key characteristic of public goods, that multiple individuals canconsume the same good without diminishing its value, is termed non-rivalry. Non-rivalry is what most strongly distinguishes public goods from private goods. A purepublic good also has the characteristic of non-excludability, that is, an individual cannotbe prevented from consuming the good whether or not the individual pays for it. Forexample, fresh air, a public park, a beautiful view, national defense.Graphically, non-rivalry means that if each of several individuals has a demand curvefor a public good, then the individual demand curves are summed vertically to get theaggregate demand curve for the public good (see Figure 7.2). This is in contrast to theprocedure for deriving the aggregate demand for a private good, where individual demandsare summed horizontally (see Figure 7.1).Figure 7.1Deriving Aggregate Demand for Private Good-2-2Why Private Goods Are Summed Horizontally:• Exclusive: once you buy it, you own it and can consume it as you please.• Rival: a good taken off the shelf it isn’t there for other people to consume.We sum private goods horizontally, because consumers cannot consume the sameunits. Rivalry in consumption is what makes the market pricing system so incrediblyeffective, and why the invisible hand hypothesis can work. A price is a per unit chargefor a good, so that, when goods are consumed away due to a rivalry between consumers,supply shortages will tend to correct the market by driving up prices as consumerscompete for the few remaining goods. Similarly, a supply surplus will cause firms tolower the price of the good until an equilibrium is met that will clear the market. Publicgoods, however, cannot be so easily and efficiently priced.Figure 7.2Deriving Aggregate Demand for Public Good Aggregate demand in the economy for a public good is the vertical sum ofindividual demand curves. Demand is summed vertically, because all individuals canenjoy the same. Therefore, for each marginal unit of water quality:aggregate demand = the sum of individual value for the unit-3-3Almost no good or service is completely non-rival. On the other hand, manygoods are not completely rival either. Hence, non-rivalry as a characteristic of a publicgood is a relative, not an absolute concept. However, for the purpose of discussion, weoften use the notion of a pure public good.A number of environmental amenities have public good characteristics. Forexample, we will discuss the socially optimal level of provision of regional air quality, arelatively pure public good. We will also discuss non-use values, which are types ofenvironmental benefits that are also public goods.Many environmental issues can be thought of in terms of public goods. Forexample, the reason the Coase Theorem may not work can be thought of in terms ofpublic goods; if air and water resources were private goods, they could be tradedefficiently in a market. We will now show why inefficiencies can arise in the provision ofpublic goods.Heterogeneity, Non-Rivalry and Market FailureConsider Two Goods with Identical Aggregate Demand:• The first good is a private good, (i.e., Chicken Sandwiches)• The second good is a public good, (i.e., Water Quality at Mono Lake)Figure 7.3DtD1 D2D1D2DtQ*=Q1*+Q2*Q1* Q2* Q*P=MCQuantityQuantityPRIVATE GOOD: PUBLIC GOOD:MC$ $P1*P2*Q2Private Good: Notice that the market price is an efficient mechanism.-4-4• The equilibrium price of a chicken sandwich is P=MC, so that each chickensandwich costs $P. Consumers compete for the consumption of sandwiches,and, at a price of $P, will self-select socially optimal quantities. Consumer 1eats Q1* sandwiches, consumer 2 eats Q2* sandwiches and Q1* + Q2* = Q*,the aggregate efficient level. The shaded regions show the total payment by eachindividual.Public Good: Notice that the market price is no longer an efficient mechanism, becausethe stock of a public good is never “consumed away”.• The equilibrium price of water quality cannot be P=MC, because then Consumer1 would not pay for any water quality improvements, Consumer 2 would payfor only Q2, and, since Q2 < Q*, the efficient level of water quality would notbe met. To see what we would like to do, note the analogy to the case of theprivate good, recognizing that public goods are the mirror image. Thus, thesocial optimal solution would be to provide Q* and then charge each consumer aunit price equal to the individuals’ marginal value at Q*, or, P1* and P2*. As inthe case of private goods, the high demand individual will pay a larger amountthan the individual with a lower willingness to pay for the good (shown as theshaded regions). Yet, such a solution may not be possible.The reason inefficiency arises in providing public goods is that, unlike price, quantityis not an effective market mechanism:• For a given quantity, individuals will not automatically self-select their optimalprice, but will instead wish to pay the lowest price possible when they cannotbe excluded from consuming the good.Non-Excludability and Market FailurePublic goods are a special concern to economists because there can be "marketfailure" in the private market provision of both pure and impure public goods. The primarycause of market failure involving public goods is non-excludability. Non-excludabilitymeans that the producer of a public good cannot prevent individuals from consuming it.Non-excludability is a relative, not an absolute, characteristic of most public goods. A goodis usually termed non-excludable if the costs of excluding individuals from consuming thegood are very high. Private markets often under-provide non-excludable public goodsbecause individuals have the incentive to free ride, or to not pay for the benefits they receivefrom consuming the public good. With a free-rider problem, private firms cannot earnsufficient revenues from selling the public


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Berkeley ENVECON C101 - Chapter 7 Public Goods

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