©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 13: Public Goods and Tax Policy.

©2012 The McGraw-Hill Companies, All Rights Reserved

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Chapter 13: Public Goods and Tax Policy


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Learning Objectives

1. Use ideas of rivalry and excludability to distinguish among private goods, public goods, collective goods, and common goods

2. Show how economic concepts can be used to find the optimal quantity of a public good

3. Describe the ways private firms can supply public goods

4. Analyze the efficiencies and inefficiencies associated with provision of a public good

5. Discuss the criteria that should be applied to taxation to promote efficiency


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Government Is Unique

Government is the only organization with the power to force actions Power to tax Power to send people into military service Power to imprison people

All other institutions – family, business, charitable organizations, etc. – rely on voluntary transactions Businesses get money only if people

voluntarily buy their products Governments can take people’s money


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Government Is Unique

Governments’ powers can be easily abused How big should the government be? What goods and services should it provide? How should it raise revenues to pay for them? What powers should it have to constrain the

behavior of its citizens? How should the various powers be apportioned

among local, state, and federal levels?Government decisions can be analyzed

using economic principles


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Government Provision of Public Goods

A primary task of the government is to provide public goods

Public good is a good that is both nonrival and nonexcludable A nonrival good is one whose

consumption by one person does not diminish its availability to others

National defense ■ Economics lectures A non-excludable good is one that is

difficult or costly to exclude non-payers from consuming

Over-the-air broadcasts ■ Fireworks displays


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Public Goods and Government

A pure public good is, to a high degree, both nonrival and non-excludable

Pure public goods are provided by government for two main reasons: Cost of production are difficult to recover

directly Free-rider problem

MC of public goods is zero once it has been produced

Charging for them is inefficient because it reduces total surplus

• Example: collective goods


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A collective good is a good or service that, to at least some degree, is nonrival but excludable Example: Cable television channels

Excluding those who do not pay is wasteful since the MC to society of their tuning in is literally zero

A good is a pure private good if Non-payers can easily be excluded and Each unit consumed by one person

means one less unit available for others One-for-one reduction


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A pure commons good is a rival good that is nonexcludable Results in a tragedy of the commons

Example: Fish in open water

The next table summarizes the classification scheme of products by nonrival and non-excludable properties

The columns of the table indicate the extent to which one person’s consumption of a good fails to diminish its availability for others


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Types of Goods


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Collective goods are sometimes provided by government and other times by private companies

Most pure public goods are provided by government, but even private companies can sometimes find profitable ways of producing goods that are both nonrival and non-excludable The only public goods the government

should even consider providing are those whose benefits exceed their costs


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Government Decisions about Public Goods

Cost – Benefit Principle applies to pure public goods, as all others Costs: The cost of the public good is the

sum of the explicit and implicit costs incurred to produce it

Benefits of a public good are different from a private good

Benefit of an additional unit of a private good is the highest price someone would pay for it

Benefit of an additional unit of a public good is the sum of the reservation of all people who use it


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Government Decisions about Public Goods

Even if the amount that all beneficiaries of a public good would be willing to pay exceeds its cost Government provision of that good

makes sense only if there is no other less costly way of providing it

Obviously, if the benefit of a public good does not exceed its cost, we are better off without it


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Paying for Public Goods

Not everyone benefits equally from a public good or service Ideally, it might seem that the most

equitable method of financing a public good would be to tax people in proportion to their willingness to pay for the good

Example: Jalal values a public good at $100 Sadik values the same public good at $200 The cost of the public good is $240

Tax Jalal $80 and Sadik $160 public good is provided and each receive a surplus of 25% of their tax payment


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In practice though, governments usually lack the information they would need to tax people in proportion to their willingness to pay for specific public goods Think about it: If your country’s government

asked you how much you would be willing to pay to have a new highway and you knew you would be taxed in proportion to the amount you responded, what would you say?

Because of this fact, there are 3 main problems that arise when financing a public good


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Example Ali and Ghali have adjacent summer

cottages Fighting zebra mussel infestation New device to control mussels is $1,000 to

serve both houses Both owners feel equally strongly about

having the filter But because Ghali earns twice as much as

Ali he is willing to pay up to $800 Ali, a retired school teacher is only willing

to pay $400


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Scenario 1: Sharing the Cost

Neither will purchase the filter individually because each has a reservation price that is below its selling price But, together both value the filter at $1,200 Ali and Ghali negotiate the joint purchase

Value is $1,200; cost is $1,000 Total economic surplus would be $200 higher

than if they did not buy the filterSince sharing the filter is the efficient

outcome, we might expect that Ali and Ghali would quickly reach agreement to purchase it


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Scenario 1: Sharing the Cost

However, some conditions make a private negotiated solution difficult to achieve Suppose there are a large number of parties

Communication and negotiation are costly Free rider problem

• Everyone has an incentive to withhold contributions "Fair" sharing of costs may be difficult to agree

• Ali and Ghali might be reluctant to disclose their true reservation prices

Government provision could be a solution?


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Scenario 2: "Equal tax" Rule

Local government offers to install the device for Ali and Ghali Equal sharing of costs with a head tax

A head tax is a tax that collects the same amount from every taxpayer

• A regressive tax has a tax rate that varies inversely with income

Majority of affected parties must agreeResult: no new device

$500 is more than Ali's reservation price

Ali vetoes device


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Scenario 3: Proportional Tax on Income

A proportional income tax requires all taxpayers to pay the same proportion of their incomes in taxes Majority rule applies

Tax Ali $333 and Ghali $667Government buys the device

Economic surplus: Ghali: $800 – $667 = $133 Ali: $400 – $333 = $67 Total surplus increases $200


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Marital Budgeting

Suppose Haifa earns $2,000,000 per yearHer husband Badr earns only $20,000Married couples usually pool their incomes

If each contributed proportionately, consumption would be limited by the lower income

Haifa will find it attractive to pay considerably more than 50% for jointly consumed goods because doing so would enable both of them to consume in the manner their combined income permits

Combining incomes allows them to consume at a level appropriate to their combined incomes


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Private and Public Goods

Individuals consume whatever quantity and quality of most private goods they choose to buy Jointly consumed goods must be provided in the

same quantity and quality for all People's willingness to pay increases with income

Suppose public goods are financed by a head tax Higher income groups will not get the amount of

public goods they demand Progressive taxes take a larger share of higher

incomes as tax These taxes support a better outcome for all

groups


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Unfair Taxation

A head tax is regressiveWith a proportional tax, the tax bill, in

dollars, is higher for high-income groupsSome argue that progressive taxes

unfairly burden the higher income groups If public goods are normal goods, the higher

income group demands more public goods than other groups

Evidence shows that the income elasticity of public goods is substantially greater than 1


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The Optimal Quantity of a Public Good: The Market for Public Goods

Problem: How much of a public good should be provided? Cost – Benefit Principle applies

Benefit of an additional unit of a public good is the sum of the reservation of all people who use it Vertical interpretation of demand curve

Different from horizontal summation of private goods

Costs are the same as for private goods


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Quantity (units/day)

Pri

ce (

$/u

nit

)

24


Pri

ce (

$/u

nit

)

D1

18

24

D2

36

Market 2

Market 1

9

18

Q = Q1 + Q2

Pri

ce (

$/u

nit

)60

D = D1 + D2

Total Market

24

9

18

Private Good Demand


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Private Good Demand


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Public Good Demand

Pri

ce ($

/unit

)

D2

18

24Quantity (units/day)

Pri

ce ($

/unit

)

36

D1

24


8

24

Market 1

Market 2

42

36

Total Market

Pri

ce ($

/unit

)Quantity (units/day)

D = D1 + D2

8

24


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Public Good Demand


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The Optimal Quantity of Parkland

Hectares of parkland

Pri

ce (

$0

00

s/h

ect

are

)

A*

140

200

A0

80 Demand

MarginalCost


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Government Provision of Public Goods

Government provision has advantages Low cost to collect additional revenue Expedient: no negotiations over distribution

of costs Only feasible provider for non-excludable

goodsGovernment provision has disadvantages

One-size-fits-all Some pay for goods they do not want Some do not get goods they would pay for

Taxation is coercive


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Private Provision of Public Goods

Alternative ways to raise revenues Funding by donation

Volunteer action and funding (dot-orgs) Exclude non-payers (new technology

allows that) Scrambled TV signals

Private contracting Gated communities and homeowners

associations Sale of by-products

Advertising on TV, Internet


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Reality Show v. Classical Music Concert

Show funded by advertising Advertiser values the largest audience

Reality Show wins Classical Music Concert is the efficient

outcomeFunding public goods through

advertising does not assure maximum total surplus

Reality Show Music Concert

Market Share 20% 18%

Willingness to Pay

$10 million $30 million


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Making Advertising Work

Pay-per-view methods avoid the inefficiency of advertiser's choosing public goods Viewers register preferences Willingness to pay measures strength of

preferencesMarginal social cost of watching a

program is zero Charging introduces inefficiencies

Measure size of inefficiencies to select the optimal approach Advertisers choose programs Pay-per-view


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Pay-Per-View Market

Pay per view fee $10 Audience is 10 million

households If broadcast viewing is

free Marginal cost of an

additional viewer is zero Audience is 20 million

Lost surplus from pay-per-view is $50 million The more elastic the

demand, the greater the loss in total surplus

Viewing households (M)

Cost

($/e

pis

ode)

20

2010

10

Lost surplus

from $10 viewing fee


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Additional Functions of Government

Two roles of government Regulation of activities that generate

externalities Increase market efficiency Examples: pollution, education,

vaccinations, driving on the right Defining and enforcing property rights

Example: regulating access to fishing waters and public forests


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Additional Functions of Government

While one function of government is to regulate activities that arise from externalities It is important to note that

The mere fact that an externality exists does not necessarily mean that the best outcome is for the government to regulate it

• Regulation entails costs- Regulation costs may be greater than the

inefficiency created by the externality


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Sources of Inefficiency in the Political Process

Inefficiencies often arise in the public sphere not because of incompetent or ignorant legislators but because of structural incentive problems We identify two examples

Patronage Legislation Rent Seeking

Patronage Legislation Ahmad and nine friends are having

dinner in a restaurant It is now time to decide on dessert


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Structural Incentives Problem: Patronage Legislation

The dessert options and Ahmad's reservation price suggest no dessert tonight if Ahmad is the only one paying (or if he were dining alone)

However, assume that they have agreed in advance to split the cost of their meal equally, with each paying one-tenth of the total check

Will Ahmad order dessert, and, if so, which one?

Blueberry PieChocolate Mousse

Menu Price $10 $6

Ahmad’s Reservation Price

$4 $3


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Structural Incentives Problem: Patronage Legislation

Ahmad’s consumer surplus: From Blueberry Pie = $4 - $1 = $3 From Chocolate Mousse = $3 - $0.6 = $2.4

Ahmad will order the pie

Blueberry PieChocolate Mousse

Actual Paying Price $10 / 10 = $1 $6 / 10 = $0.6

Ahmad’s Reservation Price

$4 $3


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Structural Incentives Problem: Patronage Legislation (Patronage

Spending)

Ahmad’s nine friends have the same preferences regarding dessert

Each will order blueberry pie and each person’s share of the total bill will rise not by $1 but by the full $10 Compared to the alternative of no one

having dessert, each diner suffers a $6 loss in consumer surplus

Still, it made sense for each to order blueberry pie, since failure to do so would have reduced each diner’s bill by only $1


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Structural Incentives Problem: Patronage Legislation (Patronage

Spending)

Patronage spending is public expenditure greater than the total value created Supported by legislator because the benefits

to his district exceed the costs to his districtSuppose a voting district has 1% of the

taxpayers Project creates $100 million in benefits with

total costs of $150 million District's share of the cost is $1.5 million

$98.5 million surplus for the districtLogrolling occurs when legislators

support each other's patronage projects


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Structural Incentives Problem: Rent-Seeking

A source of inefficiency in the public sphere arises because the gains from government projects are often concentrated in the hands of few beneficiaries This occurs while costs are usually spread out

among many This means that beneficiaries often have a

powerful incentive to organize and lobby in favor of public projects

On the other hand, Individual taxpayers have little at stake in any public project There is little incentive to incur the cost of

mobilizing themselves in opposition


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Rent seeking is the term for socially unproductive efforts to gain a prize Firms competing for a single contract

spend potential profits on bid preparation and lobbying

Similar to inefficiency of positional arms race

Example: Auction of a $20 bill Rules:

• Requires an initial bid of at least $0.50 • Bids increase in $0.50 amounts


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Auction rules for $20 When the bidding ceases, both the

highest bidder and the second-highest bidder must give the amounts they bid to the auctioneer

Highest bidder wins, pays last bid, gets $20

• Second-highest bidder pays his last bid and gets nothing

- How high will the winning bid be, on average?


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Optimal outcome is to not bid Participants are in a cost-escalation

gameSimilar process occurs with bids for

government contract or license How much will cellular phone companies

bid for an exclusive license? Example: License to provide mobile phone

services• Two firms have applied for the license• The franchise lasts for exactly one year

- During which time the franchisee can expect to make an economic profit of $20 million


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How much will cellular phone companies bid for an exclusive license?

The government will choose the applicant that spends the most money lobbying legislators

• If the applicants cannot collude, how much will each spend on lobbying?

If both spend the same, each will have a 50-50 chance at the $20 million prize This means an expected profit of $10

million minus the amount spent lobbying


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If the applicants cannot collude, how much will each spend on lobbying? If the lobbyists could collude, each would

agree to spend the same small, token amount on lobbying

But in the absence of a binding agreement, each will be strongly tempted to try to outspend the other

Once each firm’s spending reaches $10 million, each will have an expected profit of zero (a 50-50 chance to earn $20 million, minus the $10 million spent on lobbying)


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If the applicants cannot collude, how much will each spend on lobbying? Further bidding would guarantee an

expected loss If one firm spent $10,000,001 while the

other stayed at $10 million, the first firm would get the franchise for sure and earn an economic profit of $9,999,999

The other firm would have an economic loss of $10 million

Rather than face a sure loss of $10 million, it may be tempted to bid $10,000,002

But then, of course, its rival would face a similar incentive to respond to that bid


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What Should We Tax?

The primary purpose of the tax system is to generate the revenue needed to fund public goods and other government expenditures

Taxes have also other consequences Taxes alter the relative costs and benefits

of engaging in different activities Taxes affect the distribution of real

purchasing power in the economyThe best tax system is one that raises

the needed revenues while at the same time having the most beneficial, or least harmful, side effects


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What Should We Tax?

Federal spending generally exceeds tax revenues Government deficits cause crowding out

Crowding out is the reduction in private investment caused by increases in interest rates from government borrowing

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


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Tax on Cars

Assume the car market is constant-cost and perfectly competitive No external costs or benefits

Initial equilibrium is $20,000 and 6 million cars

$2,000 tax on cars shifts supply curve up New equilibrium at $22,000

and 4 million Total surplus decreases

• Loss in economic surplus is $2 billion

Quantity (millions of cars/year)

Cost

($

00

0s/

car)

S20

6

22 S + T

4

D


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Tax Policy Issues

Some economists argue that the economy performs better with low taxes and smaller government spending However, the economic loss of a tax

may be offset by the surplus created from the public good or service

Deadweight loss from a tax is smaller if the good taxed has inelastic demand and supply


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Tax Policy Issues

Taxes on externalities increase economic efficiency Taxes to reduce traffic congestion Carbon taxes on greenhouse gas

emissions by cars and factories Deposits on containers to reduce litter

©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 13: Public Goods and Tax Policy.

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Transcript of ©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 13: Public Goods and Tax Policy.