No Such Thing as a Free Lunch: Principles of Economics (Part 78)

“Economics is a study of cause-and-effect relationships in an economy. It's purpose is to discern the consequences of various ways of allocating resources which have alternative uses. It has nothing to say about philosophy or values, anymore than it has to say about music or literature.”

― Thomas Sowell, Basic Economics: A Citizen's Guide to the Economy

Externalities, Public Goods, Imperfect Information, and Social Choice

(Part E)

by

 Charles Lamson

Public Provision of Public Goods

All societies, past and present, have had to face the problem of providing public goods. When members of society get together to form a government, they do so to provide themselves with goods and services that will not be provided if they act separately. Like any other good or service, a body of laws (or system of justice) is produced with labor, capital, and other inputs. Law and the courts yield social benefits, and they must be set up and administered by some sort of collective, cooperative effort.

Notice that we are talking about public provision, not public production. Once the government decides what service it wants to provide, it often contracts with the private sector to produce the good. Much of the material for national defense is produced by private defense contractors. Highways, government offices, data processing services, and so forth are usually produced by private firms. 

One of the immediate problems of public provision is that it frequently leads to public dissatisfaction.  It is easy to be angry at government. Part, but certainly not all, of the reason for this dissatisfaction lies in the nature of the goods that government provides. Firms that produce or sell private goods post a price---we can choose to buy any quantity we want, or we can walk away without any. It makes no sense to get mad at a shoe store, because no one can force you to shop there.

You cannot shop for collectively beneficial public goods. When it comes to national defense, the government must choose one and only one kind and quantity of (collective) output to produce. Because none of us can choose how much should be spent or on what, we are all dissatisfied. Even if the government does its job with reasonable efficiency, at any given time about half of us think that we have too much of national defense and about half of us think that we have too little.

Optimal Provision of Public Goods

In the early 1950s, Paul Samuelson demonstrated that there exists an optimal, or a most efficient, level of output for every public good. The discussion of Samuelson's solution that follows leads us straight to the thorny problem of how societies, as opposed to individuals, make choices.

Samuelson's Theory An efficient economy produces what people want. Private producers, whether perfect competitors or monopolists, are constrained by the market demand for their products. If they cannot sell their products for more than it costs to produce them, they are out of business. Because private goods permit exclusion, firms can withhold their products until households pay. Buying a product at a posted price reveals that it is "worth" at least that amount to you and to everyone who buys it.

Market demand for a private good is the sum of the quantities that each household decides to buy (as measured on the horizontal axis). The diagrams in Figure 4 review the derivation of a market demand curve. Assume society consists of two people, A and B. At a price of $1, A demands 9 units of the private good and B demands 13. Market demand at a price of $1 is 22 units. If price were to rise to $3, A's quantity demanded would drop to 2 units and B's would drop to 9 units; market demand at a price of $3 is 2 + 9 = 11 units. The point is that the price mechanism forces people to reveal what they want and it forces firms to produce only what people are willing to pay for, but it works this way only because exclusion is possible.

For private goods, market demand is the horizontal sum of individual demand curves---we add the different quantities that households consume (as measured on the horizontal axis). For public goods, market demand is the vertical sum of individual demand curves---we add the different amounts that households are willing to pay to obtain each level of output (as measured on the vertical axis).

Samuelson argued that once we know how much society is willing to pay for a public good, we need only compare that amount to the cost of its production. Figure 6 reproduces A's and B's demand curves and the total demand curve for the public good. As long as society (in this case, A and B) is willing to pay more than the marginal cost of production, the good should be produced. if A is willing to pay $6 per unit of public good and B is willing to pay $3 per unit, society is willing to pay $9.

Furthermore, if we ask households directly about their willingness to pay, we run up against the same problem encountered by our protection services salesman mentioned earlier. If my actual payment depends on my answer, I have an incentive to hide my true feelings. Knowing that I cannot be excluded from enjoying the benefits of the good and that my payment is not likely to have an appreciable influence on the level of output finally produced, what incentive do I have to tell the truth or to contribute?

How does society decide which public goods to provide? We assume that members of society want certain public goods. Private producers in the market cannot make a profit by producing these goods, and the government cannot obtain enough information to measure society's demands accurately. No two societies have dealt with this dilemma in the same way. In some countries, dictators simply decide for the people. In others, representative political bodies speak for the people's preferences. In still others, people vote directly. None of these solutions works perfectly. We will return to the problem of social choice in a future post.

Local Provision of Public Goods: Tiebout Hypothesis

In 1956, Charles Tiebout made this point: To the extent that local governments are responsible for providing public goods, an efficient market-choice mechanism may exist. Consider a set of towns that are identical except for police protection. Towns that choose to spend a lot of money on police are likely to have a lower crime rate. A lower crime rate will attract households who are risk-averse and are willing to pay higher taxes for lower risk of being a crime victim. Those who are willing to bear greater risk may choose to live in the low tax/high crime towns. Also, if some town is very efficient at crime prevention, it will attract residents given that each town has limited space, property values will be a bit up in this town. The higher home price in this town is the "price" of the lower crime rate.

According to the Tiebout hypothesis, an efficient mix of public goods is produced when local prices (in the form of taxes or higher housing costs) come to reflect consumer preferences just as they do in the market for private goods. What is different in the Tiebout world is that people exercise consumer sovereignty not by "buying" different combinations of goods in a market, but by "voting with their feet" (choosing among bundles of public goods and tax rates produced by different towns and participating in local government). 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 318-321*

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