Public Choice

Prof. John M. Abowd

Themes of Today's Lecture

• Externalities
• Public goods
• Market failures
• Government failures
• The importance of property rights and transactions costs
• Designing voting rules to provide public goods
• Using markets as a part of regulation

What is an Externality?

• Costs or benefits of production or consumption of a good spill over onto nonproducers or consumers.
• Positive externality: benefits spill over to someone who did not produce or consume the good.
• Negative externality: costs spill over to someone who did not produce or consume the good.

Market Failure

• When a market does not deliver either Pareto efficiency or informational efficiency, we say that the market has failed.
• When a market fails, government can sometimes improve social welfare by intervening.
• Sometimes, however, the government cannot improve the market outcome.

Example of a Negative Externality Production processes that pollute the air inflict a cost on society that is not paid by the producer (in the absence of regulations). The market equilibrium (quantity demanded = quantity supplied) is not Pareto Efficient. The social optimum occurs where marginal social cost (including the cost of the pollution) equals marginal private benefit (demand). Note that because there is no externality affecting the buyers, marginal private benefit (demand) equals marginal social benefit.

Solution to the Negative Externality Imposing a tax on producers that is exactly equal to the difference between marginal social cost and marginal private cost will make the market equilibrium Pareto Efficient again. To impose this tax, called a Pigovian tax, the government must know the marginal social cost caused by the pollution.

Example of a Positive Externality Education increases the efficiency of a society and improves the quality of life for others besides the educated. The market equilibrium (quantity demanded = quantity supplied) is not Pareto Efficient. The social optimum occurs where marginal social benefit (including the benefit to society of the extra education) equals marginal private cost (supply). Note that in this case the externality doesn't affect the suppliers so marginal private cost and marginal social cost are equal.

Solution to the Positive Externality Providing an educational subsidy equal to the difference between the marginal private benefit and the marginal social benefit will cause the new demand equation to exactly equal the marginal social benefit. The new equilibrium will be Pareto Efficient.

What is a Public Good?

• Nonrivalry: more consumption by one person doesn’t reduce the consumption of another.
• Nonexcludability: once the good is produced, no one can be prevented from consuming it.
• We refer to a “pure” public good as one that has both of these properties, without qualification.

A Tale of Three Bridges

Each of these three-person cities must decide whether or not to build a bridge. The tables show each citizen's (consumer's) marginal benefit if the bridge is built. The bridge will cost $1,500 to build.

Decisions to Make

There are five ways the bridge might be built, shown in the columns of the table above. Read the handout and decide whether or not bridge 1 would be build by a majority-rule government that promised to finance the bridge with a $500 tax levy on each citizen.

Bridge 1 Analyzed The total social benefit of bridge 1 is $2,000 and the bridge cost is $1,500. If every citizen's interests can be represented by the marginal benefit assigned to the bridge, total social benefits exceed total social costs, so the bridge should be built. A majority-rule government would build the bridge if taxes were equal: all would pay $500 in taxes. Xenon and Yolinda would get benefits exceeding their tax payments and would, presumably, vote for the bridge.

More Decisions

• Now, decide whether or not a majority-rule government would build bridges two and three.

Bridge 2 Analyzed The total social benefits still exceed the total social costs in bridge 2, so the bridge should be built (same assumptions as for bridge 1). With a majority-rule government and equal taxes, only Ursula will vote for the bridge, so it will not be built.

Bridge 3 Analyzed For the third bridge, total social benefits are only $1,450, which is less than total social costs of $1,500, so the bridge should not be built (same assumptions as bridge 1) A majority-rule government that proposes equal taxes; however, will build the bridge because Randolph and Sylvie both vote for the bridge. They have positive net benefits after paying their taxes.

Monopoly Provision of the Bridges

• The bridges might also be built by a monopolist who would charge a single toll to cross the bridge.
• Think of this like joining a club: if one pays the toll, one has the right to use the bridge.
• Would a monopolist build bridge 1 and what price would be charged?
• Now decide whether a single price monopolist would build bridges 2 and 3.

Bridges Analyzed under Single Price Monopoly

Bridge 1 The profit-maximizing price for this bridge monopoly is $750 because two consumers (Xenon and Yolinda) would pay. The monopolist would earn $1,500 in revenues and bear $1,500 in costs. The single-price monopoly is competitively viable and the monopolist does not earn any economic profits. In this case the economic viability of the single-price monopolist means that the market solution is efficient because bridge 1, which has social benefits greater than social costs, would be built by the monopolist. Bridge 2 A single-price monopolist maximizes profits in this case by charging $1,250 and there is a single customer (Ursula). The monopoly pays $1,500 to build the bridge, so it loses $250. The single-price monopoly is not competitively viable-it makes negative economic profits. In this case the fact that the monopolist makes negative profits means that the market has failed because the bridge still has social benefits greater than social costs and should be built. Bridge 3 A single-price monopolist maximizes profits in this case by charging $700 and there are two customers (Randolph and Sylvie). Total revenues are $1,400 The monopoly pays $1,500 to build the bridge, so it loses $100. The single-price monopoly is not competitively viable-it makes negative economic profits. In this case the fact that the monopolist makes negative profits and does not build the bridge means that the market has not failed. This bridge has social benefits less than social costs and should not be built, so the failure of a monopoly is a success for the market.

Government Use of a Single Access Fee

• Would a majority rule government build any of the three bridges if it could design a single access fee system?

Majority Rule Government and Bridge Access Fees (1) A government that commits to a single access fee for the bridge may also use the tax system to finance the bridge. Bridge 1 is built with an access fee of $750 and no taxes (this will get 2 of 3 votes) but other financing schemes are possible $700 fee (still two users Xenon and Yolinda) but all three citizens must pay taxes of $33.34 to provide enough money to build the bridge (also gets 2 votes of 3).

Majority Rule Government and Bridge Access Fees (2)

• Bridge 2 is not built because there is no combination of fees and taxes that provides $1,500 in total revenue and would receive at least 2 votes.
• The problem in building bridge 2 is that the sum of the taxes and the access fee cannot exceed $375 in order to get at least 2 votes. The taxes do not provide access, so Vladimir and Warren vote no unless the fee is set so low that the sum of the access fee and taxes is no more than $375
• A single access fee, even combined with taxes that do not grant access, is not sufficient to get bridge 2 built, even though it would be efficient to build it.

Majority Rule Government and Bridge Access Fees (3)

• Bridge 3 is built because there are many combinations of taxes and access fees that provide $1,500 in total revenue. For example, taxes of $100 per citizen yield $300. An access fee of $600 attracts Randolph and Sylvie for additional revenue of $1,200. Total revenue is $1,500.
• Randolph and Sylvie expect to pay $700 each if the bridge is built and each gets $700 of benefit, so they vote yes. Toscanini votes no, loses, and must still pay the tax.
• Bridge 3 should not be built because total social benefits are less than total social costs, so this is an example of failure of the majority rule voting system.

What are Market Failures?

• A market fails when it does not deliver either Pareto Efficiency or Informational Efficiency.
• A market fails when the market equilibrium does not maximize social welfare.
• Social welfare is maximized when marginal social benefit equals marginal social cost.
• If there are no externalities or public good problems, social welfare is maximized when marginal private benefit equals marginal private cost because private and social benefits are equal in this case.

Did the Market Fail for Any of the Bridges?

• The market seems to have worked fine for bridge 1--a single price monopoly earned no economic profits and supplied the bridge services to exactly those for whom marginal benefit exceeded or was equal to price.
• Nevertheless, once the bridge is built it is efficient to let Zephyr use it since the marginal private cost of his use is zero.
• The monopoly market failed for both of the other two bridges.

Would the Market Fail if We Allowed Price Discrimination?

• Which of the bridges would be built by a price-discriminating monopolist?

Price Discriminating Monopoly Solves the Market Failure

• Because a price discriminating monopoly only builds the bridges when the net social benefit is positive and because all those with positive social benefit use the bridges that are built, the price discriminating monopolist solves the market failure.

Government Use of Variable Access Fees

• Would a majority rule government build any of the three bridges if it could design a variable access fee system?

Variable Access Fees

A price discriminating government would build all three bridges in this case. For bridges 1 and 2 the access fee for each citizen is set equal to marginal benefit. Total revenues exceed total costs and the extra $500 can be used to reduce each citizen's bridge payments (reduction of access fee by $166.67/citizen). In both cases the vote would be 3 to 0 in favor. For bridge 3, the project runs a deficit of $50, which must be recovered as a general tax, so a feasible outcome is the same as the single access fee case. Toscanini still votes no, but the others vote yes

Government Intervention in the Bridge Market (Summary)

The table summarizes the results for each of the cases we considered. Notice that the efficient outcome is for bridges 1 and 2 to be built and for all three citizens to have access to the bridge once it is built. The price discriminating monopoly achieves this result. No single fee system (neither private monopoly nor government monopoly) achieves this result. Majority rule governments consistently build bridge 3, which does not generate benefits in excess of its construction costs because the majority can force the minority to pay for services it does not value highly (government with equal taxes) or will not use (government with access fee or price discriminating government.

Did Government Fail in the Bridge Decisions?

• Majority rule with equal taxes or equal access fees failed for at least one of the bridges.
• The majority rule price discriminating government (variable access fee) also failed because bridge 3 was built when it shouldn’t have been.
• There isn’t a majority rule government that perfectly emulates the price discriminating monopolist in this example.
• A majority rule government could, however, decide to auction the right to build the bridge to a price discriminating monopolist. For this example the high bid would be positive for bridges 1 and 2 and negative for bridge 3. This form of regulation is socially efficient in this example.

Were the Failures Due to Externalities?

• No.
• There was no congestion, so no negative externality
• There was no benefit if the bridge was not actually used, so no positive externality.

Were the Failures Due to Public Goods?

• No.
• The fact that the bridge was not congested means that there was no rivalry in consumption.
• The fact that either the government or the private company could set up an access fee means that the consumption was excludable.

What Did Cause the Market and Government Failures?

• The failures in these examples were caused by three distinct problems:
  • property rights
  • transactions costs
  • design of the voting rules

Importance of Property Rights and Transactions Costs

• Property rights mean that all citizens know who owns the right to buy or sell something.
• Transactions costs mean that there is a cost associated with finding a buyer or seller and completing the sale.

Why Were Property Rights an Issue in the Bridge Example?

• In order for the private company to supply the bridge it had to be given the right to control access.
• In addition, the private company had to be given the right to set variable fees in order to get full social efficiency.

Why Were Transactions Costs Important in the Bridge?

• We eliminated the transactions costs by saying that the marginal benefits of all citizens were public information.
• This allowed us to determine which laws would receive a majority vote and which market structures would survive.

The Coase Theorem

• Ronald Coase has established that the clear allocation of property rights and the elimination of transactions costs makes it possible to find socially efficient solutions to problems where markets or governments fail.
• The socially efficient solution is the resource allocation determined by the price discriminating monopolist.
• In our bridge example the Coase Theorem says that if the right to build the bridge is clearly established and if all the citizens reveal their marginal benefits, then the socially efficient outcome will occur (bridges 1 and 2 will be built and all citizens will use them, bridge 3 will not be built).

Designing Voting Rules

• It is not easy to design voting rules that let governments find more efficient outcomes than the market.
• Governments generally don't use the variable toll (price discrimination) system, so they do find outcomes that are more equitable.

Did the Voting Rule Affect the Bridge Decisions?

• Majority rule never improved upon the price discriminating monopoly outcome but it did cause the bridge to be built (case 3) when it wasn't efficient to do so.
• Single price monopolists inefficiently exclude some citizens (bridge 1) or don't build the bridge at all (bridge 2).

Using Markets as a Part of Regulation

• Markets can complement regulation by providing a mechanism for reducing the transactions costs associated with finding an efficient resource allocation.
• For markets to work as a complement to regulation, property rights must be carefully defined for all aspects of the transaction.

Were Markets Important in the Bridge Example?

• Yes.
• By assigning the property rights controlling access to the bridge to a private company we were able to achieve the efficient outcome.
• But, only when price discrimination was allowed.

Summary of Lecture

• Market failure is often used to justify governmental intervention in the form of direct provision, regulation or prohibition.
• A government fails when it achieves an outcome that is worse than the unregulated market outcome.
• The supply of goods by a government is a complicated problem even with complete information.
• Governments do not have complete information about people’s preferences or firms’ costs.
• Usually, neither the unregulated market outcome nor the regulated result are strictly preferable, some people gain and some lose in each situation.

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