CHAPTER 14
Government is imperfect. But markets are also imperfect, and all successful societies rely on a mix of government and private production to meet their economic demands.©tupungato/Getty Images
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1. LO1Use the concepts of rivalry and excludability to distinguish among private goods, public goods, collective goods, and commons goods.
2. LO2Show how economic concepts can be used to find the optimal quantity of a public good and describe the ways in which private firms can supply public goods.
3. LO3Analyze the types of efficiencies and inefficiencies that are associated with the provision of public goods.
4. LO4Discuss the criteria that should be applied to taxation in order to promote efficiency.
Government has the power to tax. Unlike a private business, which can get our money only if we voluntarily buy its product, the government can take our money even if we don’t want the particular mix of goods and services provided.
Government also has a monopoly on the legitimate use of force. If people break the law, government has the power to restrain them, using force if necessary. It also has the power to deprive lawbreakers of their liberty for extended periods, and, in some places, even to execute them. Government can draft law-abiding citizens into the armed forces and send them into situations in which they must kill others and risk being killed themselves.
These are awesome powers. And although they are often used in the pursuit of noble ends, the historical record abounds with illustrations of their abuse. Voters and politicians of both parties are keenly aware of these abuses. Indeed, contemporary political rhetoric almost invariably entails criticism of bloated, out-of-control government bureaucracy. Even mainstream Democrats—ostensibly the party of activist government in the United States—have conceded the need to curb government’s role. For example, former president Clinton remarked in his 1996 State of the Union message, “the era of big government is over.”
Others advocate even more radical retrenchment. For instance, Harry Browne, the 1996 Libertarian Party presidential candidate, called for abolition of the Internal Revenue Service, the agency responsible for collecting the federal income tax. This step would be tantamount to abolishing the federal government itself, for without tax revenues, there would be no way to pay for public goods and services.
Browne is right, of course, that a sure way to prevent government abuse of power is simply to have no government. But since virtually no society on earth lacks a government, we may suspect that governments, on balance, do more good than harm.
But how big, exactly, should government be? What goods and services should it provide? How should it raise the revenue to pay for them? What other powers should it have to constrain the behavior of its citizens? And how should the various powers we assign to government be apportioned among local, state, and federal levels? Our goal in this chapter will be to employ the principles of microeconomics in an attempt to answer these pragmatic questions.
GOVERNMENT PROVISION OF PUBLIC GOODS
One of the primary tasks of government is to provide what economists call public goods such as national defense and the criminal justice system.
PUBLIC GOODS VERSUS PRIVATE GOODS
Public goods are those goods or services that are, in varying degrees, nonrival and nonexcludable. A nonrival good is one whose consumption by one person does not diminish its availability for others. For example, if the military prevents a hostile nation from invading your city, your enjoyment of that protection does not diminish its value to your neighbors. A good is nonexcludable if it is difficult to exclude nonpayers from consuming it. For instance, even if your neighbors don’t pay their share of the cost of maintaining an army, they will still enjoy its protection.
Another example of a nonrival and nonexcludable good is an over-the-air broadcast of The Late Show with Stephen Colbert. The fact that you tune in one evening does not make the program any less available to others, and once the broadcast has been beamed out over the airwaves, it is difficult to prevent anyone from tuning in. Similarly, if the City of New York puts on a fireworks display in New York harbor to celebrate a special occasion, it cannot charge admission because the harbor may be viewed from many different locations in the city. And the fact that additional persons view the display does not in any way diminish its value to other potential viewers.
In contrast, the typical private good is diminished one-for-one by any individual’s consumption of it. For instance, when you eat a cheeseburger, it is no longer available for anyone else. Moreover, people can be easily prevented from consuming cheeseburgers they don’t pay for.
CONCEPT CHECK 14.1
Which of the following, if any, is nonrival?
a. The website of the Bureau of Labor Statistics at 3 a.m.
b. The World Cup soccer championship game watched in person.
c. The World Cup soccer championship game watched on television.
Goods that are both highly nonexcludable and nonrival are often called pure public goods. Two reasons favor government provision of such goods. First, for-profit private companies would have obvious difficulty recovering their cost of production. Many people might be willing to pay enough to cover the cost of producing the good, but if it is nonexcludable, the company cannot easily charge for it (an example of the free-rider problem discussed in Chapter 12, The Economics of Information). And second, if the marginal cost of serving additional users is zero once the good has been produced, then charging for the good would be inefficient, even if there were some practical way to do so. This inefficiency often characterizes the provision of collective goods—nonrival goods for which it is possible to exclude nonpayers. Pay-per-view cable television is an example. People who don’t pay to get HBO don’t get to watch programs shown only on HBO, a restriction that excludes many viewers who would have benefited from watching. Because the marginal cost to society of their tuning in is literally zero, excluding these viewers is wasteful.
A pure private good is one from which nonpayers can easily be excluded and for which one person’s consumption creates a one-for-one reduction in the good’s availability for others. The theory of perfectly competitive supply developed in the chapter on perfectly competitive supply applies to pure private goods, of which basic agricultural products are perhaps the best examples. A pure commons good is a rival good that is also nonexcludable, so-called because goods with this combination of properties almost always result in a tragedy of the commons (see Chapter 11, Externalities, Property Rights, and the Environment). Fish in ocean waters are an example.
The classification scheme defined by the nonrival and nonexcludable properties is summarized in Table 14.1. The columns of the table indicate the extent to which one person’s consumption of a good fails to diminish its availability for others. Goods in the right column are nonrival and those in the left column are not. The rows of the table indicate the difficulty of excluding nonpayers from consuming the good. Goods in the top row are nonexcludable; those in the bottom row, excludable. Private goods (lower-left cell) are rival and excludable. Public goods (upper-right cell) are nonrival and nonexcludable. The two hybrid categories are commons goods (upper-left cell), which are rival but nonexcludable, and collective goods (lower-right cell), which are excludable but nonrival.
Collective goods are provided sometimes by government, sometimes 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 nonexcludable. An example is broadcast radio and television, which covers its costs by selling airtime to advertisers.
Cost-Benefit
The mere fact that a good is a pure public good does not necessarily mean that government ought to provide it. On the contrary, the only public goods the government should even consider providing are those whose benefits exceed their costs. The cost of a public good is simply the sum of all explicit and implicit costs incurred to provide it. The benefit of a public good is measured by asking how much people would be willing to pay for it. Although that sounds similar to the way we measure the benefit of a private good, an important distinction exists. The benefit of an additional unit of a private good such as a cheeseburger is the highest sum that any individual buyer would be willing to pay for it. In contrast, the benefit of an additional unit of a public good such as an additional broadcast episode of Sesame Street is the sum of the reservation prices of all people who will watch that episode.
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. For example, whereas city governments often pay for fireworks displays, they almost invariably hire private companies to put on these events. Finally, 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 given public good. For example, some people find fireworks displays highly entertaining, but others simply don’t care about them, and still others actively dislike them. Ideally, it might seem that 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. To illustrate this approach, suppose Jones values a public good at $100, Smith values the same good at $200, and the cost of the good is $240. Jones would then be taxed $80 and Smith would be taxed $160. The good would be provided, and each taxpayer in this example would reap a surplus equal to 25 percent of his tax payment: $20 for Jones, $40 for Smith.
In practice, however, government officials 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 an IRS agent asked you how much you would be willing to pay to have a new freeway and you knew you would be taxed in proportion to the amount you responded, what would you say?) The following three examples illustrate some of the problems that arise in financing public goods and suggest possible solutions to these problems.
EXAMPLE 14.1Joint Purchase
Will Prentice and Wilson buy a water filter?
Prentice and Wilson own adjacent summer cottages along an isolated stretch of shoreline on Cayuga Lake. Because of a recent invasion of zebra mussels, each must add chlorine to his water intake valve each week to prevent it from becoming clogged by the tiny mollusks. A manufacturer has introduced a new filtration device that eliminates the nuisance of weekly chlorination. The cost of the device, which has the capacity to serve both houses, is $1,000. Both owners feel equally strongly about having the filter. But because Wilson earns twice as much as Prentice, Wilson is willing to pay up to $800 to have the filter, whereas its value to Prentice, a retired schoolteacher, is only $400. Would either person be willing to purchase the device individually? Is it efficient for them to share its purchase?
Neither will purchase the filter individually because each has a reservation price that is below its selling price. But because the two together value the filter at $1,200, sharing its use would be socially efficient. If they were to do so, total economic surplus would be $200 higher than if they did not buy the filter.
Since sharing the filter is the efficient outcome, we might expect that Prentice and Wilson would quickly reach agreement to purchase it. Unfortunately, however, the joint purchase and sharing of facilities is often easier proposed than accomplished. One hurdle is that people must incur costs merely to get together to discuss joint purchases. With only two people involved, those costs might not be significant. But if hundreds or thousands of people were involved, communication costs could be prohibitive.
With large numbers of people, the free-rider problem also emerges (see Chapter 12, The Economics of Information). After all, everyone knows that the project will either succeed or fail independently of any one person’s contribution to it. Everyone thus has an incentive to withhold contributions—or get a free ride—in the hope that others will give.
Finally, even when only a few people are involved, reaching agreement on a fair sharing of the total expense may be difficult. For example, Prentice and Wilson might be reluctant to disclose their true reservation prices to one another for the same reason that you might be reluctant to disclose your reservation price for a public good to an IRS agent.
These practical concerns may lead us to empower government to buy public goods on our behalf. But as the next example makes clear, this approach does not eliminate the need to reach political agreement on how public purchases are to be financed.
EXAMPLE 14.2Head Taxes
Will government buy the water filter if there is an “equal tax” rule?
Suppose Prentice and Wilson could ask the government to help broker the water filter purchase. And suppose that the government’s tax policy must follow a “nondiscrimination” rule that prohibits charging any citizen more for a public good than it charges his or her neighbor. Another rule is that public goods can be provided only if a majority of citizens approve of them. Will a government bound by these rules provide the filter that Prentice and Wilson want?
A tax that collects the same amount from every citizen is called a head tax. If the government must rely on a head tax, it must raise $500 from Prentice and $500 from Wilson. But because the device is worth only $400 to Prentice, he will vote against the project, thus denying it a majority. So a democratic government cannot provide the water filter if it must rely on a head tax.
A head tax is a regressive tax, one for which the proportion of a taxpayer’s income that is paid in taxes declines as the taxpayer’s income rises.
The point illustrated by this example is not confined to the specific public good considered. It applies whenever taxpayers place significantly different valuations on public goods, as will almost always happen whenever people earn significantly different incomes. An equal-tax rule under these circumstances will almost invariably rule out the provision of many worthwhile public goods.
As our third example suggests, one solution to this problem is to allow taxes to vary by income.
EXAMPLE 14.3Proportional Income Tax
Will the government buy the filter if there is a proportional tax on income?
Suppose that Prentice proposes that the government raise revenue by imposing a proportional tax on income to finance the provision of the water filter. Will Wilson, who earns twice as much as Prentice, support this proposal?
A proportional income tax is one under which all taxpayers pay the same proportion of their incomes in taxes. Under such a tax, Wilson would support Prentice’s proposal because if he didn’t, each would fail to enjoy a public good whose benefit exceeds his share of its cost. Under the proportional tax on income, Prentice would contribute $333 toward the $1,000 purchase price of the filter and Wilson would contribute $667. The government would buy the filter, resulting in additional surpluses of $67 for Prentice and $133 for Wilson.
The Economic Naturalist 14.1 example makes the point that just as equal contributions are often a poor way to pay for public goods, they are also often a poor way to share expenses within the household.
The Economic Naturalist 14.1
Why don’t most married couples contribute equally to joint purchases?
Suppose Hillary earns $2,000,000 per year while her husband Bill earns only $20,000. Given her income, Hillary as an individual would want to spend much more than Bill would on housing, travel, entertainment, education for their children, and the many other items they consume jointly. What will happen if the couple adopts a rule that each must contribute an equal amount toward the purchase of such items?
Why do married couples usually pool their incomes?
This rule would constrain the couple to live in a small house, take only inexpensive vacations, and skimp on entertainment, dining out, and their children’s education. It is therefore easy to see why Hillary might find it attractive to pay considerably more than 50 percent for jointly consumed goods because doing so would enable both of them to consume in the manner their combined income permits.
Public goods and jointly consumed private goods are different from individually consumed private goods in the following important way: Different individuals are free to consume whatever quantity and quality of most private goods they choose to buy, but jointly consumed goods must be provided in the same quantity and quality for all persons.
As in the case of private goods, people’s willingness to pay for public goods is generally an increasing function of income. Wealthy individuals tend to assign greater value to public goods than low-income people do, not because the wealthy have different tastes but because they have more money. A head tax would result in high-income persons getting smaller amounts of public goods than they want. By increasing the total economic surplus available for all to share, a tax system that assigns a larger share of the tax burden to people with higher incomes makes possible a better outcome for both rich and poor alike. Indeed, virtually all industrialized nations have tax systems that are at least mildly progressive, which means that the proportion of income paid in taxes actually rises with a family’s income.
Progressive taxation and even proportional taxation often 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. The irony in this charge, however, is that exclusive reliance on head taxes, or even proportional taxes, would curtail the provision of public goods and services that are of greatest value to high-income families. Studies have shown, for instance, that the income elasticity of demand for public goods such as parks and recreation facilities, clean air and water, public safety, uncongested roads, and aesthetically pleasing public spaces is substantially greater than 1. Failure to rely on progressive taxation would result in gross underprovision of such public goods and services.
RECAP
PUBLIC GOODS
A public good is both nonrival and nonexcludable. Private firms typically cannot recover the costs of producing such goods because they cannot exclude nonpayers from consuming them. Nor would charging for a public good promote efficiency, since one person’s consumption of the good does not diminish its availability for others.
Both obstacles can be overcome by creating a government with the power to levy taxes. Even high-income citizens often favor progressive taxes because proportional or regressive taxes may generate insufficient revenue to pay for the public goods those taxpayers favor.
THE OPTIMAL QUANTITY OF A PUBLIC GOOD
In the examples considered thus far, the question was whether to provide a particular public good and, if so, how to pay for it. In practice, we often confront additional questions about what level and quality of a public good to provide.
Cost-Benefit
Standard cost-benefit logic also applies to these questions. For example, New York City should add another rocket to a fireworks display if and only if the amount that citizens would collectively be willing to pay to see the rocket is at least as great as its cost.
THE DEMAND CURVE FOR A PUBLIC GOOD
To calculate the socially optimal quantity of a public good, we must first construct the demand curve for that public good. The process for doing so differs in an important way from the one we use to generate the market demand curve for a private good.
For a private good, all buyers face the same price and each chooses the quantity he or she wishes to purchase at that price. Recall from the chapter on demand, to construct the demand curve for a private good from the demand curves for individual consumers, we place the individual demand curves side by side and add them horizontally. That is, for each of a series of fixed prices, we add the resulting quantities demanded on the individual demand curves. In Figure 14.1, for example, we add the individual demand curves for a private good, D1 and D2 [parts (a) and (b)], horizontally to obtain the market demand curve for the good D [part (c)].
FIGURE 14.1 Generating the Market Demand Curve for a Private Good.To construct the market demand curve for a private good (c), we add the individual demand curves (a) and (b) horizontally.
For a public good, all buyers necessarily consume the same quantity, although each may differ in terms of willingness to pay for additional units of the good. Constructing the demand curve for a public good thus entails not horizontal summation of the individual demand curves but vertical summation. That is, for each of a series of quantity values, we must add the prices that individuals are willing to pay for an additional unit of the good. The curves D1 and D2 in Figure 14.2(b) and (c) show individual demand curves for a public good by two different people. At each quantity, these curves tell how much the individual would be willing to pay for an additional unit of the public good. If we add D1 and D2 vertically, we obtain the total demand curve D for the public good [part (a)].
FIGURE 14.2 Generating the Demand Curve for a Public Good.To construct the demand curve for a public good (a), we add the individual demand curves (b) and (c) vertically.
CONCEPT CHECK 14.2
Bill and Tom are the only demanders of a public good. If Bill’s demand curve is PB = 6 − 0.5Q and Tom’s is PT = 12 − Q, construct the demand curve for this public good.
In the following example, we see how the demand curve for a public good might be used in conjunction with information about costs to determine the optimal level of parkland in a city.
EXAMPLE 14.4Using the Demand Curve to Determine Optimal Levels
What is the optimal quantity of urban parkland?
The city government of a new planned community must decide how much parkland to provide. The marginal cost curve and the public demand curve for urban parkland are as shown in Figure 14.3. Why is the marginal cost curve upward-sloping and the demand curve downward-sloping? Given these curves, what is the optimal quantity of parkland?
FIGURE 14.3 The Optimal Quantity of Parkland.The optimal number of acres of urban parkland is A *, the quantity at which the public’s willingness to pay for additional parkland is equal to the marginal cost of parkland.
Increasing Opportunity Cost
Equilibrium
The marginal cost schedule for urban parkland is upward-sloping because of the Low-Hanging-Fruit Principle: The city acquires the cheapest parcels of land first and only then turns to more expensive parcels. Likewise, the marginal willingness-to-pay curve is downward-sloping because of the law of diminishing marginal utility. Just as people are generally willing to pay less for their fifth hot dog than for their first, they are also willing to pay less for the 101st acre of parkland than for the 100th acre. Given these curves, A* is the optimal quantity of parkland. For any quantity less than A*, the benefit of additional parkland exceeds its cost, which means that total economic surplus can be made larger by expanding the amount of parkland. For example, at A0, the community would be willing to pay $200,000 for an additional acre of urban parkland, but its cost is only $80,000. Similarly, for any quantity of parkland in excess of A*, the community would gain more than it would lose by selling off some parkland.
PRIVATE PROVISION OF PUBLIC GOODS
One advantage of using the government to provide public goods is that 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 goods. Another advantage is that because government has the power to tax, it can summarily assign responsibility for the cost of a public good without endless haggling over who bears what share of the burden. And in the case of goods for which nonpayers cannot be excluded, the government may be the only feasible provider.
But exclusive reliance on government also entails disadvantages. Most fundamentally, the government’s one-size-fits-all approach invariably requires many people to pay for public goods they don’t want, while others end up having to do without public goods they want desperately. For example, many people vehemently oppose the provision of any sex education in the public schools, while others fervently believe that far more such instruction should be provided than is currently offered in most current public school curriculums. Mandatory taxation strikes many people as coercive, even if they approve of the particular public goods being provided.
It is no surprise, then, that governments are not the exclusive providers of public goods in any society. Indeed, many public goods are routinely provided through private channels. The challenge, in each case, is to devise a scheme for raising the required revenues. Here are some methods that seem to work.
Funding by Donation
In 2016, Americans gave more than $390 billion to private charities, many of which provide public goods to their communities. People also volunteer their time on behalf of organizations that provide public goods. When you paint your house, mow your lawn, or plant a flower garden, you are enhancing the quality of life in your neighborhood, and in that sense you are voluntarily providing a public good to your neighbors.
Development of New Means to Exclude Nonpayers
New electronic technology makes it possible to exclude nonpayers from many goods that in the past could not be thus restricted. For instance, broadcast television stations now have the ability to scramble their signals, making them available only to those consumers who purchase descrambling devices.
Private Contracting
More than 11 million Americans now live in gated private communities—private homeowners’ associations that wall off contiguous properties and provide various services to residents. Many of these associations provide security services, schools, and fire protection and in other ways function much like ordinary local governments. Recognizing that individual incentives may not be strong enough to ensure socially optimal levels of maintenance and landscaping, these associations often bill homeowners for those services directly. Many of the rules imposed by these associations are even more restrictive than those imposed by local governments, a distinction that is defended on the grounds that people are always free to choose some other neighborhood if they don’t like the rules of any particular homeowners’ association. Many people would be reluctant to tolerate a municipal ordinance that prevents people from painting their houses purple, yet such restrictions are common in the bylaws of homeowners’ associations.
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 goods. For instance, as noted earlier, radio and television programming is a public good that is paid for in many cases by the sale of advertising messages. Internet services are also underwritten in part by commercial messages that pop up or appear in the headers or margins of web pages.
Given the quintessentially voluntary nature of privately provided public goods, it might seem that reliance on private provision might be preferred whenever it proved feasible. But as The Economic Naturalist 14.2 example makes clear, private provision often entails problems of its own.
The Economic Naturalist 14.2
Why do television networks favor the Kardashians over Masterpiece Theatre?
In a given time slot, a television network faces the alternative of broadcasting either Keeping Up with the Kardashians or Masterpiece Theatre. If it chooses the Kardashians, it will win 20 percent of the viewing audience, but only 18 percent if it chooses Masterpiece. Suppose those who would choose the Kardashians would collectively be willing to pay $10 million for the right to see that program, while those who choose Masterpiece would be willing to pay $30 million. And suppose, finally, that the time slot is to be financed by a detergent company. Which program will the network choose? Which program would be socially optimal?
A detergent maker cares primarily about the number of people who will see its advertisements and will thus choose the program that will attract the largest audience—here, the Kardashians. The fact that those who prefer Masterpiece would be willing to pay a lot more to see it is of little concern to the sponsor. But to identify the optimal result from society’s point of view, we must take this difference into account. Because the people who prefer Masterpiece could pay the Kardashians viewers more than enough to compensate them for relinquishing the time slot, Masterpiece is the efficient outcome. But unless its supporters happen to buy more soap in total than the Kardashians viewers, the latter will prevail. In short, reliance on advertising and other indirect mechanisms for financing public goods provides no assurance that the goods chosen will maximize economic surplus.
Of course, the fact that the programs that best suit advertisers’ needs may not be socially optimal does not mean that government decisions would necessarily be better. One can imagine, for example, a cultural affairs ministry that would choose television programming that would be “good for us” but that few of us would want to watch.
Why do detergent companies care more about audience size than about how much people would be willing to pay to see the programs they sponsor?
One way to avoid the inefficiency that arises when advertisers choose programming is to employ pay-per-view methods of paying for television programming. These methods allow 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.
But although pay-per-view TV is more likely to select the programs the public most values, it is also less efficient than broadcast TV in one important respect. As noted earlier, charging each household a fee for viewing discourages some households from tuning in. And since the marginal social cost of serving an additional household is exactly zero, limiting the audience in this way is inefficient. Which of the two inefficiencies is more important—free TV’s inefficiency in choosing among programs or pay TV’s inefficiency in excluding potential beneficiaries—is an empirical question.
In any event, the mix between private and public provision of public goods and services differs substantially from society to society and from arena to arena within any given society. These differences depend on the nature of available technologies for delivering and paying for public goods, and also on people’s preferences.
EXAMPLE 14.5The Impact of Pay-per-View on Economic Surplus
By how much is economic surplus reduced by a pay-per-view charge?
If Mystery Theater is shown on pay-per-view television at 10 p.m. on Thursdays, the demand curve for each episode is as given in Figure 14.4. If the regulated pay-per-view charge is $10 per household, by how much would economic surplus rise if the same episode were shown instead on “free” broadcast public TV?
FIGURE 14.4 The Loss in Surplus from a Pay-per-View Fee.Twice as many households would watch the program if its price were zero instead of $10. The additional economic surplus is the area of the blue triangle, or $50 million.
With a fee of $10 per episode, 10 million households will watch (see Figure 14.4). But if the same episode were shown instead on broadcast public TV, 20 million households would watch. The additional economic surplus reaped by the extra 10 million households is the area of the blue triangle, which is $50 million. The marginal cost of permitting these additional households to watch the episode is zero, so the total gain in surplus is $50 million.
In general, charging a positive price for a good whose marginal cost is zero will result in a loss in surplus. The size of the loss that results when price is set above marginal cost depends on the price elasticity of demand. When demand is more elastic, the loss in surplus is greater. Concept Check 14.3 provides an opportunity to see that principle at work.
CONCEPT CHECK 14.3
How would your answer to Example 14.5 have been different if the demand curve had instead been as shown below?
RECAP
THE OPTIMAL QUANTITY OF A PUBLIC GOOD
Because the quantity of a public good must be the same for every consumer, the total demand curve for a public good is constructed by adding individual demand curves vertically. Optimal production of a public good occurs at the quantity for which the demand curve intersects the marginal cost curve for the public good.
Government need not always be the best way to provide public goods. Such goods can be provided by private organizations that rely on charitable contributions or the sale of by-products. Private for-profit companies also can become providers when new technologies such as pay-per-view television convert public goods into collective goods.
LAWS, REGULATIONS, AND THE QUESTION OF CENTRALIZATION
The provision of public goods is not the only rationale for the existence of government. Government also creates and enforces the rules without which the efficient production of private goods would not be possible.
EXTERNALITIES AND PROPERTY RIGHTS
As we saw in Chapter 11, Externalities, Property Rights, and the Environment, externalities often stand in the way of socially optimal resource allocation in private activities. We saw, too, that optimal allocations are unlikely to result whenever property rights are poorly defined (for example, the tragedy of the commons). These observations suggest the existence of two additional important roles for government: the regulation of activities that generate externalities and the definition and enforcement of property rights.
These rationales for government action explain why most governments regulate activities that generate pollution, subsidize education (on the grounds that an educated public creates positive externalities), control access to fishing waters and public timberland, and enforce zoning laws. Most laws, in fact, represent attempts to define property rights or to control externalities. The law requiring motorists to drive on the right, for example, is an attempt to prevent the activities of one motorist from causing harm to others.
Proponents of minimalist government often object that the government unjustly curtails our freedom when it uses zoning laws to limit the size of the houses we build or imposes fines on motorists who violate highway speed limits. Yet the justification for such regulations is precisely the same as for the laws that prohibit your fist from occupying the same physical space as your neighbor’s nose. You are free to swing your fists as you please, provided you cause no harm to others. But if your fist strikes your neighbor’s nose, you become a violator of the law and subject to punishment. If the proponents of minimalist government approve of restricting behavior in this way, why do they disapprove of other attempts to discourage behaviors that cause harm to others?
Perhaps their fear is that, because externalities are so pervasive, governments that were empowered to regulate them might quickly get out of control. This is by no means an idle fear, and we emphasize that the mere fact that an externality exists does not necessarily mean that the best outcome is for the government to regulate it. As we will see in the next section, regulation entails costs of its own. The ultimate question is therefore a practical one: Will government regulation of the externality in question do more good than harm? Slogans about being free to live without government interference provide little help in answering such questions.
LOCAL, STATE, OR FEDERAL?
Framers of the U.S. Constitution were deeply skeptical of centralized government power. In drafting the Constitution, therefore, they explicitly tried to limit the powers of the federal government as much as possible, delegating most important powers to the states, which in turn delegated many of their powers to governments at the local level.
It is no surprise that the dangers of remote, centralized government ranked high among the founding fathers’ concerns. After all, fresh in their memories was the autocratic treatment received by the American colonies at the hands of the monarchy in England. The founding fathers recognized that government will be more responsive the shorter the distance between officeholders and the voters who elect them.
Another obvious advantage 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 even on what kinds of public goods to provide. When such decisions are made at the local level, people can shop for a community whose voters’ preferences largely coincide with their own. Those who like high levels of public goods and services can band together and authorize high taxes to pay for them. Others who place less value on public services can choose communities in which both services and taxes are lower.
Why, given the many attractions of decisions made at the local level, did the founding fathers create federal and state governments at all? One reason is economies of scale in defense. For a country to survive politically, it must be able to deter aggression by hostile governments. A country consisting only of, say, Concord, New Hampshire, would be ill-equipped to do that. Large, well-equipped armies and navies cost a lot of money, and countries without sufficient population simply cannot afford them.
Defense, however, is not the only reason to empower governments beyond the local or state level. The problem of pollution, for example, is difficult to solve when the various sources of pollution are not subject to regulatory control by a single government. Much of the acid rain experienced in Canada, for instance, is the result of sulfur dioxide emissions from industrial sources in the upper Midwest of the United States. These emissions are beyond the reach of Canadian environmental regulations. In many instances, as with the discharge of greenhouse gases, not even a coalition of all the governments in North, Central, and South America would have power to take effective action. Carbon dioxide emitted anywhere on the planet disperses to uniform concentrations around the globe in a matter of months.
The choice between different levels of government, then, often confronts us with difficult trade-offs. Ceding the power of taxation to a federal government often entails painful compromises for voters in individual states. But the loss of political autonomy is an even less attractive option. Similarly, nations are understandably reluctant to cede any of their sovereign powers to a higher authority, but failure to take such steps may entail unacceptable environmental costs in the long run.
RECAP
LAWS, REGULATIONS, AND THE QUESTION OF CENTRALIZATION
Government creates economic surplus not only by providing public goods but also by regulating activities that generate externalities and by defining and enforcing property rights. These rationales explain why most governments regulate pollution, subsidize education, control access to fishing waters and public timberland, and enforce zoning laws.
Although the framers of the Constitution disliked centralized government power, they recognized that some government functions are not best performed at the local or even state level. Economies of scale argue for provision of defense at the national level. Externalities that transcend local boundaries provide an additional rationale for national or even international government.
SOURCES OF INEFFICIENCY IN THE POLITICAL PROCESS
In most countries, expenditures on public goods, tax policy, and laws regulating behavior are determined in large part by the votes of democratically elected representatives. This process is far from perfect. (Winston Churchill called democracy “the worst form of government, except for any other.”) Inefficiencies often arise in the public sphere not because of incompetent or ignorant legislators but because of structural incentive problems.
Pork Barrel Legislation
The following example, drawn not from the public sector but from everyday private life, illustrates one of the important incentive gaps.
The Economic Naturalist 14.3
Why does check-splitting make the total restaurant bill higher?
Sven Torvaldsen and nine friends are having dinner at La Maison de La Casa House, a four-star restaurant in Minneapolis. To simplify the task of paying for their meal, they have agreed in advance to split the cost of their meal equally, with each paying one-tenth of the total check. Having cleared the entree dishes, the waiter arrives with the dessert menu, on which Sven’s two favorite items are pumpkin bread pudding ($10) and chocolate mousse ($6). Sven’s reservation prices for these items are $4 and $3, respectively. Will he order dessert, and, if so, which one? Would he order dessert if he were dining by himself?
Does check-splitting make people more likely to order dessert?
When Sven and his friends split the total check equally, Sven’s payment goes up by one-tenth of the menu price of any dessert he orders. Thus, the prices—to him—of the bread pudding and chocolate mousse are $1 and 60 cents, respectively. Because he gets $4 − $1 = $3 of consumer surplus from the bread pudding and only $3 − $0.60 = $2.40 from the chocolate mousse, he will order the bread pudding. If Sven were dining alone, however, his bill would increase dollar for dollar with the menu price of any dessert he ordered. And since the menu prices exceed his corresponding reservation prices, he would not order dessert at all.
The irony, of course, is that if Sven’s nine friends have the same preferences regarding dessert, each will order bread pudding 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 bread pudding since failure to do so would have reduced each diner’s bill by only $1.
CONCEPT CHECK 14.4
In The Economic Naturalist 14.3 example, would Sven have ordered dessert if there had been only 5 people splitting the check instead of 10?
Alert readers will have noticed the similarity between the problem posed in the preceding example and the one posed in Chapter 11, Externalities, Property Rights, and the Environment (The Economic Naturalist 11.4), in which identical twins had a single milkshake to share with two straws. The same incentive problem leads to the inefficient outcome in both cases.
The Economic Naturalist 14.4 example illustrates how the very same incentive problem rears its head in the legislative process.
The Economic Naturalist 14.4
Why do legislators often support one another’s pork barrel spending programs?
Pork barrel programs are government programs that benefit local areas but are of questionable value from a national perspective. Why do voters seem to support legislators who initiate such projects even when the total effect of all such projects on local tax bills far exceeds the local benefits?
Consider a voter in a congressional district that contains one one-hundredth of the country’s taxpayers. Suppose that voter’s representative is able to deliver a public project that generates benefits of $100 million for the district but that costs the federal government $150 million. Since the district’s share of the tax bill for the project will be only $150 million/100 = $1.5 million, residents of the district are $98.5 million better off with the project than without it. And that explains why so many voters favor legislators with a successful record of “bringing home the bacon.”
But why would legislator A support such a project in legislator B’s home district? After all, B’s project will cause A’s constituents’ taxes to rise—albeit by a small amount—yet they will get no direct benefit from the project. The answer is that if A does not support B’s project, then B will not support A’s. The practice whereby legislators support one another’s pet projects is known as logrolling. This practice creates a bias toward excessive spending, much like the bias created when a dinner check is split equally.
Rent-Seeking
A related source of inefficiency in the public sphere occurs because the gains from government projects are often concentrated in the hands of a few beneficiaries, while the costs are spread among many. This means that beneficiaries often have a powerful incentive to organize and lobby in favor of public projects. Individual taxpayers, by contrast, have little at stake in any public project and therefore have little incentive to incur the cost of mobilizing themselves in opposition.
Suppose, for example, that a price support bill for sugar will raise the price of sugar by 10 cents per pound and that the average American family currently consumes 100 pounds of sugar per year. How will this legislation affect the average family’s consumption of sugar? Recall from the chapter on demand that a good such as salt or sugar whose share in most family budgets is small is likely to have a low price elasticity of demand. Hence, each family’s sugar consumption will decline only slightly as a result of the 10-cent price hike. The resulting increase in each family’s annual expenditures on sugar—roughly $10—is scarcely a noticeable burden, and surely not enough to induce many people to complain to their representatives. The same legislation, however, will raise sugar industry revenues by nearly $1 billion annually. With a sum that large at stake, it is certain that the industry will lobby vigorously in its favor.
Why don’t citizens vote against those legislators who support such bills? One reason is the problem of rational ignorance, discussed in Chapter 12, The Economics of Information. Most voters have no idea that a price support bill for sugar and other special-interest bills even exist, much less how individual legislators vote on them. If all voters became well-informed about such bills, the resulting increase in the quality of legislation might well be sufficient to compensate each voter for the cost of becoming informed. But because of the free-rider problem, each voter knows that the outcome of votes in Congress will not be much affected by whether he or she becomes well-informed.
Still other sources of inefficiency arise even in the case of projects whose benefits exceed their costs. In the 1980s, for example, the federal government announced its decision to build a $25 billion high-energy physics research facility (the “superconducting supercollider”), which ignited an intense competition among more than 20 states vying to be chosen as the site for this facility. Hundreds of millions of dollars were spent on proposal preparation, consultants’ fees, and various other lobbying activities. Such investments are known as rent-seeking, and they tend to be inefficient for the same reason that investments by contestants in other positional arms races are inefficient (see Chapter 11, Externalities, Property Rights, and the Environment).
Efforts devoted to rent-seeking are socially unproductive because of the simple incentive problem illustrated in the following example.
EXAMPLE 14.6Incentives
Why would anyone pay $50 for a $20 bill?
Suppose a $20 bill is to be auctioned off to the highest bidder. The rules of this particular auction require an initial bid of at least 50 cents, and succeeding bids must exceed the previous high bid by at least 50 cents. When the bidding ceases, both the highest bidder and the second-highest bidder must give the amounts they bid to the auctioneer. The highest bidder then receives the $20, and the second-highest bidder gets nothing. For example, if the highest bid is $11 and the second-highest bid is $10.50, the winner earns a net payment of $20 − $11 = $9, and the runner-up loses $10.50. How high will the winning bid be, on average?
Auctions like this one have been extensively studied in the laboratory. And although subjects in these experiments have ranged from business executives to college undergraduates, the pattern of bidding is almost always the same. Following the opening bid, offers proceed quickly to $10, or half the amount being auctioned. A pause then occurs as the subjects appear to digest the fact that with the next bid the sum of the two highest bids will exceed $20, thus taking the auctioneer off the hook. At this point, the second-highest bidder, whose bid stands at $9.50, invariably offers $10.50, apparently preferring a shot at winning $9.50 to a sure loss of $9.50.
In most cases, all but the top two bidders drop out at this point, and the top two quickly escalate their bids. As the bidding approaches $20, a second pause occurs, this time as the bidders appear to recognize that even the highest bidder is likely to come out behind. The second-highest bidder, at $19.50, is understandably reluctant to offer $20.50. But consider the alternative. If he drops out, he will lose $19.50 for sure. But if he offers $20.50 and wins, he will lose only 50 cents. So as long as he thinks there is even a small chance that the other bidder will drop out, it makes sense to continue. Once the $20 threshold has been crossed, the pace of the bidding quickens again, and from then on it is a war of nerves between the two remaining bidders. It is common for the bidding to reach $50 before someone finally yields in frustration.
One might be tempted to think that any intelligent, well-informed person would know better than to become involved in an auction whose incentives so strongly favor costly escalation. But many of the subjects in these auctions have been experienced business professionals; many others have had formal training in the theory of games and strategic interaction. For example, psychologist Max Bazerman reports that during one 10-year period, he earned more than $17,000 by auctioning $20 bills to his MBA students at Northwestern University’s Kellogg Graduate School of Management, which is consistently among the top-rated MBA programs in the world. In the course of almost 200 of his auctions, the top two bids never totaled less than $39, and in one instance they totaled $407.
The incentives that confront participants in the $20 bill auction are strikingly similar to those that confront companies that are vying for lucrative government contracts. Consider the following example.
EXAMPLE 14.7Bidding for an Exclusive License
How much will cellular phone companies bid for an exclusive license?
The State of Wyoming has announced its intention to grant an exclusive license to provide cellular phone services within its borders. Two firms have met the deadline for applying for this license. The franchise lasts for exactly one year, during which time the franchisee can expect to make an economic profit of $20 million. The state legislature 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, which means an expected profit of $10 million minus the amount spent 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).
Further bidding would guarantee an expected loss. And yet, 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. No matter where the escalation stops, it is sure to dissipate much of the gains that could have been had from the project. And perhaps, as in the $20 bill auction, the total amount dissipated will be even more than the value of the franchise itself.
From the individual perspective, it’s easy to see why firms might lobby in this fashion for a chance to win government benefits. From society’s perspective, however, this activity is almost purely wasteful. Lobbyists are typically intelligent, well-educated, and socially skilled. The opportunity cost of their time is high. If they were not lobbying government officials on behalf of their clients, they could be producing other goods or services of value. Governments 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. Society will be more successful the more its institutions encourage citizens to pursue activities that create wealth rather than activities that merely transfer existing wealth from one person or company to another.
Starve the Government?
Nobel laureate Milton Friedman said that no bureaucrat spends taxpayers’ money as carefully as those taxpayers themselves would have. And indeed, there can be little doubt that many government expenditures are wasteful. Beyond the fact that logrolling often results in pork barrel programs that would not satisfy the cost-benefit test, we must worry that government employees may not always face strong incentives to get the most for what they spend. The Pentagon, for example, once purchased a coffeemaker for $7,600 and on another occasion paid $600 for a toilet seat. Such expenditures may have been aberrations, but there seems little doubt that private contractors often deliver comparable services at substantially lower costs than their public counterparts.
In their understandable outrage over government waste, many critics have urged major cutbacks in the volume of public goods and services. These critics reason that if we let the government spend more money, there will be more waste. This is true, of course, but only in the trivial sense that there would be more of everything the government does—good and bad—if public spending were higher.
One of our most extensive experiences with the consequences of major reductions in government spending comes from the Proposition 13 movement in California. This movement began with the passage of State Proposition 13 in 1978, which mandated large reductions in property taxes. As Californians have belatedly recognized, this remedy for government waste is like trying to starve a tapeworm by not eating. Fasting does harm the tapeworm, sure enough, but it harms the host even more. Residents of the Golden State, who once proudly sent their children to the nation’s best schools, are now sending them to some of its worst.
The physician treats an infected patient by prescribing drugs that are toxic to the parasite but not to the host. A similar strategy should guide our attack on government waste. For example, we might consider the adoption of campaign-finance reform laws that would prevent legislators from accepting campaign contributions from the tobacco industry and other special interests whose government subsidies they support.
The question, then, isn’t whether bureaucrats know best how to spend our money. Rather, it’s “How much of our money do we want to spend on public services?” Although we must remain vigilant against government waste, we also must remember that many public services deliver good value for our money.
RECAP
SOURCES OF INEFFICIENCY IN THE POLITICAL PROCESS
Government does much to help the economy function more efficiently, but it also can be a source of waste. For example, legislators may support pork barrel projects, which do not satisfy the cost-benefit criterion but which benefit constituents by more than their share of the extra taxes required to pay for the projects.
Rent-seeking, a second important source of inefficiency, occurs when individuals or firms use real resources in an effort to win favors from the government. Voters often fail to discipline legislators who abet rent-seeking because the free-rider problem gives rise to rational ignorance on the part of many voters.
Concern about government waste has led many to conclude that the best government is necessarily the smallest one. The solution favored by these critics is to starve government by reducing the amount of money it can collect in taxes. Yet starving the government reduces one kind of waste only to increase another by curtailing public services whose benefit exceeds their cost.
WHAT SHOULD WE TAX?
Although the primary purpose of the tax system is to generate the revenue needed to fund public goods and other government expenditures, taxes also have many other consequences, some intended, others not. For example, taxes alter the relative costs and benefits of engaging in different activities. They also affect the distribution of real purchasing power in the economy. The best tax system is one that raises the needed revenues while at the same time having the most beneficial, or least deleterious, side effects.
On the first criterion, the federal tax system has not performed particularly well. Although the federal budget began to show a modest surplus in the late 1990s, until then it had been in continuous deficit since 1969, during which time the federal government had to borrow trillions of dollars to pay its bills. And now, in the early decades of the twenty-first century, the federal budget is again in deficit.
The fact that governments and private corporations borrow money in the same capital market explains the phenomenon economists call crowding out. When government increases its demand in the market for borrowed funds, interest rates rise, causing firms to cancel some of their planned investment projects. 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.
What about the effect of taxes on incentives? Taxes will hold production and consumption below socially optimal levels in markets in which the private costs and benefits coincide exactly with all relevant social costs and benefits. Suppose, for example, that the long-run private marginal cost of producing cars is $20,000 per unit and that the demand curve for cars is as shown in Figure 14.5. The equilibrium quantity and price will be 6 million per year and $20,000, respectively. If no externalities accompany the production or consumption of cars, these will be the socially optimal levels for quantity and price. But if we now add a tax of $2,000 per car, the new equilibrium price and quantity will be $22,000 and 4 million, respectively. The loss in economic surplus will be equal to the area of the blue triangle ($2 billion per year), which is the cumulative sum of the differences between what excluded buyers would have been willing to pay for extra cars and the marginal cost of producing those cars.
FIGURE 14.5 The Loss in Surplus from a Tax on Cars.If the supply and demand curves for cars embody all relevant cost benefits of producing and consuming cars, then placing a tax on cars will lead to underproduction of them and a corresponding reduction in economic surplus.
Economists who write for the popular press have long focused on the loss in surplus caused by taxes like the one shown in Figure 14.5. These economists argue that the economy would perform better if taxes were lower and total government expenditures were smaller.
But arguments for that claim are far from compelling. For example, even if a tax in a market like the one shown in Figure 14.5 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. The deadweight loss from taxing that good (or activity) will be greater for goods whose supply and demand curves are more elastic. This principle suggests that deadweight losses could be minimized by concentrating taxes on goods with highly inelastic supply or demand curves.
Another difficulty with the argument that taxes harm the economy is more fundamental—namely, that taxes need not cause any loss in surplus at all, even in the markets in which they are directly applied. Suppose, for example, that in the market for cars considered earlier, private marginal cost is again $20,000 but that the production and use of cars now generates air pollution and congestion, negative externalities that sum to $2,000 per car each year. The socially optimal quantity of cars would then be not 6 million per year but only 4 million (see Figure 14.5). Without a tax on cars, the market would reach equilibrium at a price of $20,000 and a quantity of 6 million per year. But with a tax of $2,000 per car, the equilibrium quantity would shrink to 4 million per year, precisely the socially optimal number. Here, the direct effect of the tax is not only not to reduce total economic surplus but actually to augment it by $2 billion per year.
Could we raise enough tax revenue to run the government if we limited ourselves to taxing only those activities that generate negative externalities? No one knows for sure, but it might be possible, for the list of such activities is a long one.
For instance, when someone enters a congested freeway, he creates additional delays for the motorists already there. Existing technology would enable us to levy road-use taxes that reflect these congestion externalities. Each time fossil fuels are burned, they emit greenhouse gases into the atmosphere, which will accelerate the trend toward global warming. A tax on carbon would increase economic surplus by causing decision makers to take this external cost into account. Taxes on other forms of air and water pollution would have similarly benign effects on resource allocation. Recent experience with refundable taxes on food and beverage containers demonstrates that taxes like these can raise needed revenue while at the same time contributing to a cleaner environment.
SUMMARY
· Our aim in this chapter was to apply principles of microeconomics to the study of the government’s role in modern society. One of government’s principal tasks is to provide public goods such as national defense and the criminal justice system. Such goods are, in varying degrees, nonrival and nonexcludable. The first property describes goods for which one person’s consumption does not diminish the amount available for others, while the second refers to the difficulty of preventing nonpayers from consuming certain goods. (LO1)
· Goods that are both highly nonexcludable and nonrival are often called pure public goods. A collective good—such as pay-per-view cable television—is nonrival but excludable. Commons goods are goods that are rival but nonexcludable. (LO1)
· The criterion for providing the optimal quantity or quality of a public good is to keep increasing quantity or quality as long as the marginal benefit of doing so exceeds the marginal cost. One advantage of using the government to provide public goods is that 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 to finance additional public goods. A second advantage is that because government has the power to tax, it can easily assign responsibility for the cost of a public good. And in the case of goods for which nonpayers simply cannot be excluded, the government may be the only feasible provider. (LO2)
· One disadvantage to exclusive reliance on government for public goods provision is the element of coercion inherent in the tax system, which makes some people pay for public goods they don’t want, while others do without public goods they do want. Many public goods are provided through private channels, with the necessary funding provided by donations, by sale of by-products, by development of new means to exclude nonpayers, and in many cases by private contract. A loss in surplus results, however, whenever monetary charges are levied for the consumption of a nonrival good. (LO2)
· Because not everyone benefits equally from the provision of any given public good, charging all taxpayers equal amounts for the provision of public goods will generally not be either feasible or desirable. As in the case of private goods, people’s willingness to pay for public goods generally increases with income, and most governments therefore levy higher taxes on the rich than on the poor. Tax systems with this property have been criticized on the grounds that they are unfair to the wealthy, but this criticism ignores the fact that alternative tax schemes generally lead to worse outcomes for both rich and poor alike. (LO2)
· In addition to providing public goods, government serves two other important roles: the regulation of activities that generate externalities and the definition and enforcement of property rights. Despite a general view that government is more responsive the shorter the distance between citizens and their elected representatives, factors such as economies of scale in the provision of public goods and externalities with broad reach often dictate the assignment of important functions to state or national governments. (LO3)
· Although history has shown that democracy is the best form of government, it is far from perfect. For example, practices such as logrolling and rent-seeking, common in most democracies, often result in the adoption of laws and public projects whose costs exceed their benefits. (LO3)
· To finance public goods and services, governments at all levels must tax. But a tax on any activity not only generates revenue; it also creates an incentive to reduce the activity. If the activity would have been pursued at the optimal level in the absence of a tax, taxing it will result in too little of the activity. This observation has led many critics to denounce all taxes as harmful to the economy. Yet the negative effects of taxes on incentives must be weighed against the benefits of the public goods and services financed by tax revenue. (LO4)
KEY TERMS
collective good
crowding out
head tax
logrolling
nonexcludable good
nonrival good
pork barrel spending
progressive tax
proportional income tax
public good
pure commons good
pure private good
pure public good
regressive tax
rent-seeking
REVIEW QUESTIONS
1. Answer the following questions related to these goods: apples, Stephen King novels, street lighting on campus, and NPR radio broadcasts. (LO1)
a. Which of these goods are nonrival?
b. Which of these goods are nonexcludable?
2. Give examples of goods that are, for the most part: (LO1)
a. Rival but nonexcludable.
b. Nonrival but excludable.
c. Both nonrival and nonexcludable.
3. Why might even a wealthy person prefer a proportional income tax to a head tax? (LO1)
4. True or false: A tax on an activity that generates negative externalities will improve resource allocation in the private sector and also generate revenue that could be used to pay for useful public goods. Explain. (LO3)
5. Consider a good that would be provided efficiently by private market forces. Why is the direct loss in surplus that would result from a tax on this good an overstatement of the loss in surplus caused by the tax? (LO2, LO4)
PROBLEMS
1. 1.Two consumers, Smith and Jones, have the following demand curves for Podunk Public Radio broadcasts of recorded opera on Saturdays:
Smith: PS = 12 − Q
Jones: PJ = 12 − 2Q,
where PS and PJ represent marginal willingness-to-pay values for Smith and Jones, respectively, and Q represents the number of hours of opera broadcast each Saturday. (LO2)
a. If Smith and Jones are the only public radio listeners in Podunk, construct the demand curve for opera broadcasts.
b. If the marginal cost of opera broadcasts is $15 per hour, what is the socially optimal number of hours of broadcast opera?
2. 2.Suppose the demand curves for hour-long episodes of the Kardashians and Masterpiece Theatre are as shown in the following diagram. A television network is considering whether to add one or both programs to its upcoming fall lineup. The only two time slots remaining are sponsored by Colgate, which is under contract to pay the network 10 cents for each viewer who watches the program, out of which the network would have to cover its production costs of $400,000 per episode. (Viewership can be estimated accurately with telephone surveys.) Any time slot the network does not fill with the Kardashians or Masterpiece will be filled by infomercials for a weight-loss program, for which the network incurs no production costs and for which it receives a fee of $500,000. Viewers will receive $5 million in economic surplus from watching each installment of the infomercial. (LO2)
a. How will the network fill the two remaining slots in its fall lineup?
b. Is this outcome socially efficient?
c. By how much would total economic surplus be higher if each episode of Masterpiece were shown on PBS free of charge than if it were shown by a profit- maximizing pay-per-view network?
3. 3.When a TV company chooses a pay-per-view scheme to pay for programming, which of the following statements is true? Explain. (LO2)
a. The outcome is socially efficient.
b. The programs selected will maximize advertising revenue.
c. The marginal cost to an additional viewer of watching the programs is lower than when advertising is used to finance programming.
d. The outcome is always more socially efficient than when advertising is used to finance programming.
e. The variety of programs provided is likely to rise.
4. 4.When a group of people must decide whether to buy a shared public good or service, the free-rider problem frequently occurs because: (LO2)
a. People have an incentive to understate how much the facility is really worth to them if they have to pay taxes to finance it.
b. Each individual’s needed contribution is an insignificant amount of the total required.
c. People have an incentive to overstate how much the facility is worth to them if they don’t have to pay taxes to finance it.
d. People hope that others will value the facility enough to pay for it entirely.
e. Only one of the above statements is not a reason for the existence of the free-rider problem.
5. 5.The town of Smallsville is considering building a museum. The interest on the money Smallsville will have to borrow to build the museum will be $1,000 per year. Each citizen’s marginal benefit from the museum is shown in the following table, and this marginal benefit schedule is public information. (LO2, LO3)
a. Assuming each citizen voted his or her private interests, would a referendum to build the museum and raise each citizen’s annual taxes by $200 pass?
b. A citizen proposes that the city let a private company build the museum and charge the citizens a lump-sum fee each year to view it as much as they like. Only citizens who paid the fee would be allowed to view the museum. If the private company were allowed to set a single fee, would any company offer to build the museum?
c. A second citizen proposes allowing the private company to charge different prices to different citizens and auctioning the right to build the museum to the highest-bidding company. Again, only the citizens who pay the fee may view the museum. What is the highest bid a private company would make to supply the museum to Smallsville?
6. 6.Jack and Jill are the only two residents in a neighborhood, and they would like to hire a security guard. The value of a security guard is $50 per month to Jack and $150 per month to Jill. Irrespective of who pays the guard, the guard will protect the entire neighborhood. (LO2)
a. What is the most a guard can charge per month and still be assured of being hired by at least one of them?
b. Suppose the competitive wage for a security guard is $120 per month. The local government proposes a plan whereby Jack and Jill each pay 50 percent of this monthly fee and asks them to vote on this plan. Will the plan be voted in? Would economic surplus be higher if the neighborhood had a guard?
7. 7.Refer to Problem 6. Suppose Jack earns $1,000 per month and Jill earns $11,000 per month. (LO1, LO2)
a. Suggest a proportional tax on income that would be accepted by majority vote and would pay for the security guard.
b. Suppose instead that Jack proposes a tax scheme under which Jack and Jill would each receive the same net benefit from hiring the guard. How much would Jack and Jill pay now? Would Jill agree to this scheme?
c. What is the practical problem that prevents ideas like the one in part b from working in real-life situations?
8. 8.The following table shows all the marginal benefits for each voter in a small town whose town council is considering a new swimming pool with capacity for at least three citizens. The cost of the pool would be $18 per week and would not depend on the number of people who actually used it. (LO2, LO3)
a. If the pool must be financed by a weekly head tax levied on all voters, will the pool be approved by majority vote? Is this outcome socially efficient? Explain.
b. The town council instead decides to auction a franchise off to a private monopoly to build and maintain the pool. If it cannot find such a firm willing to operate the pool, then the pool project will be scrapped. If all such monopolies are constrained by law to charge a single price to users, will the franchise be sold, and if so, how much will it sell for? Is this outcome socially efficient? Explain.
c. Suppose now that all such monopolies can perfectly price-discriminate. Will the franchise be sold, and if so, how much will it sell for? Is this outcome socially efficient? Explain.
d. The town council decides that, rather than auction off the franchise, it will give it away to the firm that spends the most money lobbying council members. If there are four identical firms in the bidding and they cannot collude, what will happen?
ANSWERS TO CONCEPT CHECKS
1. 14.1a. The BLS website at 3 in the morning has the capacity to serve far more users than it attracts, so an additional user calling up the site does not prevent some other user from doing so. Other websites, however, do not show the nonrival property, at least during certain hours, because they attract more users than their servers can accommodate. (LO1)
b. The stadium at the championship game is always full, so anyone who watches the game in person prevents someone else from doing so.
c. Additional people can watch the game on television without diminishing the availability of the telecast for others.
2. 14.2To construct the demand curve (a), we first graph Bill’s demand curve (c) and Tom’s demand curve (b) and then add the two individual demand curves vertically. The equation for the demand curve is P = 18 − 1.5 Q. (LO2)
3. 14.3Whereas elasticity of demand was 1 at a price of $10 on the original demand curve, it is 2 on the new demand curve. As a result, the $10 fee now excludes 20 million viewers, and the resulting loss in surplus (again the area of the blue triangle) is now $100 million. (LO2)
4. 14.4If Sven orders bread pudding, his share of the bill would now go up by $2 instead of $1. If he orders chocolate mousse, his share of the bill would go up by $1.20 instead of $0.60. So he would still order the bread pudding (surplus = $4 − $2 = $2) rather than the chocolate mousse (surplus = $3 − $1.20 − $1.80). (LO3)