Principles of Microeconomics
11. Public Goods and Common
Resources*
Juan Pablo Chauvin
August 10, 2011
* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint
Contents
1. Review of previous lecture
2. An Investment proposition
3. Classifying different types of goods
4. Public Goods
5. Common Pool resources
6. Introduction to Production Costs
1. Review
Externalities
• The uncompensated impact of one
person’s actions on the well-being of a
bystander.
• Can be negative
• Making social costs higher than private
costs
• Leads to an over-production of the good
(with respect to the optimal quantity)
• … or positive
• Making social value greater than private
value
• Leads to an under-production of the good
(with respect to the optimal quantity)
Policy responses to
externalities
• Command-and-control policies (regulation)
• Market-based policies
• Corrective taxes (pigouvian taxes) or subsidies
• Taxes that induce private decision makers to take into
account the social costs generated by a negative
externality
• Subsidies that induce private decision makers to take
into account the social benefits generated by a positive
externality
• Tradable pollution permits
• Firms with lower costs of reducing pollution can sell
their permits to firms with higher costs of reducing
pollution.
• Market-based policies (theoretically) can achieve
the same goals as regulations, but more efficiently
Refer to the figure below. The socially
optimal level of output is
Price
Social Cost
Supply
(Private
Cost)
P0
P1
P2
P3
P4
Demand
(social value)
Q1
Q2
1.
Q1.
2.
Q2.
3.
Q3.
4.
Q4.
Q3
Q4
Quantity
Refer to the figure below. Which of the following
would improve economic efficiency in the market?
Price
Social Cost
Supply
(Private
Cost)
P0
P1
P2
P3
P4
Demand
(social value)
Q1
Q2
Q3
Q4
Quantity
1.
a tax equal to P1 - P3
2.
a tax equal to P0 - P4
3.
a subsidy equal to P1 - P3
4.
a subsidy equal to P0 - P4
2. An investment
proposition
An investment proposal:
THE CCU
• Welcome to the CCU!
(“Class Credit Union”)
– your place to invest!
• All the students of the
class collectively own
the CCU.
• This is your lucky day!
We bring you an
investment opportunity!
An investment proposal:
THE CCU
•
You currently own 800 “brownie points” (BP)
•
You can invest any amount from 100 to 800 BP (in increments of 100) with the
CCU
•
You can also decide not to invest at all and keep your 800 BP
•
Your individual investment will go to a common class investment pool
•
The CCU will pay a return of 10% (one extra BP
for every 10 BP that the class invest) at the end of
this exercise
•
Then, the full amount (capital plus interests) will be
redistributed equally to all the students in this
class.
•
Note that everybody will receive an equal share
from the investment fund final balance,
regardless of whether they invested or not!
How much will you deposit to
the Class Credit Union?
A - Nothing
F – 500 dollars
B – 100 dollars
G – 600 dollars
C – 200 dollars H – 700 dollars
D – 300 dollars I – 800 dollars
E – 400 dollars
Given your recent experience, How much will
you now deposit to the Class Credit Union?
A - Nothing
F – 500 dollars
B – 100 dollars
G – 600 dollars
C – 200 dollars H – 700 dollars
D – 300 dollars I – 800 dollars
E – 400 dollars
3. Classifying different
types of goods
Important Characteristics of
Goods
• A good is excludable if a person can be
prevented from using it.
• Excludable: fish tacos, wireless internet
access
• Not excludable: FM radio signals, national
defense
• A good is rival in consumption if one
person’s
use of it diminishes others’ use.
• Rival: fish tacos
• Not rival:
An MP3 file of Ben Harper’s latest single
The Different Kinds of Goods
Rival
Not Rival
Excludable
Not
excludable
Private goods
e.g. food
Common resources
e.g. fish in the ocean
Natural monopolies
Public goods
e.g. cable TV
e.g. national defense
STUDENTS’ TURN
Categorizing roads
• A road is which of the
four kinds of goods?
• Hint: The answer depends
on whether the road is
congested or not, and
whether it’s a toll road or
not. Consider the 4
different cases that arise
from this observation.
Answers
• Rival in consumption? Only if congested.
• Excludable? Only if a toll road.
Four possibilities:
Uncongested non-toll road: public good
Uncongested toll road: natural monopoly
Congested non-toll road: common resource
Congested toll road: private good
4. Public Goods
Public Goods
• Are goods that are nonexcludable and non-rival
• Some important public goods
are:
• National defense
• Knowledge created through basic
research
• Fighting poverty
• Public goods are difficult for
private markets to provide
because of the free-rider problem.
The free-riding problem
• Free rider: a person who
receives the benefit of a
good but avoids paying for it
• If good is not excludable,
people have incentive to be
free riders, because firms
cannot prevent non-payers
from consuming the good.
• Result: The good is not
produced, even if buyers
collectively value the good
higher than the cost of
providing it.
Cost-benefit analysis
• If the benefit of a public good exceeds
the cost of providing it, government
should provide the good and pay for it
with a tax.
• Problem: Measuring the benefit is
usually difficult.
• Cost-benefit analysis: a study that
compares the costs and benefits of
providing a public good
• Cost-benefit analyses are imprecise, so
the efficient provision of public goods is
more difficult than that of private goods.
5. Common Pool
Resources
Common Resources
•
Like public goods, common resources are not excludable.
• Cannot prevent free riders from using
• Little incentive for firms to provide
• Role for government: seeing that they are provided
•
Additional problem with common resources:
rival in consumption
• Each person’s use reduces others’ ability
to use
• Role for government: ensuring they are not overused
•
Some important Common Resources are:
• Clean air and water
• Congested roads
• Fish, whales, and other wildlife
The Tragedy of the Commons
• A parable that illustrates why common
resources get used more than is socially
desirable.
• Setting: a medieval town where sheep
graze on common land.
• As the population grows, the number of
sheep grows.
• The amount of land is fixed, the grass
begins to disappear from overgrazing.
• The private incentives (using the land for
free) outweigh the social incentives (using
it carefully).
• Result: People can no longer raise sheep.
The Tragedy of the Commons and
externalities
• The tragedy is due to
an externality:
Allowing one’s flock
to graze on the
common land
reduces its quality for
other families.
• People neglect this
external cost,
resulting in overuse
of the land.
STUDENT’S TURN
Policy options for common resources
• With your knowledge
about externalities, you
can help the people of this
town!
• What could the
townspeople
(or their government)
have done to prevent the
tragedy?
• Try to think of two or
three options.
Answers
• Impose a corrective tax on the
use of the land to “internalize
the externality.”
• Regulate use of the land (the
“command-and-control”
approach).
• Auction off permits allowing
use of the land.
• Divide the land, sell lots to
individual families; each
family will have incentive not
to overgraze its own land.
6. Introduction to
Production Costs
Let’s take a step back…
• We have started discussing situations in
which the market outcomes may not be the
most efficient for society as a whole
• Externalities
• Public Goods
• Common Pool Resources
• Another very important case is that of
Monopolies.
• In order to analyze Monopolies, we need to
have a deeper understanding of how firms
make decisions.
• Let’s take a step back to explore what is
behind the Supply Curve!
Total Revenue, Total Cost, Profit
• We assume that the firm’s goal is to maximize profit.
Profit = Total revenue – Total cost
the amount a
firm receives
from the sale
of its output
the market
value of the
inputs a firm
uses in
production
Costs: Explicit vs. Implicit
• Explicit costs require an outlay of money,
e.g., paying wages to workers.
• Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time.
• Remember one of the Principles of Economics:
The cost of something is
what you give up to get it.
• This is true whether the costs are implicit or explicit.
Both matter for firms’ decisions.
Explicit vs. Implicit Costs: An
Example
You need $100,000 to start your business.
The interest rate is 5%.
• Case 1: borrow $100,000
• explicit cost = $5000 interest on loan
• Case 2: use $40,000 of your savings,
borrow the other $60,000
• explicit cost = $3000 (5%) interest on the loan
• implicit cost = $2000 (5%) foregone interest you could
have earned on your $40,000.
In both cases, total (exp + imp) costs are $5000
Economic Profit vs. Accounting
Profit
• Accounting profit
= total revenue minus total
explicit costs
• Economic profit
= total revenue minus total
costs (including explicit
and implicit costs)
• Accounting profit ignores
implicit costs, so it’s higher than
economic profit.
The Production Function
• A production function shows the relationship
between the quantity of inputs used to produce a
good and the quantity of output of that good.
• It can be represented by a table, equation, or
graph.
• Example:
• Farmer Golib grows Cotton.
• He has 5 acres of land.
• He can hire as many workers as he wants.
• To build Golib’s Production Function we need to
determine how many additional bags of cotton
he would produce each time he hires one
additional worker for his farm.
EXAMPLE: Farmer Golib’s Production Function
Q
(no. of (bags of
workers) cotton)
3,000
Quantity of output
L
2,500
0
0
1
1000
2
1800
3
2400
500
4
2800
0
5
3000
2,000
1,500
1,000
0
1
2
3
4
No. of workers
5
Marginal Product
• If Golib hires one more worker, his output rises by
the marginal product of labor.
• The marginal product of any input is the increase in
output arising from an additional unit of that input,
holding all other inputs constant.
• Notation:
∆ (delta) = “change in…”
Examples:
∆Q = change in output, ∆L = change in labor
• Marginal product of labor (MPL) =
∆Q
∆L
EXAMPLE: Farmer Golib’s Total &
Marginal Product
L
Q
(no. of
(bags
workers) of cotton)
∆L = 1
∆L = 1
∆L = 1
∆L = 1
∆L = 1
0
0
1
1000
2
1800
3
2400
4
2800
5
3000
MPL
∆Q = 1000
1000
∆Q = 800
800
∆Q = 600
600
∆Q = 400
400
∆Q = 200
200
MPL = Slope of Prod Function
L
Q
MPL
3,000
0
0
1
1000
2
1800
3
2400
4
2800
5
3000
1000
800
600
400
200
Quantity of output
MPL
(no. of
(bags
workers) of cotton)
equals the
slope of the
2,500
production function.
2,000
Notice that
MPL diminishes
1,500
as L increases.
1,000
This explains why the
500
production
function
gets
flatter
0
as L0increases.
1
2
3
4
No. of workers
5
Why MPL Is Important
• Recall one of the Principles of
Economics:
Rational people think at the
margin.
• When Farmer Golib hires an
extra worker,
• his costs rise by the wage he pays the
worker
• his output rises by MPL
• Comparing them helps Golib
decide whether he would benefit
from hiring the worker.