Lecture on Local Government
and Public Goods
Based on Chapter 19 in Urban Economics by Arthur
O’Sullivan, 5th edition
Adapted and summarized by Austin Troy,
University of Vermont
What is the role of government?
• Stabilization: monetary and fiscal policy
used to control unemployment and inflation
• Redistribution: Taxation and transfers used
to remedy inequities
• Resource allocation: makes production
decisions either directly (e.g. through
municipal utility) or indirectly (e.g. through
subsidies or taxes on allocations).
• See Musgrave and Musgrave (1980)
Local Government
• Does not have the responsibility of fiscal
stabilization for obvious reasons
• Does not have redistributive role because of
mobility of citizens. Poor will immigrate
and rich will emigrate to other city
• Both of these roles are better filled by
national government
• Local government primarily fills third role
When does local government
intervene in resource allocation?
1. Provides goods produced under natural
monopoly conditions
2. Provides goods that generate positive
externalities
3. Provides public goods
Externalities
• Represent a “market failure”
• Where one person or firm’s consumption of a good
creates benefits or costs for others
• Individual makes a personally efficient decision (I.e.
consumes until MB=MC) but externality causes there
to be a social cost or benefit that is not considered;
socially inefficient
• Causes divergence between private and social benefits
and/or costs
• The cost or benefit is not “internalized” by producer
Positive Externalities (e.g.education)
Marginal social benefit
Marginal
private
benefit
Marginal cost
E’
E*
E’=how much
market would
provide
E*=socially
optimal
amount
Negative Externalities (e.g.
pollution)
P’=pollution
produced in
private market
Marginal social benefit
Marginal social cost
K
Marginal private cost
Marginal
private
benefit
P*
P’
P*=optimal
pollution amount
K=amount of
externality
Natural Monopoly
• Where production of a good subject to large
scale economics: that is, very big fixed costs,
so those costs don’t get paid off until the scale
of operation gets very large
• Natural monopolies have decline average costs
throughout their range of production
• Private firms would underprovide service
because high scale economies mean that
average cost> marginal cost
• Marginal cost pricing means operates at loss
• City must step in and make up deficit
Natural Monopoly in Bus Service
MR
Demand= Marginal
social Benefit
P’
LRAC
deficit
LRMC
P*
Government
sets this
price
Quantity
S’
S*= optimum
Natural monopoly
• In absence of regulation, firm produces S’ and
receives a price of P’
• Problem is that firm producing at optimal point
(S*) will lose money because D curve shows
people not willing to pay that much
• But there is a social cost to not having enough bus
service, so to get residents to buy the socially
optimal amount, P must be lower than market
price; locality subsidize this difference
• If set at P*, then socially optimal amount of S* is
demanded.
• Because falls below Av Cost, government must
make up the difference, equal to rectangle
Why Marginal Pricing?
P
If profit = TR-TC, then want to produce where
distance between two is maximized, which is where
the slopes, or marginal values are the same
TR
p
TC
Q
Marginal and Average Price
P
• Normally looks like this: MC gets bigger
than AC
MC
Q
AC
Normally
MC=MR occurs
In
natural monopoly
the
wherewhere
MC>AC
but are
in
range
people
NaturaltoMonopoly
large
willing
pay is in the
scale economies
downward
slopingmeans
area one
firm can set price higher
and quantity lower that
social optimum
Public Goods Provision
• Local governments provide goods that the
market cannot provide either because they
cannot price it, charge for it, or exclude
Public Good Characteristics
• Nonrivalrous: can be consumed by many at
once, such as clean air
– Pure local public is were MC of additional
user=0; does not decrease other’s utility
– Semi-rivalrous: where is non-rivalrous at small
amounts or at certain times but not at others
– E.g. streets may be non-rivalrous at certain
times of day but not others
Public Good Characteristics
• Nonexcludable: impossible/impractical to
exclude any from consuming
– Examples: Defense, air waves, other examples?
• Hard to charge for the service
• Can’t tell who is willing to pay and who is
not, who is benefiting and who not
• Some are non-excludable by choice, because
alternative would be inequitable
– Examples fire service
Pure and Partial Public Goods
• A common situation is that goods are nonrival at smaller usage levels, but rivalrous at
large usage levels
• Example: with a park, an additional
household’s use does not diminish anyone’s
enjoyment, until you reach carrying
capacity C at which point each marginal
user does impose additional costs
Local Public Goods
• These are public goods where the benefit is
confined to a contained geographic area, like
a city.
• Ideally, the size of jurisdictions would be
determined by the level of “localness” of the
public goods being provided
• The more extensive the benefits, the larger
the jurisdiction needed to internalize those
Why provide certain public
goods at the local level?
•
Wallace Oates (1972) proposed three criteria:
1. Diversity of Demand: “one size fits all” vs. local
diversity of preferences
2. Externalities/spillovers: are external effects
locally contained or do they spill over?
3. Scale economies: higher levels of government
can leverage bigger scale economies
•
The test for local provision of a public good
is whether 1 outweighs 2 and 3
Tradeoff 1: Scale Economies v.
Diversity of Demand
• Assume 1 public good (library service) and
two municipalities in metro area
• High Demand in city H and low in L
• No externalities/spillovers between towns
• Scale economies: regional library can
produce unit “literary services” cheaper
than local library
• Identical services in towns
Who should make library
allocation?
• If towns merge and form metro government, pool
resources to build bigger library system, then good
news is that cost/ unit service is lower, but bad
news is that L is paying for more library service
than they want and H is getting less library
services/person than it had before.
• Only efficient to merge if savings due to scale
economies are large relative to losses in efficiency
from the uniformity of service provision
Empirical Results
• Moderate scale economies in things like
sewer and water provision, because capital
intensive
• Police, fire and schools, have scale
economies (gains to scale) occurring until
about 100,000 people, at which point fewer
gains to consolidation
• Some areas have regional government
entities that provide services with large scale
economies
Tradeoff 2: Externalities vs.
Demand Diversity
• Where service creates positive externalities
that spill over into other jurisdictions, it will
be underprovided, because they consider the
costs but, not all the benefits
• Inefficiency occurs because boundaries of
jurisdiction is too small to contain benefits
Example: Water pollution
• Town X in the Champlain Valley will
underprovide stormwater management
services (unless mandated) because benefits
are realized by all Lake Champlain users,
and they only consider local benefits
Example: Parks Provision
• Cities will tend to underprovide parks,
because only consider benefits to local
residents, when their parks could potentially
be important resource for people regionally
• However, if a regional government takes
over and DD is high, there will be too many
parks for certain types of people and too
few for others
Diversity of Demand and
small,
Spillovers IfS’externalities
will be close to S*,
Town S:
small parks
MLB(s)
S’ S*
Town M:
medium parks
MSB(s)
MLB(m)
M’ M*
Town L:
large parks
M’ close to M*, etc.
Then, municipal
decisions are efficient.
This is reinforced if
DD is very large and
S* is far from M* etc.
MSB(m) MLB(l)
L’ L*
MSB(l)
Tradeoffs in level of PG
provision: summary
• If DD is large relative to scale economies or
spillovers, local is better
• If spillovers or scale economies are large
relative to DD, then regional is better
• In previous slide, gaps between individual
demanders are greater than gaps between
MSB and MLB, so local provider is better
Examples
• Which category do these services fall into
and why?
–
–
–
–
–
–
Flood control
Structural fire protection
Wildfire protection
Air quality
University system
Highway patrol
How much of a public good
should a city provide?
• Park example: how big to make it?
• Assumptions: decisions made by majority
rule, three-person city, no congestion, no
spillover benefits
• Efficient amount: where MB of additional
acre equals MC
• To get MB we add up everyone’s demand
curves, which represent WTP
Cost/
acre
How big should park be?
Marginal social benefit=
MB1+MB2+MB3
Ideal amount
is 70 acres
MC
$60
MB curves
for three
citizens
MB1
MB2
MB3
Here WTP > MC of
additional acre
70 acres
Here WTP < MC of
additional acre
Methods for determining the
amount of local public good
1. Benefits taxation: ideal, but impractical
2. Median voter: practical and common, but
inefficient
3. Household mobility and sorting: practical
and efficient under some conditions, but
not necessarily equitable. We’ll talk about
this after Spring Break
Benefit taxation
• Tax people on their WTP for the optimum size of
the good (e.g. park) ; the greater the WTP, the
greater the tax
• This will yield optimum amount of the park, even
if population is heterogeneous
• Impractical because must know shape of
everyone’s demand curves and because there is no
incentive for taxpayers with high WTP to reveal
that willingness
Median Voter Approach
• Assuming there is no interjurisdictional
mobility
• Often such decisions made through vote
• Will efficient size be chosen?
• No, not when charged by benefits taxation
• This is because the Q will be chosen where the
median voter’s private MB= marginal private
cost, or tax
• MC= $60/acre so each citizen pays $20/acre
Cost/
acre
Park provision under voting
Marginal social benefit=
MB1+MB2+MB3
Marginal social
cost
$60
MB1
Marginal
private
cost
MB2
$20
MB3
10
55 70 acres
115
Median voter rule
• In election between 115 and 55 acres, 55 would win
because person 3 and person 2 would vote for it. In
election between 10 and 55, 55 would win because
person 1 and person 2 would vote for it.
• Where spending level vs. service is being voted on
the median voter’s desired outcome gets the most
votes.
• Inefficient because everyone pays equally, but some
want it more than others
• The magnitude of persons 1 and 2’s preferences
don’t matter because median will always win
How do growth controls fit into
this?
• Growth controls are another way for
controlling the amount of public services
provided by a municipality and the average
cost to residents
• It is also a way of preventing transfers of
wealth from existing residents to new.
Inflation and Services
• Imagine a community of 100 people and $10,000
repayment cost for municipal facilities= $100/household
• Now another 100 move into town; without inflation, all
are equal.
• But with inflation, the nominal cost of the new
infrastructure goes up to $20,000 for the same amount,
which equals $200 per new resident.
• But that new burden must be shared equally, so everyone
pays $150. Old residents are worse off
• Because new residents pay less than marginal cost, too
many move to municipality and resource is congested
• Problem: no transparent means for charging marginal cost
• Old way (and Prop 13 in CA): limit reassessments on
houses of long-time residents; only reassess for transfer.
From Fischel chap 15
Inflation and services
• Strong motivation for growth controls when inflation
• The big question is: do the additional nominal costs of new
development outweigh the benefits of increased economies of scale in
service provision?
• Keep in mind that this only applies to fixed capital cost services, not
variable cost items, like salaries of teachers
• Also, there are devices for recovering some additional costs from new
residents, like exactions and impact fees
• Fischel: key goal is to eliminate fiscal incentive to exclude by state aid
to moving in of new people
• Reduce reliance on property tax to finance local services
• Unintended consequence of inclusionary zoning is it gives incentive
for wholesale exclusion of all development.
• Perhaps then inclusionary zoning is a ruse by many communities to
give appearance of complying with law while being able to exclude
fully.
• How does Act 60 fit in?
From Fischel chap 15