WELFARE ECONOMICS AND PUBLIC CHOICE THEORY

City & Metropolitan Economics Week 01 – Publicly Provided Goods, Public Choice Theory and the Median Voter January 16, 2018

City and Metro Economics Week 2 (Tuesday) • Publicly provided goods and the challenges of collective consumption;

• Public choice and the median voter

Questions on everybody’s minds… • When should public sector provide & subsidize?

• How to get quantity right without a market- determined price?

Privately-produced Public Goods, Public Goods and Their Challenges

Government should involve itself in provision or subsidy of… 1. Industries where natural monopoly or significant economies

of scale exist 2. Public goods 3. Goods with positive externality effects 4. Merit goods

Cost structure of natural monopoly • High fixed costs • Low (and constant or declining) marginal costs • Economies of scale (i.e. declining average costs)

Natural monopoly • Sometimes returns to scale are so great that efficiency requires that there be only one producer in a region

• This producer may be government-run or simply government regulated

Where do we have a natural monopoly? Rocky Mountain Power • Provides a regulated,

investor-owned, load- serving electric utility.

• Regulated by the Utah Public Service Commission.

Pros and Cons – What Solar Revealed Pros • Low, stable pricing • High reliability—

shareholders absorb risk of loss in price volatility (otherwise passed along to consumers)

• Obligation to provide universal service

Cons • Can make decisions as

a monopoly without risk of outside competition

• Definition of “fair and reasonable” ROI is not well-defined

• Commissioners are political appointees with 6 year term limits

Public Goods

• A “pure public good” is one that is both non-rival and non-excludable • Non-rival - consumption of the good by one individual does not reduce the amount of the good available for consumption by others

• non-excludable – hard to keep people who don’t pay (“free riders”) from using the good

William Forster Lloyd, 1833 Garrett Hardin, 1968

Pricing challenges for public goods

If something is truly non-rivalrous and non-excludable, it is impossible to reveal its price in a market.

• my use of it doesn’t limit another’s use of it or vice versus

• I can’t be excluded from it, nor can I exclude anyone else

• if both conditions hold, I have no incentive to pay

Pricing challenges for public goods Why would I pay for something that I cannot be excluded from? Since I’m not acquiring access, what would that payment provide (since I’m already eligible to receive it)?

Even if I felt like paying, how would I set my price? I wouldn’t set it higher than others because it can’t be consumed…

I can’t outbid others as there is no reason to try to outbid others. Outbidding doesn’t “win” me anything. Instead, I’ll lower my acquisition price to the point where I realize I don’t have to pay anything.

Pricing challenge: undersupply If there is no motivation for individuals to pay, there will be no rational incentive to supply the public good unless government monetizes the social benefit and determines how to incent payment (e.g., taxes).

Government can introduce exclusion by creating user fees (e.g., tolls on a bridge).

Other government approaches include (1) rationing and (2) queuing.

How much to provide? – economists approach the question 1 option - Impose user charges where feasible

Another option - Provide a uniform amount to everybody • This is inevitable with a public good • With some goods, a “service standard” approach is used

How much to provide? – economists approach the question • Queueing: In the absence of prices or user charges, the government must estimate the demand curve (aka marginal social benefit curve) for publicly provided goods, which is a difficult thing to do.

Free rider problem • Effectively, if people believe that there is no rationing

price for a public good, government either (a) undersupplies or (b) supplies but at a loss.

• If a private firm decides to provide the public good, but individuals still are not incented to pay the full cost of the good, then we have a free rider problem.

Free rider problem Intent is not well- documented, but… • in 1750s, plaques like

these were used to identify homes with fire insurance

• may have been tied to different fire companies or fire insurance

• possible that bldgs. would burn without them

How much to provide? – economists approach the question • Even if the demand curve is perfectly estimated, some people are going to get less of a non- priced good than they want and some people are going to get more.

Individual Demand Curve- Opera Tickets

Individual demand curve -- opera tickets

0

50

100

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200

250

0 1 2 3 4 5 6 7 8 9

quantity

pr ic

e marginal benefit

quantity

Pr ic

e

market demand curve for opera tickets

0

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200

250

0 1 2 3 4 5 6 7

tickets (in 00's)

P ri

ce market demand (marginal benefit across consumers)

Market Demand Curve for Opera Tickets

Tickets (in 00’s)

Pr ic

e

market supply of opera tickets

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300

0 1 2 3 4 5 6 7 8 9

quantity (in 00s)

pr ic

e

market supply (marginal cost across producers)

Market supply of Opera Tickets

Quantity (in 00s)

price

Consumer surplus is willingness to pay less amount paid • Willingness is teal + light blue. Surplus is just the light blue.

p

Q Demand curve

Y= mx + b or

p = m(q) + b

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0 1 2 3 4 5 6 7 8 9 10

pr ic

e of

ti ck

et s

$

quantity of tickets (in 000s)

p= -25(q) + 225

m arket dem and

Equation for demand curve:

Y = mx + b

P = m(q) + b

p=-25 (q) +225

Quantity of Tickets (in 000s)

Pr ic

e o

f t ic

ke ts

$

• If we know that the price of a ticket is $125…

$125 = -25(q) + 225

Q =4

Market-clearing price = $125 Market-clearing quantity = 4,000

0

50

100

150

200

250

300

0 1 2 3 4 5 6 7 8 9 10

quantity of tickets (in 000s)

p ri

ce o

f t ic

ke ts

$

market supply market demand

Consumer surplus = ((225-125)*(4,000-0))/2 =200,000

225

125

Demand curve: p= -25(q) + 225

Quantity of Tickets (in 000s)

Pr ic

e o

f t ic

ke ts

$

Market-clearing price = $125 Market-clearing quantity =4,000

Questions

Median Voter Theory

Public choice theory

• Resource allocation decisions in the public sector in a democratic society are made through voting

Majority voting • Among alternatives, the one that receives the majority of votes wins • In publicly provided goods context this could be “yes” or “no” on a public swimming pool, $1 million this year vs. $2 million on new firefighting equipment

The Median voter

• The outcome of majority voting corresponds to the preferences of the median voter.

• Median voter determines the level of expenditure on public goods.

The Median voter

• In a two-party system, vote maximizers from both parties will converge toward the position of the median voter

The Median voter • In any vote related to public expenditure, this person compares the benefits he receives with the costs (in taxes) he bears.

• If the benefits of the next unit of expenditure are greater than the costs, he votes to increase expenditures.

How the voter thinks • As govt. increases spending on public goods an individual

receives additional marginal utility (cost depends on tax structure). That utility is a function is a function of existing levels of expenditure, the voter’s income and her preferences

The Median voter • The median voter is that voter for whom it is true that exactly half of the rest of the people in the jurisdiction prefer the government to spend less than it does and exactly half prefer the government to spend more than it does.

Problems • Preference revelation (so easy in the market, so hard in the politial arena) • Elections of representatives convey limited information about voters’ attitudes toward specific public goods

• Representatives must be motivated to ascertain the preferences of their constituents

Problems • Hard for people to predict what benefit they may receive from a public expenditure – “rational ignorance”

• If surveyed, people have an incentive to understate their tax prices in hopes of “free-riding” on collective expenditure

• Only voters get a say

Problem • Representatives (and the bureaucracies they supervise) may not aggregate preferences for public goods in informed or honorable ways

Problem

• Special interests promote policies with concentrated benefits and diffuse costs • Policies do not have enough potential cost for diffuse “losers” to spur them to action, so small groups that stand to realize concentrated benefits win out

Fire equipment example • Median voter is willing to vote for an increase of $2m (given marginal costs and benefits of improved fire protection)

• Council vote, not a referendum

• Council does survey -- voters understate preferences in hopes of free-riding – thus the revealed preference for expenditure is only $1.5m

And meanwhile… • City Council reps are listening to the firefighters’ union, which can raise money for them when they run for re-election.

• This is why Richardson and Gordon are so down on government – it doesn’t aggregate preferences the way a competitive market can

• R & G tend to think that government failure dwarfs market failure.

But remember…

• Many believe there are good reasons not to run government like a market – other principles and values at work.

• Principle of redistribution is considered by some to be on par with the benefit principle (notion that taxpayer should get back in benefit exactly what he sacrifices in taxes)

For next class…