Public Finance and Budgeting
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PART ONE The Economic Basis for Gove rnment Activity
D :rr;a~~n!n~ ttee ~a:1:i t~::::i;;~r;::~ i:at~~ai:is;~i!~~ ~:::~~:;t;~ in 2002 and 2003 have contributed 10 increased defense spending and Congress allocated more funds for defense and homeland security. Defense-related spending in the United States rose from 3 percent of GDP in 200 l to 5.5 percent of GDP in 2011. When the federal government provides national defense, it must employ labor and procure capita l in the form of weapons systems, aircraft, naval vessels, and land ro use as military bases and airfields. The production aspect of national defense is very simi lar to that of any business operation. Labor must he hi red; work rules musl be established; research and development contracts must he nego- tia1ed for new capita l equipment and new products, such as weapons that can penetrate deep bunkers, stealth fighter planes, and remote-controlled aircraft. However, the similarity with business ends on the output side of the picture. The output of the federal government agencies that supply national defense is not sold in the market to buyers like cars, cookies, or clothing. In fact, it is inconceivable to imagine defense services being packaged into neat bundles that can be sold over the counter to cager buyers. Although the production of national defense is similar to that of any other good, its consumption is fundamenrally different. Products such as national defense are collectively consumed. As soon as we defend any one person, we defend all.
Because defense is not so ld by the unit in markets and cannot be parceled out to individuals to enjoy in greater or smaller amounts according to their tastes, we all consume the total amount produced. We all pay taxes to finance the production of national defense, and we must consume the amount made available, even though we might prefer to have more or less than the government provides. An issue that concerns us all is how much of our resources we allocate to services such as national defense.
This chapter explores the characteristics of goods that are collectively con- sumed. We eva lu ate alternative methods of supplying public goods and show why it is efficient for people ro share the costs of producing goods with sha red benefits.
CHARACTERISTICS OF PUBLIC GOODS Chapter 3 showed how markets tend to fail to produce efficient amounts of goods that result in externalities when exchanged. Many of the goods and se rvices actually provided by governments, such as national defense, wou ld result in positive exter- nalities were they made available for sa le to individual buyers in markets. An entire class of goods, including environmenta l protection, roads, and public safety, has benefits that must be shared by large groups of individuals. The production of these goods for sale in the marketplace would be accompanied by positive external- ities because any such items purchased for individual use would provide externa l benefits ro a large number of third parries as well. Market provision of goods with benefits shared by people other than those who purchase them for their own use is unlikely to result in an efficiently large amount of output.
Goods with benefits that cannot be withheld from those who do not pay and arc shared by large groups of consumers a rc pu~bc goods . Public goods arc usually made availab le politically through the ballot box as people vote to decide how much to supply rather than through the marketplace, where those who care to pay
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CHAPTER 4 Public Goods
the price can buy as much as they like for their own exclusive use. In most cases, government provision of public goods implies that the goods are freely available to all rather than being sold in markets. The costs of making the goods available are usually financed by iaxes.
Let's begin our analysis of public goods by examining their characteristics more closely. Public goods arc 11011m·al in consumpuon, meaning that a given quantity of a public good can be enjoyed by more than one consumer without decreasing the amounts enjoyed by rival consumers. For example, television and radio transmis- sions are nonrival in consumption. A given amount of programming per day can be enjoyed by a large number of consumers. When an additional viewer switches on a television set, the quantity of programming cnjored by other viewers is not reduced. Similarly, the benefits of national defense services arc nonrival. When the population of a nation increases, no citizen suffers a reduction in the quantity of national defense because more people are being defended at any time.
Goods that are rival in consumption are called pri~·~1c- Jlinod\. A given quantity of fish available on a dock is said to be rival in consumption. As the number of fish made available to any one consumer increases, the quantity available for rival con- sumers who desire the fish decreases. Except when externalities are present, prices can efficiently allocate goods that are rival in consumption. The price serves the purpose of making any one person who desires a unit of the good consider the decrease in benefits to rivals who wish to consume that unit.
Pricing a good that is nonrival in consumption serves no useful purpose. After all, an additional consumer of a nonrival good does not reduce the benefit to others who wish to consume it. In other words, the marginal cost of allowing additional people to consume a given amount of a good with nonrival benefits is zero. It is therefore inefficient to price goods that are nonrival in consumption.
Tn most cases, it is al so unfeasible to price units of a public good. This charac- teristic of public goods, c.illed anm:xchnion, implies that it is too costly to develop a means of excluding those who refuse to pay from enjoying the benefits of a given quantity of a public good. For example, it is unfeasible to exclude those who refuse to pay for cleaner air from enjoying the benefits of a given amount of air quality improvement, once it has been supplied for the benefit of other people. Air quality improvement has the property of nonexdusion.
From a practical point of view, goods that arc nonrival in consumption need not necessarily be subject to nonexclusion. Television broadcasting services, as was pointed out earlier, are nonrival. However, it is feasible to exclude those who refuse to pay from the benefits of transmissions through cable provision of the broadcasts or use of signal coding for satellite transmission. Similarly, the benefits of roads are often nonrival. However, it is feasible to use tolls to exclude those who refuse to pay. The characteristics of nonrival consumption and nonexclusion vary in degree from good to good. Much, however, can be learned from further investigation of the problems involved in making available efficient amounts of a good that is both nonrival in consumption and the benefits of which are nonexclu sive.
Pure Public Goods and Pure Private Goods A pure public ~ood is nonrival in consumption for an entire population of consu- mers, and its benefits have the characteristic of nonexdusion. A given quantity of a pure public good is consumed by all members of a community as soon as it is pro- duced for, or by, any one member. In contrast, a pure- pri,at1.: j,ijDud is one that, after
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PA RT ONE The Economic Basis For Gove rnment Activity
PUBLIC POLICY PERSPECTIVE
NotlOnal Defitl'IMI S~OC,ng in t he United States
Tre nds in Defe nse Spending National defense is a classic example of a public good. Spending on nationa l defense in the United States amounted to nearly 10 percent of GDP in 1968 during the Vietnam conflict. Between 1968 and 1978 defense spending as a share of GDP stead ily declined to less than 5 percent. In the 1980s there was another increase in defense spend ing in the United States as government pur- chases for new military hardware and weapons systems inc reased. By 1986 defense spending absorbed 6.2 percen t of GDP . With the demise of the former Soviet Union and the communist reg imes of Eastern Europe, defense spending began to decline significantly. Military bases were closed and mil itary procurement was sharply reduced . By 1999 defense spending in the United States amounted to only 3 percent of GOP. How- ever, terrorism attacks in 2001 on the United States and subsequent military operations in Afgh a nistan and Iraq reversed the downward trend in military spend ing. By 2008 defense spend ing in the United States was 5.2 percent of GOP . With the end of mil itary operations in Iraq in 2011, defense spend - in g decli ned slightly from a peak of 5.6 percent of GDP in 2009 and 2010 to S.S percent of GOP in 201 1. The fo llowi ng chart shows the trend in defense spending as a share of GDP in the United States since 1962.
The military operations in Iraq and Afghanistan have been costly with tota l appropriations by Con- g ress runn ing at about $1.4 trillion (including an esti- mated $127 billion for fisca l year 2012). Of the total approp ri ations , about $1 .25 tri lli on has gone to the Department of Defense. An add itional $150 bill ion was allocated for train ing indigenous security fo rces and for foreign aid for Iraq and Afghanistan . These costs only inclu de government outlays and do not measure othe r costs such as loss of lives and other human casualt ies. Because these military operations are a component of national defense (a public good) that all must consume, the mount- in g costs of the war have given rise to controversy and politica l conflict as many citizens come to d if- fere nt conclusions about the benefits of the military
ope rations. It is clear that costs have exceeded est imates whe n the operat io ns were initiated . Also, some of the initi a l benefits upon which the decision to engage in the operations were made were evaluated on the basis of faulty intell igence about weapons of mass destruction and terrorism li nks in Iraq.
The economic aspect of the debate on mi litary operations ultimately relates to disagreements about the margina l social benefits and margi nal soc ia l costs of continuing to spend sca rce resources in Iraq . Critics of the mi litary operations argue that the marginal social costs are too high relative to the marg ina l social benefits and that mil itary and other resources could be spent more efficiently in othe r ways to protect against terrorism and mi litary aggression by national governments . Others argue that national defense efforts need to be better coor- dinated withi n government by a llowing more coop- eration between the military and those charged with providing homeland security.
Cutting Military Spending In future years the Departme nt of Defense is plan- ning for a leaner and more focused mil itary. As part of an overall plan to cut the federa l government' s budget deficit, the U.S. armed forces are likely to be reduced in number and revamped to use new technology for an effective defense aga inst future th reats to nat ional security. It is difficult to forecas t how much the budget of the U.S. Department of Defense will actually be cut in the fut ure because of political uncertainty within the nation and uncer- tainty about the actual threats that will be faced in the future . However, the fisca l real ity is that defense spending is likely to be subject to substant ial reduc- tions in future years. The hope is that by using more effective technology to achieve limited goals defense output could be provided fo r citizens at a reasonab le level with lower costs. Of course, the actua l, if a ny, reductions in defense spending unt il hinge o n po lit i- cal considerations . As of 2012, some polit icians were arguing that defense spend ing in future years should remain fixed in real terms-with appropriations grow- ing with the rate of inflation.
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A number of possible areas for cuts were being considered as of 2012. The Obama administration proposed cuts in military spending by $450 billion over a ten-year period. However, some have been calling for even more substantial cuts of $1 trillion over the same peri od, which would amount to a 17 percent cut in the Department of Defense base budget. The issue that remains is how much of a cut in spending ca n allow an effective level of national security.
Some cuts in spending, such as those for military health insurance and retiree benefits, would not directly affect the level of output of national defense . Other areas for cuts such as reduction in military personnel, closing of bases, and reduction in the number of air wings decrease the inputs used in providing national defense and, unless off- set by increased efficiency, can also reduce output of defense service s. Cuts were also being consid- ered in new weapons purchases and the nuclear arsena l of the nation . Technological improvement including cyber warfare, more use of sophisticated drones, and special operations can allow more
focused objectives that protect aga inst t hreats from te rrorists with a min imum of labor input. Sub- stitution of capital and technology for labor can maintain levels of nat io nal security at lower costs. Labor costs currently account for one third of total national defense spending. As of 2012 tota l labo r costs were $181 billion per yea r, and $50 bi ll ion of that amount was allocated to hea lt h care while another $24 billion was for retired personnel pensions
Hea lth care costs are a significant problem for the military as it is for the nation as a who le . The Department of Defense is actually the nation's larg- est employer and in recent years th e share of its budget going to health care for its workers, includ- ing active military and retired military personnel has been increasin g as a share of total costs. Changes in the military retirement system can also cut costs. The health in surance plan for the mil itary , called Tricare , currently has only min imal co-pays and deductibles. Changing the system for reti red per- sonnel allowing higher out-of-pocket fees for service could reduce military spending.
PART ONE The Economic Basis for Government Activity
producers receive compensation for the full opportunity costs of production, pro- vides benefits only to the person who acquires the good, and not to anyone else. A pure private good is rival in consumption, and its benefits are easily excluded from those who choose not to pa y its market price.
Market exchange fo r pure private goods results in neither positive nor negative externalities. A pure public good, on the other hand, results in widely consumed external benefits to all peop le, even if made available for only one person. These two extremes can be considered as poles on a continuum, where goods are ranked according to their degree of publicness or privateness in terms of the range and extent to which their production or consumption generates exte rnalities.
Pure public "bads" can also exist. These activities result in external costs affect- ing a wide range of the population. The quantities of public bads are of concern to all individuals. Air pollution, for example, is a pure public bad if pollutants diffuse in the atmosphere, thereby affecting a ll individuals, ind ependent of the location of their residence. At the other extreme, national defense can be considered a pure public good. h is imposs ible to protect any one individual against harm from a for- eign invasion or anack without protecting all other individuals in th e nation at the same time.
The marginal cost of distributing a pure public good to an additional consumer is zero for a given amount of the public good. This follows from the nonrival char- acteristic of pure public goods. Figure 4.1 A shows that the marginal cost of allow- ing additional people to consume certain amounts of a pure public good falls to zero after the good ha s been made available for any one perso n. Be ca reful not to confuse distribution cost with production cost. The marginal costs of accommodat- ing an additional consumer will be zero for a given q11a11tity of a pure public good. However, the marginal cost of producing additional units of the public good will be positi ve, as is the case for all economic goods, because increasing the quantity of a pure public good requires additional resources. This is illustrated in Figure 4.18, where we assume that the average cost of a pure public good is constant. Two units of the public good cost twice as much as one unit. In this case, if the average cost of the public good is $200 pe r unit, rhe marginal cost will also be $200.
We can emphasize the di stincrion between pure public goods and pure private good s in still anothe r way. 1 A pure public good is not di visi ble into units that can be apportioned among consumers. A given quantity of a pure public good can on ly be shared rather than enjoyed individually. Its benefits arc collectively consumed by the entire population. A unit of a pure private good, on the other hand, can be enjoyed only by a single consumer. The more units of a given amount available to be consumed by one person, the less is avai lab le to rival consumers.
An Example: Bread versus Heat A si mple example will help to clarify the di st inction between pure public goods and pure private goods. Suppose a communiry of a certain number of people is confined to a room. Decisions made in that room affec t only those in the room and no one else. Each da y, residents of the room receive a fi xed quantity of bread and a certain amount of fuel to heat the room. The bread is a pure private good in the sense that
' Thi, point ii •mphaiized by Sam...twn ;,, l>ii dauic: p~, on put• public goods: Paul Sa,,.,.,.lson, "Th• Pu.-. n-..ory of Public: E•l)'lnditut•, • R.,,;.w of Economic, a,ncJ S1afi1tic:s 36 (No,,.mi,., 19S4): 387-389 and " Di~ram- mMic: Exposition of&..~ of Public &,p.nditur•." 1r.,..;.,.. of Economic, ar,cJ S'!• tjsfic:J 37 (No_,.mi,., 1955 ): 3SO-JS6
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CHAPTER 4 Public Goods
11@11 IIMM Marginal Costs of Consuming and Producing a Pure Public Good
200 -
0 1
Marginal Cost of Allowing an .,,,,,,,,--- Additional Person to Consume a
Given Quantity of Pure Public Good
/
Number of Consumers
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Units of a Pure Public Good per Year
The diagram in A shows that the marginal cost of allowing an additional person to con- r sume a given quantity of a pure public good falls to zero after it is made available to any ! one person. The graph in B shows that the marginal cost of producing the good is always t positive. In this case, the marginal cost of each extra unit of the good is $200. f
it is possible to slice it and divide it among the individuals. The total amount of bread available each day equals the sum of the amounts consumed by the people in th e room. If more bread is allocated to any one person, less will remain available per day for the others. Bread could be easil y sold in a marker where th e price would be established each day by th e interaction of dem and and supply. Given the daily price of bread, the people in the room could adjust their consumption of bread according to their preferences and economic circumstances.
On the other hand, it is impossible to di vide the room's heat among the people. All individuals in th e room at any point in time experience the same temperature level. Assume that the room is large enough so that the effect of the heat emitted by additional bodies on the amount of fuel needed is negligible. Therefore, addi- tional peop le can be accommodated in the room at a given temperature without using more or less fuel. It is impossible for o ne person to consume more hea t in
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137
PART ONE The Economic Basis for Gove rnment Activity
such a way as to reduce the amount made available to others. Finally, it is impossi- ble for different people in the room to consume different quantities of heat; that is, the level of heat produced for any one individual is the level that all individuals must consume. Individual consumers of heat will lack the ability to adjust the amount of heat they consume in accordance with their own tastes and economic circumstances. It is impossible for two individuals simultaneously to occupy a room in which the temperature is both 65 degrees and 78 degrees Fahrenheit. The level of heat in the room will have all the characteristics of a pure public good for those who occupy the room.
An important consideration in discussing public goods is the range of their bene- fits. Some public goods, such as wor ld peace, might conce ivab ly provide collectively consumed benefits to every single individual, no mancr where they arc on the face of the eanh. Some goods are co llectively consumed within the confines of given nations, although others might produce collectively consumed benefits that are locally con- sumed. The geographic range of shared benefits influences the desirability of having public goods supplied by various levels of government (fo r example, federal, state, or local). This problem is extensively investigated in Pan 5 of this book.
1. 'Nhat are the characteristics of public goods? 2 . How do p ure public goods differ from pure private goods? 3 . 'Nhy is the marg inal cost of allowing another consumer to enjoy the benefits of
a pure p ublic good always zero even though the margina l cost of producing the good is positive?
PROVISION OF PRIVATE GOODS AND PUBLIC GOODS: MARKETS AND GOVERNMENT The supply of goods and services and the mechanisms of distributing them among individuals reflect co llecti vely agreed-upon institutional arrangements that have emerged in a community. It is difficult to make genera li1.ations about the most appro- priate means for making goods and services available. Private goods that are individ- ually consumed arc sometimes supplied through markets by government, as is the case for certain transportation services, electricity, and other public utility services. On the other hand, many goods that are nonrival in consumption and which have characteristics of public goods, are privately produced and supp li ed through market s. This is the case for certain recreational services sold through private clubs, television and other communication services, and private police protection. In many cases, goods and services are supplied both through markets under private production and by governments through political institutions. For example, both private and public schools are available. Recreational services and facilities, such as parks, tennis courts, and golf courses, are suppl ied by both the government and the private sector.
It is possible to imagine, at the extreme, pure pr ivate goods being supplied through government and financed through taxa tion. For example, citizens could agree collectively to supply clothing through government and allow every person
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CHAPTER 4 Public Goods
one identical suit of clothes per year at no direct charge, financing the production and distribution of the clothing through taxation. Similarly, it is possible to envi- sion goods that have the characteristics of public goods being produced privately and sold through markets when the costs of exclusion are not very high. This is the case for cable television services in which programming that is nonrival in con- sumption is produced by profit-maximizing firms that sell monthly subscriptions to their programming services. The fee serves as an exclusion device, making the ser- vice available only to those who sign a contract and agree to pay.
In practice, it is not possible to draw a neat line between pure private goods and pure public goods. Many intermediate cases exist in which external benefits or costs accrue only to some people, and the transaction costs associated with trad- ing goods with collectively consumed benefits arc not prohibitive. In those cases, both private supply and government supply are feasible, and it is often difficult to determine which supply merhod is appropriate.
Congestible Public Goods and Private Goods with Externalities Government supply through political institutions and private supply through mar- kets are alternative means of making any good available. These two alternatives can be evaluated according to the extent to which externalities arc associated with either the production or consumption of the good and the extent to which it is pos- sible to develop a means of selling rights to use the good or service.
C~hhl~ p uhlic lt'--.xls are those for which crowding or congestion reduces the benefits to existing consumers when more consumers arc accommodated. The marginal cost of accommodating an additional consumer is not 1.cro after the point of conges- tion is reached. For example, an additional user of a congested road decreases the ben- efits to existing users by slowing down traffic and increasing the risk of an accident. This is illustrated in Figure 4.2. After N• users of a road have been accommodated per hour, the marginal cost of aUowing another user on that rood becomes positive.
Pri~·c·i: xdud.ih l,i: puhlii: gmtel\ are those with benefits that can be priced. Private clubs are often set up to share facilities, such as tennis courts, swimming pools, and dining areas for small groups. Membership rights, which :1.re sold in the market , are sometimes negotiabl e and can be sold by their holders to others. By joining clubs and paying dues, members share in the cost of facilities and services that they oth- erwise would be unable to afford. Dues and limits on the number of members are determined by collective agreement of existing members.2 The dues ration the facil- ities of the dub to avoid the effects of congestion. Other pricc-cxdudable public goods include such public facilities as schools and hospitals. These goods can be priced, but their provision results in positi ve externalities.
Table 4.1 summarizes alternative means for producing. distributing, and financ• ing goods and services. Goods and services have been divided into four categories:
1. Pure private goods 2. Pricc-excludablc public goods 3. Congestible public goods 4. Pure public goods
2See Todd Sandlerand John T. TK hirhart. " The Econom >C Theory of Clubs: An Evaluative Survey." Jou,n.-1 of Economicliter,ture18(December 1980): 1481 - 1521 .
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140 PART ONE The Economic Basis for Government Activity
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0 I Number of Consumers per Hour
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The first category represents goods that approximate the ideal of a pure private good that is individually consumed and subject to low-cost exclusion from benefits for those who do not pay for the right to receive such benefits. The production of these goods usually does not generate an externality, but some individuals believe that externa l benefits are associated with others who consume these goods. Such private goods might be sold in markets either by private firms or by government. When sold in markets, their costs of production arc financed by the revenue obtained from sales to individual buyers. Alternatively, they may be produced or purchased by government from private firms, distributed free of direct charge to eli- gible recipients, and financed by taxes. Such is the case for public welfare programs that give medical services, food, housing, and other services to low-income citizens who meet certain eligibility tests. These services also could be sold at subsidized prices, with losses made up from tax-financed subsidies.
Second, some goods can be individually consumed and are subject to exclusion, but their production or consumption is likely to generate externalities. These are price-excludable public goods. Again, such goods can be distributed through mar- kets when produced either by private firms or by government. The production or consumption of these goods can be subsidized to account for the positive external- ity associated with their sale. The good would be financed by both the revenue from sales and the taxes used to finance the subsidy. Such is the case for private and pub- lic hospitals, ma ss rransit facilities, and schooling. These goods also can be pro- duced by government and distributed with no direct charge. In such cases, however, 1hc quantity and quality of the se rvice would be determined collectively through political institutions, and costs would be financed through taxation. This is the case for public schooling, public sanitation service, and government-supplied inoculations that are available at public health facilities.
Congestible public goods are nonrival in consumption only up to a certain point. After the number of consumers exceeds a certain amount, the goods become
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PART ONE The Economic Basis for Government Activity
at least partially rival in consumption. An increase in the use of the good by one consumer decreases the benefits from a given amount of the good that can be enjoyed by others. Exclusion from benefits of these goods is often possible through application of certain fees. Congesrible public goods, in some cases, are also price- cxduda blc public goods. These goods arc often in the form of services flowing from shared facilities that can be distributed in markets either by government or by firms through the sale of admissions, memberships, or other use-related fees; these might receive public subsidies. Privately supplied examples include dubs for sharing recre- ational or other facilities, amusement parks, theaters, and sporting events. Government-supplied goods of this type might be partially or fully financed by taxes. Public parks are an examp le, as are other forms of public recreation, civic centers, auditoriums, roads, bridges, and similar public facilities.
Pure public goods result in collectively consumed benefits that are nor subject to crowding and are subject to high-cost exclusion. It is difficult to sell use rights to the benefits of these goods, and markets are unlikely to provide a convenient mechanism for distributing them. Conceivably, they could be produced privately through voluntary contributions, with the quantity and quality of service provided being contingent on the amount of revenue collected. Private charity is often pro- vided and financed in this manner. However, goods resembling pure public goods are most likely to be distributed free of direct cha rge by governments, with the quantity and quality of the service determined through political in st itutions and financed by taxes. Such is the case for national defense, environmental protection, and other goods resembling pure public goods.
Semipublic goods exist in a continuum ranging from pure private goods to pure public goods. Figure 4.3 shows how goods could be categorized according to the degree of rivalry in consumption and the degree of excludability. The horizontal
,,_ Classifying Goods According to the Degree of Riva lry and Exclud- ability of Benefits from Their Use
H •
0 - - Rivalry - - 1
A pure public good corresponds to point 8, where there is no rivalry for benefits and excludability from benefits is impossible. A pure private good corresponds to point A on .r the g ra ph. A nonrival good, such as 1V transmissions, for which exclusion is possible, ] corresponds to a point like C. A congestible public good for which it is possible to i charge for use, such as a limited access highway, corresponds to a point like H.
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CHAPTER 4 Public Goods
axis of the graph plots the extent to which the benefits of the good are rival on a sca le of zero to one. A pure private good with benefits that are full y rival in con- sumptio n would rare a value of o ne on rhe hori zontal axis, while a pure public good wi1h benefits that are co mplet ely nonri va l in consumption would rate a zero o n the hor izonta l axis. A congestible pub lic good with benefits th at a re o nl y par- tiall y nonrival would be ass igned a number between zero and one on th e ho rizontal axis depending on th e degree o f its co ngestib ili ry.
The vertica l axis meas ures the exd udabili ry of the good o n a scale o f zero to one. A pure private good, which is perfectly exclu dab le because its benefits ca n be fully wi thh eld fro m someone who does nor pay, wou ld be assigned a one o n the vertical ax is. Similarl y, a pure public good that is not price excludable woul d be assigned a zero. Goods, such as highways for which tolls can be charged and other price-excludable goods, would be assigned a number between zero and one depend - ing on the ease with which the benefits of the product can be priced.
According ro thi s cl assificat ion scheme, a pure pri vate good wou ld correspond to po int A o n th e graph. At th a t point, there is fu ll exd udability an d full rivalry for the benefits of th e good. Similarl y, a pure public good wou ld correspond to point B at which the benefits are fully nonriva l and price exdudabiliry is impossible. Some goods, such as cable 1V transmi ss ions, wou ld correspond to a point on the venica l axis like C. For such a product, the benefits are nonrival, but p ri ce exclus ion is rel - atively easy because signa ls can be scra mbled and those who decline to pay for a hookup ca n be denied the benefits. A high way subj ect to congestion would corre- spond to a point like H, where there is a degree of riva lry, and price exclusion is possible through rolls.
Education as a Pub lic Good Education is a service that has some characte ristics o f a publ ic good whi le at the same rime having characteristics of a private good. Education is commonly be lieved to result in widely ranging external benefits when it is provided at least at some minimal level to all chi ld ren in a soc iety. However, at the same time, the exclusio n principle can eas- il y be app li ed to educational services so that it ca n be withh eld from those who do not pay fo r it. Education is a clea r exa mpl e o f a partia ll y public good. Decisions must be made, therefore, abou t how to supply ii. Education ca n be made available through the marketplace like any private good. Education can a lso be supplied by governments and given out free o f cha rge in equal amounts to all chi ldren in a sociery.
In th e United Sta tes, as well as in most other natio ns, a mi x o f both private and publi c schools has emerged bmh through the marketp la ce and politica l interaction as a means of supplying education. Howeve r, in the United Sta res and in mosr other nations as we ll , on the primary and seconda ry leve l, education is mainly a government-su pplied service. For exa mple, in the United Sta tes a ppro xima tely 90 percent of children attend public elementary and secondary schoo ls. Fo r higher edu cation there are, of course, many public co lleges and universities. But few public institutions of higher learning fully finance their activities with tax revenues. Stu- dents at colleges a nd uni vers ities pay a port ion of th e cos t of their education through tuition and fees, and these prices have bee n increasing in rece nt yea rs. Fur- thermore , about 40 percent of students at insti tution s of higher lea rning in the United States attend private school s.
It is clear ly feasib le to price edu cational se rvices. And because the ma rginal cost of educating a stud ent is certainly not zero, a zero price for th e serv ice is not an
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PART ONE The Economic Basis for Government Activity
efficient alternative. Nonetheless, it is commonly agreed that education is such an important generator of positive externalities that it should be universally subsidized by government tax revenues. In the case of elementary and secondary education, the subsidization is complete and the price ro families of children attending public schools is set at zero. In the United States, the costs of providing educational ser- vices is financed with a combination of local, state, and federal tax revenue, with the bulk of the revenues (more than 90 percent) coming from State and local tax coffers. State governments, through direct appropriations to colleges and universi- ties, also heavily subsidize higher education. Federal subsidies to individuals and institutions and tax credits to individuals also help finance higher education. Educa - tion at the elementary and secondary level is almost universally compulsory up to a certain age. Thus, governments intervene in the supply of education to make sure every citizen consumes at least a minimal amount of this service.
What are the externalities associated with the production and consumption of education that result in such universa l support of government supply and subsidiza- tion? Many beli eve that wide-ranging externalities exist when we live in a soc iety where we can be sure everyone has a minimal level of education so that they can be productive citizens. We want to be sure everyone can read, have minimal computational ski lls so that they can manage their finances, and have adequate appreciation of public institutions and the duties of citizens to each other. This min - imal le vel of education helps us all li ve in a reasonably civi l society and therefore has a component that ca n be viewed as a public good that is equally consumed by all. Education has a "socializing"' function. It provides students with the ability to function effectively in a society by following rules, obeying orders, and working together with colleagues. It also provides students with such basic ski lls as punctu- ality, ability to follow direction s, and other skills that increase their productivity as workers. 3 Universal education also screens students by helping them to identify their abilities and to choose appropriate occupations as adults. In this way another public good aspect of education is its function of providing a better match of work - ers to jobs, thereby increasing productivity levels for a nation.
Many be lieve that some citizens would purchase less than the efficient amount of education for their children if it were provided in a competitive market. If thi s were rh e case, many brilliant minds cou ld be deprived of sufficient education, and we would all be deprived of their possible future contributions to society. Further, some parents might not va lue education as much as others, and this cou ld deprive their chi ldren of an adequate education. Whether or not underconsumption of edu- cation would actua ll y result, it is clear that this idea is behind the principle of free and compulsory public education. Public education helps integrate all children into society. Education is especia ll y useful for helping immigrant groups to understand the basics of an adopted culture and political system and to learn a new langua ge.
However, the fact remains that education has characteristics of a private good. No government can guarantee that all children in a society receive an equal amount of education. Wide disparities exist in the quantity and quality of education provided among school districts in the United States. Production of a given output of education might take varying amounts of inputs depending on the students being taught. In areas where schools have a disproportionate number of disadvantaged stude nts, higher expenditures per pupil are necessary to achieve the same level of output as
"S.. Andrew W• iq, "Human Capii,I W<SU$ Si9"aling Explanation$ of Wag'", " JOU<na/ of Economj, P-,,p•"jv• s 9,4(F, ll1995): 133-154.
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CHAPTER 4 Public Goods
those areas where srudents have better home environments. Most srud ies show that the level of support pa rents can give sru dents at home increases with household incomes, an d home support is an important facto r in learning for children.
Even if it were possibl e to eq ualize the quality and q uanrity of education pro- vid ed in public schoo ls, there is no way to prevent parents who wa nt more than thi s standardized quantity and quality of education for their children from buying it in the marketplace. And since upper-income parents have more ability to pay for educa- tional services, their children are more likel y to obtain supplementary instructio n or attend pri va te schoo ls where the quality and quantity of instruction cou ld be higher.
1 How do co ngestible public goods differ from pure public goods? 2 How do price-excludable public goods differ from pure public goods? 3. Give some examples of "semipublic goods" that are provided through the
ma rketp lace by profit-motivated businesses. Discuss the characteristics of these goods in terms of the excludability of their benefits and the rivalry among consumers for the benefits of given amounts of the goods.
THE DEMAND FOR A PURE PUBLIC GOOD The demand for a pure public good mu st be interpreted differentl y from the demand for a pure private good. Th e market demand curve for a pure private good gives the sum of the quantities demanded by all consumers at each possible price per unit of the good. Th e mark er demand curve for a pure private good, suc h as bread, is illust rated in Figu re 4.4. For a ny given price, a poi nt o n the market
hi!§H if PA Demand for a Private Good 7
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012345678910 Loaves of Bread Purchased per Week
. . . . ·- r The demand for a priva te good 1s obtained by addmg the quantit ies demanded by each consumer at each possible price. The efficient output is six units per week, which corre- t sponds to poi nt E. At a price of $3 per loaf, MBA = MB8 = MBc = MC. ~·
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146 PART ONE The Economic Basis for Gove rnment Activity
demand curve for a pure private good is found by simply adding the quantity that each individual would purchase at that price. The individual demand curves are added laterally over the horizontal axis to obtain the market demand curve.
In Figure 4.4, there are only three consumers of the private good. At a price of $3 per loaf, the person whose demand curve is DA purchases one loaf per week. That is the quantity for which the price equals his or her marginal benefit per week (MBA = $3). The person whose demand curve is represented by Dff purchases two loa ves per week at a price of SJ per loaf. At that amount of weekly purchase of bread, MBa = $3. Finally, the person with demand curve De purchases three loaves per week at a price of $3 per loaf because MB c = $3 at that amount of weekly consumption. The tota l market quantity demanded by these three consumers is six loaves per week at a price of $3 per loaf. This is represented by point£ on rhe mar- ket demand curve. Unti l the price falls below $4 per loaf, the only individual pur- chasing the good wi ll be the one whose demand curve is represented by De. At lower prices, the other individuals whose demands are represented by D8 and DA progressively enter the market, and the quantities that they demand as prices are lowered arc added to that of the consumer whose demand is De. The market demand curve for the private good is labeled D = tQ 0 .
For a pure public good, all co11sumers must consume the same quantity of the good. Purchasers of a pure public good would not be able to adjust their consump- tion so that one person had one unit per week, while another person enjoyed two units per week, and still another had three units per week. If consumer A had three units per week, all other peop le wou ld consume three unirs per week. For a pure public good, consumers cannot adjust the amounts purchased until the price of the good equals their marginal benefit from the good per week. In fact, a pure public good cannot be priced because of its nonexdusion property.
How then can a demand cu rve for a pure public good be derived? The variables on 1hc vertical axes arc not market prices. Instead, the y a rc the maximum amounts that peop le would pay per unit of the pure public good as a function of the amount of the good actually available. For example, suppose the three co nsumers live together in a small community and desire to provide themselves with security pro- tection. The quantity of security pro1ec1ion can be measured by the number of secu - rity guards hired per week 10 patrol their community. Security guards represent a pure public good for these three consumers. No way exists for any one person in this community of three to hire a security guard for his or her own benefit without benefiting his or her neighbors.
Figure 4.5 shows each person's demand curve for sec urity guards. A point on any of the indi vidual demand curves represents the maximum amount that the con- sumer wou ld pay to get each 1111it of the correspondi ng quantity of the publi c good . This maximum amount is the marginal benefit of security protection at each quan- tity. Each individual's demand curve shows how the marginal benefit of sec urity gua rd s declines as more are made availab le.
The total amount that would be given up per security guard hired per week is the sum of the annual weekly marginal benefits of each of the three consumers. Points on the aggregate demand curve for a pure public good cou ld be obtained by adding each person's marginal benefit at each possible quantity. The demand curve for a pure public good is obtained by summing the individual demand curves vertically. The marginal benefit, or demand price, that each person would pa y per unit of the public good is summed al each quantity of the good, because all people mu st consume th e sa me quantity.
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CHAPTER 4 Public Goods
11@11 ,,_ Demand for a Pure Public Good 800
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Security Guards per Week
For example, th e person with the demand curve DA would pay a maximum of $300 per security guard if only one guard were provided per week. Similarly, rhe maximum amounts the people with demand curves D 11 and De would give up per security guard if only one were provided per week would be $250 and $200, respectively. A point on the market demand curve therefore is obtained by adding these max imum amounts. Because the maximum amounts rencct the marginal ben- efit of security protection, the point on the market demand curve represented by point Z 1 corresponds to the sum of the marginal benefits of all three consumers. This equals $750 per year when only one security guard is provided.
The marginal benefit of additional units of a pure public good declines in the same fashion as do those of pure private goods. The amount per security guard that could be collected if two guards were made available per week is less than that which could be collected per guard when only one is provided per week. This too is shown in Figure 4.5. The maximum amount per guard that each of the three consumers would give up when two guard s are made available per week is $250 for A, $200 for B, and $150 for C. Therefore, the sum of the marginal benefits when two security guards per week are provided is $600, as represented by point Z2 in Figure 4.5. Adding the marginal benefit received by each consumer from any num- ber of security guards in this way gives points on the demand curve for the pure public good. This curve is labeled D = EMB;.
EFFICIENT OUTPUT OF A PURE PUBLIC GOOD Efficiency requires that all economic activities be undenaken up to the point that their marginal social benefit is equated with their marginal social cost. This princi- ple holds for pure public goods as well.
Suppose a person were to attempt to produce or purchase a pure public good for hi s or her own use. By making a unit of the public good available in the
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, .. PART ONE The Economic Basis for Gove rnment Activity community, this person will generate benefits not only for himself or herself but also for every other member of the community in which she resides. The marginal social benefit of this good will be more than the extra benefit to its purchaser. Addi- tional benefits will accrue to each and every other person who will simultaneously enjoy each unit made available. Summing up these benefits to all people in the com- munity gives the marginal social benefit for each extra unit of output produced. The marginal social benefit of any given amount of a pure public good is the sum uf the individual marginal benefits received by all cons11mers.
The efficient quantity per rime period of a pure public good corresponds to the point at which output is increased so that the sum of the marginal benefits of con- sumers equals the marginal social cost of the good. The efficiency conditions for a pure public good arc
MSB = LMB = MSC. 4. 11
Market sale of a pure public good for individual purchase would generate wide-ranging positive externalities, because a purchaser of the good would consider only his o r her marginal benefit in deciding how much to buy. The marginal exter- nal benefit would be the sum of the marginal benefits to all other consumers. When individual buyers do not take the marginal external benefit into account, sale of the good to individuals in a market is likely to result in less than the efficient annual quantity. A pure private good has no external benefits of additional production. In evaluating the benefit of extra production, it is necessary to count on ly the benefit received by the indi vidual who actually purchases and consumes the extra output.
The efficiency conditions for a pure public good can also be written as ,_,
MSB = MB, + ~MB;
Equation 4.2 states the marginal socia l benefit of a unit of a pure public good as the sum of the benefits accruing to any one person acquiring it (MB,) and of the extra benefits that accrue to the remaining (n - l) members of the community (LMB,). The marginal social benefit is the sum of an individual benefit and an external benefit accruing to all other members of the community. The summation term
represents the marginal externa l benefit of a unit of a pure public good made avail- able to an y one perso n. The production of a pure public good gene rates externa l benefits that arc positively va lued by a ll members of a community .
A Numerical Ex.ample Table 4.2 provides data on the marginal benefits of three consumers who desire secu- rity protection in a community. These data summarize the numbers used to derive the demand curve for security protection in Figure 4.5. In the table, the marginal benefits of as many as four security guards per week are shown for each consumer.
Suppose the weekly cost per security guard is S450. If as many guards as desired can be hired at that rate, the average cost of security protection wou ld be constant at $450 per unit. In this case, a unit of security protection per week is pre- sumed to be perfectly corre lated with the se rvices of one security guard per week.
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