Prof. Bryan Caplan

Econ 410


Week 1: Public Goods, Externalities, and Comparative Institutions

I.             What Is Public Choice?

A.           Economists usually study and analyze markets; when they need to talk about government, they often "tack it on" to the analysis in an ad hoc manner.

1.            Ex: Free trade and tariffs

2.            Ex: The macroeconomy and monetary and fiscal policy

B.           But why not instead study and analyze government in the same way that we normally study and analyze markets?

1.            Separation of positive and normative questions

2.            Internally consistent models

3.            Looking at evidence

C.           Alternate description: "endogenizing government behavior."

D.           Beginning about 40 years ago, the branch of economics known as "public choice" has tried to do precisely this.

E.           In addition to "public choice," there are several other terms that more or less describe the same field of study and approach:

1.            Political economy (or "positive political economy")

2.            Rational choice theory

3.            Social choice theory

4.            Formal political modeling

5.            Economics of governance

6.            Endogenous policy theory

F.            Public choice is one of the fields GMU is best-known for, especially because of James Buchanan's Nobel prize for work in this area.

G.           Main alternative to public choice: the "public interest" or "civics textbook" view.

II.            Private vs. Social Benefits and Costs

A.           Background to public choice: realization that private and social effects can differ.

B.           Ex: A thief clearly enjoys private benefits of stealing.  But looking only at the thief's benefits misses the big picture: The thief making himself better off by making others worse off.

C.           Ex:  A person driving a polluting car is better off from driving, but that person isn't the only one who consumes the exhaust.

1.            Contrast with: Worker safety trade-offs.

D.           How to measure "social benefits"?  The same way we always do: willingness to pay.  If some people benefit and some people suffer from a policy, the net social benefits are the SUM of the private benefits (positive and negative).

E.           Issues frequently become political when private and social costs differ.

F.            Moreover, once a decision is political, it almost inevitably implies costs and benefits for people who opposed the decision, not just its supporters.

III.          The Tragedy of the Commons

A.           Economists usually focus on how ownership gives people incentives to use resources in a sensible way.

B.           But it is possible for something to be unowned.  This has frequently happened.  For example, a pasture may be "common property."  Oceans are normally unowned, accessible to all.

C.           Frequently, however, common ownership gives rise to what economists call the "tragedy of the commons."  Since no one owns it, people use it without regard to the effect on others.

D.           And, once you realize that people think this way, you also have an incentive to take as much as possible NOW, because the resource won't be useful very long.  This can "snowball" into an awful outcome that benefits no one.

E.           Key idea: If one person owned the fisheries, or a forest, or a pasture, they would have the incentive to maintain it, improve it, and take a long-term perspective.

F.            That is the benefit of property rights that is absent in the commons - a benefit not just for owners, but for users as well.

IV.          Negative Externalities

A.           In sum, the basic idea of the tragedy of the commons is that when no one owns a resource, it gets over-used.

B.           Question: But what exactly does "over-use" mean in economic terms?

C.           Answer: It means that there are costly side effects that selfish agents don't factor into their decisions.  Economists call these costly side effects "negative externalities."

D.           How do you diagram negative externalities?  In addition to the demand curve, draw a "social benefits curve."  With negative externalities, the social benefits curve will lie below the demand curve. 

E.           Social optimum is at the intersection of the social benefits curve and the supply curve, but market equilibrium is at the intersection of the demand curve and the supply curve. 

F.            Economists call this a market failure, since self-interested behavior leads to inefficient results.

G.           Negative externalities are also often called "public bads," especially when the externalities are large relative to demand (so the socially optimal quantity is close to zero).

H.           Ex: Pollution.  People value better air, but polluters normally have no incentive to care. 

I.             The key: non-excludability.

1.            There is no feasible way to exclude non-payers from the cleaner air.  

2.            Since you do not have to pay to use it, selfish people will not pay to use it. 

3.            And if no one will pay for it, why would selfish producers provide it?

V.           Positive Externalities

A.           Positive externalities are the other side of the coin.  Positive externalities are beneficial side effects that selfish agents don't factor into their decisions.

B.           How to diagram?  Draw a social benefits curve above the demand curve. 

C.           Positive externalities are also often called "public goods," especially when the externalities are large relative to demand (so the equilibrium quantity is close to zero).

D.           Non-excludability is once again the key attribute.  If you can't exclude, there is no incentive to pay; if there is no incentive to pay, there is no incentive to produce.

E.           Ex: Defense.  People value defense, but how can suppliers be paid to provide it?

VI.          Understanding Externalities

A.           Many textbook treatments of externalities and public goods/bads also emphasize "non-rivalrousness" - the low or zero marginal cost of providing them.  But I see this as a distraction, so we'll ignore it.

B.           David Friedman's two caveats:

1.            Must distinguish benefits from external benefits.  (E.g. education).

2.            Must include both positive and negative externalities in your calculations.  (Important case: "pecuniary externalities").

C.           Some popular and plausible examples: air pollution, national defense, highways and roads (especially local roads), law enforcement (especially victimless crimes)...

D.           Some popular but dubious examples: education, health and safety, fire, R&D...

E.           Some unpopular but plausible examples (depending on the society): censorship, persecution of religious minorities...

F.            Further insight from Friedman: "It is easy to misinterpret problems of market failure as unfairness rather than inefficiency... The problem with public goods is not that one person pays for what someone else gets but that nobody pays and nobody gets, even though the good is worth more that it would cost to produce." (p.278)

VII.        Correcting for Negative Externalities

A.           A common initial reaction people have to negative externalities is: "Ban it!"

B.           Obvious objection: The cure is worse than the disease.  Many valuable activities (like driving) – and even many activities essential to life (like breathing!)  - have negative externalities.

C.           If they grasp this point, many people's next impulse is to set quantitative limits – like emissions inspections, or technological mandates - like new emissions standards for cars.

1.            A particularly crazy variant: "Best Available Technology."

2.            Perverse effects of technological mandates: Since they raise the price of new cars, they encourage people to keep driving old cars that pollute a lot more.

D.           These approaches are highly inefficient.  Quantitative limits and technological mandates ignore heterogeneity: Some firms can reduce pollution more cheaply than others; some people may value polluting more than others; some technologies may cost more than they are worth.

1.            Application: Carpool lanes.

E.           More efficient regulatory solutions that take heterogeneity into account exist:

1.            Taxes

2.            Tradable permits

F.            Advantage: This gets you the same pollution level at a lower price.  Firms that can easily switch to less polluting technologies sell their permits to firms where reducing pollution is expensive.

G.           Complication: Getting the margin right.  A tax on cars reduces the number of cars produced, but does nothing to discourage people who own cars from polluting.

VIII.       Correcting for Positive Externalities

A.           A common initial reaction people have to positive externalities is: "This is a job for government, not the market."

B.           Obvious objection: Overkill.  There is no need for government to take over the whole industry just because of some positive externalities.

C.           A much less intrusive option is for government to subsidize activities with positive externalities.

D.           Getting the margin right: Suppose there are positive externalities of voter education, but not math.  If you subsidize ALL education, adjusting for the externalities of voter education leads to an inefficiently high level of mathematical education.

IX.          Externalities, Property Rights, and Coasean Bargaining

A.           The economist Ronald Coase pointed out that government action to correct externalities is often premature. 

B.           Another solution to the externality problem is to define property rights, then allowing parties to bargain.  So long as "transactions costs" are low, externalities won't be a problem.

1.            Caveat: Common sense ethics tells us to distinguish e.g. polluters from pollutees.  But from an economic point of view it can be equally efficient to make polluters pay pollutees for the right to pollute, or have pollutees pay the pollutees to pollute less.

C.           Corollary: eliminating property rights can turn any situation into a public goods problem.  (E.g. provision of food).

D.           Interesting application:

1.            International pollution trading

X.           Externalities as a Rationale for Government Intervention

A.           Externalities/public goods are probably the main economic rationale for government intervention.

B.           When economists see negative externalities, their usual reaction is to say "Government should tax (or ban) that."

C.           When economists see positive externalities, their usual reaction is to say "Government should subsidize (or produce) that."

D.           Big problem: If government has the power to tax negative externalities, political forces may lead it to tax all sorts of things with no negative externalities to speak of.  Similarly, if government has the power to subsidize positive externalities, political forces may lead it to subsidize all sorts of things with no positive externalities to speak of.

E.           In other words, externalities may affect government behavior as well as market behavior.  If so, we face a choice between market failure and government failure.

1.            Ex: Voter acquisition of information

XI.          The Comparative Approach to Markets and Government

A.           The tale of the Roman emperor and the two minstrels.

B.           Moral: The sensible approach is comparative.

C.           What are the main public goods problems markets face?  The main public goods problems governments face?

D.           How can markets and governments solve public goods problems?

E.           Market solutions to market's public goods problems:

1.            Most general: Have private property rights whenever possible, and don't restrict bargaining.

2.            The unanimous contract (condo association)

3.            The privileged minority (mowing your lawn)

4.            Bundling (commercials on radio and TV)

5.            Merger (orchard owner marries beekeeper)

F.            Market solutions to government's public goods problems: ?

G.           Government solutions to market's public goods problems: get around high transactions costs by coercion.

1.            Subsidize/mandate (national defense)

2.            Tax/regulate (air pollution)

H.           Government solutions to government's public goods problems: ?

1.            Constitutional reform is a popular answer, but there is every reason to think that constitutional politics works just like regular politics.

I.             Important: If the government is unable to solve the public goods problems of government, then there is no reason to think that government will want to solve the public goods problems of markets that it can solve!

J.            Perhaps this explains why most of what actual governments do has nothing to do with public goods: Social Security, Medicare, education...