Government As Producer

GOVERNMENT AS PRODUCER

[The following discussion borrows heavily from Kerr, A Backdoor to Economics (1999)]

EXTERNALITIES AND ECONOMIC EXTERNALITIES

Externalities abound throughout the human experience. Quite broadly, an externality is something that affects you even though you did nothing to bring it about. It may benefit you in which case it is called a positive eternality or external benefit (EB). Obviously, a negative externality or external cost (EC) is detrimental. In economics, the source of an externality must emanate from a transaction between two parties other than the recipient of the externality. The farmer who enjoys a bountiful harvest due to ample rain and sunshine at the right times is indeed the beneficiary of an externality. Economics can analyze the impact of crop-conducive weather, but economists are not meteorologists. Accommodative weather is not an externality that arises from an exchange between two parties. The bottomland farmer who enjoys better yields due to better conservation measures by the neighboring highlanders is also the beneficiary of an externality. Economics can analyze the source of this externality. While economists cannot predict the weather, economics does have something to say about the behavior the highlanders.

PRIVATE, EXTERNAL AND SOCIAL BENEFITS

When your classmate, Tom, buys and eats a sandwich at lunch, he directly benefits; he is a direct beneficiary of the transaction between him and the University’s food service. Tom has been buying sandwiches all semester and there is some total private benefit involved with them. What Tom pays for this additional sandwich is a measure of his marginal private benefit.

private benefit: The benefit that Tom derives from consuming all the sandwiches from an arbitrary starting point, say the beginning of the semester. 2

marginal private benefit (MPB): The benefit that Tom derives from his most recent purchase, the last sandwich that he bought and ate.

Sitting with Tom at the lunch table, neither you nor anyone else is likely to receive any benefit from his eating the sandwich. There is no marginal external benefit (MEB). Suppose that Tom also buys a piping hot cup of strong coffee. If you love the aroma of coffee, then there is likely to be some marginal external benefit from Tom’s purchase. What would you pay for this benefit? If Tom were short 10 cents, would you give him a dime simply to enjoy the smell of the espresso? Suppose Tom is perfectly happy buying regular coffee for ten cents less, would you pony up 10 pennies for the more aromatic brew? If so, the 10¢ is a measure of the marginal external benefit. The benefit that accrues to both you and Tom is the marginal social benefit (MSB), which is the sum of both the marginal private benefit (Tom’s) and the marginal external benefit (yours and others at the table who enjoy the aroma of coffee).

marginal social benefit = marginal private benefit + marginal external benefit

or MSB = MPB + MEB

PRIVATE, EXTERNAL AND SOCIAL COSTS

Having finished his sandwich, Tom now draws a cigarette from the pack in his shirt pocket. That he experiences a private benefit becomes obvious with his first deep drag. Are there any external benefits? costs? While you and others may enjoy the aroma of Tom’s coffee and may even find your grandfather’s pipe smoke pleasurable, you are less likely to get a buzz from Tom’s cigarette smoke. Rather than a benefit, you and others may suffer from Tom’s secondhand smoke. The detrimental effect from Tom’s most recent smoke is its marginal external cost (MEC). While Tom’s marginal private cost (MPC) is easily measured by the price that he paid for the pack of cigarettes, an accurate measure of the MEC is more elusive. Regardless of whether or not you are entitled to a smoke free environment, what would you and others be willing to pay Tom to forgo his smoke until after lunch? This would be a measure of the MEC. 3

The cost incurred by both you and Tom is the marginal social cost (MSC). It is the sum of both the marginal private cost (Tom’s) and the marginal external cost (yours and others at the table who suffer from secondhand smoke).

marginal social cost = marginal private cost + marginal external cost

or MSC = MPC + MEC

ALLOCATIVE EFFICIENCY

The notion of allocative efficiency might best be illustrated by a man working to survive on an otherwise deserted island, i.e., a Crusoe economy. The legendary Robinson Crusoe was the only source of labor on an otherwise resource rich island. Every activity, whether picking berries to eat or swimming in the sea for recreation, required the expenditure of labor. If he was observed picking berries, it would be logical to conclude that he determined the picked berries to be more valuable than the labor expended to get them. Another way to say this is that Robinson felt that the marginal private benefit was greater than the marginal private cost.

MPB > MPC

In fact as long as Crusoe felt that the additional or marginal benefit exceeded the additional cost, he would continue to pick. Were Crusoe to reach the point where picking additional berries was more trouble than it was worth, i.e., MPB less than MPC, his berry picking would cease. For simplification without loss of fidelity, economists argue that Crusoe would be allocatively efficient at the point where the cost of picking another berry is just equal to the benefit of eating it.

MPB = MPC implies ALLOCATIVE EFFICIENCY.

Since there are no externalities in the Crusoe economy, MEB and MEC are both zero. Hence, it can easily be argued that

MSB = MSC implies ALLOCATIVE EFFICIENCY.

Consider your friend Tom. Dining alone, his purchase of coffee is likely to be allocatively efficient, i.e., MPB = MPC. There would be no externalities and the second notion of 4 allocative efficiency (i.e., MSB = MSC) would be moot. Your presence creates positive externalities, or external benefits. With a positive MEB,

MSB > MSC.

From the group’s point of view, there is an underconsumption of coffee (or an underallocation of resources to the production of coffee). More coffee should be produced and consumed, if only incidentally through the olfactory senses. Alternatively, consider Tom’s smoking. In isolation, his purchase of cigarettes is likely to be allocatively efficient, i.e., MPB = MPC. Considering the detrimental impact that secondhand smoke has on others

MSB < MSC.

From the group’s point of view, there is an overconsumption of cigarettes (or an overallocation of resources to the production of cigarettes). Fewer cigarettes should be produced and consumed.

PRIVATE VS. PUBLIC GOODS

The schism created by externalities between social and private benefits (or costs) is often misused in economic analysis. Many use it to distinguish between public and private goods, when it should be used to separate publicly-provided goods from “market-provided” goods. A publicly-provided good is any good afforded by government (local, state, or federal). Consider the following definitions.

Private Good: This is the type of good or service that is normally presumed. It has two characteristics that are not typically highlighted. First, it is a rival good or competitive in consumption. Consider a cupcake. If Adam eats it, Debbie cannot. If Debbie is to enjoy a cupcake, another must be produced; additional costs must be incurred.

Second, a private good is an excludable good. Both Debbie and Adam can be kept from eating the cupcake. Mom may simply say, “No dessert until you’ve finished your vegetables.” Or the baker/retailer will withhold his product (or simply not produce it) until you offer something in exchange (typically cash). 5

Public Good: A public good is a nonrival and nonexcludable. Consider a radio broadcast signal. First, it is noncompetitive in consumption. If Adam tunes in a rock music station’s signal, he does not diminish or use up the signal. Debbie may tune to the same station. (Of course, each must have a radio, a private good). The signal is available to Debbie at no extra cost. Second, a radio broadcast signal is nonexcludable. No one with a radio can be kept from consuming the broadcast.

Either of the aforementioned goods may be provided by private markets or through some sort of government intervention. Since public goods are nonrival and nonexcludable, it has been argued that private producers will not produce them or not produce them in allocatively efficient amounts. Consequently it falls upon government to pick up the slack. The confusion between “public goods” and “publicly provided goods” is born.

POSITIVE EXTERNALITIES AND PUBLIC GOODS

This confusion has been exacerbated by those who have extended the definition of a public good to a good that has large positive externalities or external benefits. The fault with this criterion is the subjectivity involved with the word “large.” Are the external benefits of Tom’s espresso “large” enough to warrant a government subsidy to encourage greater consumption? Since you benefit from Tom’s coffee, should you be required to pay part of his tab? While education is clearly a private good in the nomenclature of the previous section, are the external benefits of your receiving an education “large” enough to warrant the government’s 100 percent subsidy for kindergarten through twelfth grade (i.e., K through 12)? through college sophomore? Figure 1 on the following page represents the market for formal education in the absence of any government involvement.

DPRIVATE reflects only the benefits that the immediate/direct consumers of the training expect to receive (be it the students and/or their families); SPRIVATE represents the supply of only private producers. The equilibrium price and quantity are $18 per hour and 24,000 hours of instruction, respectively. 6

Figure 1

It is commonly argued that the education of an individual produces benefits for all of society. Any breakthrough in medicine illustrates this. The education of Dr. Jonas Salk and a relative handful of others delivered the baby boomers and subsequent generations from the scourge of polio. Society anxiously awaits similar breakthroughs in cancer and AIDS. To paraphrase Winston Churchill, “Never will so much be owed by so many to so few.” Yet, benefits accruing to those outside of the immediate transaction (i.e., indirect benefits) are largely, if not totally, ignored in the current market. The equilibrium quantity is the amount of education from which the students and/or their families perceive direct benefits. Because the market provides no vehicle to register the demand for the numerous indirect beneficiaries, there is an underallocation of resources to the production of education. How might the market recognize this indirect demand? Figure 2 focuses attention on the demand side of the market.

DPRIVATE is repeated from Figure 1. The market price of $18 is a measure of the MPB (marginal private benefit); it reflects the value of the 24,000th hour of instruction to the direct beneficiaries. The indirect benefit of this 24,000th hour of instruction to those outside the immediate transaction is $7; this is the MEB (marginal external benefit). The total benefit of the 24,000th hour of instruction is the sum of the MPB (the 7 value to the student) and MEB (the value to the rest of society); this is the MSB (marginal social benefit). Point X identifies the price that both the direct and indirect beneficiaries would pay for the 24,000th hour of instruction. Similar points could be found for each hour of instruction. The collection of these points (the loci) make up what your text labels “MSB.” It could be viewed as a demand curve that captures the effective demand of both direct and indirect beneficiaries of the good and could be labeled DSOCIAL. Figure 2

Figure 3 adds DSOCIAL to Figure 1. The intersection of DSOCIAL and

SPRIVATE identifies the allocatively efficient quantity of education (28,000 hours of instruction). The production and consumption of the 28,000th hour matches the marginal social benefit (MSB) with the marginal social cost (MSC). [It has been presumed that there are no external costs, i.e., MEC = 0. Hence MSC equals MPC.] 8

Figure 3

Since the market provides no mechanism to allow the indirect beneficiaries to participate, only 24,000 hours of instruction will be produced. How could the allocatively efficient level of 28,000 hours be achieved? The traditional approach has been for government to increase supply directly through the provision of public schools. This tack is illustrated in Figure 4. Following the Second World War (1939-45), the political process decided that a college education was warranted for any serviceman. With thousands of GIs being mustered out, the existing public universities could not handle the onslaught. Out of necessity, government mobilized private educational resources via the GI Bill. Under this early day voucher plan, the government simply paid the tuition of former soldiers attending private institutions of higher education. Though scaled back, such assistance remains for veterans today. 9

Figure 4

With the funds channeled through the individual consumer, the impact on the market is through the demand side as is the case in Figure 3. The increase in price should not be construed as an increase in cost over a public school alternative. The shift in supply in Figure 4 does not come at zero cost. Under either alternative, costs will increase because more resources are being used. In recent years, a growing number of parents and taxpayers have become disappointed with the performance of the publicly provided schools and have embraced voucher plans. Instead of funds being channeled directly to public institutions, they must pass through the hands of the ultimate consumers first. Any institution that wants a share of these funds must persuade the individuals to attend and thereby, be more responsive to the individuals’ demands.