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FME REVIEWER from available resources. The extra production will make it possible for some persons to consume more without EFFICIENCY, MARKETS AND GOVERNMENT...

FME REVIEWER from available resources. The extra production will make it possible for some persons to consume more without EFFICIENCY, MARKETS AND GOVERNMENT reducing the amounts consumed by others. As a result, it would be possible to make some individuals better off POSITIVE AND NORMATIVE ECONOMICS without harming anyone else by avoiding waste in production. Positive economics is a scientific approach to analysis that establishes cause-and-effect relationships among Another important aspect of efficiency is freedom to engage economic variables. Positive theory attempts to be in mutually advantageous exchanges. If we are free to objective, making no presuppositions about what is good or engage in transactions for gain, we can obtain more bad or what should be accomplished. It merely formulates satisfaction out of our income. Freedom to trade is an hypotheses of the “If … then” variety that can be checked important aspect of efficiency. Both buyers and sellers can against facts. gain in markets when the value a buyer places on an item exceeds the cost the seller incurs by making it available for The normative approach is based on value judgments sale. Constraints that prevent resources being used and about what is desirable or what should be done to traded to allow mutual gains will prevent achievement of achieve the desired outcome. Normative theory begins efficiency. When efficiency is attained, mutual gains from with predetermined criteria and is used to prescribe policies reallocating resources in productive use or through that best achieve those criteria. Normative economics is further exchange of goods and services among designed to formulate recommendations as to what should individuals are no longer possible. be accomplished. Because it is based on underlying values, this approach, unlike the positive approach, is not objective. Many citizens argue that not all mutually gainful trades It can evaluate alternative policies and actions only on the should be allowed. They demand that the powers of basis of the underlying value judgments. government be used to prevent exchanges they find morally objectionable. They argue that government should exercise paternalistic powers over choices of citizens. Thus, it is common to observe laws banning the sale of Both the positive and the normative approaches are useful – certain drugs, gambling services, prostitution, and other dependence between the two approaches. Normative activities in which some persons might wish to engage but theory cannot make recommendations to achieve which others find morally objectionable. certain outcomes without an underlying theory of human behavior. If normative criteria are used to The criterion of efficiency is based on an underlying value recommend that government authorities undertake a judgment that individuals should be allowed to pursue particular policy to increase the incomes of certain their self-interest as they see fit, provided that no one is individuals, the impact of such actions on incentives to harmed in the process. Those who wish to intervene to produce and consume must be predicted. Well-intentioned prevent others from pursuing their self-interests disagree policies can have results opposite to those desired when no with this underlying value judgment. The individualistic account is taken of their effects on economic incentives. ethic underlying the efficiency criterion, therefore, is not acceptable to all persons Positive theory embodies techniques of analysis and so can benefit from the work of normative theorists by MARKETS, PRICES, AND EFFICIENCY CONDITIONS using normative guidelines to choose which areas of human interaction to analyze. Therefore, the normative An efficient economic system allocates resources so as approach is useful to the positive approach in that it to set the marginal social benefit of each good or defines relevant issues. service equal to its marginal social cost. Markets are organized for the purpose of allowing mutually gainful trades NORMATIVE EVALUATION OF RESOURCE USE: THE between buyers and sellers. A system of perfectly EFFICIENCY CRITERION competitive markets can result in efficient resource use in an economy which exists if Efficiency is a normative criterion for evaluating the effects of resource use on the well-being of individuals. 1) All productive resources are privately owned. The efficiency criterion is satisfied when resources are used over any given period of time in such a way as to 2) All transactions take place in markets, and in each make it impossible to increase the well-being of any one separate market many competing sellers offer a person without reducing the well-being of any other standardized product to many competing buyers. person (Italian economist Vilfredo Pareto (1848–1923) - Criterion of Pareto optimality). The criterion represents a 3) Economic power is dispersed in the sense that no precise definition of the concept of efficiency which buyers or sellers alone can influence prices. means producing a desired result with a minimum of 4) All relevant information is freely available to buyers effort, expense, or cost. Synonymous with this is the and sellers. minimization of wasted effort which produces no useful result. 5) Resources are mobile and may be freely employed in any enterprise. Given available amounts of productive resources and the existing state of technical knowledge in an economy, elimination of wasted effort will allow more production The market prices reflect the free interplay of supply and necessary to finance government programs can impair the demand. Neither businesses nor buyers can control prices; ability of markets to achieve efficiency. The marginal social they can only react to them. When deciding how much of a benefits of a government program must exceed its marginal good to purchase, buyers consider their own marginal social costs to result in net benefits. private benefit, which is the value placed on additional units of the good by individual consumers. When confronted with The basic problem that causes inefficiency in competitive market prices, consumers trade until they adjust the markets is that prices do not always fully reflect the marginal private benefit received from consuming a marginal social benefits or marginal social costs of good per period to what they must forgo to purchase output. This often occurs because of the nature of certain one more unit of the good per period. goods, which makes them difficult to package and trade easily in markets. The services of environmental resources What they forgo is measured by the price of one more are often used for disposal of wastes without adequate unit; that is, the amount of money they give up that consideration of the benefits these resources have in could have been spent on other items. If the value of the alternative uses. This happens because rights to the use of money they give up (the price) exceeds the marginal private environmental resources are in dispute. Because no one benefit of that last unit, they would be made worse off by owns these environmental resources, market exchange of trading those money for the good. Therefore, they maximize the ownership right to use these resources is unlikely. This their gains from trading by adjusting the amount of any good means that sellers using environmental resources to make they consume per month (or any other period of time) until goods available do not pay for the right to use those the marginal private benefit received is just equal to the resources. This leads to situations in which the marginal price. The marginal private benefit received by consumers private cost of output incurred falls short of the marginal purchasing the good is also equal to the marginal social social cost. Similarly, for services with collective or shared benefit of the good, provided that no one except the buyer benefits, it might be difficult to package the benefit flowing receives any satisfaction when the good is consumed. from output into units that can be sold to individuals. When packaging into salable units is difficult, so is pricing. The Producers maximize their gains from trading when they failure of markets to price and make available certain goods, maximize profits. When it is no longer possible to add gives rise to demands for government production and any gain by selling one more unit, profits are maximized. regulation. The firm will increase profits whenever the revenue obtained from selling an additional unit exceeds the cost Monopolistic Power of producing and selling that extra unit. The marginal private cost of output is the cost incurred by sellers to make Markets will fail to result in efficient levels of output when an additional unit of output available for sale. The extra monopolistic power is exercised. A firm exercises revenue obtained from selling one more unit is its price, monopolistic power when it influences the price of the assuming that the firm can sell as much as it likes at the product it sells by reducing output to a level at which price going market price. The firm will maximize profits when it exceeds marginal cost of production. A monopolist adjusts its output sold to the point at which price is equal to maximizes profits at a level of output at which marginal the marginal private cost of output. If marginal private cost revenue equals its marginal private cost (MR=MC). exceeds price, the gains from trade (profit) would decline. Government intervention in the market to increase output The marginal private cost of output incurred by sellers is the would be prescribed by normative economists seeking to marginal social cost, provided that opportunity cost of all attain efficiency. resources used in making the product available is included in How Taxes Can Cause Losses in Efficiency in Competitive the sellers’ total costs. Markets A perfectly competitive market, in which both buyers and sellers maximize their net gains from trade, will result in a When a product or a service is taxed, the amount that is level of output for which marginal private benefit equals traded is influenced by the tax paid per unit, as well as marginal private cost. If consumers are the only recipients of by the marginal social benefit and marginal social cost benefits when a good is sold, sellers bear all the cost of of the item. The tax distorts the decisions of market making that good available. The market equilibrium will participants. Taxes influence our decision to work by achieve the efficient output. If this condition is met in all reducing the net gain from working. When evaluating the markets and all goods are tradable in markets, the overall marginal cost of a new government program, we must add allocation of resources in the economy will satisfy the any loss in net benefits from distortions in market behavior to efficiency criterion. When the prices of all goods and the dollar amount of additional tax revenue required to services equal the marginal social benefits and marginal finance the program. Government spending programs can social costs of these items, the market system achieves provide net benefits to citizens in the aggregate only when the marginal social benefits of additional spending exceed an efficient outcome. both the tax revenue collected and the dollar value of the When Does Market Interaction Fail to Achieve Efficiency? loss in efficiency (the excess burden) in markets that occurs as a result of the distortions in choices caused by the tax. Markets operating under conditions of perfect competition produce efficient outcomes. The possibility that political How Government Subsidies Can Cause Losses in Efficiency interaction might allow further net benefits to be squeezed from available resources can be explored. However, Governments often subsidize private enterprises or political action will not always result in net benefits. operate their own enterprises at a loss, using taxpayer funds to make up the difference. Taxes can impair Government activity itself can cause inefficiency. Taxes market efficiency, and so can subsidies. Suppose the (education, fire protection, and vaccines for government guarantees farmers a certain price for their diseases). crops. When the market price falls below the “target” price guaranteed by the government, the government will pay eligible farmers a subsidy equal to the difference between the market price of the product and 3) Lack of a Market for a Good with a Marginal Social Benefit That Exceeds Its Marginal Social Cost. In the target price. many cases, useful goods and services cannot be provided efficiently through markets because it is impossible or difficult to sell the good by the unit. Contents: Benefits of such goods can be shared only. These goods are called “public” goods as opposed to  Market Failure: A Preview of the Basis for private goods which are consumed by individuals Government Activity and whose benefits are not shared with others who do not make the purchase. Public goods can  Equity versus Efficiency be enjoyed by additional consumers at no reduction in benefits to existing consumers.  Positive Analysis Trade-off between Equity and Increases in population occur daily, and the Efficiency additional population can be defended without any reduction in benefits to the existing population. Public goods’ benefits cannot be easily withheld MARKET FAILURE: A PREVIEW OF THE BASIS FOR from people who choose not to contribute to their GOVERNMENT ACTIVITY finance. Firms selling public goods will have great difficulty collecting revenue necessary to finance Markets cannot be relied to provide all goods in efficient costs to produce such goods. amounts. Market failure to make goods and services available in cases for which the marginal social benefits of the goods outweigh the marginal social costs of those goods or services often results in demands for In many cases, government provision of goods is justified government action. The following forms of market failure to because of a conviction that the marginal social benefit of achieve efficient outcomes are commonly used as a basis for the good exceeds the marginal social cost at quantities that recommending government intervention in markets or would result if the good were supplied through markets. For government provision of services: example, government provision of health insurance, deposit insurance, and flood insurance are common because many 1) Exercise of Monopoly Power in Markets. When persons believe that these are useful services that cannot be markets are dominated by only a single firm, the provided profitably in efficient amounts by profit-maximizing potential exists for the exercise of monopoly firms selling in competitive markets. Similarly, direct power. Firms exercising monopoly power can add payments or subsidized loans to students attending to their profits by adjusting prices to the point at institutions of higher education are often justified by arguing which marginal revenue equals their marginal that government should encourage education because the private costs without fear of new entrants into the marginal social benefits of its consumption exceed the market. To prevent monopoly control over price, marginal private benefits received by individual students. governments typically monitor markets to ensure that barriers to entry do not encourage the exercise of monopoly power. Governments also 4) Incomplete Information. Government must often regulate the pricing policies of monopoly intervene in markets because we have incomplete producers. information about the risks of purchasing certain products or working in certain occupations – testing new drugs and to prevent hazardous 2) Effects of Market Transactions on Third Parties products from being sold and to establish Other Than Buyers and Sellers. When market standards for safety in the workplace. transactions result in damaging or beneficial effects on third parties who do not participate in the decision, the result will be inefficiency. When 5) Economic Stabilization. Market imperfections give the effects are negative, people demand rise to excessive unemployment in response to government policies to reduce the damaging or decreases in aggregate demand. Governments beneficial effects of market transactions on third engage in monetary and fiscal policies to stabilize parties who do not participate in such decisions. the economy to correct market failures to ensure For example, exhaust fumes from cars, trucks, full employment. Governments also seek to avoid buses, heating systems, factories, and power excessive and erratic inflation that can erode plants decrease air quality and impair public purchasing power and can impair the functioning health. When the effects are beneficial, of financial markets. Although the stabilization government policies are often used to encourage activities of government do not absorb significant production of the item benefiting third parties amounts of economic resources, they do represent  an important complement to the efficient confronted with the inevitable conflict between the quests for functioning of markets. Modern public finance both efficiency and equity. concentrates on the microeconomic aspects of government activity and finance rather than the POSITIVE ANALYSIS TRADE-OFF BETWEEN EQUITY macroeconomic aspects. AND EFFICIENCY The positive approach attempts to explain why efficient outcomes are, or are not, achieved. It can also be used to EQUITY VERSUS EFFICIENCY predict how government intervention in private affairs affects the likelihood of achieving efficiency while avoiding any Efficiency is not the only criterion used to evaluate resource direct judgments on the desirability of efficiency as an allocation. Many citizens argue that outcomes should also be outcome. Rather than recommending changes that will result evaluated in terms of equity in terms of the perceived in efficient outcomes, the positive approach attempts to fairness of an outcome. The problem involved with predict whether changes in government policy or spending applying criteria of equity is that persons differ in their will be agreed upon through existing political institutions. The ideas about fairness. Economists usually confine their analysis is firmly based on models of maximization of analyses of questions of equity to determinations of the personal gains from exchange. impact of alternative policies on the distribution of well-being among citizens. Positive economic analysis of the outcomes Achievement of efficiency would allow the given amount of of market and political interaction is useful in providing resources in the economy to produce more net benefits, but information about the effects of policies on income the total shares of larger pie accruing to groups opposing the distribution. Analysts usually try to determine the effects of change would be less than what they would have with the government actions on both resource allocation and the smaller pie. Individuals are not concerned with net social distribution of well-being to provide useful information that benefit. Rather, they maximize their net personal benefits. citizens can use to judge the equity of alternative policies of The trick in devising efficient policies is to make their own notions of fairness. maximization of net personal benefits coincide with maximization of net social benefit. In evaluating public policy, The Trade-off between Equity and Efficiency in a System of it is important to understand both the efficiency and the Competitive Markets distributive consequences of alternatives. Improvements in efficiency are often opposed vigorously by special-interest A perfectly competitive market system can be given high groups that would suffer losses if the improvements were marks because it is capable of achieving efficiency. The enacted. These groups are concerned with protecting their efficient outcome in a market system is a point on the utility- income shares at the expense of reduced output and well- possibility curve. In a market system, each person’s money being in the economy as a whole. The actual policies and income will depend on the amount of productive resources institutions that emerge reflect the conflict between groups of owned and the returns obtained from selling productive individuals seeking to protect and enlarge their income services to others in markets. The distribution of income will shares and the benefits of efficient resource use that accrue determine the willingness and ability to pay for various goods to individuals comprising the entire community. and services that the economy can produce with available resources and technology. A further factor affecting the outcome is the effectiveness of economic institutions in allowing those who receive benefits Many critics of the market system argue that it cannot be from policy change to bargain with those who bear costs so given high marks on the basis of equity criteria. They as to reach a compromise agreement. One problem in using complain that many participants in the system cannot satisfy the efficiency criterion as a normative tool is that the actual their most basic needs because low incomes provide them number of allocative changes that will satisfy the criterion with little capacity to pay for market goods and services. might be few and quickly exhausted. Most debates Poverty in the midst of wealth is regarded as inequitable by concerning resource allocation involve benefits to some many people. The market system caters to those with the groups and losses to others. In such cases, no one can ability to pay, which depends on earnings. This, in turn, easily predict whether the change in resource allocation will depends on the marginal social benefit of resources that a be made, in as much as there will be both gainers and person owns. The poor lack resources. Often they are losers. The efficiency criterion can only recommend changes unskilled and undereducated, and, as a result, the quality of when there are gainers only (and no losers) or when the their labor service is low. In many cases, the poor are gainers can compensate the losers at transaction costs that unemployable or employable only at low wages. In addition, do not exceed the gains. Some normative theorists try to they usually own no land or capital, meaning that their non- overcome this problem by using compensation criteria, which labor income is also low. attempt to measure the value of the gains to gainers and compare these with the value of the losses to losers. If the Critics of the market system also argue that these poor value of gains outweighs the value of losses, normative people should receive transfers financed by taxes on more theorists argue that it is efficient to make the change, fortunate members of society. The incomes of the poor, and regardless of whether the losers are compensated for their therefore their level of annual well-being, would be kept from losses. Such a change, however, still will be opposed by the falling below minimum standards. This, however, creates a losers. Although some might argue that the change will dilemma. Often, taxes and subsidies used to alter the improve efficiency, its approval cannot be predicted because distribution of income distort incentives to produce that prevent achievement of efficiency. Policy makers are it involves losses in income to some individuals. Most public policy issues involve trade-offs between gains in good. Air quality improvement has the property of non- efficiency obtained at the expense of losses by certain exclusion. Goods that are non-rival in consumption need not groups. The positive approach can make a contribution by necessarily be subject to non-exclusion. The characteristics generating information on the gains, losses, and transaction of non-rival consumption and non-exclusion vary in degree costs associated with particular policy changes and on the from good to good. distribution of such benefits and costs among citizens. Without such information, it would be impossible for the Pure Public Goods and Pure Private Goods normative economist to make prescriptions for achieving efficiency in resource allocation and for attaining equity A pure public good is non-rival in consumption for an goals. Such information is indispensable to voters entire population of consumers, and its benefits have themselves when they are deciding how to vote on questions the characteristic of non-exclusion. A given quantity of a concerning the functions of government and the extent of its pure public good is consumed by all members of a community as soon as it is produced for, or by, any one powers and expenditures. member. In contrast, a pure private good is one that, after producers receive compensation for the full opportunity costs of production, provides benefits only to the person who PUBLIC GOODS acquires the good, and not to anyone else. A pure private good is rival in consumption, and its benefits are easily CHARACTERISTICS OF PUBLIC GOODS excluded from those who choose not to pay its market price. Market exchange for pure private goods results in Many of the goods and services actually provided by neither positive nor negative externalities. A pure public good governments would result in positive externalities were they on the other hand results in widely consumed external made available for sale to individual buyers in markets. An benefits to all people, even if made available only for one entire class of goods have benefits that must be shared by person. large groups of individuals. The production of these goods for sale in the marketplace would be accompanied by PROVISION OF PRIVATE GOODS AND PUBLIC GOODS: positive externalities because any such items purchased for MARKETS AND GOVERNMENT individual use would provide external benefits to a large number of third parties as well. Market provision of goods The supply of goods and services and the mechanisms of with benefits shared by people other than those who distributing them among individuals reflect collectively purchase them for their own use is unlikely to result in an agreed-upon institutional arrangements that have emerged efficiently large amount of output. Goods with benefits that in a community. It is difficult to make generalizations about cannot be withheld from those who do not pay and are the most appropriate means for making goods and services shared by large groups of consumers are public goods. available. Private goods that are individually consumed Public goods are usually made available politically through are sometimes supplied through markets by the ballot box as people vote to decide how much to supply government. On the other hand, many goods that are rather than through the marketplace, where those who care non-rival in consumption and which have characteristics to pay the price can buy as much as they like for their own of public goods, are privately produced and supplied exclusive use. Government provision of public goods implies through markets. It is possible to imagine, at the extreme, that goods are freely available to all rather than being sold pure private goods being supplied through government and in markets. The costs of making the good available are financed through taxation. Similarly, it is possible to usually financed by taxes. envision goods that have the characteristics of public goods being produced privately and sold through Public goods are non-rival in consumption, meaning markets when the costs of exclusion are not very high. that a given quantity of a public good can be enjoyed by Many intermediate cases exist in which external benefits or more than one consumer without decreasing the costs accrue only to some people and the transaction costs amounts enjoyed by rival consumers. Goods that are associated with trading goods with collectively consumed rival in consumption are called private goods. Except benefits are not prohibitive. In those cases, both private when externalities are present, prices can efficiently allocate supply and government supply are feasible, and it is often goods that are rival in consumption. The price serves the difficult to determine which supply method is appropriate. purpose of making any one person who desires a unit of the good consider the decrease in benefits to rivals who wish to Congestible Public Goods and Private Goods with consume that unit. Pricing a good that is non-rival in Externalities consumption serves no useful purpose. After all, an additional consumer of a non-rival good does not reduce the Government supply through political institutions and private benefit to others who wish to consume it. In other words, the supply through markets are alternative means of making any marginal cost of allowing additional people to consume a good available. These two alternatives can be evaluated given amount of a good with non-rival benefits is zero. It is according to the extent to which externalities are associated therefore inefficient to price goods that are non-rival in with either the production or consumption of the good and consumption. the extent to which it is possible to develop a means of selling rights to use the good or service. In most cases, it is also unfeasible to price units of a public good. This characteristic of public goods, called non- Congestible public goods are those for which crowding exclusion, implies that it is too costly to develop a or congestion reduces the benefits to existing means of excluding those who refuse to pay from consumers when more consumers are accommodated. enjoying the benefits of a given quantity of a public The marginal cost of accommodating an additional consumer is not zero after the point of congestion is reached. Price- partially or fully financed by taxes. Public parks are an excludable public goods are those with benefits that can be example, as are other forms of public recreation, civic priced. These goods can be priced, but their provision results centers, auditoriums, roads, bridges, and similar public in positive externalities. facilities. Pure public goods result in collectively consumed benefits that are not subject to crowding and are subject Goods and services have been divided into four categories: to high-cost exclusion. It is difficult to sell or use rights to 1) Pure private goods 2) Price-excludable public goods 3) the benefits of these goods, and markets are unlikely to Congestible public goods 4) Pure public goods. provide a convenient mechanism for distributing them. Conceivably, they could be produced privately through Pure private goods represents goods that approximate voluntary contributions, with the quantity and quality of the ideal of a pure private good that is individually service provided being contingent on the amount of revenue consumed and subject to low-cost exclusion from collected. Private charity is often provided and financed in benefits for those who do not pay for the right to receive this manner. However, goods resembling pure public goods such benefits. The production of these goods usually does are most likely to be distributed free of direct charge by not generate an externality, but some individuals believe that governments, with the quantity and quality of the service external benefits are associated with others who consume determined through political institutions and financed by these goods. Such private goods might be sold in markets taxes. Such is the case for national defense, environmental either by private firms or government. When sold in markets, protection, and other goods resembling pure public goods. their costs of production are financed by the revenue Semipublic goods exist in a continuum ranging from pure obtained from sales to individual buyers. Alternatively, they private goods to pure public goods. may be produced by government or purchased by government from private firms, distributed free of direct Education as a Public Good charge to eligible recipients, and financed by taxes. Such is the case for public welfare programs that give medical Education is a service that has some characteristics of a services, food, housing, and other services to low-income public good while at the same time having characteristics of citizens who meet certain eligibility tests. These services a private good. Education is commonly believed to result in also could be sold at subsidized prices, with losses made up widely ranging external benefits when it is provided at least from tax-financed subsidies. at some minimal level to all children in a society. However, at the same time, the exclusion principle can easily be applied Second, some goods can be individually consumed and are to educational services so that it can be withheld from those subject to exclusion, but their production or consumption is who do not pay for it. Education is a clear example of a likely to generate externalities. These are price-excludable partially public good. public goods which can be distributed through markets when produced either by private firms or government. The Education can be made available through the marketplace production or consumption of these goods can be subsidized like any private good. Education can also be supplied by to account for the positive externality associated with their governments and given out free of charge in equal amounts sale. The good would be financed by both the revenue from to all children in a society. It is clearly feasible to price sales and the taxes used to finance the subsidy like private educational services. And because the marginal cost of and public hospitals, mass transit facilities, and schooling. educating a student is certainly not zero, a zero price for the These goods also can be produced by government and service is not an efficient alternative. Nonetheless, it is distributed with no direct charge. However, the quantity and commonly agreed that education is such an important quality of the service would be determined collectively generator of positive externalities that it should be universally through political institutions, and costs would be financed subsidized by government tax revenues. through taxation like public schooling, public sanitation service, and government-supplied inoculations that are Governments intervene in the supply of education to make available at public health facilities. sure every citizen consumes at least a minimal amount of this service. What are the externalities associated with the Congestible public goods are non-rival in consumption production and consumption of education that result in such only up to a certain point. After the number of universal support of government supply and subsidization? consumers exceeds a certain amount, the goods Many believe that wide-ranging externalities exist when we become at least partially rival in consumption. An live in a society where we can be sure everyone has a increase in the use of the good by one consumer minimal level of education so that they can be productive decreases the benefits from a given amount of the good citizens. We want to be sure everyone can read, have that can be enjoyed by others. Exclusion from benefits of minimal computational skills so that they can manage their these goods is often possible through application of certain finances, and have adequate appreciation of public fees. Congestible public goods, in some cases, are also institutions and the duties of citizens to each other. This price-excludable public goods. These goods are often in the minimal level of education helps us all live in a reasonably form of services flowing from shared facilities that can be civil society and therefore has a component that can be distributed in markets either by government or by firms viewed as a public good that is equally consumed by all. through the sale of admissions, memberships, or other use- related fees; these might receive public subsidies. Privately Education has a “socializing” function. It provides supplied examples include clubs for sharing recreational or students with the ability to function effectively in a society by other facilities, amusement parks, theaters, and sporting following rules, obeying orders, and working together with events. Government-supplied goods of this type might be colleagues. It also provides students with such basic skills as punctuality, ability to follow directions, and other skills that community of three to hire a security guard for his own increase their productivity as workers. Universal education benefit without benefiting his neighbors. also screens students by helping them to identify their abilities and to choose appropriate occupations as adults. In EFFICIENT OUTPUT OF A PURE PUBLIC GOOD this way another public good aspect of education is its function of providing a better match of workers to jobs, Efficiency requires that all economic activities be thereby increasing productivity levels for a nation. Many undertaken up to the point that their marginal social benefit is equated with their marginal social cost. This believe that some citizens would purchase less than the efficient amount of education for their children if it were principle holds for pure public goods as well. Suppose a provided in a competitive market. If this were the case, many person were to attempt to produce or purchase a pure public brilliant minds could be deprived of sufficient education, and good for her own use. By making a unit of the public good we would all be deprived of their possible future contributions available in the community, this person will generate benefits to society. Further, some parents might not value education not only for herself but also for every other member of the as much as others, and this could deprive their children of an community in which she resides. The marginal social benefit adequate education. Whether or not under consumption of of this good will be more than the extra benefit to its education would actually result, it is clear that this idea is purchaser. Additional benefits will accrue to each and every other person who will simultaneously enjoy each unit made behind the principle of free and compulsory public education. available. Summing up these benefits to all people in the Public education helps integrate all children into society. community gives the marginal social benefit for each extra Education is especially useful for helping immigrant groups unit of output produced. The marginal social benefit of any to understand the basics of an adopted culture and political given amount of a pure public good is the sum of the system and to learn a new language. However, the fact individual marginal benefits received by all consumers. remains that education has characteristics of a private good. No government can guarantee that all children in a society The efficient quantity per time period of a pure public receive an equal amount of education. Wide disparities exist good corresponds to the point at which output is in the quantity and quality of education provided among increased so that the sum of the marginal benefits of school districts in the United States. Production of a given consumers equals the marginal social cost of the good. output of education might take varying amounts of inputs Market sale of a pure public good for individual depending on the students being taught. In areas where purchase would generate wide-ranging positive externalities, because a purchaser of the good would schools have a disproportionate number of disadvantaged students, higher expenditures per pupil are necessary to consider only his marginal benefit in deciding how much achieve the same level of output as those areas where to buy. The marginal external benefit would be the sum of the marginal benefits to all other consumers. When individual students have better home environments. 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 Most studies show that the level of support parents can give private good has no external benefits of additional students at home increases with household incomes, and production. In evaluating the benefit of extra production, it is home support is an important factor in learning for children. necessary to count only the benefit received by the individual Even if it were possible to equalize the quality and quantity of who actually purchases and consumes the extra output. education provided in public schools, there is no way to prevent parents who want more than this 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 educational services, their children are more likely to obtain supplementary instruction or attend private schools where the quality and A Cooperative Method of Efficiently Supplying Pure quantity of instruction could be higher. Public Goods: Voluntary Contributions and Cost Sharing THE DEMAND FOR A PURE PUBLIC GOOD To achieve the efficient output of three guards per week, members of the community will have to cooperate to share The demand for a pure public good must be interpreted the costs per unit of security protection. By sharing the costs, differently from the demand for a pure private good. The members can pool their resources to enjoy public goods that market demand curve for a pure private good gives the they could not afford if they had to purchase them on their sum of the quantities demanded by all consumers at own in a market. In small communities, pure public goods each possible price per unit of the good which are the conceivably could be made available in the efficient amounts maximum amounts that people would pay per unit of the and financed by voluntary contributions. Understanding why pure public good as a function of the amount of the this is unlikely to occur in larger communities is the key to good actually available. For example, suppose the three understanding the reasons that citizens resort to consumers live together in a small community and desire to governments to provide many public goods. It also helps provide themselves with security protection. The quantity of provide insights into the reasons governments finance most security protection can be measured by the number of of their activities with compulsory taxes instead of voluntary security guards hired per week to patrol their community. contributions. Voluntary contributions in small groups can Security guards represent a pure public good for these three achieve the efficient output of a pure public good. consumers. No way exists for any one person in this THE FREE-RIDER PROBLEM A system of voluntary contributions for reaching agreement three-member group example, the individuals know that if on the financing and quantity of a pure public good could more than one of them is a free rider, no security protection work well when a community comprises only a few is possible. This provides a strong incentive for them to individuals. In fact, a great deal of similarity exists between cooperate. In large groups, the incentive for any one person voluntary agreements on the supply of pure public goods to be a free rider is greater because each person might and the Coasian small-number externalities. When the reason that the vast multitude of other beneficiaries will number of people involved in reaching the voluntary contribute enough to finance the good. Therefore, the agreement is small, the transactions costs are likely to be probability of the free-rider problem reducing the actual low. In small groups, individuals know each other well and contributions to zero is all the greater in a community with a have a good idea of each other’s benefits from the large number of members. availability of a public good. People in the community are well aware of the common benefit of the shared good. Any Compulsory Finance attempts by individuals to conceal their actual marginal benefits from the good can be easily detected. However, as In view of the free-rider problem, communities commonly the number of people involved in the decision increases, and require compulsory payments to help finance the costs information about neighbors’ tastes and economic of public goods made available to large groups. This circumstances becomes scarcer, the likelihood that leads to government supply of public goods and individuals will inaccurately reveal their preferences financing of the cost by taxation. Of course, not all goods supplied by governments are pure public goods. Some becomes higher. This is because no one person in a large group is likely to have accurate information on the actual government services can be priced and could be sold in marginal benefits of others. If people know that they are markets to individuals. However, it is common for required to pay a share of the unit cost of the public good government services that involve some degree of collective dependent on their marginal benefits, they have an incentive consumption to be financed through a compulsory tax to understate their true marginal benefits. To do this is in scheme to avoid the possibility of free riding. An important their interest because it conserves their incomes. At the lesson remains from the model of voluntary cost sharing of same time, they do not have to forgo all the benefits of public public goods. Under compulsory taxation, a voter is told, not goods because these benefits are nonexclusive. A person asked, to contribute. In democratic nations, because political might, in fact, choose to contribute nothing toward the outcomes are determined by voting, the willingness of any financing of government activity in the hope of enjoying voter to vote in favor of a proposal depends on his or her tax benefits made possible by other people’s contributions. share per unit of the good. Clearly, if all citizens behave in this way, no source of finance for the budget exists, and therefore no benefits. But the individual who behaves in this manner assumes others will EXTERNALITIES AND GOVERNMENT POLICY continue to contribute. EXTERNALITIES A free rider is a person who seeks to enjoy the benefits of a public good without contributing anything to the cost of Externalities are costs or benefits of market transactions not financing the amount made available. reflected in prices. When an externality prevails, a third party (other than the buyers or sellers of an item) is affected by its The free-rider problem stems from the incentive people production or consumption. The benefits or costs of the third have to enjoy the external benefits financed by others, party, either a household or a business, are not considered with no cost to themselves. Free riding can be a by either buyers or sellers whose production or use results in reasonable strategy for any one individual, provided that no an externality. penalty exists and that only a few individuals choose the strategy. If all members of the community choose the free- The third parties are people who bear the costs of polluted rider strategy, no vehicle is available to hitch a ride on air and water. These third parties often organize politically to because no production of the public good would be lobby legislators and public officials to protect their rights to a forthcoming. Everyone would be worse off under this clean environment. Environmentalists have emerged as an strategy because the benefits of the public good will be effective, potent political force to induce governments to forgone completely. Under a system of voluntary pass laws that limit the rights of producers and consumers to contributions when large numbers of people are involved, emit wastes that pollute the air, water, and land. Market attempts by individuals to play the free-rider strategy almost prices do not accurately reflect either all the marginal social guarantee that the equilibrium amount of pure public good benefit or all the marginal social cost of traded items when will be less than the efficient amount. Therefore, voluntary an externality is involved. cost sharing of pure public goods will result in insufficient amounts of the public good being produced relative to the Negative externalities (external costs) are costs to third efficient amounts. Individual members of the community can parties other than the buyers or the sellers of an item not be made better off by engaging in free-rider strategies. reflected in the market price. An example of a negative externality is the damage done by industrial pollution to The free-rider problem tends to become more acute as the people and their property. The harmful effects of pollution are size of the group benefiting from a pure public good impairments to good health and reductions in the value of becomes larger. This is because each individual member of business and personal property and resources. Another a small group reasons that if he or she withholds his or her example of a negative externality is the dissatisfaction contribution, the result could be a significant reduction in the caused by the noise of low-flying aircraft as experienced by quantity of the good that is supplied in equilibrium. In the residents who are located near an airport. Those bearing pollution damages are third parties to market exchanges The marginal external cost is the extra cost to third parties between the buyers and the sellers of goods or services. resulting from production of another unit of a good or service. Their interests are not considered by the buyers and sellers MEC is part of the marginal social cost of making a good of goods and services when an externality is present. available. However, it is not reflected in the price of the good. In reality, the marginal external cost could increase with Positive externalities are benefits to third parties other than output either because emissions per ton increase as more the buyers or the sellers of a good or service not reflected in output is produced or because the damages done by the prices. Buyers and sellers of goods that, when sold, result in fixed amount of emissions per ton of output are greater when positive externalities, do not consider the fact that each unit more is emitted per year. When the marginal external cost of produced provides benefits to others. For example, a production increases with output, the pollution damages are positive externality is likely to exist for fire prevention a more serious social problem at higher levels of output than because the purchase of smoke alarms and fireproofing at lower levels of output. The negative externality stems from materials benefits those other than the buyers and sellers by the fact that dumping wastes decreases the usefulness to reducing the risk of the spread of fire. Buyers and sellers of other users. these goods do not consider the fact that such protection decreases the probability of damage to the property of third parties. Fewer resources are devoted to fire prevention than would be the case if it were possible to charge third parties for the external benefits that they receive. The marginal cost that producers base their decisions on is Effects of market exchanges on third parties are not the marginal private cost (MPC) of production. To obtain the externalities when those effects are included in prices. For marginal social cost, the marginal external cost of output, example, if a person’s hobby is photography, increases in MEC, must be added to the marginal private costs, MPC. the demand for photographic equipment by others could When a negative externality exists, the marginal private cost make that person worse off by increasing the price of the of a good falls short of its marginal social cost of output. equipment. These higher prices, however, merely reflect the Efficiency requires that the full marginal social cost of a good fact that such goods have become scarcer relative to the be considered in the productive decision. When a negative demands placed on them. The higher price serves to transfer externality exists, too much output is produced and sold in a income from buyers to sellers and to increase incentive to competitive market relative to the efficient amount. produce these goods, while existing production is rationed through higher prices. Some economists refer to these as Positive Externalities pecuniary externalities; that is, the effects of increases (or When a positive externality is present, prices do not fully decreases) in the price of a good on existing consumers as a equal the marginal social benefit of a good or service. For result of changes in the demand or supply of a good. example, suppose inoculation against a disease results in a Pecuniary externalities merely result in changes in real positive externality. Those who are vaccinated benefit income of buyers or sellers. Real externalities are unpriced themselves by reducing the probability that they will contract costs or benefits. They are the effects of market exchanges a contagious disease. But they also provide benefits to those external to prices who do not receive inoculations by reducing the number of persons who will become hosts for the disease. This, in turn, Externalities and Efficiency reduces the probability of outbreaks of the disease for the Why do externalities pose problems for resource allocation in entire population, including those who are not vaccinated. a market system? Unregulated competitive markets result in Eventually, if the disease is eradicated in this way, the entire prices that equal the marginal costs and marginal benefits world population will benefit. The external benefit of that sellers incur and buyers enjoy. When an externality inoculations is the reduction in the probability that those exists, the marginal costs or marginal benefits that market other than the persons purchasing vaccinations will contract participants base their decisions on diverge from the actual the disease. The marginal benefit that consumers base their marginal social costs or benefits. With a negative externality, decisions on is the marginal private benefit (MPB). Less than firms producing a product neither pay for nor consider the the efficient output results from market interaction because damage the production or consumption of that product can the marginal social benefit at the market equilibrium exceeds do to the environment. Similarly, with a positive externality, the marginal social cost. No divergence exists between buyers and sellers of a product in the marketplace do not marginal social cost and marginal social benefit. For positive consider the fact that their production or consumption of the externalities such as these, with a marginal value that item benefits third parties. We can now apply the framework declines with output, competitive markets fail to perform developed to understand why externalities prevent efficiently only at low levels of output. competitive markets from achieving efficient outcomes. Once this is understood, we can look at alternative government INTERNALIZATION OF EXTERNALITIES policies to correct resource allocation problems that result Internalization of an externality occurs when the marginal from externalities. private benefit or cost of goods and services are adjusted so that the users consider the actual marginal social benefit or Negative Externalities cost of their decisions. In the case of a negative externality, When a negative externality exists, the price of a good or the marginal external cost is added to marginal private cost service does not reflect the full marginal social cost of for internalization. For a positive externality, the marginal resources allocated to its production. Neither the buyers nor external benefit is added to marginal private benefit to the sellers of the good consider these costs to third parties. internalize the externality. Internalizing an externality results in changes in prices to reflect full marginal social cost or 2) Recreational and commercial users of the stream, benefit of a good. Internalization of externalities requires as well as taxpayers in general, will vote in favor of identification of the individuals involved and measurement of the corrective tax to the extent to which they have the monetary value of the marginal external benefit or cost. few interests in paper production or consumption. Economic policy toward externalities is sometimes To internalize the externality through the use of a controversial because of strong differences of opinion corrective tax will result in some groups receiving concerning the actual value of the external cost or external benefits at the expense of other groups bearing benefit. For example, because strong disagreement exists the costs. In other words, the internalization of the among physical and biological scientists as to the costs of externality also will result in income redistributive pollution, the necessary information required for internalizing effects, which, in turn, will influence the willingness the externality can be elusive. of the individuals involved to support the scheme. Corrective Taxes: A Method of Internalizing Negative 3) The gain in efficiency resulting from the corrective Externalities tax measures the increase in net social benefits when annual paper output is reduced to the point A corrective tax is designed to adjust the marginal private at which its marginal social benefit equals its cost of a good or service in such a way as to internalize the marginal social cost. externality. The tax must equal the marginal external cost per unit of output to achieve this objective. In effect, a corrective tax is exactly like a charge for emitting wastes. It is designed to internalize a negative externality by making sellers of the How a Corrective Tax Could Be Used to Reduce Global product pay a fee equal to the marginal external costs per Warming unit of output sold. The actual amount of that reduction will depend on the availability and cost of alternative disposal A corrective tax on the emission of carbon wastes is one methods relative to the corrective tax and on the impact of possible way to reduce the economic costs associated with the tax on the profitability of producing paper. The tax is global warming. Global warming results from the designed to force the producer to compare the marginal “greenhouse effect” of carbon dioxide and other gases that benefit (in terms of profits) of dumping wastes with the trap energy in the atmosphere. Carbon dioxide is a waste marginal external cost of emitting untreated wastes. It does from the burning of fossil fuels, such as coal, oil, and gasoline. Some scientific forecasts suggest that the amount so by adding the marginal external cost to producers’ marginal private cost. The tax revenue collected can be used of carbon dioxide in the atmosphere could double in the for a variety of purposes. This payment would compensate future, causing average temperatures to increase by as them for the loss of their free right to dump. Finally, the much as 9 degrees. The resulting global warming could then revenue collected could go toward a reduction in other taxes have high costs including reduced agricultural productivity, increased flooding from rising sea levels, and other damage or an increment in government services. to the natural environment. The corrective tax on carbon In summary, the corrective tax causes the following results: would raise the prices of gasoline, heating oil, and natural gas. The tax on carbon could double current pollution control 1) An increase in the price of paper and a reduction costs. To decide whether these additional costs are in the quantity demanded, to the efficient level, worthwhile requires a comparison of the marginal benefit of where the marginal social cost equals the marginal preventing global warming. Unfortunately, scientists social benefit of paper. themselves disagree on the possible effects of global warming, making calculation of such benefits difficult. 2) A consequent transfer of income away from paper producers and consumers in favor of individuals Internalizing Negative Externalities Associated with Goods who use the recreational services of streams and Sold in Imperfectly Competitive Markets of others who might have their taxes reduced or enjoy the benefit of increased government Such economic problems as externalities are typically looked services if the revenue collected is used for those at one at a time. In many cases, however, two or more purposes. factors contributing to losses in efficiency might exist in a single market. Suppose that a negative externality is 3) A reduction in, but not the elimination of, use of the associated with output sold by a monopoly. Also assume that stream for disposal purposes and a consequent the transactions costs (through political or other action) reduction in damage to alternative users of the involved in attempting to break it up are too high to make this stream. a feasible alternative. In this case, two distortions prevent the attainment of the efficient output. The firm’s monopolistic power results in less than the efficient output. On the other hand, because the monopoly causes negative externalities, In view of these results, the following predictions can be other things being equal, it produces more than the efficient made concerning political support for enactment of such a output. corrective tax: A “first best” solution would be to break up the monopoly, 1) Paper producers, employees, and consumers will thereby increasing output as competition among firms in the likely vote against it to the extent to which they are industry lowers price to a level that equals marginal social not involved in alternative uses of the stream and cost. The output of the competitive industry then could be will not be compensated for their losses. taxed to internalize the negative externality. This would increase price in the industry and decrease output. However, PROPERTY RIGHTS TO RESOURCE USE AND an alternative way exists to achieve the same efficient INTERNALIZATION OF EXTERNALITIES: THE COASE outcome. The monopoly initially is producing an annual THEOREM output level lower than the one corresponding to the equality between price and marginal social cost. This is equivalent to Externalities arise because the property rights of some saying that it is behaving as a perfectly competitive industry resource users are not considered in the marketplace by for which marginal cost has been increased to account, say, buyers or sellers of products. The willingness of people to for a negative externality. In effect, the monopolistic distortion engage in market transactions involving property or goods can offset part or all of the distortion resulting from the and services depends on both the gains expected from the negative externality. In actuality, the efficient output could be transactions and the costs involved in acquiring those gains. greater or less than the monopolist’s output. The Transactions costs include the time, effort, and cash outlays monopolist’s output is the efficient one when the externality involved in locating someone to trade with, negotiating terms is present. The monopolist’s power thereby allows net gains of trade, drawing contracts, and assuming risks associated in well-being. This would not be possible in a competitive with the contracts. Transactions costs depend, in part, on market. These gains offset the social losses from property rights to use resources. monopolistic power. Government has the power to change property rights. By A “second best” alternative to achieve efficiency is to allow doing so, transactions costs will be affected, as will the the monopoly to continue operating. Efficiency could be potential net gains realizable through market exchanges. If a attainable without even taxing the monopolist’s output if the government lowers transactions costs, efficiency will be output reduction due to monopolistic power exactly offsets improved in cases for which new gains from trading outweigh the external cost. In general, a corrective tax on the the costs involved in establishing or modifying preexisting monopolist’s output must be less than the corrective tax that property rights. Governments can and have modified the would be necessary to achieve efficiency if the good were right of business firms to emit wastes in the air and water produced by a competitive industry. This illustrates an and can lower transactions costs involved in trading existing application of the general theory of second best. Essentially, rights to dispose of wastes in the environment. Provided that the theory states that when two opposing factors contribute transactions costs of the exchange do not outweigh the net to efficiency losses, they can offset one another’s distortions. benefits possible to the parties, exchange of these property If it is costly to eliminate a market distortion associated with rights will help achieve efficiency. By establishing property some given economic activity, then, to achieve efficiency, an rights and seeking to lower transactions costs associated offsetting distortion in another economic activity departing with their exchange, governmental authority can increase net from the standard efficiency conditions in that activity is benefits to citizens. required. In evaluating resource allocations, the economist The Coase theorem states that governments, by merely has to treat each problem on an improvised basis to establishing the rights to use resources, can internalize determine if there are any “second best” problems present. externalities when transactions costs of bargaining are zero. Corrective Subsidies: A Means of Internalizing Positive Once these property rights to resource use are established, Externalities the Coase theorem holds that free exchange of established rights for cash payments among the affected parties will A corrective subsidy is similar in concept to a corrective tax. achieve efficiency. This result holds irrespective of which of A corrective subsidy is a payment made by government to the involved parties is granted the right. For example, either buyers or sellers of a good so that the price paid by suppose only two competing uses exist for a stream: a consumers is reduced. The payment must equal the convenient place to dump wastes from paper production and marginal external benefit of the good or service. The subsidy a site for recreation. Suppose the transactions costs of is paid from tax revenues. For example, many municipal trading established rights to use the stream between the governments make special pickups of trash and such large paper factory and the recreational users of the stream are waste items as discarded furniture at prices well below zero. Under these circumstances, the Coase theorem marginal cost. The difference between the actual price and maintains that it makes no difference whether the factory is the marginal cost of the pickup can be regarded as a granted the right to pollute the stream or the recreational corrective subsidy designed to avoid accumulation of trash users are given the right to a pollution-free stream. In either and unauthorized dumping. Some city governments also case, an efficient mix of industrial and recreational uses of subsidize property owners who plant trees by the curbs of the stream will emerge from private bargaining between the their property. They might, for example, pay half the price of factory and the recreational users. Corrective taxes or any those trees. This is designed to internalize the positive other charges are not needed, because competition for use externality associated with property beautification. Many of the stream by the interested parties will internalize the citizens believe that positive externalities are associated with externality. If the factory is granted the right, it will be in its college enrollments. Some states provide subsidies to interest to reduce pollution if the recreational users will offer students attending both public and private colleges. a payment that more than offsets the reduction in profits Governments often provide services that result in positive resulting from reduced polluting. If, instead, the recreational externalities free of charge and establish minimum levels of users have the right to a pollution-free stream, they would consumption. However, not all subsidies are designed to give up part of this right if the factory can offer them a internalize positive externalities. Many subsidies are based payment in excess of the losses they incur from increased on other goals, such as alleviating poverty. pollution. By creating the right, the government gives the user who receives it a valuable asset that can be exchanged for a cash payment from the other user. The exchange of those rights will lead to efficient resource use, provided that uses, strikes a balance between the net social value of both no third parties are affected by the exchange of the uses. government-created rights. The transactions costs of bargaining to exchange rights include the costs of locating a trading partner and agreeing PUBLIC CHOICE AND THE POLITICAL PROCESS on the value of the traded right. In general, these THE SUPPLY OF PUBLIC GOODS THROUGH POLITICAL transactions costs tend to be close to zero when the parties involved in trading the right are few in number. Under such INSTITUTIONS: THE CONCEPT OF POLITICAL circumstances, those who are granted a right are likely to EQUILIBRIUM know who (if anyone) is willing to purchase it, and a price A public choice is one made through political interaction of can easily be agreed upon to internalize any externality. many people according to established rules. Political Those who purchase the rights of others to pollute know that institutions rarely require unanimous agreement on both the no other polluters will continue to cause damages after the quantity of the public good to produce and the cost-sharing deal is completed. The kinds of externalities for which the scheme. Coase theorem is relevant are called small-number externalities. In dealing with externalities of this type, or any In fact, a variety of public choice rules are used to make externality for that matter, it is useful to divide the parties decisions in communities, the most familiar of which is involved into two groups: emitters and receptors. The majority rule. distinction is, however, somewhat arbitrary because the emitter could as well be designated the receptor and the The model of voluntary cooperation for supplying public receptor could be considered the emitter. The essential goods is useful in gaining insights into the factors that social problem that exists for any externality is the disputed influence the actual political choices. use of a productive resource. Under government supply of goods and services, taxes Significance of the Coase Theorem rather than voluntary contributions are usually used to finance the goods and services provided. The remarkable conclusion of the Coase theorem is that the efficient mix of output will result simply as a consequence of Citizens who vote against an outcome that is enacted must the establishment of exchangeable property rights. It makes abide by the results. no difference which party is assigned the right to use a resource. Provided the transactions costs of exchanging the This differs from the voluntary cost-sharing model for right are zero, the efficient mix of outputs among competing supplying public goods in which individual citizens can veto uses of the resource (in this case, land) will emerge. When proposed outcomes if they are dissatisfied with their share of transactions costs of exchanging the right to resource use the costs. are low and the number of parties involved is few, a government need do no more than assign property rights. Political Equilibrium Bargaining among the interested parties will do the rest to A political equilibrium is an agreement on the level of achieve efficiency. However, governments assigning property production of one or more public goods, given the specified rights provide a valuable resource to those who get the rule for making the collective choice and the distribution of rights. Although it makes no difference for resource tax shares among individuals. allocation who gets the rights, it makes a big difference to the parties involved in terms of their incomes! Clearly, a Tax shares, sometimes called tax prices, are preannounced corporation is better off if it is granted the right to pollute. levies assigned to citizens and are equal to a portion of the Under those circumstances, those who want cleaner air will unit cost of a good proposed to be provided by government. have lower incomes because they will have to pay to get the To a voter, these tax shares represent price per unit of a corporation to reduce pollution. On the other hand, the government-supplied good. corporation would be worse off if environmentalists and citizens at large were granted the right to pollution-free air. The sum of the tax shares must equal the average cost of Under those circumstances, the corporation would have to the public good to avoid budget surpluses or deficits. pay for the right to pollute and its annual income would be lower. The users who are initially granted the right are better The cost of producing a public good influences the amount of off, because then they own a valuable property right that can taxes that citizens must pay to finance the production of either be used or exchanged. Therefore, the assignment of each unit of the good. Given the distribution of tax shares per the property right by the government affects the distribution unit of a public good among individuals, an increase in the of income between the two parties using the resource. The average cost of producing the public good will increase the Coase theorem points out that negative externalities are individual’s tax bill per unit of the public good. Unless such really disputes concerning the rights to use certain increases in cost are accompanied by increases in benefits, resources. The parties involved have conflicting claims on the increased taxes likely will serve to diminish support for the use of certain resources for their own benefit. But, the increases in the output of the public good. In reality, use of the disputed resource for one purpose diminishes its information on costs of producing the good is difficult to usefulness for the other purpose. Externality is a reciprocal obtain. Debates preceding an election may influence the relationship between the parties involved, with no need to willingness of voters to support various levels of output of the label good guys or bad guys. The efficient solution, involving public good. Political campaigns provide information on both a trade-off between the social value of competing resource the costs and the benefits of the alternative programs being offered to voters for their consideration. Control over information concerning the costs and benefits of public approved. One such benefit is the pleasure received from goods is an important factor influencing collective choices exercising the duties of being a citizen. and their efficiency. The actual outcome depends, in part, on the particular public choice rule used to make the decision. One of the costs involved in voting is the time and effort it Proposals that cannot gain approval under unanimous takes to go to the polls. Other costs include those of consent might very well be approved under majority rule. In gathering the information necessary to make a choice. This general, the smaller the proportion of the community involves reading newspapers and going to meetings to required to approve any given issue, the greater the understand the issues and positions of the candidates. This probability the issue will be approved. The analysis can be a time-consuming process. Many citizens quite concentrates on choices made through simple majority rule, rationally believe that their votes will not make any difference under which a proposal is approved if it receives more than in the outcome of an election. Indeed, any given citizen’s half the votes cast in an election. choosing not to bother to vote very likely does not affect the outcome of any given election. Voters reason that the Elections and Voting probability of their votes influencing the election will be close to zero when the number of voters is large. Because the Public choices are made formally through elections in which costs of voting are positive while the expected benefits, in each individual is usually allowed one vote. The economic terms of influencing the outcome, are close to zero for an analysis of the political process assumes that people individual voter, it is rational not to vote. In effect, nonvoters evaluate the desirability of goods supplied by government in try to become free riders on the time and effort put in by the same way they consider market goods and services. those who do vote. If all voters were to reason this way, a democratic nation would not be able to function as such They are presumed to vote in favor of a proposal only if they because no one would vote! In fact, some democratic will be made better off by its passage. nations make voting a legal requirement for citizens in order to avoid free riding by nonvoters. A rational person’s most-preferred political outcome is the quantity of the government-supplied good corresponding to However, even in nations where voting is not legally the point at which the person’s tax share is exactly equal to required, voters turn out to the polls in surprisingly large the marginal benefit of the good. numbers. This indicates that other forces, such as the pleasure of exercising the duties of being a citizen or social This level of output of the good provides the maximum pressures, motivate citizens to vote. In general, the closer possible satisfaction to that person. Increasing the quantity the alternatives are, the less the benefit obtained from of the government-supplied good a fraction of a unit over this choosing one alternative over another. In these cases, the amount would make the person worse off. net benefit of voting is likely to be very low, even if the A voter will vote in favor of any quantity of a public good as probability of influencing the result of the election is long as the marginal benefit of that quantity is not less than significantly greater than zero. Therefore, some might argue the marginal tax he or she must pay to finance that amount. that voters are less likely to vote when they see little or no differences between the alternatives considered in the For a given public choice rule, the outcome of an election will election. depend, in part, on the distribution of tax shares among individuals. Proposals to increase the output of public goods In other cases, a given voter’s most-preferred position might that cannot gain approval under a certain distribution of tax be so far from the alternatives being offered that the shares might be approved under a different distribution of tax probability of receiving any net benefits as a result of casting shares, because a change in tax shares will change the a vote is very low. The voter will choose to stay away from most-preferred outcomes of voters. the polls under these circumstances. The decision to vote therefore depends on the cost and the expected benefit of Similarly, the political equilibrium will depend on the that action, as is the case for any economic activity. Some distribution of benefits among individuals. voters who do vote do so on the basis of scanty information, and their votes might be different if they knew more about A change in the distribution of benefits for a given public the issues. When an individual casts a vote based on poor project alters its chances of approval, because it changes information, it is doubtful that the social benefit obtained is the most-preferred outcomes of voters. The distribution of any greater than if the voter had stayed away from the polls. benefits of such programs as military installations is often a crucial factor influencing congressional approval of increases To vote intelligently, voters must have information on the or decreases in spending. Politicians, by manipulating the marginal costs, including extr