Assignment: Public Goods

Detailed Analysis of Microeconomic

Provision

Submitted for Evaluation

Topic: The Economic Theory of Public Goods

Submission Date: March 29, 2026

Introduction

The study of externalities reveals that simple inefficiencies can often be

eliminated through the clear specification of property rights. In Chapter 34, we
explored scenarios where consumption externalities between two individuals
could be resolved via negotiation and trade of the right to generate an
externality. Market signals provided the necessary information to achieve an
efficient allocation, particularly in cases of production externalities or common
property management. Assignment of property rights often serves as the
panacea for these bilateral or limited-party issues.

However, the complexity of externalities scales dramatically when multiple

economic agents are involved. When a negative externality, such as smoke,
affects a group rather than an individual, coordination problems emerge that
transcend bilateral bargaining. Consider a scenario with three roommates: one
who smokes and two who do not. The smoke serves as a simultaneous negative
externality for both nonsmoking roommates. Even with well-defined rights to
clean air, the nonsmokers must find a way to agree among themselves on the
permissible level of smoke and the appropriate level of compensation for their
shared environment.
Defining the Public Good

The smoke externality with three people is a prototypical example of a

public good. A public good is defined as a commodity or service that must be
provided in exactly the same amount to all affected consumers. In the
roommate example, the amount of smoke generated in the shared living area is
the same for all consumers; while each individual may value that condition
differently—some finding it more repulsive or harmful than others—they all
face the same physical environment.

In a national contexts, millions of inhabitants may be involved in such

externalities. Classic examples of public goods provided by governments
include streets, sidewalks, and national defense. Every citizen has access to the
same national defense infrastructure. Although some may desire a higher level
of expenditure and others a lower level, the final quantity and quality provided
are uniform across the entire population. Public goods represent a troublesome
category of externalities because traditional decentralized market solutions do
not allocate them efficiently. Individuals cannot choose different personal
amounts of national defense; instead, a collective social decision must be made
to determine a single, common quantity.
Criteria for Providing a Public Good

To determine the ideal amount of a public good, let us consider a simplified

case of two roommates (1 and 2) deciding whether to purchase a television.
Given the television will be located in their common living room, it will
necessarily be a public good. The question facing them is whether the
acquisition is worth the cost. Let w1 and w2 denote their initial wealth
endowments, while g1 and g2 represent their individual contributions to the
cost of the TV. Let x1 and x2 represent the money each person has left for
private consumption. The budget constraints for the two individuals are given
by:

x1 + g1 = w1

x2 + g2 = w2

The cost of the TV is defined as c dollars. For the roommates to purchase

the television, the sum of their individual contributions must satisfy the
technology requirement of the good:

g1 + g2 ≥ c
 The utility derived by each person depends on their private consumption x
and the presence of the public good G (where G=1 if the TV is present and
G=0 if it is not). Because G is a public good, it bears no individual subscript—
it is shared by both roommates without being "used up" by either.
Reservation Prices and Valuation

Individual valuations for the services of the public good differ. We measure
these valuations using the reservation price concept. The reservation price, r1,
for Person 1 is the maximum amount they would be willing to pay to have the
TV present. It is the price at which Person 1 is indifferent between paying r1
for the TV and having no TV at all with their initial wealth intact. This is
expressed through the utility equation:

u1(w1 - r1, 1) = u1(w1, 0)

Similarly, a reservation price r2 can be defined for Person 2. Note that

reservation prices are generally sensitive to wealth; an individual's willingness
to pay depends on their ability to pay. Using these concepts, we can evaluate
Pareto efficiency. An allocation is Pareto efficient if no change can make both
roommates better off. Conversely, it is Pareto inefficient if a Pareto
improvement is possible—that is, if there is a way to make both individuals
better off simultaneously.
Pareto Efficiency Conditions

In the context of the television purchase, provision is a Pareto improvement

if both parties would be better off contributing their share than having no TV.
This requires:

u1(w1, 0) < u1(x1, 1) and u2(w2, 0) < u2(x2, 1)

By substituting the reservation price identity, we can observe that Person 1

is better off if their cost share g1 is less than their reservation price r1. The
same holds for Person 2. Thus, the condition for a Pareto improvement is:

r1 > g1 and r2 > g2

Crucially, if each willingness to pay exceeds the respective individual cost

share, the total sum of willingnesses to pay must exceed the total cost of the
TV:

r1 + r2 > g1 + g2 = c

This condition (r1 + r2 > c) is a sufficient condition for provision or Pareto

improvement. If satisfied, there will always exist a payment plan (g1, g2) such
that both people are better off with the public good. Whether provision is
efficient, however, often depends on the initial distribution of wealth (w1, w2),
as individual reservation prices are functions of that distribution.
Private Provision of Public Goods

Even if providing a public good is Pareto efficient, it doesn't automatically

follow that independent agents will decide to acquire it. The outcome depends
on the mechanism they use for joint decision-making. If they cooperate and are
honest about their valuations, agreement is straightforward. However, under
many conditions, they may not have incentives to tell the truth. A person might
claim zero valuation for the TV, hoping their roommate will buy it anyway and
they can enjoy the services for free. This is the essence of the free-rider
problem.

When individuals attempt to free ride, they hope other agents will purchase
the public good on their own. Since everyone consumes the same amount of a
public good, each individual has an incentive to minimize their contribution.
This individual rational behavior leads to collective outcomes that are Pareto
inefficient, as the good may not be provided despite high aggregate valuation.
Game Theoretic Analysis of Free Riding

Consider a numerical example of two players, A and B, choosing whether

to buy a \$150 TV. Each player has a wealth of \$500 and values the TV at \
$100. If A buys the TV alone, they realize a benefit of \$100 and a cost of \
$150, for a net benefit of -\$50. However, if A buys it, B can watch it as well,
gaining a \$100 benefit for free. The payoffs for this strategic interaction are
depicted below:

The dominant strategy equilibrium for this game is for neither player to
buy the TV. If A buys, B is better off free riding (100 vs 25/50). If A does not
buy, B is better off not buying (0 vs -50). Thus, both choose "Don't buy,"
resulting in a (0, 0) payoff. This outcome is inefficient because buy-buy or a
split payment would result in positive net benefits for the collective
roommates.
Variable Levels of Public Good Provision

The choice is often not binary but concerns the level, quality, or quantity
(G) of the public good. Let x1 and x2 represent private consumption and G
measure the "quality" of a public good with cost function c(G). The social
budget constraint is:

x1 + x2 + c(G) = w1 + w2

A Pareto efficient allocation is one where Consumer 1 is as well-off as

possible given a fixed level of utility for Consumer 2. The optimality condition
for this variable provision is that the sum of the absolute values of the marginal
rates of substitution (MRS) between the private good and the public good for
the consumers must equal the marginal cost of providing an extra unit of the
public good:

|MRS1| + |MRS2| = MC(G)

Spelling out the definitions of MRS, we get:

(MUG/MUx1) + (MUG/MUx2) = MC(G)

Efficiency Conditions for Public Goods

This efficiency condition for public goods can be illustrated graphically by

vertically summing each individual's MRS curve and finding the intersection
with the Marginal Cost (MC) curve. At this point, the aggregate marginal
willingness to pay equals the marginal cost of production.
 Contrast this with private goods: for a private good, each person's MRS
must independently equal the marginal cost. For a public good, it is the sum of
MRS values that must equal marginal cost because everyone consumes the
same quantity but values it differently at the margin. Voluntary provision
consistently fails this condition because individuals stop contributing when
their own private MRS equals 1 (the cost), rather than when the aggregate
social MRS does.
Quasilinear Preferences and Efficiency

The optimal amount of a public good generally varies with different wealth
allocations. However, if consumer preferences are quasilinear (u = xi + vi(G)),
a unique, wealth-independent level of the public good is supplied at every
efficient allocation. In this instance, the marginal utility of private consumption
is constant (1), and thus the MRS depends only on G. This makes the sum of
the willingnesses to pay a fixed value relative to the quantity of the public
good, simplifying social decision mechanisms and bypassing the dependency
on initial endowments.
Environmental Economics: Public Bads

Pollution represents a "public bad" that affects multiple agents equally. In a

model featuring a steel firm producing pollution (x) that harms two fisheries,
the Pareto efficient level of pollution is found by maximizing the sum of the
profits of all three firms. This minimizes total social cost. The marginal
condition for this problem is:

Δcs/Δx + Δcf1/Δx + Δcf2/Δx = 0

This equation indicates that the sum of the marginal costs (or benefits) over
the economic agents determines the optimal provision. Increasing pollution
reduces steel production costs but increases fishing costs; the efficient balance
is reached when the marginal gains to the polluter are exactly offset by the
marginal damages to all affected parties.
The Free Rider Problem in Voluntary Provision

In a voluntary environment (Nash equilibrium), individuals choose their

own contribution gi based on their forecast of others' contributions. Each
person considers their maximization problem: maximizing utility u1(x1, g1 +
g2) subject to their personal budget x1 + g1 = w1. This individual optimization
results in Person 1 contributing until their personal MRS equals 1. If the other
person's valuation is also high, they may both pay, but it is common for one
agent to find the other's contribution sufficient and choose to pay nothing at all,
as shown in the following analysis.
 In Figure 36.2, Person 2 decides to free ride on Person 1's contribution
because the provided endowment of G by the roommate is already optimal
from Person 2's individual viewpoint. This illustrates why voluntary
equilibriums result in a supply of public goods that is lower than the socially
optimal efficient level.
Decision Making Mechanisms: Voting

Due to the failures of the private market, social institutions like voting are
used. Voting on public goods expenditure can lead to nontransitive outcomes,
often called the paradox of voting. Outcomes depend on the voting order
(Agenda Manipulation). However, if preferences are single-peaked, voting
outcomes are stable and reflect the median expenditure.

The VCG mechanism provides a mechanism to elicit truth by charging

agents a "Clarke Tax" if their vote is pivotal to the social outcome. This
ensures that every individual internalizes the cost of their decision on the rest
of the group, leading to theoretical Pareto efficiency despite high
implementation complexity and reliance on quasilinear utility.