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Public Goods and Spillover Benefits Review for AP Economics

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By — McGraw-Hill Professional
Updated on Mar 2, 2011

Review questions for this study guide can be found at:

Public Goods, Externalities, and the Role of Government Review Questions for AP Economics

Main Topics: Private and Public Goods, Spillover Benefits and Positive Externalities

Private and Public Goods

So far, when discussing goods and services, we have focused on private goods and services. Private goodsare goods that are both rival and excludable. A bag of potato chips and a cup of herbal tea are all private goods. These are rival in that only one person can consume the good, and so consumption by one consumer necessarily means another cannot. Private goods are excludable in that consumers who do not pay for the good are excluded from the consumption.

Public goodshowever, are special cases where the goods are both nonrival and nonexcludable. These characteristics mean that one person's consumption does not prevent another from also consuming the good. If a public good is provided to some, it is necessarily provided to all, even if they do not pay for the good. Common examples of public goods are national defense, local fire and police services, space exploration, and environmental protection.

Who Pays?

In the case of private goods, each individual decides whether he or she is going to pay the going price. If the marginal benefit to me is at least as high as the price, I might decide to purchase and consume the good. For private goods, those who want the good badly enough are the ones who pay.

Maybe you have confronted the difficulty in paying for a public good if you have been assigned a group project in school. If each group member receives the same grade, regardless of his or her level of effort, some members of the group might slack off and benefit from the hard work of the others. If this sounds familiar, you have experienced the free-rider problem.The free-rider problem pops up whenever some members of the community understand that they can consume the public good while others provide for it.

A small town has a community meeting to decide how to pay for local police protection. The mayor passes a collection plate around the room and we each make a voluntary donation toward this public good. There are some difficulties with paying for a public good in this way. How much do I use or value the next unit of police services in my protection? Is this more than, less than, or the same as my neighbor's use and value of police protection? It is impossible to answer this question and even if it were possible to determine how much my neighbor values police service, maybe he won't pay his fair share. After all, if police protection is going to be provided to the entire community, and this protection cannot be denied to anyone, some members of the community might become free riders.The free-rider problem and the nonexcludable nature of public goods require that the government collect taxes to pay for their provision.

Spillover Benefits

In graduate school I rented a small house on a dead-end street. On the other side of the street, two older ladies had an immaculately landscaped yard with gorgeous rosebushes. Riding my mountain bike home from campus I was happy to see, and smell, the results of their hard yard work. I'm sure that I was not the only neighbor who felt that way. When one person's consumption of a good provides utility to a third party who has not directly purchased the good, there exist spillover benefitsthat are not reflected in the market price of that good. In my case, my neighbors went to the trouble, expense, and effort, to beautify their yard. In the process, they beautified the neighborhood and provided benefits to those of us who received utility from the landscaping and the roses. This situation is described as a positive externalityand is illustrated in Figure 11.1.

Public Goods and Spillover Benefits

The market demand curve for roses captured the private benefits received by consumers of roses, but did not capture the additional benefits received by neighbors of those who consumed roses. Figure 11.1 incorporates the spillover benefits to the market for roses. The private demand curve, which does not include the spillover benefits, lies below the societal demand curve. The market produces only Qmkt roses, but the optimal amount is greater at Qsocial. Because the market produces less than the socially optimal amount, it is said that there is an underallocation of resources to rose production. In other words, society wants more than the market provides.

  • The existence of spillover benefits in a market results in an underallocation of resources in that market. In other words, there is not enough of a good thing.

The older ladies who lived across the street from my house were essentially pro-viding a public good that we might call "community beautification" and the rest of us were free riding on their activity. How could we have contributed to the provision of the public good? Maybe we could have brought these ladies cash donations, or we could have volunteered our labor. Each of these gestures would have lessened their burden and freed up their private resources to provide even more landscaping for the neighborhood.

Subsidies

On a larger scale, this type of market failure can be remedied through government intervention. Our goal as economic policymakers is to move the equilibrium quantity from Qmkt to Qsocial. One solution might be to provide a subsidy to gardeners equal to the amount of the spillover benefit that their activity provides to the community. By sending a check (or voucher) to the ladies, they would have increased their demand for roses and other landscaping and shifted the private demand out to equal the social demand. This is seen in Figure 11.2. The price received by the firm has risen to Pfirm, but when the consumer applies the voucher, the actual price to the consumer is lower at Pcons.

Another possibility is to provide a subsidy to producers of roses. This type of subsidy would result in an outward shift in the supply curve so that the equilibrium quantity of roses would be at Qsocial. This policy is seen in Figure 11.3. The price to consumers, Pcons, is also lower in this case, while producers receive, with the subsidy, Pfirm.

Public Goods and Spillover Benefits

Public Goods and Spillover Benefits

Review questions for this study guide can be found at:

Public Goods, Externalities, and the Role of Government Review Questions for AP Economics

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