Chapter 4

ECON 441: Public Economics
Dan Silverman
Arizona State Economics
Fall 2016
Silverman (Arizona State Economics)
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Relaxing The Assumptions Behind FFTW
In Chapter 2 we made the case for competitive markets.

Competitive markets are good as they oer pareto improvements over initial
endowments.
The competitive model oers no justication for the vast amount of
government activity (chapter 3).
In a competitive setting, government activity is not just unnecessary, it
produces Pareto inferior allocations.
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Relaxing The Assumptions Behind FFTW
The competitive model is built on a number of important assumptions

Some of these may not hold in reality.
Now we examine those assumptions in detail and consider the consequences
of relaxing them.
We will see that relaxing these assumptions can imply a positive role for
government intervention.
Guiding for public policy analysis: "Where is the market failure? and How
might this public policy function to improve upon the market allocation?
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Assumption 1: No Strategic Behavior (Price Taking)
Key assumption of the competitive model: all actors take prices as given.
I.E., no economic actor believes that he/she/it can aect prices for goods by
making dierent choices.
In reality, this often is not true.
Microsoft and Nintendo, and skilled labor in Redmond, Washington.
Apple and iPhones.
United Airlines and ights between Houston and Newark.
Firms can exert market power and generate ine ciency. Thus a potential
justication for government intervention.
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Example: Monopoly
Typical rms problem
max P (Q ) Q
C (Q )
With constant marginal cost of production c

max P (Q ) Q
First-order condition
P 0 (Q ) Q + P (Q ) =
|
{z
}
marginal revenue
c
|{z}
marginal cost
Competitive rm is a price taker. In that case P 0 (Q ) = 0

P
|{z}
marginal revenue
c
|{z}
marginal cost
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Example: Monopoly
The monopolist produces Qm to maximize his prots. Why?
Quantity traded is ine cient. Why?
P
MC
MR
Demand
MC -s
Q
Qm
Qpo
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Is There a Role for Govt. Intervention?
What is the role of the government facing this monopoly?

Market power implies too little trade.
Government could bust up the monopoly.
Government could regulate prices. (What price should it set?)
Government could provide the good itself (at what price, and is govt.
capable?)
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Is There a Role for Govt. Intervention?

Government could also oer a subsidy, say, via a tax rebate s on every unit of
production.
Important questions: Who will fund the subsidy? Who should fund the
subsidy?
P
MC
MR
Demand
MC -s
Q
Qm
Qpo
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Is There REALLY a Role for Govt. Intervention
Important note of caution.

If e ciency is really the primary concern, the monopolist can probably take
care of this itself.
Indeed, protecting market power can pave the way to great e ciency
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Suppose, as seems natural, the monopolist can charge an entry (membership)

fee in addition to a price per unit.
If so, the monopolist maximize prots by setting price equal to marginal cost
and using the membership fee. charge the shaded area as the entry fee and
then
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Consumer pays entry fee equal to the shaded area and consumes Qpo .
P
profits without entry fee
profit with entry fee
MC
MR
Demand
Demand
Q
Qm
Qpo
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Strategic Behavior is Common
Monopoly is just one example of a failure of price-taking.

Economic exchange in small groups is often strategic.
Cartels
Large unions and their employees
Even institutional investors and various nancial markets.
Whether government can improve on ine ciencies driven by market power is

often debatable.
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Public Goods
Public goods usually dened as non-rival

The value to any individual of consuming the good is unaected by the fact
that another individual consumes the good.
It is common, but often less important, to assume that public goods are also
non-excludable.
No individual can be forbidden from enjoying the benets of the public good
there is.
Classic examples are national defense, reworks displays and radio broadcasts.
Public goods will typically be underprovided by decentralized mechanisms,
including markets.
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Decentralized Mechanisms Will Underprovide Public Goods
Consider two agents, Art and Bob.

There are three possible levels of production of the public good:
G =0; costs nothing
G =1; costs $1 in utility terms to produce
G =2; costs $2 in utility terms to produce.
Utility benet of the public good to each agent equals 0.7 G .
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The Utilitarian Planners Optimum
Utilitarian optimum sets G = 2.

At this level of production social welfare equals
Arts utility
0.7 G
Bobs utility
Cost in utility terms
0.7 G
= 0.8.
Social welfare would equal 0.4 if G = 1 or zero if G = 0.

Note that G = 2 is also Pareto optimal. If G < 2 both agents would made
be better o by producing an additional unit of the good and splitting the
additional utility cost equally them.
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Decentralized Mechanism: A Market
Consider a rm (monopolistic or competitive, no matter)

Firm produces and sells units of the public good.
It costs $1 to produce one unit of the public good.
Value of one unit of the public good is 0.7 to each agent
Each agent will buy a unit (or more) if and only if the price per unit is less
than $0.7.
At that price, however, the rm makes a loss on each unit, so it produces
none.
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Decentralized Mechanism: Voluntary Contributions
Suppose, instead, that Art and Bob each choose whether to contribute to the
production of a public good G .
To make it simple, suppose that contributions must be made in the xed
amount of $1 each.
The utility cost of contributing 1 dollar is 1
So neither agent will contribute to the public good: each agents private
benet from contributing is negative.
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Observations from the Real World
Indeed, public goods are not typically sold in competitive markets.

Voluntary contributions do, however, seem pretty common.
Charitable giving is 2% of GDP in the U.S., on a par with Federal taxes on
corporate prots.
Pretty much unique to the U.S.; similarly rich countries have much lower levels
of contribution.
How do we understand this level of giving?
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Observations from the Real World (contd.)
One explanation: These arent really pure public goods

Some forms of charitable giving generate important value to others, while
also generating substantial private value.
Example: Dues required in order to participate in various religious
organizations.
Example: Buying green or charitable products like Ben & Jerrys or
Neumans Own.
Example: Giving that oers return for access, inuence, or social status
ASUs Brick Layers
Stanfords Institute for Economic Policy Research
Cals Travers Department of Political Science
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Real-World Mechanisms: Seed Money
Many charitable organizations launch campaigns with seed money or

encourage large donors to oer matching funds.
In a simple model of charitable giving, these tactics dont make too much
sense.
Seed money just crowds out the giving of others.
Matching funds lower the price of giving for others but, again, in a simple
model, the total amount given wont be altered.
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Why might seed money work?

Andreoni (JPE 1998) oers a reason
He takes the usual model of voluntary contributions, but assumes a convex
production technology.
The usual assumption is that the technology is everywhere concave (often
linear)
!
G =f
gi
i
where gi is individual is charitable contribution.

Andreoni notes that many public goods arent worth much when provided a
very low levels.
Schools, bridges, public radio stations.
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f(g
s)=G
The usual
assumption
Andreonis
assumption
g
s
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Why, if the public good technology takes this form, might seed money help?
Suppose that, on their own, each person would be willing to pay a constant
but small amount of money for an additional unit of the public good.
Preferences are linear in G .
If so, then everyone giving nothing is an equilibrium.

If no one else is giving anything, then no one has any incentive to give since
giving generates absolutely no value.
A big piece of seed money breaks this equilibrium, by putting marginal

donations on the high part of the curve.
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Real-World Mechanisms: Giving Over Time
Similar mechanisms motivate schemes where people make several small

donations over time.
Think of the rising thermometer that so many groups use.
Giving little-by-little generates trust.

Supports an equilibrium with higher levels of giving where the punishment for
deviating is that other people in the game stop giving.
In theory, this only helps if there is a discrete jump in the value of the public
good once giving reaches a threshold (the project is nished).
Bridge, new playground, money to hire a new director.
In practice, giving little-by-little helps even when there is no such threshold.

Why?
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Real-World Mechanisms: Fund-raising Through Lotteries
Many organizations and even some governments raise contributions for public
goods through lotteries.
Two common forms
Fixed-prize ra- e: Firm donates a prize, at cost. Individuals buy ra- e tickets.
Ticket sales pay for the car, with remainder going to provide the public good.
Parimutuel lottery: Ticket sales fund, proportionally, a cash prize. Constant
fraction of ticket sales goes to provide the public good.
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John Morgan (Berkeley) shows that xed prize lotteries can, in theory and
experiment, bring public good contributions closer to e cient levels.
How do they work?
Contributions to public goods generate public value beyond private gain.
Individual incentives to contribute are thus, from a social perspective, too
weak.
Purchases of xed prize ra- e tickets generate private gain at the expense of
public value.
#ticketsi
prob (Wini ) =
N
#ticketsj
j =1
Private incentives to buy tickets are thus, from a social perspective, too
strong.
In Morgans model, these competing incentives to under/over contribute
cancel out.
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That argument works for xed-prize ra- es, because each ticket purchases
increases the buyers probability of winning at the expense of everyone elses
probability, AND the prize remains xed.
When the lottery is pari-mutuel, this is no longer the case. Now buying a
ticket increases also increases the value of the prize.
With pari-mutuel lotteries, private and public incentives to buy are better
aligned. This kills the tendency to buy too many tickets.
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The Key Idea of Public Goods: The Free-rider Problem
Each of the examples we have discussed is, in one way or another, special.
Some mechanisms will generate more or less public good provision.
The underprovision result is, however, generic.
Public goods will be underprovided by decentralized mechanisms.
The force that leads agents to undercontribute to the production of non-rival
goods is called free-riding.
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Free-rider Problem
Public goods will be underprovided if provision is left to individuals (or to the
market).
This is because social utility of one unit of the good exceeds private utility, so
no one individual will have enough (from the point of view of society)
incentives to acquire enough of the public good.
In one individuals trade-o, the public good is less valuable than it is for the
whole of society (the social value of one hour of television programming far
exceeds the value to one individual).
The same is not true of private goods (such as food, clothes, etc.). For
private goods, the social value coincides with the private value (a unit of food
only gives utility to the person who eats it, in contrast to television
programming which can be enjoyed by an almost unlimited amount of
people).
Thus, in the presence of public goods we have a failure of the welfare
theorem; the competitive outcome is not necessarily Pareto optimal. This
creates a reason for government intervention and regulation.
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Condition for E ciency of Public Good Provision
Suppose that producing G units of the public good has a social cost of c (G ).
The utilitarian solves
max [U1 (G ) + U2 (G ) +
G
+ UN (G )
c (G )] .
First order condition:

U10 (G ) + U20 (G ) +
+ UN0 (G )
c 0 (G ) = 0.
The Lindahl-Samuelson condition.

Marginal social cost of producing the good (c 0 (G )) must equal the marginal
social utility of that production.
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Externalities
Public goods can be viewed as a special case of positive externalities.

Negative externalities are, then, like the opposite of public goods.
In general, externalities are the benets or cost that one individual imposes
on the rest of society by consuming or producing some good.
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Externality Examples
Negative externality examples:

Air and water pollution from electricity production
Cows ruining downstream shing
Cell phone use at ASU football games
Buying lottery tickets for a xed-prize ra- e!
Positive externality examples:

Home beautication and investment.
Increases in home e ciency
Buying a Nissan Leaf
Taking the bus.
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Externalities
Externalities are worth noting only if they are not taken into account by the
price system.
For example, MC of electricity production doesnt include the pollution costs
to others.
MC of milk production doesnt include the trashed trout shing downstream.
If prices do not account for externalities, individuals will consume or produce
too much or too little of these goods.
Here, too much or too little is relative to the quantity that a utilitarian
social planner would choose.
A utilitarian social planner would take into account the costs imposed on
others by the behavior of some agents.
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Example: Gasoline Producer

Suppose, in addition to the private marginal cost, gas production generates
pollution cost $sc per unit.
The producer does not take this pollution cost into account: it is concerned
only with private marginal cost.
If rms behave competitively, Q is the equilibrium quantity. Overprovision.
P
MC+sc
MC
Demand
Q
Qse
Q*
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Example: Gasoline Producer and Pigouvian Tax

With such a negative externality, there is a role for governement intervention.
Classic response is a Pigouvian tax
In the case below, if rms have to pay tax $sc for each unit produced, then
they perceive their marginal cost as MC + sc
Output would then be socially e cient.
P
MC+sc
MC
Demand
Q
Qse
Q*
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Correcting Externalities (sort of) Without Intervention
Pigouvian taxes or command and control in the form of permits and

penalties can be hard to implement.
They have important administrative and enforcement costs.
They can be hard to target correctly.
They may distort unintended activities.
Is there some way to correct the ine ciencies of externalities without such
direct government intervention?
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Correcting Externalities (sort of) Without Intervention
Essential problem of (negative) externalities is that eects of certain forms of

consumption/production arent priced.
That means there is no market in which such eects might be traded for
other things.
Breathers cant trade their fresh air for money.
Cell phoners cant pay other users to turn o their phones so a *really*
important text message gets through during the game.
If we were in an Edgeworth box, externalities would be like one agent taking

some part of the others endowment and oering nothing in exchange.
Whats a natural (trivial?) x, then, to such a problem?
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The Coase Theorem
The natural x to externality problems is one of the most inuential ideas in

economics: The Coase Theorem.
Named for Ronald Coase whos 1960 JLE article made the argument.
Simple idea is to extend property rights to all goods and thus complete
otherwise incomplete or missing markets.
Fresh air
Clean water
If markets are complete, then you cant take some of my clean air endowment
unless you compensate me for the loss.
Just like you cant come into my house and take my TV.
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The Coase Theorem (We Already Learned It!)
If complete markets are also competitive then the First Fundamental

Theorem of Welfare applies and, thus, resulting allocations are competitive.
Does the e ciency of competitive equilibria depend on initial endowments?
Does FFTW break down if some agent is endowed with too many apples
relative to oranges?
Of course not.
Coase Theorem Once property rights are assigned, the resulting outcome
after trade is e cient irrespective of the initial allocation of property rights.
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The Importance of the Coase Theorem: An Example
To understand Coase better, consider taxes on gasoline.

Suppose 100 barrels of gasoline generates $1,000 of value to the producer.
Case I: cost of production (the smell) to a person who lives next to the plant
is $100.
If tax on gas production < 1,000, then the company produces and this is
e cient. If tax > 1,000, the company will not produce and this is ine cient.
Case II: cost of smell to individual is $1,100.

In this case, if tax on gas < 1,000, then the company produces but this is
ine cient. If tax > 1,000, the company will not produce and this is e cient.
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The Importance of the Coase Theorem: An Example
Example shows how taxes may be hit or miss. Coase oers a solution.
A Coasian plan: government assigns the individual property rights over the
externality.
The individual thus has the right to clean air and may trade it.
In Case I, the individual will sell the right to the renery for a price between
$100 and $1,000, and the company will produce.
In Case II, the individual will not sell the right and the company will not
produce. Again, e cient.
Individual is, of course, much happier if property rights are assigned to him
(doesnt have to buy them).
Of course, this is unimportant if concerns is only over e ciency.
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Cautions About Coase
Coasian perspective suggests a pretty radical view of government intervention.

Assign and protect property rights, then get out of the way
Agents themselves can reach an e cient allocation, making appropriate
trade-os themselves. Government cannot get it wrong.
Why worry?
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Cautions About Coase
In reality, many individuals are aected (perhaps in modest ways) by

externalities.
Only when you aggregate over the population does the impact of the
externality amount to something substantial.
Air quality for the typical consumer is only a bit worse because of a electricity
plants production.
One familys summer vacation is only slightly worse because the sh arent
biting downstream from the dairy farm.
Who, then, has individual incentive to go out and negotiate with the rm
when these rights are violated?
Class action suits, advocacy groups, unions, government, often needed and
often bring their own ine ciencies.
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A More Practical Hybrid: Tradable Pollution Permits
In practice, government sometimes sets a level of externality production

(old-fashioned permits)
But in, a Coasian twist, allows those permits to be traded among producers.
In some cases, the permits can also be purchased by consumer (groups) who
would be aected by the externality and level of externality can be further
reduced.
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Example: Tradable Pollution Permits
Three rms, i = 1, 2, 3.
Firm is MC = i.
Each produces the same good which sells at price 4.
Each rm is assigned 1 pollution permit, amounting to the right to produce 1
unit of the good.
The economy demands 3 units of the good.
Social e ciency calls for rm 1 to produce all 3 units.
Social surplus is highest in that case.
Story meant to capture dierences in rms ability to produce cleanly.
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Example: Tradable Pollution Permits
Will trade in permits achieve the socially e cient allocation of production?

Suppose a market for the permits opens and the permit price is p = 2.
Firms 2 and 3 will sell so supply is 2, but Firm 1s demand is innite.
Suppose the price is p = 3. Again, rms 2 and 3 will sell.
At this price, Firm 1 is indierent between buying and not buying and buys 2
permits.
p = 3 is the equilibrium price and the production allocation is e cient.
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Dont Forget About Positive Externalities
Focus is typically on negative externalities.

Positive externalities also exist. They are like public goods, but less restrictive
Like public goods, goods with positive externalities will be underprovided by
markets.
Classic example is the exterior beauty of your house, which benets you and
your neighbors.
Your choices about the exterior reect only your private gain, so houses will
be ine ciently shabby.
Too many couches on porches.
Motivates building codes and zoning.
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Complete Markets
Coasian remedy for externalities amounts, in eect, to building markets that

are missing.
It seems obvious that, if markets are entirely missing, assumptions necessary
for FFTW wont hold.
But even incomplete markets wont generate e ciency.
In a sense, incompleteness means ine ciency: Trade in some good or service
does not go on at all or goes on between too few agents.
In these cases some mutually benecial exchanges are not executed.
This is essentially what we mean by market failure.
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Complete Markets
There are many reasons why a market might be missing or incomplete

The absence or weakness of property rights
Complementarities of consumption
Car markets are thin in places with no roads.
Asymmetries of information
One side of an exchange knows more about themselves/their product than the
other.
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Asymmetries of Information: Examples
The used car market

Seller knows more about the quality of the car than potential buyers do.
The market for loans

Applicant knows more about his/her default risk than the bank does.
Disability insurance
Applicant knows more about how painful it is to work.
Unemployment insurance
Applicant knows more about how hard he/she tried to nd a job.
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Imperfect Info. Need Not Be Asymmetric

It is important to distinguish asymmetric information from imperfect
information and simple uncertainty.
Imperfect information need not generate ine ciencies.
For example, the market for shares of an S&P 500 index fund.
Neither buyers nor sellers know for sure what shares in the fund will be worth
in a year.
Information is imperfect
Each side of the market might reasonably have dierent needs for the asset
(thus trade).
Importantly, however, neither buyers or sellers have special knowledge that
the other side doesnt have.
Allocations in a competitive market with imperfect but symmetric
information should be e cient.
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Important Dierences in Kinds of Asymmetry
Hidden Actions (Moral Hazard)

Unemployment insurance
Applicant may not try so hard to nd a job because he/she has insurance
Disability insurance
Applicant decides his back is too painful to work because he/she has insurance.

Applicant takes on more risky strategies because he can default.
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Important Dierences in Kinds of Asymmetry
Hidden Types (Selection)

The used car market
Seller knows more about the quality of the car
Health insurance market

Buyer knows more about his/her health risk

Applicant knows more about the odds of his/her job loss or divorce.
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Incomplete Markets Due to Adverse Selection
Adverse selection is a very important reason for market incompleteness.

In an extreme, adverse selection can cause only bad customers go to the
market good customers stay out.
Ine ciency emerges because, for example, good risks would benet from
health insurance too.
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Adverse Selection: An Example
Three types of consumers distinguished by their risk

Type
Prob (sick )
Fraction of population
I
0.1
II
0.4
III
0.8
1
3
1
3
1
3
The cost of getting sick is $2000 for each type.

Health insurance pays the entire cost of getting sick.
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Suppose each type is very slightly risk averse.

So each will purchase insurance only if its price is very close to the actuarially
fair rate for their type.
The actuarially fair rate is the expected cost of getting sick.
For a type I, this is (cost of being sick) + (1
) (cost of being well)
0.1 $2, 000 + 0.9 $0 = $200

Assume that insurance companies behave competitively in the face of free
entry.
They, therefore oer insurance at the actuarially fair rate.
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Suppose all three types were purchased health insurance

Suppose the rm can only charge one premium (price) to all of the types
Cant tell the dierence between them.
The actuarially fair rate is then:

1
3
1
1
I $2000 +
I $2000
3
3
(0.1) $2000 + (0.4) $2000 + (0.8) $2000
=
3
I
$2000 +
= act. fair rate

= 0.4333 $2000 = $860.
Note, $860 is more than type I s willingness to pay (I $2000 = $200) .

So, at that price, type I s wont actually be in the market.
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Adverse Selection: The Unraveling
But if Type I s are out of the market, $860 isnt actuarially fair.
The new actuarially fair price is:
(0.4) $2000 + (0.8) $2000

= 0.6 $2000 = $1, 200.
2
Naturally, the price has increased to reect the fact that the risk pool got
worse. The best risks dropped out.
But now, Type II s arent interested. Their willingness to pay was just
0.4 2000 = $800. They drop out.
In the end the market serves only Type III s and charges them a premium of
$1,600.
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Incompleteness from Asymmetric Information
Because the rm couldnt tell good risks from bad, the market unravelled.
The market is ine ciently small (incomplete).
Risk averse Types I and II dont buy valuable insurance that rms would
have gladly sold them.
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Incompleteness from A.I.: Market Solutions
Why dont rms just ask: whats your type?

If they could measure type well, would rms want to?
If such measurement were possible, would consumers agree to be measured?
Think Ebay Motors.
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Incompleteness from A.I.: Govt. Solutions
If markets cant complete themeselves, what should government do?

Provide the good and insist on participation
Medicare (old-age health insurance)
Social Security (old-age annuities)
Regulate markets and, in eect, insist on/subsidize risk pooling.

Car insurance (you cannot drive without insurance)
Employer-provided health insurance (BIG Subsidy)
Recent healthcare reform.
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Incompleteness due to adverse selection is a powerful idea

It has a great deal of currency in policy circules.
Practically speaking, is it a huge deal?
Relatively new empirical literature tries to evaluate this question.
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Relevant data has been hard to come by.

Suppose, however, you had information on individualsinsurance purchases x
and their (subsequent) rates of illness .
Whats your prediction about the correlation between x and ?
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Suprisingly, in several examples, studies fail to nd a positive correlation

between x and .
Example: Car insurance in France.
Young drivers who purchase more insurance are not more likely to have
accidents.
Example: Supplemental health insurance (Medigap)

Older people who buy supplemental health insurance have lower realized
medical expenditures.
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What Explains the Lack of Correlation?
Maybe there is no meaningful asymmetry of information.

Could be that young drivers dont know much more about their driving ability
than rms do.
Maybe there is Advantageous Selection.

This requires, at least, that one side of the market knows more than the
other about many things, not just risk.
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Advantageous Selection
Advantageous selection requires multiple dimensions of private information.

In particular, you need something (unobsered or just unpriced) that is
negatively correlated with risk and positively correlated with insurance
purchase.
Mechanism leading to negative correaltion with risk and positive correlation
with insurance purchase, need not be causal.
Simple correlation is ne.
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Advantageous Selection
Example: People vary in health risk and risk aversion.

Negative correlation between risk and risk aversion with perhaps a causal
link
More risk averse buy more insurance (because they dont like risk).
But more risk averse are less risky perhaps because they are more careful
about everything.
In this case, the negative correlation between risk and risk aversion may lead
(on net) to advantageous selection
Those who buy more insurance may be, on average, less risky.
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The Nature of Selection: Graphical Analysis

Price
Marginal
Cost
Demand
Quantity
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The Nature of Selection: Graphical Analysis

Price
Marginal
Cost
Demand
Quantity
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E ciency and Advantageous Selection
Suppose a market is characterized by asymmetric information.

But suppose, on net, selection is advantageous
Will that market still be incomplete?
Will it be e cient?
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E ciency and Advantageous Selection

Think about what actuarially fair means with advantageous selection.
Price
Marginal
Cost
Average
Cost
Demand
Qeff
Qeq
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Quantity
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Asymmetric Information: An Example
Consider a large market for loans. T

Three types of borrowers, I , II , III .
Each type of borrower has no money in period 1. But, with dierent
probabilities, each type will nd a job in period 2 and earn $2000.
If a borrower doesnt nd a job in period 2, she earns no money and pays
back nothing (defaults) on her loan. If, however, she has su cient money to
repay the loan, she cannot default.
is the probability of default.
I
0.1
0.5
II
0.2
0.25
ECON 441 Chapter 4
III
0.5
0.25
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Let utility be linear in money

Assume borrowers discount the future only very slightly
Suppose all loans are for $1000 and are associated with an interest rate r
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Expected utility to each type from not taking a loan
0 + (1
I
II
III
0 + (1
0 + (1
0 + (1
) 2000 + 0
0.1) 2000 + 0.1 0 = 1800

0.2) 2000 + 0.2 0 = 1600
0.5) 2000 + 0.5 0 = 1000
Expected utility to each type from taking a loan

Expected Utility
I
II
III
2000
2000
2000
= 1000 + (1 ) (2000 (1 + r ) 1000) + 0

= 2000 1000r 1000 + 1000r
1000r
1000r
1000r
1000 0.1 + 1000r 0.1 = 1900

1000 0.2 + 1000r 0.2 = 1800
1000 0.5 + 1000r 0.5 = 1500
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800r
500r
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What is the highest rate of interest r that each type of consumer would be
willing to pay for a $1000 loan in this market?
Type
I
II
III
Indierence condition
1800 1900 900r or r
1600 1800 800r or r
1000 1500 500r or r
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9
1
4
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If types are private information, what interest rate is charged by competitive

rms if all were being served?
It is the interest rate that just equates the expected value of the loan
tomorrow with the value of the loan today ($1000).
1000
1
(1 + r )
1
0.775
r
= (1 + r ) 1000 [1
= [1
(0.5 0.1 + 0.25 0.2 + 0.25 0.5)] ()
(.225)] ()
= 1 + r ()
0.29
But from our analysis before, we know that only type IIIs would take a loan
at that interest rate. This is not an equilibrium.
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Suppose, now, that type I and type II consumers dier from type IIIs in an
additional way. Type I and IIs are half as patient as type IIIs. So if type IIIs
preferences are represented by
UIII (m1 , m2 ) = m1 + m2
then type I and IIs preferences are represented by
1
UI /II (m1 , m2 ) = m1 + m2
2
Can the whole market now be served?
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Now, for both Types I and II the expected utility of not taking a loan is
1
0 + [(1
2
) 2000] = 1000
1000
And the expected utility of taking the loan is
1
1000 + [(1
2
1500 500r
) (2000
1000(1 + r ))]
500 + 500r
So the consumer takes the loan if

1500
500r
500 + 500r
1+
1
1000
1000 ,
The left hand side >1 for all , so now all three would be willing to take a
loan at r 0.29.
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Whats crucial here is that there is another dimension of unobserved

heterogeneity, patience.
In this case, patience is negatively correlated with the demand for a loan and
positively correlated with risk of default.
This leads to advantageous selection that counters the adverse selection
based on default risk alone.
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Application: Medicare Reform
Medicare: Federally sponsored health insurance for Americans age 65 and

older
Parts A and B pay for hospital treatments and doctor visits, etc.
Substantial deductible and cost-sharing
Part A is automatic, Part B is optional and involves a relatively small premium
Very little coverage for nursing home care
No coverage for prescription drugs.
Medicare part D now oers subsidized and regulated prescription drug

coverage.
Parts A D are subsidized by payroll taxes on current workers.
Re-imbursement rates for diagnoses set at the national level
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Application: Medicare Reform
Why should Medicare exist?

What is/are the market failures?
In light of these potential failures, does the current policy make sense?
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A Problem with Medicare
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A Proposed Reform
The Ryan-Rivlin Plan

In 2021, those who turn 65 would no longer enroll in Medicare, but instead
receive a voucher with which to purchase private health insurance.
Voucher represents a subsidy for private health insurance
Replaces the current system in which government provides the insurance
directly.
Make the subsidies a decreasing funtion of income.
Allow the value of the subsidies to rise only slowly.
Also, slowly increase the age eligibility for Medicare.
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A Proposed Reform
What arguments can we make in favor of this reform?

What arguments can we make against this reform?
What additional information would be helpful in making suggestions for its
improvement/adjustment?
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ECON 441: Public Economics

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Relaxing The Assumptions Behind FFTW

In Chapter 2 we made the case for competitive markets.

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Relaxing The Assumptions Behind FFTW

The competitive model is built on a number of important assumptions

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Assumption 1: No Strategic Behavior (Price Taking)

Silverman (Arizona State Economics)

ECON 441 Chapter 4

With constant marginal cost of production c

Competitive rm is a price taker. In that case P 0 (Q ) = 0

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Is There a Role for Govt. Intervention?

What is the role of the government facing this monopoly?

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Is There a Role for Govt. Intervention?

Is There REALLY a Role for Govt. Intervention

Important note of caution.

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Is There REALLY a Role for Govt. Intervention

Suppose, as seems natural, the monopolist can charge an entry (membership)

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Is There REALLY a Role for Govt. Intervention

profits without entry fee

profit with entry fee

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Strategic Behavior is Common

Monopoly is just one example of a failure of price-taking.

Whether government can improve on ine ciencies driven by market power is

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Public goods usually dened as non-rival

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Decentralized Mechanisms Will Underprovide Public Goods

Consider two agents, Art and Bob.

Utility benet of the public good to each agent equals 0.7 G .

Silverman (Arizona State Economics)

ECON 441 Chapter 4

The Utilitarian Planners Optimum

Utilitarian optimum sets G = 2.

Cost in utility terms

Social welfare would equal 0.4 if G = 1 or zero if G = 0.

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Decentralized Mechanism: A Market

Consider a rm (monopolistic or competitive, no matter)

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Decentralized Mechanism: Voluntary Contributions

Silverman (Arizona State Economics)

ECON 441 Chapter 4

Observations from the Real World