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devil duck

armchair economics

Some weeks ago I followed a link on Paul Krugman's blog to an article at AEI-Ideas, the group blog of the American Enterprise Institute.  And ever since then I've been getting e-mail notifications of further articles and reader comments on that blog -- probably a dozen a day.  It's an interesting exercise to read stuff written by people with extremely different political/economic views from mine, and figure out which of their statements I can find some logic in and which seem just utterly bonkers.  James Pethokoukis is the "sane, moderate" voice on the blog: he generally favors less government, less regulation, less taxes, etc. but recognizes the reality that after five years of Obama and quantitative easing, inflation has NOT exploded, interest rates have NOT exploded, the Federal budget deficit has NOT exploded (indeed it's shrunk dramatically), and the parts of the world that enacted the most stringent Austerian policies have been the ones to go into double- and triple-dip recessions, while those that didn't cut government spending as much have recovered better.  Other columnists are less willing to acknowledge reality, and some of the readers are even farther immersed in unquestionable right-wing assumptions.

I got into a debate with one such on the issue of externalities.  His position appears to be that you should pay exactly as much for public goods (police and fire protection, clean air and water, street lights, etc.) as you feel like paying for them; people who value them more should and will pay more for them, and that's fair; he shouldn't be asked to pay anything for other people's actions, even actions that benefit him.  I was skeptical about how this works in the real world, and pointed out that whenever the benefits of something are public and the costs are private, it's almost guaranteed to happen at less than the optimal level ("positive externalities"), while when the benefits are private and the costs are public, it'll happen at more than the optimal level ("negative externalities").  After I had written a longer post than I intended, I decided to copy it here so I don't lose track of it.

Ron H. writes:
“People who value things the least value them at $0, so most often that’s the amount that actually gets charged for positive externalities"

Not necessarily.  It's quite possible that EVERYBODY in a community places a positive value on a particular common good (say, a fire engine), and the total value they place on it is more than enough to buy the fire engine, but still it doesn't happen.  Why?  Because no one community member, even the person who places the highest value on a fire engine, can afford to buy a whole fire engine; it has to be bought jointly.  And if all of my neighbors are chipping in to buy a fire engine, it'll probably be bought whether I chip in or not, so I have a strong temptation not to chip in.  If everybody reasons that way, nobody chips in and it doesn't get bought, even though EVERY SINGLE PERSON wants it.

"Who gets to decide what is the “optimal level”? It would seem that the “optimal level” of something is determined by the number of people who want it, and the price they are willing to pay for it."

Yes, it is.  I'm using the word "optimal" in the usual economic sense of "maximizing total average utility."  I'm not an economist, but I hope I can describe this correctly :-)

We assume that each person in society has a "utility curve" indicating how much that person would be willing to pay, in isolation, for various quantities of the good in question.  Such curves usually rise steeply at first, then gradually level off with satiety.  The person's "average utility" is that person's utility divided by the amount of the good, in other words how much that person would be willing to pay PER UNIT for various quantities of the good.  Average utility curves typically rise to a peak (or maybe several) and then fall off.  The peak of your average utility curve is how much of the good you would want to buy, in the ideal world; it maximizes your personal "bang for the buck".  Different people, not surprisingly, have peaks in different places.

The "total average utility curve" is what you get by adding up each person's average utility curve.  Since it's a sum of curves that each rise to one or more peaks and then fall off, it too rises to one or more peaks and then falls off.  The "optimal level" of a good is the highest peak on this curve, i.e. the amount of the good that maximizes the TOTAL "bang for the buck", as measured by adding up how much each person would be willing to pay per unit if buying that much of it individually -- or in other words, how much benefit each person feels (s)he is getting per unit.

So yes, it IS based on what people are willing to pay.  And in a market where everybody's purchases are independent of one another, you can indeed find "the" optimal level by having each person buy at that person's own optimal level.  But in a market with externalities, where your purchase affects me and vice versa, that doesn't work.  Inevitably some people's peaks are to the left of the total peak, and others' are to the right.  If everybody is expected to pay the same amount, people whose peaks are to the left of the total peak feel oppressed by being asked to subsidize those who value it more.

So let's NOT have everybody pay the same amount; instead, have everybody pay as much as the value they place on the good.  This doesn't work either, because in a market with positive externalities, there's a strong temptation to lie and say you value it less than you actually do; you'll still get the benefit of everybody else paying for it, at less cost per-unit to yourself.  It's especially tempting for people who value the good less than most, as they can be reasonably confident that other people who value it more will cover them.  If you want a fire truck in the neighborhood, but you have a brick house and most of your neighbors have wooden houses, you'll be tempted to pay not just less than they do, but even less than YOU think it's worth, because you know that your neighbors will pay.

If lots of people do that, the market behaves as though their peaks were to the left of where they really are, so the amount of the good actually provided is less than most people (or possibly even ALL people) would be willing to pay for if they were doing it individually.  That's what I mean by "positive externalities are provided at less than the optimal level."

Similarly, negative externalities (e.g. pollution) are provided at above the optimal level because people have a strong temptation to understate how much the externality bothers them, and therefore how much they're willing to pay to avoid it; the result is that not much is paid to avoid it, and we end up with more than most people (or perhaps even ALL people) want.

““…most or all of the employees want more of them, but it somehow doesn’t happen.”

That’s because they are relying on someone else to pay for them. When you “put your money where your mouth is”, you are determining the real value you place on something.”

The first sentence is right: the good is not provided because people who would benefit from it are freeloading, paying less than they actually value it (or nothing at all), and are therefore relying on someone else to pay for them.  The second sentence is right only in an independent market, not one with externalities.  Define "the real value you place on something" as what you would be willing to pay for it in isolation.  Being part of a group tends to lower the amount you're willing to pay for it, even though you benefit just as much; in other words, once you're part of a group, what you're willing to pay does NOT reflect the real value you place on it.


There are two versions of the "Stone soup" story I have heard. Version one illustrates a communal structure. Someone starts a project, it seems interesting enough for someone to contribute, this leads to other contributions, resulting in a successful project.

The other version works as you describe above. Everyone is supposed to contribute to the communal stew for a party, but everyone assumes everyone else is contributing, decides to save own resources, and puts in a stone instead. Result, really awful stone soup.

Both stories occur in reality. the problem with the Fire Truck is that you really don't want to take a risk you'll end up with the bad version of the story.