Public goods in a participatory economy

Why do market economies under-supply public goods?

People gain well-being from consuming public goods just as they gain well-being from consuming private goods. Moreover, just as people have different preferences for private goods they have different preferences for public goods as well. What is different about public goods is that their consumption is what economists call “non-rival.” That is, when one person consumes a public good this does not diminish the extent to which others can consume it as well. And this difference is what creates the well-known “free rider” incentive problem:

Since everyone in a market economy who benefits from a public good knows that when others purchase it they will be able to benefit as well, there is a perverse incentive for everyone to wait for others to purchase the public good, leading to too little of what economists call “effective demand” for public goods compared to private goods, at least in market economies.

Our personal experience with public goods is also more frustrating than with private goods because just as we have different preferences for private goods than other people do, we have different preferences for public goods as well. But in the case of public goods we must all end up consuming the same bundle of public goods, whereas we can each satisfy ourselves by consuming whatever bundle of private goods we like. So, while I have only myself to blame if I am dissatisfied with the private goods I purchased, there are always a host of others I can blame when the public goods available to me are inevitably different from what I would have chosen myself!

The modern literature on public goods

We cannot change the fact that public goods are non-rival, and therefore presumably nobody will be fully satisfied with the bundle of public goods they consume. But contrary to what economists believed prior to the 1970s, there are ways around the perverse free rider incentive, and thereby provide the efficient amount of different public goods. And a tax which charges all who will benefit from a public good an equal share of the cost of producing it is what economists call “an incentive compatible demand revealing mechanism.”

Suppose we ask people how much they would be willing to pay for public goods under the assumption that they will be charged their proportionate share of the cost of providing them. Perhaps surprisingly, there is no incentive for them to lie, and instead an incentive for them to do their best to tell the truth. If they like the public good, they should say so because this will have the effect of increasing the amount provided. And they need not fear that by revealing that they like the good a great deal they will be charged any more than others who like it less, since all will be charged the same amount. If they don’t like the public good, they should say so because this will have the effect of moving the supply decision in the direction they prefer, even if it doesn’t mean they will pay less than everyone else.

In short, when all pay their proportionate share of the cost of providing public goods it is what economists call “incentive compatible” because it will induce people to report their preferences honestly, and thereby allow us to calculate the efficient amount to supply, the amount at which the sum total reported willingness to pay for an additional unit is equal to the marginal social cost of producing an additional unit.

Public goods during participatory annual planning

Our goal is to avoid the bias against public goods in market economies and put public goods on the same footing as private goods during annual planning. Some public goods, such as national defense, national parks, and the interstate highway system are “consumed” by everyone in the nation. Other public goods, like state parks and state roads, are consumed primarily by all residents of a state. Other public goods, like a city public transit or library system are consumed mostly by residents of a city. We simply include the national federation of consumers, state federations of consumers, and city federations of consumers along with neighborhood consumption councils, all of whom submit consumption proposals during the annual participatory planning procedure.

For two reasons we propose that requests for different levels of public goods start with the highest level and proceed to lower levels, and all public good requests precede requests for private consumption during each round of the planning procedure. In this way consumers will know what public goods they have when they are deciding what private goods they want as well, and also know how much of their income remains when they are submitting proposals at different levels. This may also help correct the long-standing bias against public goods which people have developed from their experience living in market economies where public goods have long been under supplied while private goods are over supplied.

Demand revealing mechanisms for public goods

While simple and efficient, people may feel that charging all consumers of a public good the same amount is unfair to those who truly do benefit less. However, an ingenious literature on what are called “demand revealing mechanisms” developed in the 1970s came up with ways to solve this problem as well. The key to incentive compatibility is not to permit a respondent’s reported willingness to pay influence how much he or she will actually be assessed. Once your response has no effect on the tax you pay, there is every incentive to respond truthfully. The trick is to devise a tax system where an individual’s reported willingness to pay does not enter into the formula for calculating their tax, but the tax assessment for those who report they are willing to pay more will nonetheless be higher than the assessment for those who report they are willing to pay less.¹

Theodore Groves and John Ledyard proposed the following tax rule: Everyone should be charged her proportionate share of the cost, minus the sum reported consumer surplus of all other people, where an individual’s consumer surplus is her reported willingness to pay minus her proportionate share, plus a budget balancing sum unrelated to what the individual reports. Nowhere in this formula does the individual’s own willingness to pay appear, so it is incentive compatible, and all have an incentive to report truthfully. However, consider two people, Jill with a high willingness to pay, and Jack with a low willingness to pay. What is subtracted from equal pay for Jill is a sum that does not include her own high consumer surplus but does include Jack’s low consumer surplus. Whereas what is subtracted from equal pay for Jack is a sum that does not include his own low consumer surplus but does include Jill’s high consumer surplus. So Jill, with high willingness to pay, ends up with a tax assessment that is higher than the assessment for Jack with the low willingness to pay. Ingenious!

Contrary to what economists once believed, it turns out there are a number of tax formulas which accomplish the dual goal of inducing respondents to report truthfully while charging those who report lower willingness to pay less and those who report higher willingness to pay more. In any case, while equal assessments is incentive compatible and therefore will lead to an efficient supply of public goods, in cases where there may be large differences between how much different people benefit from a public good, any participatory economy that wishes to make assessments for public goods more fair is free to explore any of a number of incentive compatible demand revealing taxation mechanisms now available in the public finance literature.

1 For over a century economists specializing in the filed of public goods assumed this was impossible, only to discover to their surprise that it was not impossible when a PhD candidate at the University of Chicago named Theodore Groves described his incentive compatible mechanism to his world renown advisor, George Stigler, who was so sure Groves could not be right that he initially rejected his dissertation proposal.