On the Definition of Public Goods

Frances Woolley had a nice post over at the Worthwhile Canadian Initiative yesterday about the textbook treatment of public goods. Her beef is with the use of national defence as the canonical example.

I have a more fundamental beef. Could we please please all agree to change the definition of what constitutes a pure public good. The classic definition is that a pure public good is one that is a) non-rivalrous in consumption, and b) non-excludable.

I want to remove the second of these from the definition. Non-rivalrousness relates to the nature of the good; non-excludability relates to what mechanisms would allow for it to be provided. This conflates two quite distinct ideas and so is not helpful for a number of reasons.

First, microeconomics courses typically move straight from the definition of a public good to finding the condition for the optimal level of its provision (the Samuelson condition in intermediate micro; or, in partial-equilibrium terms, stating that the sum of the willingness to pay should equal the marginal cost). This optimality condition is equally true of any good that is non-rivalrous in consumption, whether it be excludable or not, but that is not the impression you would get reading treatments that show the optimality conditions after imposing a definition of excludability.

Second, non-excludability is neither necessary nor sufficient for public provision to be the only or even the best means of provision: Just because a good is excludable, it does not necessarily follow that it can be profitably supplied by the private sector if there is variation in consumers’ willingness to pay and limited opportunities for price discrimination; and a good being non-excludable does not mean that it could not be provided privately through philanthropy, being tied to other goods, etc.

Third, the standard definition leaves a gaping hole in most (possibly all) textbook treatments of market failures. We typically move from the first welfare theorem (a competitive market outcome is Pareto efficient) to a listing of potential market failures under which the theorem may not hold—incomplete markets, lack of property rights, transactions costs, monopoly, asymmetric information, externalities, and public goods. If public goods are required to be non-excludable by definition, this list is missing a very important market failure—non rivalrous but excludable goods, which might be provided by a private market, but not at the efficient level.

Finally, by conflating properties relating to the provision of a good with properties relating to how it enters consumers preference functions, we add to the likelihood of students thinking that a public good is one that is provided by the government and a private good one provided by the public private sector. And this, I think, leads to exactly the problem that Frances raises: that arguments about national defence being a public good “confounds the abstract—defence, protective services—and real world military spending”.

O.K. So I am not going to be able to bring about a change in the world’s textbooks with this post, but any prospective Canterbury ECON 203 students who might be reading this, please take note: We will be using the non-standard definition next semester!

Should we teach IS/LM?

With this year’s Nobel having gone macro, Offsetting needs a macro post.

I have been enjoying the discussion about the IS/LM model in the blogsphere. It started with Tyler Cowen here discussing why he doesn’t like IS/LM. Brad Delong, Krugman, Scott Sumner and others responded in different ways, pro and con (see the links at Steve Landsburg's take on the issue here). WCI’s Nick Rowe makes the point that in many ways, the argument is one of semantics—“It's still IS/LM to me”.

For me, the interesting question is not whether IS/LM is a useful abstraction for some questions, but how (and when) it should be taught. After all, academic economists have access to the full range of models, but typical economics graduates will be highly constrained by the basic models with which they were introduced to macroeconomics. So, I am going to imagine that I were able to write some rules to guide the content of undergraduate macroeconomics texts and ask what role IS/LM would play in those rules. This is what I came up with.

1. Start with the determinants of long-run economic growth.

Depending on the level, this could be a long-run dynamic general equilibrium model or just a simple presentation of growth accounting. The key thing is to emphasise the role of investment and, by extension, saving rather than fiscal and monetary policy in determining long-run growth. This was important during the great moderation, but it is arguably even more important now when we want to emphasise that the current situation is not normal and so policy prescriptions need to start from an analysis of what makes the situation different.

2. Spend a lot of time on the 45-degree line model when introducing the notion of aggregate demand.

When I first learnt macroeconomics, it was standard to start with the Keynesian cross in both principles and intermediate courses, but it seems to no longer be in fashion. I think that is a mistake. Both the IS and the AD curves show combinations of variables that have equilibrium properties, but both look like they should be read as a causal behavioural relationship from the horizontal to vertical axes, just like a micro demand curve. The 45-degree line model contains a causal, behavioural relationship and an important accounting identity. Students need to understand the difference between them thoroughly, how the economy will always be on the 45-degree line, and how undesired changes in inventories (or potentially quantity rationing) explain how the economy can exist away from the equilibrium point. The diagram is also a useful way of conveying the notion of hot-potato money.

3. Go straight from the 45-degree line to the AD/potential-output diagram.

Cut to the chase: this is the diagram that combines the LR determinants of output from step 1 (the vertical potential output line) with the Keynesian SR model from Step 2. It doesn’t matter what story you tell for why the equilibrium relationship between output and price is negative or how policy can affect the position of the AD curve. With this diagram, coupled with an expectations-augmented Phillips curve, one can discuss price dynamics, expectations, optimal Taylor rule type polices explaining why it is better to respond harder to aggregate demand shocks than to price shocks, etc.

Once this framework is in place, then, and only then, in my view, is it appropriate to explore graphical models of the determinants of aggregate demand, such as IS/LM. But before getting to that…

3a. …Remove any mention of the words “demand” and “supply” from this diagram…

Potential output is not “supply” in an analogous sense to a supply curve, indicating the willingness of producers to bring goods to market as a function of the price. Even more, the downward-sloping aggregate demand curve looks like a micro-style demand curve showing the amount buyers would like to buy at a given price, ceteris paribus, when in fact it is a locus of equilibrium points at which planned output equals actual output. Calling these curves aggregate demand and aggregate supply is guaranteed to confuse 90% of undergraduate students.

3b. ... And even with a different name, there is no place for the curve sometimes called short-run aggregate supply…

SRAS serves no useful purpose that I can see. One can describe price dynamics in terms of an economy moving along the AD curve without having a SR supply curve. I am open to being corrected here but as far as I can make out, the so-called SR aggregate supply curve is nothing more than the following: i) In the short-run, the economy will be on the so-called AD curve, but not necessarily on the vertical LRAS curve; ii) students, however, will want the location of the economy to be at the intersection of two curves, so we need a new curve; and iii) since the first curve has been misnamed aggregate demand and is downward sloping, we might as well label the other curve aggregate supply and make it upward-sloping.

3c….And why assume the economy is on the AD curve in the short-run?

The economy is only on the AD curve if it is at equilibrium in the 45-degree line diagram. Why assume that in the short-run there are no unplanned changes in inventories?

4. Return to your favourite version (or versions) of IS/LM.

Now that the basic ideas of macro are in place—long-run output depends on long-run capacity determination, short-run capacity utilisation may depend on the determinants of nominal spending, and the big policy questions concern how much one wants to manipulate nominal spending and how one brings that about—then is the time to get into details about liquidity traps, what interest rates the central bank can control, real versus nominal interest, the role of financial intermediation in the whole process, the possibly complicated feedback loops between SR nominal spending and LR capacity accumulation; etc. IS/LM is probably a useful diagrammatic tool to have in the mix here, but let’s do the basics first.

Messing with the GST

From the Worthwhile Canadian Initiative, I see that the both the right-leaning Conservatives and left-leaning New Democrat Party in the Ontario provincial elections are campaigning to remove their equivalent of the GST from home heating and electricity. This is, of course, an economic nonsense. Liveo di Matteo from WCI attributes it to the dead-hand of mediaeval thought concerning the “just price” still resonating in the voting public’s consciousness. He may well be right on this, but it is noteworthy that political parties from opposite sides of the spectrum are promoting the same nonsense, so I suspect that there is more at play here.

The trouble is that the argument against favouring home heating and electricity in Canada is much harder to make than the argument against removing New Zealand’s GST from fresh fruit and vegetables. The reason for this is that Canada messed up its GST from the start by zero-rating basic foodstuffs. The transactions costs that are created when moving from a clean GST to one with exceptions are already part of the Canadian system, and the argument against favouring some goods over others, while still valid, loses its power if the system is already riddled with such judgements.

The main cost of introducing a new exception is the greater difficulty of defending against the next exception and then the next and so on. If we are not going to put the GST on home heating and electricity, why not apply the same logic to clothing, to home repairs, to … In fact, why not remove the GST from everything except luxury boats?

New Zealanders continue to owe a huge debt of gratitude to the 1984 Labour government for giving us a clean GST, but eternal vigilance is required to keep it that way.

Is good economics necessarily bad politics?

Over at the Worthwhile Canadian Initiative, Frances Woolley has been wondering why the HST (previously known as the GST, a value-added tax like New Zealand’s GST), is levied on used furniture. Frances, quite correctly, notes that a sensible VAT would tax the commission part of a dealer’s income (the value-added from dealing services), but not the full value of the furniture. Eric in the comments discussed the New Zealand case, which led the comments thread to talk about the silliness of exemptions, and the limits of what is politically feasible.

This has led me to wondering if politicians consistently underestimate the economic sophistication of the voting public, or at least overestimate the extent to which pandering to a lack of sophistication will translate into success in elections.

I was living in New Zealand when the GST was first announced and debated here in 1984, and when it was implemented in 1986. By 1989 I was living in Canada and witnessing the announcement, debate, and implementation of the GST there. The thing that struck me was the parallels. In both countries, the calls for exemptions of all sorts started immediately, there were assertions that “a tax on books is a tax on knowledge”, there were cries that a value-added tax is regressive and so basic foodstuffs must be exempt (technically, zero-rated, but the public discourse never distinguishes between exemption and zero-rating), etc.

Politically, though, things were very different. In New Zealand I went to two talks by government ministers on campus discussing the GST. In one, associate finance minister David Caygill openly admitted that it would probably cost the government the next election, but it wouldn’t matter as the opposition wouldn’t actually change it. He then went on to say, “but you never know; we might become the first ever democratic government to introduce a value-added tax and still win the next election!”. Associate minister of revenue, Trevor De Cleene, soft-talked a room or angry students and converted just about everyone present over to the logic of a clean VAT. In Canada, in contrast, I went to a presentation by finance minister Michael Wilson also speaking to angry students at McGill, brilliantly explaining the definitional problems that arise when trying to exempt some goods, but completely evading the question of why his logic didn’t apply to food.

In New Zealand, the suposedly politically naive, VAT-introducing government went on to increase its majority at the next election. In my classes at McGill, I used to joke how the Canadian government looked to New Zealand to what was different about their VAT that enabled them to beat the curse of losing the next election. They discovered two differences: first, NZ introduced a clean VAT with no exemptions; second, they named it GST not VAT. So the Canadians, convinced that it was all in a name, introduced a dirty VAT, but called it the GST. The result? The government was reduced to only two seats at the next election.
So what is the political lesson from all this. One could be simply that regressions with two observations and lots of missing variables (non-Canadians please google “Meech Lake”) can’t tell you much. Another might be that, if there is an air of economic crisis about, a policy that is blatantly not populist might serve a role of signalling that a government really is trying to do what is right and be poliically sucessful, not becuase of its true merits but, in a kind of reverse Yogi Bera, be popular because of tis perceived unpopularity.

But I wonder if the message is that politicians should forget the aphorism about a week being a long time in politics, and conclude that doing the right thing can be the right policy for winning elections, even if it is not the best way of doing well in the next opinion poll? Or am I just being naive?