Private Goods and Public Goods

1. Private Goods and Public Goods • This is a key distinction in “microeconomics” • Why? Because private goods will be provided efficiently by the market, and public goods will not. • Why not? --- That is our first subject today.

2. First, Private Goods: The competitive market is efficientprice = marginal cost: Why is that efficient? Demand curve Built-in assumption: to define the demand curve, the clocks are ordered by the users’ WTP. Define the size of the market by the area under the demand curve, say, v. Competitive price p=MC Marginal cost, MC - Clocks

3. Private Goods: What if a “template” must be developed?That is, what if clocks require some R&D? • The market will not provide clocks. A competitive market permits free entry (that is one way to define “competitive”). Therefore the market depresses profits to zero. But these are ex post profits – the cost of developing the clock template is sunk. In a competitive market, the developer gets nothing. • Another way to say this: The template for making a clock is knowledge. Knowledge is a public good, not a private good. • What does this mean, “public good”?

4. The (Public Goods) Nature of Knowledge • Public Goods are defined by two properties. Nonrivalness: High cost to ceate; zero cost to distribute or use. What does this mean for efficient pricing? For profit? Nonexcludability: If the good is nonexcludable, market is impossible!! Why would anyone pay? • Whence the name, “public good”? There is an argument that they should be provided by the government, because the market will not provide them efficiently. WHY? • Longitude Example: What is the lesson? • What do these have in common: Knowledge that “DNA is a double helix” software digital music

5. Information Goods are public goods: the market doesn’t work(What is the price with free entry?)(What is the price with intellectual property?) Idea for new product (v,c) Assume MC of production=0 Consumers’ surplus, mv Monopoly price, pm Monopoly profit per period, pv Deadweight loss dv Competitive price p=MC=0 software users

6. What does IP do? • First, IP creates (as a legal matter) excludability. • Does this “solve” the public goods problem? • What about nonrivalness? • Second, IP provides at least a weak efficiency test as to whether the value of investment exceeds cost • Third, IP does a bad job of delegation • It does not privilege the more efficient firms • It does not regulate entry and duplication • Fourth, IP leads to deadweight loss • Fifth, concentrates costs among the users

7. Intellectual Property: Compared to what? Public Sponsorship? • 1840’s, photography: A patent buy-out. • 1960’s and 1970’s Super Sonic Transport Public support for private enterprise. • 1700’s and 1800’s Lyons’ weavers Prizes in a guild • Napoleon: Food preservation Invention for the public good • NIH, NSF: Researcher-initiated projects • NASA: Targeted government objectives

8. What is the objective of the incentive system?(Depends on the context) • A specific context: Suppose an “idea” opens a market. The idea is defined by (v,c), v=value, c=R&D cost (See the market diagram above.) • Investment is efficient if (1/r) v > c . What is the (1/r)? The per-period value is v, and the value goes on forever. Adding up “forever” at discount rate r (e.g., r=.05) is v/r , e.g., v/r= 20 X v. • In this simple model, the incentive system should elicit investment if (1/r) v > c .

9. Should rewards (patents or prizes)be linked to social value? to cost? • Should the reward be equal to v? Give arguments for and against -- in the simple model -- more generally • Should the reward be equal to c? Give arguments for and against -- in the simple model -- more generally • Are either cost or value verifiable? (Contract theorists distinguish “observable” from “verifiable.”)

10. Verifiability: Can a prize be linked to value or cost?Can a patent be linked to value or cost? • Patent: Is the patent value linked to cost or the value? What is the defect of patents in the diagram? • Prize: Is it possible to link a prize to cost? What is “cost?” Accounting cost? Realized cost? Including or excluding overhead? What if the inventor wasted money or was inefficient? • Is it possible to link prizes to the social value of the innovation? • Patents and prizes can both lead to inefficiencies. How are they different? The same?

11. Targeted objectives:What if there is more than one idea? • Contestants 1,2 have ideas (v1,c1) , (v2,c2): Need to aggregate information and choose the best idea: Invest in idea-1 if (v1/r-c1) > (v2/r-c2) (Not necessarily the lower-cost idea.) c2 v2/r c1 v1/r • How do we choose the best idea? Depends on what we can observe. • What if we can observe both value and cost? • What if we can observe (verify) value, but not cost?

12. Contests: Choosing among Ideas • Fairly easy if value is observable (Vickrey auction) • Really hard if both value and cost are unobservable or unverifiable. Why won’t an auction work? What would you auction? • Prototype Contest: firms develop prototypes; sponsor chooses What is the problem if prototypes are solicited without any commitment as to the price that will be paid? Suppose that the government can make contingent contracts before investing -- contingent on choosing the prototype. Does it solve the problem of (1) ensuring the best idea? (2) at cheapest cost?