STABILITY OF MARKETS WITH PUBLIC GOODS: A Case of Gross Substitutability

Abstract

This chapter discusses the stability of markets with public goods. One of the problems of current interest in the study of stability of multiple markets is the introduction of public goods—in particular, whether their supply is optimal at the resulting equilibrium. The stability of the adjustment process in which the planning agency decides the amount of public goods to be supplied may be considered as an example. The agency considers the marginal valuations of those goods as reported by consumers and firms, on the one hand, and the marginal production costs, on the other, while simultaneously the markets for private goods are adjusted by price changes according to excess demands. If consumers and firms reveal their valuation of public goods honestly, then the supply of public goods can be Pareto optimal at the resulting equilibrium, with the sum of individual marginal valuations being equal to the marginal cost. Because of nonexcludability, however, rational individuals will understate their preferences for public goods. Furthermore, there is no clear incentive for, or pressure on, the planning agency to supply the optimal amount of public goods even if individual preferences are honestly revealed. In the case of local public goods, however, individuals will voluntarily reveal their preferences for public goods by moving to the community whose local government best satisfies their demands.