Thursday, March 7, 2013

The Preference Revelation Problem

Consumers are utility maximizers...everybody wants more for less...we all want the most bang for our buck...we all want a free lunch...everybody really hates being ripped off.  This is a double edged sword though.  It works wonders in terms of private goods (excludable)...we end up with incredible value because we incentivize producers to be economical/resourceful (do more with less).   But when it comes to public goods (non-excludable)... we all hope that somebody else will pay for our lunch.  If too few people contribute to the production of collective goods then they might be undersupplied.  The government addresses this free-rider problem by forcing people to pay taxes.  Compulsory taxation does not, however, reveal people's true preferences for public goods...and voting does not reflect people's intensity of preferences.  Without knowledge of the actual demand for public goods, it's impossible for the government to supply optimal quantities of public goods.  So we end up with too much of some public goods and not enough of others.  But if taxpayers could choose where their taxes go (logistics), given that the cost (buck) was a foregone conclusion, then they would have a strong incentive to get the most bang.  It would be in their self-interest to reveal their true preferences/demand for public goods.  Taxpayers, as utility maximizers, would reward the producers of public goods that offer more for less (do more with less).  So just like with private goods, allowing consumers to hold the stick that the carrot is dangling from would incentivize government organizations to provide the most value for the least money.

If taxpayers can't choose which public goods they put in their shopping carts...then the cost/quality/variety of public goods will certainly reflect this.

See also:

Here are several passages on the preference (demand) revelation problem...
How, then, are demand functions revealed? It would be disingenuous, to say the least, in an exercise whose object is to discover how demand is revealed, to assume that, ex ante, centers of power know the preferences of consuming households. We must then begin our analysis of the forces that motivate citizens to reveal their preferences by focusing on a fundamental information problem. I therefore assume that as a consequence of imperfect information concerning the preferences of citizens, centers of power will provide, except by accident, goods and services in quantities that will be either larger or smaller than the quantities desired by consuming households at the taxprices they confront, and I show that these departures from optimality inflict utility loses on these households. - Albert Breton, Competitive Governments: An Economic Theory of Politics and Public Finance
In his seminal analyses of public goods, Samuelson concluded that strategic bias implied that there was ‘an inherent political difficulty of ever getting men to reveal their tastes so as to attain the definable optimum’. This view led to widespread acceptance by economists for some time that true demand for public goods could not be determined. - C.D. Throsby, Glenn A. Withers, Strategic bias and demand for public goods
One aspect of public goods that prevents the government making efficient decisions is the government's lack of knowledge of households' preferences and willingness to pay for public goods. - Gareth D. Myles, Public Economics
Prices must also play a more important role as a mechanism for revealing the true demand for - and therefore, indicating the efficient supply of - public infrastructure. The current disconnect between payment by users and services provided by specific infrastructure assets has led to too much public capital in some sectors and too little in other sectors. - Harry Kitchen, Physical Infrastructure and Financing
Thus, the revised definition allows us to see that public goods do not only face the long recognized risk of under-provision; they may also suffer from mal-provision – providing positive utility only for some and for others nothing, or sometimes even, only costs. A way to reduce the risk of such mal-provision could be to grant all concerned population groups a more direct say in selecting and shaping public goods, i.e. to better match publicness in consumption with publicness in decision-making. More issue-specific policy dialogue among all concerned actors and stakeholders could help achieve that. - Inge Kaul, Public Goods: Taking the Concept to the 21st Century
Because of the coercive nature of government activity, two additional results come forth. First, by voluntarily purchasing an item on the market, an individual demonstrates that he values the item more than the money price. But in paying taxes, he makes no such demonstration. The government does not know, as a business does, the value individuals place on its activity. Since government cannot obtain the information and incentive by demonstrated preferences of individuals, they cannot efficiently serve individuals. - Jeffrey Herbener, Austrian Methodology: The Preferred Tax Type
Pareto-optimal provision clearly also requires full knowledge of individual preference functions by the central planning agency. The preference-revelation problems involved in practice are a familiar theme in the modern public goods literature. - John G. Head, Public Goods and Multi-Level Government
Belief in the inevitability of the free-rider problem has gained wide acceptance among economists. The essence of this problem is that; for a Pareto-optimal solution to be reached, individuals must reveal their preferences for public goods. But since each individual consumes the total quantity of public good supplied, it is in any individual’s interest to understate the satisfaction he gains from consuming the public good, thereby only slightly reducing the quantity of public good supplied but significantly reducing his own tax burden. Everyone reasons in this way and the public good will be under-supplied. Thus arises a paradox: individually rational action leads to an outcome which is collectively irrational. - John McMillan, The Free-Rider Problem: A Survey
The free-rider problem is in fact not one, but three separate problems. In order for a Pareto optimum to be reached in an economy with a public good, there is a need, firstly, for consumers to contribute enough revenue to pay for an optimal quantity of the public good. Secondly, it is necessary for agents to reveal their preferences for the public good (so that it can be known what is an optimal quantity of the public good). Thirdly, a different kind of problem arises when the number of agents consuming the public good becomes large. - John McMillan, The Free-Rider Problem: A Survey
But the Samuelson condition involves individual marginal rates of substitution. In order for the set of Pareto-optimal allocations to be known, it is necessary for each consumer to tell the government what his marginal rate of substitution is. But it may be in an individual's interest to give false information about his utility function. This is what has become known as the preference revelation problem. - John McMillan, The Free-Rider Problem: A Survey
Two major problems with government provision of public goods, as discussed in the previous chapter, are the problems of preference revelation and preference aggregation: it is difficult to design democratic institutions that cause individuals to honestly reveal their preferences for public goods, and it is also difficult to aggregate individual preferences into a social decision. As a result, governments are often unable to deliver the optimal level of public goods in practice. - Jonathan Gruber, Public Finance and Public Policy
Government production of a public good has a main advantage, because a government can impose taxes and fees to pay for the public good. Still, the main problem of deciding the optimal level of public good production remains. To determine it, the government would need to know its citizens' preferences. However, as we have previously argued, since exclusion is not possible, nothing forces citizens to reveal their true preferences. Furthermore, citizens are not willing to reveal their willingness to pay for the public good if the actual payment they will be assessed depends in some way on their reported willingness to pay. - Laura Razzolini, Public Goods
One cause of inefficiency in the provision of collective goods is familiar from the theoretical writings in welfare economics and public finance, but rarely mentioned in the PPB or cost-benefit literature. That is the difficulty of getting consumers to reveal their preferences concerning a collective good or externality, and preferences must of course be known to determine how much it is optimal to provide. - Mancur Olson, Evaluating Performance in the Public Sector
But this argument generates far more difficulties than it solves. It proves too much in many directions. In the first place, how much of the deficient good should be supplied? What criterion can the State have for deciding the optimal amount and for gauging by how much the market provision of the service falls short? Even if free riders benefit from collective service X, in short, taxing them to pay for producing more will deprive them of unspecified amounts of private goods Y, Z, and so on. We know from their actions that these private consumers wish to continue to purchase private goods Y, Z, and so on, in various amounts. But where is their analogous demonstrated preference for the various collective goods? We know that a tax will deprive the free riders of various amounts of their cherished private goods, but we have no idea how much benefit they will acquire from the increased provision of the collective good; and so we have no warrant whatever for believing that the benefits will be greater than the imposed costs. The presumption should be quite the reverse. And what of those individuals who dislike the collective goods, pacifists who are morally outraged at defensive violence, environmentalists who worry over a dam destroying snail darters, and so on? In short, what of those persons who find other people's good their "bad?" Far from being free riders receiving external benefits, they are yoked to absorbing psychic harm from the supply of these goods. Taxing them to subsidize more defense, for example, will impose a further twofold injury on these hapless persons: once by taxing them, and second by supplying more of a hated service. - Murray Rothbard, The Myth of Neutral Taxation
Nevertheless, the classic solution to the problem of underprovision of public goods has been government funding - through compulsory taxation - and government production of the good or service in question. Although this may substantially alleviate the problem of numerous free-riders that refuse to pay for the benefits they receive, it should be noted that the policy process does not provide any very plausible method for determining what the optimal or best level of provision of a public good actually is. When it is impossible to observe what individuals are willing to give up in order to get the public good, how can policymakers access how urgently they really want more or less of it, given the other possible uses of their money? There is a whole economic literature dealing with the willingness-to-pay methods and contingent valuation techniques to try and divine such preference in the absence of a market price doing so, but even the most optimistic proponets of such devices tend to concede that public goods will still most likley be underprovided or overprovided under government stewardship. - Patricia Kennett, Governance, globalization and public policy
Determining the efficient level of public goods requires knowing consumer preferences. That knowledge is often assumed as given in theoretical models of optimal provision, but obtaining it is a major challenge when it comes to actual policy. - Richard A. Musgrave, Peggy Musgrave, Providing Global Public Goods
The concept of efficiency is predicated on individual evaluations of goods and services and the extent to which people are free to express those evaluations. - Richard B. McKenzie, Bound to Be Free
As a later chapter discusses in more detail, democracy (the voting mechanism) is a very poor means for determining people's preferences. Votes can be cast either for or against a limited number of proposals offered in referenda, but votes remain extraordinarily poor devices for registering the intensity of different people's wants and desires. Furthermore, why would we want to rely on the cumbersome procedures of democracy to determine how many toothpicks or bow ties to produce? - Richard B. McKenzie, Bound to Be Free
If a revenue source is earmarked but has no logical connection with the expenditure function it supports, then from an efficiency perspective the amount of the public service supplied will almost certainly be either too great or too small. - Richard M. Bird and Thomas Tsiopoulos, User Charges for Public Services: Potentials and Problems
The large theoretical literature on incentive-compatible demand revelation was inspired in part by attempts to design preference revelation mechanisms for public goods which would avoid free riding and result in the optimal decentralized provision of public goods. The incentive-compatible demand revelation devices (ICDRDs) proposed by theorists create situations in which it is in the person's selfish interest to choose to reveal his or her true preferences for a good. - Robert Mitchell, Richard Carson, Using Surveys to Value Public Goods
The problem of providing public goods optimally could, as we saw at the beginning of the chapter, be easily solved if we just knew people's preferences for public goods. We would then simply add up individual demand and find where the aggregate demand for public goods crosses the marginal cost of providing such goods. - Thomas Nechyba, Microeconomics: An Intuitive Approach
Voting and other democratic procedures can help to produce information about the demand for public goods, but these processes are unlikely to work as well at providing the optimal amounts of public goods as do markets at providing the optimal amounts of private goods. Thus, we have more confidence that the optimal amount of toothpaste is purchased every year ($2.3 billion worth in recent years) than the optimal amount of defense spending ($549 billion) or the optimal amount of asteroid deflection (close to $0). In some cases, we could get too much of the public good with many people being forced riders and in other cases we could get too little of the public good. - Tyler Cowen, Alex Tabarrok, Modern Principles of Economics
Because most public goods and services are financed through a process of taxation involving no choice, optimal levels of expenditure are difficult to establish. The provision of public goods can be easily over-financed or under-financed. Public officials and professionals may have higher preferences for some public goods than the citizens they serve. Thus they may allocate more tax monies to these services than the citizens being served would allocate if they had an effective voice in the process. Under-financing can occur where many of the beneficiaries of a public good are not included in the collective consumption units financing the good. Thus they do not help to finance the provision of that good even though they would be willing to help pay their fair share. - Vincent Ostrom and Elinor Ostrom, Public Goods and Public Choices
Nevertheless, even without perfect knowledge, the government must decide whether or not to provide the public good. It also must decide how much of the public good it should provide. Finally, the government must decide, all without guaranteed information, on a tax schema. Under such circumstances, it is not possible for the government to reach an optimal solution and a Pareto distribution of taxes for the public good. - Wilfried Eecke, Ethical Dimensions of the Economy

2 comments:

  1. I would refer you to my last comment. Pref. Rev. arose within a specific context and now has moved forward in the shape of things like auction design- which to be frank is a bit hit and miss because of some version of Aumann agreement being built into the incentive compatability model. In other words, the capacity of agents to employ specialised negotiators is negated from the start.
    This is mad. Neither Politics not Prostitution would exist if Pimps didn't exist.

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  2. I should add, that Aumann agreement increases systemic risk

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