market failure - public goods

public goods

public good: non-excludable, non-rivalrous and non-rejectable

private good: excludable, rivalrous and rejectable

• non-excludable: the situation where it is impossible or very costly to exclude non-payers from the consumption or use of a good or service once it has been provided ⇒ the provision to any one person automatically makes it available to others

• non-rivalry: the consumption or use of a good or service by one
  consumer does not reduce the quantity and/or quality available to the others

• non-rejectability: inability of consumers to refuse the consumption of a good once it has been produced

how do public goods lead to market failure → non-excludable good or service

• people cannot be prevented from enjoying it even if they do not pay

• results in the free-rider problem where people have no incentive (or willingness) to pay for the good or service

• there is no effective demand, resulting in an absence of a price signal in the market mechanism to allocate public goods

how do public goods lead to market failure → good or service that is non-rival in consumption

• once produced, it can be provided for and enjoyed by additional users at no additional cost to the producer

• the marginal cost of providing the good for additional users is zero ⇒ MC = 0

• since the allocative efficient quantity to supply is where MB=MC (P=MC), the allocatively efficient price to charge for the use of the public good should be zero (P=MC=0)

• private firms, which are assumed to be profit maximising, will not be willing to supply the good

though the marginal cost of providing the public good to an additional user is 0, the marginal cost of producing an additional unit of the good is not 0

• if public goods were left to the free market, they would not be provided at all ⇒ missing market for such goods

• the market has failed because no resources will be allocated to their production, i.e. there is complete market failure

• there is hence a need for the government to provide public goods as they will not be provided by the free market

examples of public goods

• although these public goods yield benefit to society, the free market will not provide it ⇒ provision of public goods by the government becomes necessary for allocative efficiency to be achieved

1. national defence

   • non-excludable: others who did not pay for the defence (e.g. tourists) still enjoys the same level of protection

   • non-rivalrous: once the defence system is established, everyone in the country enjoys the same security against foreign threats

   • non-rejectable: no one in the country can refuse to be defended by the military

2. street lighting network

   • non-excludable: once a street lamp network is built on a
     public street, there is no effective way of excluding anyone who walks on the street at night from enjoying the illumination provided

   • non-rivalrous: it will continue to provide the same illumination for every person that walks on the street

   • non-rejectable: no one is able to reject or refuse the benefits of the street lighting

3. lighthouses, flood-dams and public drainage

not all goods produced by the government are public goods

• e.g. education services, which could be produced by the government and offered free of-charge to students, do not exhibit the characteristics of public goods → they are considered private goods which are directly provided by the government
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direct provision → government intervention

• assuming perfect information, governments may provide public goods at the socially optimal level, Qs, thus maximising society’s welfare

• since it is assumed that the government is non-profit oriented, it does not need to charge a price to cover the cost of production

  • the government can finance the provision of public goods through tax revenue

• in some cases, the government may charge a price, citing the payment for the production or provision of the public good as a reason

  • e.g. some local governments may require residents to pay a sum for a new flood defence scheme

limitations of direct provision

imperfect information by the government

• there is a lack of information on the government’s part on the socially optimal (correct) quantity of public goods to
  provide

• because of the free-rider problem, consumers do not express their demand for public goods ⇒ government does not know how much consumers value the public good (i.e. how much they want and need it), and hence how much
  to provide

• if the government provides too little of a public good, the outcome is still allocative inefficient and social welfare is not maximised

• if the government provides too much of a public good, welfare losses will result ⇒ government failure may result if the welfare loss is greater than the case without government intervention

unintended consequences of direct provision

• opportunity cost of implementation

  • an opportunity cost in spending government funds to provide a public good such as national defence as the
    government will have less to spend on other areas such as education and healthcare

  • the government will need to consider the costs and benefits within its context to decide how much it wants to spend on each good or service

• productive inefficiency by the government

  • the government could be inefficient at providing the public good

  • administrative costs could be higher than necessary
    because of administrative red tape, over-bureaucratic government organisations, and the lack of incentive to keep costs low ⇒ not productively efficient, and the public good could have been supplied at a lower cost, requiring less of taxpayers’ money and the government budget

  • government failure results if the administrative costs involved in providing the public good exceed the welfare
    consumers gain from consuming the public good

other arguments for direct provision

political/national security arguments

• the sensitive nature of some public goods such as national defence is such that the government might be best suited to be in control of provision, instead of leaving it to the free market