Public Goods

The government spends huge sum of money each year on public goods. To understand the nature of these goods more clearly, and why the government is left to provide these for people throughout the economy, we must consider the characteristics of private goods

Private Goods

A private good has three main characteristics:

Excludability:

Consumers can be excluded from consuming the product if they are not willing to pay for it (for example - a ticket to the theatre or a meal in a restaurant)

Rivalry:

One person's consumption of a product reduces the amount available for other people to consume - because scarce economic resources are used up in producing and supplying the good or service

Rejectability:

Private goods and services are rejectable - if you don't like the look of the soup on the college menu, you can reject the chance to consume it and use your money to buy something else.

Characteristics of public goods

The characteristics of pure public goods are the opposite of private goods. They are services which are clearly in demand, but which must be provided collectively by the Government for two main reasons:

Non-excludability - goods cannot be confined to those who have paid for it. In this sense, non-payers can take a free ride and enjoy the benefits of consumption

Non-rivalry in consumption - consumption by one person does not reduce the availability of a good to others.

Examples of public goods

Examples of public goods include flood control systems, street lighting and national defence. Public goods (in fact most of them are services!) are not normally provided by the private sector in an economy. Partly this is because of the free-ride problem.

The Free Rider Problem

The "free rider" principle says that you cannot charge an individual a price for the provision of a non-excludable good because somebody else would gain the benefit from consumption without paying anything.

Consider the case of the provision of traffic wardens and safety signs on roads. One person's benefit from these services is not unique - other motorists benefit from the service as well - but they cannot be stopped and asked to pay for the benefits they derive.

Public goods and market failure

Why is there market failure with public goods? The main ...

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The Free Rider Problem

Public goods and market failure

Why is there market failure with public goods? The main reason is that private sector producers will not supply public goods to people because they cannot be sure of making an economic profit. This is due to the characteristics of public goods outlined earlier. Consumers can take a free ride without having to pay for the good or service.

The obvious solution is that these goods are provided collectively by the government, and then financed through taxation of individual households and businesses.

Externalities

Externalities can be classified as either positive or negative. The activities of private agents - both individuals and firms - frequently involve external costs or benefits. These are costs (or benefits) imposed on “third parties” - that is, on individuals who are not part of the economic transactions that generates the activity. The crucial characteristics of externalities are that they are received and generated outside the market. Externalities result in the misallocation of resources - the oversupply of goods with external costs, the undersupply of goods with external benefits - because individuals fail to take into account the “spill-over effects” of their actions.

Externalities are pervasive. The negative externalities of air and water pollution have long been of concern. Recently, the problems of global warming (a negative externality associated with excessive carbon dioxide emissions, notably from cars and power stations) and the depletion of the ozone layer (associated with the use of chlorofluoro-carbons, primarily in aerosols and refrigeration systems) have attracted world-wide attention. But these are also positive externalities such as the benefits associated with vaccinations and education.

Why externalities cause a misallocation of resources?

In the presence of externalities, the equalities between private and social costs and benefits no longer hold. A negative externality imposes a marginal external cost (MEC) that enters into the marginal cost but not the marginal private cost (MPC): MSC = MPC + MEC. It is apparent that whenever MEC is nonzero MSC willl not equal MPC and there will not be an efficient allocation of resources. There is market failure.

An efficient allocation of resources requires that marginal social cost (MSC) equal marginal social benefit (MSB). The theorem holds only if MSC=MPC (marginal social cost equals marginal private cost) and MSB=MPB. In the presence of externalities, these equalities between private and social costs and benefits no longer hold. A negative imposes a marginal external cost (MEC) that enters into the marginal social costs but not the marginal private costs: MSC=MPC+MEC. It is apparent that whenever MEC is non-zero, MSC will not equal MPC and the competitive equilibrium will not result in an efficient allocation of resources. There is a market failure.

Diagram

The industry shown in the above diagram will, under competitive market conditions end up producing OQe at price Ope. It will, rationally take into account the costs it actually experiences shown by the marginal private cost (MPC). Suppose, however, that it generates external cost in the form of damage to the lungs of people who live near to the production units. These costs are shown by the gap between the MPC curve and the marginal social cost (MSC) curve. As output expands, the marginal external costs (MEC) grow larger. The problem in the case of negative externalities is that marginal private costs is below MSC. This implies that the market equilibrium price is too low and the quantity produced too high.

How can externalities be corrected ?

The government can impose a tax on the producer equal to the damage caused by the externality (i.e the Government should set the tax, t, equal to MEC). In this case, the private producer will no longer be willing to sell the good at MPC, but instead require MPC+t to cover the tax plus his costs. But if t=MEC, then MPC+t=MPC+MEC=MSC and the socially efficient allocation will result.

At output OQe, marginal external cost is equal to AB. To allow for this, the government can impose a tax equal to MEC at each level of output, which shift the supply curve upwards from SS to S+t. This induces the industry to reduce its level of activity to optimal level OQ1, where price equals marginal social cost (MSC).

Carbon tax: One such tax which is currently the subject of debate in the US is the carbon tax. Under discussion as a response to the problem of global warming, carbon dioxide would involve levying taxes on all goods that emit carbon dioxide in production or consumption, with the rate of tax determined by the amount of carbon dioxide emitted.
Effluent fees: Another possible form for government intervention is to impose effluent fees. In contrast to Pigouvian taxes which tax the good that generates the externality, effluent fees tax the externality itself. The offending firm is charged a fee of $x per cubic metre of pollutant emitted. The advantage of this approach over Pigouvian taxation is that it creates an incentive for the firm to explore alternative production techniques that are cleaner (i.e produce less of the externality).

(iv) Direct Regulation: This involves Government setting maximum levels of emissions for different pollutants. Under this approach, firms are legally required to reduce their emissions to these levels (regardless of the cost). Direct regulation, like effluent fees, creates an incentive for firms to choose the most efficient production technique. However, it does not reduce the level of pollution in the most efficient manner because it fails to take advantage of the fact that some firms may be able to reduce their emissions at much lower cost than others. It may, however, be significantly easier (and hence less costly) to monitor than effluent fees.

By Afzal Yearoo