Concept of Different Types of Goods
Previously, we have discussed why the government in various economies is the primary provider of several essential goods and services like highways, education, and unemployment insurance, while the provision of other goods and services, such as clothing and entertainment, is generally left to the private companies?
The concept of private goods, public goods and merit goods provides the rationale behind this allocation function of the government in a country.
Generally speaking, public goods include all those goods and services provided by the public sector and all those goods left to be provided by the private market are categorized as private goods. In order to understand the difference between these goods, we need to know the underlying characteristics of them.
Concept of Public Good and Private Good
Definition of Public Good and Private Good
Goods and services that are either not supplied at all or supplied by a less than-optimal amount in the private markets are usually provided through the public sector in an economy. So, what is the difficulty of providing them through the private sector?
To understand this, we need to know the concept of “Free-rider problem” in economics. The following example will help to understand the idea.
Suppose the residents of an apartment building in Delhi need a garbage collection service. If they opt for a private service to pick up the trash regularly, the cost of this service has to be financed by a voluntary fee paid by each resident of that building.
Now, the problem is since this is voluntary, several residents can refuse to pay their share of the trash collection fee and continue to throw garbage with the hope that their neighbours will pay and they will enjoy the free service at others’ cost. This is an example of a classic Free-rider problem.
Therefore, the Free-rider problem states that when an investment has a personal cost but a common benefit, people tend to underinvest or shirk from their share. Goods that suffer from this Free-rider problem are known in economics as the Public Goods.
Public Good can be categorized as either a pure public good or an impure public good. Pure public goods are characterized by two traits:
- Non-rival in consumption
- Non-excludable
Non-rival in consumption implies one individual’s consumption of a good does not affect another’s opportunity to consume the good. Similarly, non-excludable means individuals cannot deny each other the opportunity to consume a good. These conditions for pure public goods are fairly strong and are met by very few goods in reality.
For example, the national defence of a country is a classic example of pure public good. National defence is non-rival because if I live next to your house, then my consumption will not diminish your national protection in any way.
Similarly, national defence is non-excludable because if an area is under national protection, then every house in that neighbourhood receives the same protection. There is no way the government can exclude me if I live in that neighbourhood from others.
Other examples of pure public good include lighthouses and firework displays. Therefore, goods that are perfectly non-rival in consumption and non-excludable are called pure public goods.
Most of the public goods that we see frequently are usually known as impure public goods. Goods that satisfy the two above-mentioned public good conditions (non-rival in consumption and non-excludable) to some extent, but not fully, are called impure public goods.
The following table shows all possible combinations of public goods based on the two characteristics.
Table: Pure and Impure Public Goods, Private Good
| Is the good rival in consumption? | |||
| Is the good | Yes | No | |
| Excludable? | Yes | Private Goods (Example: Ice cream) | Impure Public Good (Example: Cable TV) |
| No | Impure Public Good (Example: Crowded side-walk) | Pure Public Good (Example: National defense) | |
From the above table, we can see that there are two types of impure public goods.
Some public goods are excludable but non-rival in consumption. For example, Cable television is an example of such an impure public good. The cable company can refuse to provide you with the connection, so it is excludable. But, once you have a cable connection, you can enjoy the same shows and programs as others. Your enjoyment of cable television will not reduce the enjoyment of anybody else’s, so it is non-rival in consumption.
Other types of public goods are rival but non-excludable in nature. For example, walking on a crowded sidewalk will be the case for such a public good. When we walk on a crowded sidewalk, we reduce the enjoyment of each other’s walking as we have to struggle against even more foot traffic, so it is rival in consumption. But, no city or town can exclude anybody from walking on a crowded sidewalk, so it is non-excludable in nature.
Therefore, the table implies that when a public good is both non-rival and non-excludable, it is a pure public good. When a public good is either rival but non-excludable or excludable but non-rival, it is an impure public good.
From the table, we can see goods that are both rival and excludable in consumption are called pure private goods. For example, ice cream is a private good. It is completely rival in consumption because if you buy an ice cream cone, you cannot have that ice cream cone. It is also perfectly excludable because if you don’t want to sell ice cream to me, you can do that.
Optimal Provision of Private Good
In order to determine the optimal provision of public goods, we need to understand the mechanism of the private goods market and compare it with the public good allocation principle. The most important aspect of the public good allocation is that pure public goods are consumed collectively or jointly without exclusion. On the other hand, as we have discussed before, private goods are subject to the exclusion principle.
As a result, when a public good is supplied in an economy, it is consumed in equal amounts by all consumers, whereas for a private good, an individual can be excluded or prevented from its consumption if he doesn’t pay the price for it.
The following discussion of private goods provision will help us to revisit the pricing mechanism for such goods and understand its market demand.
Let us consider the figure above representing the market equilibrium of a pure private good, such as bread. The horizontal axis measures the quantity demanded of bread, and the vertical axis measures the price of bread.
Let, W reflects the total market quantity supplied for bread. Suppose the society has two consumers, A and B. Let Wa and Wb represent the quantities of private goods consumed by A and B, respectively. Therefore, W must be equal to the summation of Wa and Wb. Since bread is a pure private good, from our previous discussion, we know that it must be rival in consumption and excludable.
That means if consumer A uses more of good W, consumer B must use less under the condition of rivalry. Moreover, a consumer who does not voluntarily pay the price of bread is unable to consume the good at all.
For example, if the market supply of bread is 20 units and consumer A consumes 15 units of bread, then only 5 units remain for consumer B. Therefore, assuming the total production to be 20 units for a pure private good, W:
W = Wa + Wb Or
20 = 15 + 5 in this case.
The figure demonstrates the allocation of private goods in graphical terms. Here, Wa and Wb represent the individual demand curves for the bread of consumer A and consumer B, respectively.
The market demand curve W for bread, the dotted line in the figure, is derived by the horizontal summation of the two individual demand curves under the condition of the exclusion principle along with the divisibility of pure private goods.
S is the market supply curve of bread. The intersection of market demand and supply curves at point x results in the equilibrium quantity determined in the market at 20 units with a price of 50 cents per unit. At this price, 15 units of bread are demanded by consumer A and 5 units are demanded by consumer B, as reflected from their individual demand curves.
Therefore, in the case of a pure private good, the total demand for the good is the horizontal summation of the individual demands. In other words, a pure private good is divisible between consumers.
This implies that the market works better to provide the pure private good as for such a good, the efficiency condition: Marginal benefit (MB) = Marginal cost (MC) holds for each consumer. We can verify that from the above diagram.
In Figure, the vertical distance under each consumer’s demand curve at their chosen quantity measures the marginal benefit they receive from private good consumption. Therefore, at equilibrium x, both the marginal benefits derived by person A in consuming 15 units and by person B in consuming 5 units are equal to the marginal cost of 50 cents. This is an efficient solution as MB = MC for each consumer. So, in the case of pure private good:
MBa = MC For consumer A
MBb = MC For consumer B
Optimal Provision of Public Good
Now, we can discuss the optimal condition for providing a pure public good in a society and compare it with the private good provision principles. Let us consider the Figure representing the demand for a pure public good, such as National Defence.
Let us assume that Z reflects the total quantity of pure public goods. We have the same two consumers, A and B, with Za and Zb levels of consumption of the public good, respectively.
As discussed before, a pure public good like national defence is non-rival and non-excludable in consumption. Therefore, it is not divisible among consumers. Once supplied at a given level, this good is jointly consumed equally by all consumers in a society.
Assuming the total supply of pure public good Z to be 20 units, both consumers A and B will consume 20 units of the good. In other words, if the good is supplied to one of the consumers, it must also be supplied at the same level to the other consumer. So, for both consumers, the equations are:
Z = Za and Z = Zb
The figure represents the demand for pure public goods in graphical terms. The horizontal axis measures the quantity demanded of public goods, and the vertical axis measures the price of public goods Z.
Za and Zb represent the individual demand curves, respectively, for consumers A and B. The market demand curve Z for pure public goods is derived by the vertical summation of the two individual demand curves in the case of indivisible pure public goods where the exclusion principle does not apply.
Consumers A and B each individually consume the total quantity (20 units) of the pure public good. S denotes the supply curve of public goods. The equilibrium is achieved at point y where market demand curve Z intersects the supply curve S. The equilibrium supply of public goods is 20 units with a price of 50 cents per unit.
As observed from the diagram, in the case of pure public goods, individual consumers are not able to vary the quantities of the goods that can be purchased at a particular market price. Instead, both consumers must consume the entire public good provided (20 units here) equally, regardless of the price they are willing to pay for that particular quantity of the good.
As we can see from Figure, consumer A would be willing to pay 35 cents and consumer B 15 cents per unit for 20 units of the public good if a pricing mechanism as same as in the case of private goods could be worked out.
The phenomenon of different consumers willing to pay different prices for the consumption of a particular quantity of public good can be better understood if we consider the marginal benefit and marginal cost of public good consumption.
As before, the vertical distance under each consumer’s demand curve at their chosen quantity measures the marginal benefit they receive from public good consumption in Figure 2. The marginal benefit to each consumer in this case (35 cents to consumer A and 15 cents to consumer B) sums up to the marginal cost of 50 cents as determined at point y in the diagram.
Therefore, in the case of pure public good, the efficiency condition is to set the marginal cost equal to the sum of marginal benefits rather than setting it equal to each individual’s marginal benefit. So, we have the following:
MBa + MBb = MC Or
0.35 + 0.15 = 0.50 for pure public good.
Therefore, comparing the efficiency of public and private good provision, we see two significant distinctions.
Firstly, the key feature of the private good’s market equilibrium is that consumers demand different quantities of the good at the same market price. So, in the private market, we horizontally sum the individual demands of consumers to get the market demand of the private good.
On the other hand, the key feature of the public good market is that whatever amount of the public good is provided must be consumed equally by all consumers. That is, each person is forced to choose a common quantity of the public good. So, in the public good market, we vertically sum the individual demands of consumers to get the social value of the public good.
Secondly, in the case of private goods, the marginal benefit received from the good for each consumer is equal to the marginal cost of production (MB=MC for both A and B). On the other hand, for public good, social efficiency is maximized when the sum of individual marginal benefits equals the marginal cost (MBa + MBb = MC).
Concept of Merit Goods
Definition of Merit Goods
So far, we have classified economic goods into categories of private and public goods based on their consumption characteristics- joint or private. Goods that have a higher degree of joint or collective consumption characteristics are usually provided by the public sector, and those goods with a lower degree of joint consumption can be supplied by the private sector. But, there can be exceptions to this tendency, as we may notice in a society.
Sometimes, the public sector may decide to actively participate in the allocation of certain economic goods, which are essentially private goods-rival and excludable in consumption and, therefore, can be otherwise supplied by the private sector.
These economic goods are considered by the government as meritorious or important as they generate large social benefits for every individual and society. Examples of such goods and services are education, healthcare, job training programs, public libraries and others.
For these goods, the government thinks that everybody in a society should consume a certain level of these goods irrespective of their ability to pay for those goods and also believes that if left to the private sector alone, these goods will be under-provided. These governmentally supplied or heavily subsidized private goods are called Merit goods in economics.
In other words, merit goods are those goods and services with large social benefits which the government feels that people will under-consume if left to the private market alone and which ought to be subsidized or to be provided free of cost so that everybody can consume it regardless of their ability to pay for the good.
Merit goods are under-provided or supplied at a less-than-optimal level by the private sector because the private market for such goods suffers from market failure; that is, the equilibrium outcome of the private market does not maximize social efficiency. There are two main reasons for this market failure:
Firstly, the consumption of merit goods generates large positive externalities, which means social marginal benefit (SMB) from merit goods consumption exceeds the private marginal benefit (PMB) that is SMB>PMB.
For example, we can think about education. An individual receives private benefits from education through higher productivity, income, and a better job in his or her life, but others in the society also gain in terms of social benefit to becoming an educated, enlightened and responsible citizen. Therefore, the consumption of education does not only creates benefit for that person but also for others in the society, which is not accounted for in the private market equilibrium.
Secondly, people suffer from imperfect information regarding the consumption of merit goods. The government feels that individuals may not act in their own best interest partly because they don’t have complete information about the long-term benefits of merit goods.
Let’s take the example of education again. Education is a long-term investment decision for children. The costs of education are paid in the current period, but the benefits from education in terms of higher productivity, income, greater occupational mobility, and better employment opportunities could be received in the distant future.
Sometimes, people are unaware of these long-term benefits of education for their children and, therefore, under consuming it. Also, the equity ground is another argument for the public provision of merit goods. Families with low income do not have the ability to pay for their children’s education even when they know the benefits of education. Therefore, subsidized or free education from the government can help them to attain that desired level.
Therefore, merit goods can be provided both privately and publicly as we can see both private and public schools, hospitals, health insurance and other services to coexist in a society.
Read More in: Theory of Public Finance
- Public Finance: Meaning, Nature & Scope
- Role of Government in Economy
- Role of Government in Mixed Economy: Public & Private Sector
- Role of Government under Cooperation and Competition
- Role of Government in Economic Development and Planning
- Concept of Public Goods, Private Goods, and Merit Goods
- Concept of Market Failure and Functions of Government
- Market Failure and Functions of Government: Decreasing Costs
- Market Failure and Functions of Government: Externalities
- Market Failure and Functions of Government: Public Goods
- Future Market: Meaning, Role & Uncertainty
- Concept of Information Asymmetry
- Theory of Second Best: Concept & Explanation
- Problem of Allocation of Resources: Public & Private Mechanisms
- Preferences: Meaning, Types & Problems of Preference Revelation
- Preference Aggregation & Its Mechanism
- Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
- Economic Theory of Democracy: Concept & Explanation
- Politico Eco Bureaucracy: Concept & Explanation
- Rent-Seeking and Directly Unproductive Profit-Seeking Activities
- Rationale for Public Goods: Concept & Explanation
- Benefit Theory or Voluntary Exchange Theory
- Lindahl Model: Concept, Equilibrium & Limitations
- Bowen Model: Concept, Advantages & Limitations
- Samuelson’s Model of Public Expenditure
- Musgrave’s Model of Public Expenditures
- Demand Revealing Schemes for Public Goods
- Vickery-Clarke-Groves Mechanism
- Groves-Ledyard Mechanism
- Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
- Theory of Club Goods
- Keynesian Principles of Stabilization Policy
- Difference Between Keynesian Economic Thought and Others
- Role of Expectations and Uncertainty in Formulating Stabilization Policy
- Intertemporal Markets Efficiency & Failure
- Liquidity Preference Theory
- Diamond-Dybvig Banking Model
- Preference Shocks, Adverse Selection & Central Bank
- Equilibrium Deposit Contract
- Social Goods and Its Effect on Stabilization Policy
- Effect of Infrastructural Facilities on Stabilization Policy
- Effect of Distributional Inequality on Stabilization Policy
- Effect of Regional Imbalances on Stabilization Policy
- Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
- Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
- Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
- Pure Theory of Public Expenditure
- Structure & Growth of Public Expenditure in India
- Trends, Lessons & Priorities in Public Expenditure in India
- Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
- Performance Based Budgeting and Zero Based Budgeting
- Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
- Tax System and Its Principles
- Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
- Ability to Pay and Benefits Received Principle of Taxation
- Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
- Deadweight Loss of Taxation: Causes, Measurement & Example
- Concept of Equity & Efficiency in Economics
- Trade-Off Between Equity and Efficiency: Meaning & Example
- Theory of Measurement of Dead Weight Loss
- Double Taxation: Meaning, Desirability, Forms & Solution
- Solution to Problem of Double Taxation: Intra-Country & International
- Double Taxation Avoidance Agreement (DTAA) and Indian Policy
- Classical View on Public Debt
- Compensatory Aspect of Public Debt Policy
- Public Debt or Borrowings: Concept, Need, Sources & Types
- Concept of Public Debt or Public Borrowings
- Need for Public Debt or Public Borrowing
- Sources of Public Debt
- Classification of Public Debt
- Burden of Public Debt: Meaning, Types & Explanation
- Debt Through Created Money or Deficit Financing
- Public Debt (Public Borrowings) and Inflation (Price Level)
- Crowding Out of Private Investment and Activity
- Principle of Public Debt Management and Debt Repayment