Market Failure and Functions of Government: Public Goods

7 months ago

Atiqur Rahman

19 minutes

Introduction

Market failure occurs as a result of allocative inefficiency in the market system. The reasons for market failure are many, including the provision of public goods, the presence of externalities, imperfect markets, incomplete markets, etc.

Goods can be classified as private, public, merit and demerits. When a person consumes a private good, such as a hamburger, it is not available for consumption by others. But when a person consumes a pure public good such as national defence or a radio broadcast (examples of public goods), the amount of the good available for consumption by others is not diminished.

The market failure in the provision of public goods arises due to free free-riding problem. Free riding induces people not to reveal their true valuation of public goods and enjoy these goods without having to pay for them. This calls for the government to intervene, eliminate the market failure and provide the optimum level of public good.

Let us analyse in detail the market failure in the provision of public goods and the partial and general equilibrium analysis for the optimum production and consumption of public goods.

Concept of Market Failure

Market failure has become an increasingly important topic due to its adverse impact on market efficiency. Market failure occurs when resources are inefficiently allocated due to the presence of certain imperfections in the market mechanism.

The various types of market failure are:

Positive Externalities- When a market exchange confers benefits to a third party, e.g. less pollution and noise from cycling.
Negative Externalities- When a market exchange imposes cost on a third party, e.g. environmental degradation from cutting trees for commercial use.
Merit Goods- These are in the general public interest, but people underestimate the benefit of these goods, e.g. education and health.
Demerit Goods- These are in the disinterest of the public, but people underestimate the costs of these goods, e.g. smoking, liquor consumption,
Public Goods- These goods are non-rival and non-excludable – e.g. police, national defence, hence under-provided by market mechanism.
Monopoly Power- A market form where the producer has market power to set higher prices. These are higher than optimal.

All these market failures need corrective action which makes a clear case for government intervention. The government intervention is justified in the public interest. There are two types of efficiency that the government is expected to bring about:

Allocative Efficiency- It occurs when resources are distributed in such a way that no consumers could be made better off without other consumers becoming worse off. This is also called as Pareto efficiency.
Productive Efficiency- It is achieved when production is carried out at its lowest cost. This implies the minimum optimum point.

Meaning of Private Goods, Public Goods and Merit Goods

Most of the goods available in the market are private goods. They are rivals in consumption, which means that consumption by one person reduces the quantity available for the others. Also, private goods are excludable, which implies that the consumption of a private good like a burger excludes others from consuming it.

In short, private goods are those goods which yield satisfaction only to the person consuming the good. It excludes or denies others to use that good. For example, a cup of milk consumed by a person gives satisfaction to that person only, and it cannot be consumed by anyone else.

A public good, as opposite to a private good, is non-rival and non-excludable in its consumption. The consumption of a public good by one person does not reduce its availability for others. Also, it is difficult to exclude people from consuming it.

It means that public goods, once produced, give the same level of satisfaction to all consumers. Public goods include national defence, dams, clean air, roads, bridges, flood control measures, etc. The non-excludability and non-rivalry are, however the characteristics of pure public goods.

In the real world, public goods may not be completely non-rival in their consumption, and it may be possible that excess consumption of a public good like a road may lead to congestion and it will adversely affect the satisfaction derived from the public good.

Similarly, not all public goods are non-exclusive. In the provision of a public good like cable television, some houses may be excluded if the cable company refuses to hook up one more house in their system. It means that there may be some public goods which may be rival but non-excludable or non-rival but excludable. All such public goods are called as impure or quasi-public goods.

It must be noted that for the provision of some public goods, such as national defence, bridges, and roads, it is customary that the government makes the provision. However, it does not hold true vice-versa.

The public provision does not imply that a good has the characteristics of a public good. There are many goods, such as public housing, food stamps, and solid-bank programs, which are not public goods, but they are provided by the government on account of its redistributive role in the economy.

It implies that public goods can be and are many times supplied by the private sector. Goods of mass public consumption, like radio and television broadcasts, are often provided by private enterprises subject only to non-economic regulations.

Merit goods are those which satisfy all the persons in the society with equal ease; they share their characteristics with private goods, but these goods have extensive positive externalities. In the consumption of merit goods, the social benefits exceed the private benefits.

These goods assist an economy to attain a high level of efficiency and also contribute to achieving many basic objectives. These merit goods include education, health, a clean environment, vaccination, etc.

Apart from merit goods whose consumption and production are in the broader interest of an economy, there are demerit goods which are considered undesirable for consumption and whose use is discouraged by the government. The examples of demerit goods or merit bads include tobacco products, liquor, etc.

These goods have adverse effects on the people consuming these products, and these also have negative external effects on the social welfare, so these goods are discouraged by imposing taxes and by imposing market regulations on their consumption and production.

Market failure occurs in the provision of merit goods because these are underprovided by the market mechanism. This is because individuals do not take into account the positive externalities that arise from their consumption. This results in the market equilibrium quantity that is lower than the social optimum.

Public Goods and Market Failure

Public goods do not necessarily imply a good provided by the government. Rather, it means that the good is characterised by two characteristics: non-rivalry in consumption and non-exclusion.

Non-rivalry in consumption implies that with a given level of production, consumption by one more person need not diminish the quantity consumed by anyone else. Non-exclusion, on the other hand, implies that it is impossible to confine the benefits of a good or service to a selected group of people.

Due to this non-excludable characteristic of pure public goods, it is difficult to charge people for benefitting from a good or service once it is provided. This is because people will have the incentive not to reveal their true preferences for public goods, thereby free-riding on those who accurately state willingness to pay. They might think that the public good will be provided anyway, whether they reveal their true marginal valuation for the public good or not.

This behaviour is called as free riding, meaning that people desire to utilize the public goods without having to pay for it. If this behaviour is adopted by all in the market, then even though people derive social benefits from the use of public goods, it will not be provided. Thus, the free rider problem leads to under-provision or no provision of a good and thus causes market failure.

The major difference between private goods and public goods is that in the case of the former, each individual consumes a different amount but pays the same price. This is due to equal marginal valuation by each individual. While in the case of public goods, each individual consumes the same amount, but marginal valuation may differ. As public goods are non-excludable, therefore there is no link between payment and provision. This is the reason why public goods cannot be provided by the market.

For determining the efficient amount of public good to be provided, the marginal willingness to pay for all individuals should be correctly known. However, Non-excludability gives consumers an incentive to free‐ride and understate their willingness to pay.

Thus, a fundamental problem in the provision of public goods is regarding the “revelation of true preferences”. If those who benefit from a public good are asked to contribute an amount reflecting their true valuations, an individual may decide to free ride on the payments of others by understating his contribution.

Due to the free-rider problem, it is sometimes warranted that the government should provide public goods. This is said with a background condition that the government can provide public good and finance it via taxes.

This, however, does not resolve the problem of determining the public’s aggregate valuation of the good and, thus, the decision whether it should be supplied at all or not. The public or private provision of public goods can be efficient only when the individuals can be excluded from consuming the public good based on their revelations, and the free-rider problem can be resolved.

For example, not allowing satellite-dish ownership free reception of cable television induces customers to pay for the service. Therefore, by including excludability and thereby solving a free-riding problem, the efficient provision of public goods can be achieved.

Efficiency Condition for the Provision of Public Goods

The usual demand and supply analysis can be used in order to find out the optimal level of public goods to be provided. Assuming a perfectly competitive market, the marginal cost curve would serve as the supply curve of public goods.

As people will demand public goods on the basis of the marginal benefit they derive from the consumption of these goods, marginal benefit curves for all individuals will be added together in order to derive the aggregate demand or total demand curve.

Samuelson provided a theoretical partial equilibrium solution for public goods. According to it, the marginal benefit curve or the representative demand curves will be added vertically to derive the aggregate demand curve. At the point at which this intersects the supply curve, the optimal level of public good is determined. This is shown in Fig 1.

Optimum Provision of Public Good in Partial Equilibrium

In Fig 1, MBi represents demand or willingness to pay for the public good. The sum of MB represents aggregate demand, which, when intersects with MC or the supply curve, we get the optimal quantity of public goods.

The above analysis is based on the partial equilibrium analysis, but in reality, public goods are consumed along with private goods. Thus, the general equilibrium analysis will determine the optimal quantity of public goods along with a given quantity of private goods.

For this, the Samuelson condition is considered, which says that for the efficient provision of public goods, the combination of private and public goods should be such that further substitution of private goods for public goods will result in a decrease in social utility. For this the condition is:

ΣMRS = MRT

Where MRS is the marginal rate of substitution for public and private goods for all individuals, and MRT is the economy’s marginal rate of transformation between public goods and arbitrarily chosen private goods.

Let us consider the general equilibrium for the provision of public goods.

Assume that an economy has two consumers and they consume two goods, private and public. In Fig 2, TT shows the production possibilities for the economy; all points 4,8,2 on this curve show optimum or efficient combinations of private and public goods. Its slope is MRT_GX, where G is a public good, and X is a private good.

To determine,

How should resources be allocated? and
What combination of private and public goods should be produced?

We use the Samuelson approach. Samuelson’s approach is to decide first how well off a person or individual is going to be and then search for the combinations of private and public goods which make the other person as well off as possible.

If we fix the level of welfare of A at I_A², it means that A will consume Og of G and g1 of X. Individual B will also consume Og of G and the difference between g2 and g1, i.e. g3 of X, if the economy operates efficiently.

General Equilibrium Analysis for Optimum Provision of Public Good

Repeating the process for each possible output of public good, we derive CC. CC curve represents the consumption possibilities available to individual B, assuming A is kept on I_A². It is derived by deducting I_A² from TT, bearing in mind that when units of public goods are provided for one individual, these are provided for other individuals too. The welfare of B is maximizing at 3 where his IC is tangent to CC.

So, the Pareto optimum resource allocation for the economy would be Og public goods and g2 private goods. At point 3, tangency has been found by deducting MRS_GX for A from MRT_GX and then equating MRS_GX for B to the slope of CC.

MRS_GX^B = MRT_GX – MRS_GX^A

Or ΣMRS_GXⁱ = MRT_GX

Case for the State Provision of Public Goods

Public goods are those goods and services which are clearly in demand, but on account of their non-excludability, they are not normally provided by the private sector. This is because the private sector would be unable to supply them for a profit.

The private sector thus works best in the provision of private goods, which relies on the market mechanism, and people reveal their true preferences by demanding those goods because these goods are completely excludable.

There are many social benefits associated with making public goods available. Whenever we talk about social benefits, the role of government as a welfare state comes to the fore. So, it is up to the government to decide what output of public goods is appropriate for society.

The case for public provision of public goods is based upon the following reasons:

1. Due to the Characteristics of Public Goods Being:

Non-excludable – the goods cannot be confined to those who have paid for it.
Non-rival in consumption – the consumption of one individual does not reduce the availability of goods to others. For example, include flood control systems, street lighting, the police, parks, roads and national defence.

2. Due to Free Riding:

The “free rider” principle says that people will not be charged a correct price for the provision of a non-excludable good because people will understate their marginal benefit from the public good and would try to free ride or not to pay for the public good. Thus, direct provision of public goods by the government can help to overcome the free-rider problem, which leads to market failure.

3. Availability of Financing Alternatives:

Many public goods which raise social welfare are provided more or less free at the point of use and then paid for out of general taxation or other forms of charge such as a licence fee. The government to supply public goods can, therefore, either directly or indirectly (contracting out services), in both cases, fund the services through subsidy and/or taxation.

4. Maximisation of Social Welfare:

There are various types of public goods which are crucial from the point of social welfare but are not optimally produced. In the case of such public goods, state provision may help to prevent under-provision and under-consumption so that social welfare is improved

6. Cost Efficient:

As public goods are goods of mass consumption, their provision on a large scale may confer benefits of scale economies. Therefore, if the government provides public goods, they may be able to do so more efficiently because of economies of scale.

Apart from the above reasons, another reason for state provision of public goods is merit needs. There are certain public goods which are merit in the sense that their social benefits are greater than the private benefit, and it is in the interest of the economy to produce and consume such goods on a large scale. Healthcare, education and pensions are a few examples of such goods.

These goods are generally under-consumed and under-provided under the market mechanism. One reason for the under-provision is that individuals find it difficult to make rational choices when the costs arise today, and the benefits are only received in the future.

Free market forces or private provision will result in inefficient outcomes. It, therefore, makes sense for the government to intervene and force individuals to make contributions that will safeguard them against illness and retirement.

The beneficiary of education will often be not only the person who has to pay for it but also the whole economy, which can benefit from the educated population and workforce. It implies that external benefits will be the gain to the society as a whole.

Somebody who is unable to read or write could be deemed as a burden on society as they would more than likely need support, whereas an educated individual would contribute to the welfare of the nation. Educated people will also have higher incomes that result in higher property tax revenues; “educated” communities typically have lower crime levels and more voter participation.

In fact, it would not be wrong to say that an educated population is a public good because of the positive externalities educated people “spill-over”. This leads to the case for some for government provision of these goods because market mechanism will educate only those who have the capacity to pay for getting educated.

Similar is the case for health facilities; a healthy population is an asset for the economy, and private provision of health facilities will also lead to under-provision and under-consumption

There can also be other arguments for government provision of public goods. Air quality is also a public good that is under-provided in a private market. Therefore, there are a number of potential government responses to poor air quality.

Market Failure and Functions of Government: Public Goods

Introduction

Concept of Market Failure

The various types of market failure are:

Meaning of Private Goods, Public Goods and Merit Goods

Public Goods and Market Failure

Efficiency Condition for the Provision of Public Goods

Case for the State Provision of Public Goods

Read More in: Theory of Public Finance

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Introduction

Concept of Market Failure

The various types of market failure are:

Meaning of Private Goods, Public Goods and Merit Goods

Public Goods and Market Failure

Efficiency Condition for the Provision of Public Goods

Case for the State Provision of Public Goods

Read More in: Theory of Public Finance

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