Module 22: Public Goods

Policy Example: Should the Government Regulate the Extraction of Fish from the Ocean?

In waters within ten nautical miles of the United States shoreline

Exploring the Policy Question

1. Does the societal benefit from the advent of new drugs outweigh the cost to society from the creation of monopolies?
2. What other way could society promote the development of new medicines?

22.1 What is a Public Good?

Learning Objective 22.1: Describe the two key features of a public good.

22.2 The Free-Rider Problem

Learning Objective 22.2: Explain how public good lead to overuse.

22.3 Problems with the Public Provision of Public Goods

Learning Objective 22.3: Describe the problem of under-provision of public goods.

 

 

22.1 What is a Public Good?

Learning Objective 22.1: Describe the two key features of a public good.

Public goods are goods that have some degree of non-rivalry and non-excludability. Rival goods are goods that are diminished with use. An example of a rival good is a sandwich, when someone consumes a sandwich that sandwich is gone and no one else can consume it. Non-rival goods are goods that do not diminish with individual consumption, for example no amount of consumption of the music from a radio station leaves any less music for anyone else with a radio to listen to. Clean air, national defense and lighthouses are other classic examples of non-rival goods. Exclusive goods are good for which consumption can be controlled or prevented. The sandwich behind the deli counter in a market is an exclusive good, consumption can only happen if the deli workers allow it. Non-exclusive goods are things like the roads and parks in a city where anyone can drive on the roads or enjoy the park. Fisheries are another example of non-excludability.

Private goods are, like the sandwich, goods that are both rival and exclusive. What this textbook has been discussing all along are private goods. But what happens when the goods have some non-rivalry and/or some non-excludability? Public goods like these are subject to market failures. For example, suppose someone tried to charge a price for a radio transmission: The result would be that one would pay that price because they can get the radio signal for free and there is no way to stop those that didn’t pay from receiving the signal. This is known as the free-rider problem – when non-payers consume a good that has a positive marginal cost.

We can classify goods based on the presence of rivalry and excludability as is shown in the table, Table 22.1.1, below. We divide goods into four categories: private goods are goods that have both rivalry and exclusion (and are the type of goods we have studied up to this point); public goods are goods that are both non-excludable and non-rival; club goods are those that are excludable but non-rival; and common property (or common pool) resources are those that are rival but non-excludable.

	Excludable	Non-Excludable
Rival	Private goods: sandwich, gasoline, computer	Common Property Resource: fishery, roads, parks
Non-Rival	Club Good: satellite radio, cable TV, sporting event	Public Good: clean air, national defense, lighthouse.

We also distinguish between pure public goods, goods that are completely non-rival and non-excludable like radio transmissions, and impure public goods that have at least some of both non-rivalry and non-excludability. City roads are an example of an impure public good, they are non-excludable but they are not perfectly non-rival, each car takes up a little of the road space leaving just a tiny bit less for others.

22.2 The Free-Rider Problem

Learning Objective 22.2: Explain how public good lead to overuse.

Public goods are both non-rival and non-exclusive. For example, national defense is a public good. All residents of a country enjoy the protections of military defense of the territory, no one is excluded or excludable. And no matter how much one individual consumes of national defense, there is just as much national defense of the other residents of the country, so it is non-rival.

Market failures in the provision of pubic goods arise for a very simple reason: since non-payers cannot be prevented from consuming the good the incentives to pay for he good are diminished. We call this problem the free-rider problem. It is easy to understand this when we think about individual incentives. Utility for the consumption of a pubic good is increased the less the consumer pays for it.

We can illustrate this with a simple example of two neighbours with adjacent properties considering erecting a fence between their properties to provide privacy. Neighbour 1 is a private person and someone who values privacy very highly. Neighbour 2 is a someone who values privacy but much less than neighbour 1. Figure 22.2.1 shows the demand curves for the two neighbours of the length of the privacy fence in meters. D¹ is neighbour 1s demand curve and D² is neighbour 2s demand curve. These demand curve represent the value to each neighbour of a meter of fence. By adding these two values together we get the true social benefit of the fence and we can show this in the figure as the vertical sum of the two demand curves which is labeled D^SB where SB stands for social benefit. For example, to erect a 10 meter fence Neighbour 1 is willing to pay $30 a meter and Neighbour 2 is willing to pay $20 a meter. The social willingness to pay for the shared fence is the sum of the two individual’s willingness to pay or $50. Notice immediately that the social marginal benefit of the good is not the same as the private marginal benefits for either neighbour.

Figure 22.2.1: The Free-Rider Problem and the Under Provision of Public Goods.

Contrast this with a private good where consumption benefits only the buyer and therefore the social marginal benefit is the same as the private marginal benefit. Recall that when determining the total demand or the social marginal benefit curve for the market for a private good, we sum the individual demand curves horizontally because benefit to a consumer only comes from when they consume their own private units of the good. The difference here is the lack of rivalry, so that same unit of a public good benefits all consumers in the market, so we have to add up all of the individual benefits for each unit of the public good or sum the demand curves vertically.

Fences are costly, however, and we will assume that the cost per meter of erecting a fence is $50. This is marginal cost of fencing and is the social marginal cost since that is the total cost to the two neighbours of erecting a meter of fence.

The socially optimal amount of fencing for the two neighbours is the point at which the social marginal benefit of the fence, given by the demand curve D^SB, intersects the marginal cost of the fence. In Figure 22.2.1, this intersection occurs at 10 meters.

To understand what will actually occur, notice that the individually optimal amount of fencing for neighbour 1 is 6 meters. In other words, if the neighbour was going to build a fence individually, 6 meters is the amount that neighbour would build. Neighbour 2 would not build any fence individually as the marginal cost of building is higher than the marginal benefit even for the first meter of fence. Since Neighbour 2 does not want to collabourate on the fence, Neighbour 1 will build it alone, build 6 meters of fence, and Neighbour 2 will enjoy the benefit of the fence without contributing to it. We see in this example how private provision of public goods is subject to under-provision: Neighbour 2 free rides off Neighbour 1s fence and thus only 6 meters of fencing is constructed while 10 meters is socially optimal.

To ensure public goods are provided, governments usually step in and provides the good themselves or subsidizes or mandates its provision. An example is local fire departments. Fire protection is a classic public good, all those in the fire district benefit from the service and the protection of one household leaves no less for the other households in the district. Left to the market, we can be confident that a suboptimal amount of fire protection would be provided, thus it because part of the accepted role of government to levy a tax on homeowners and provide fire protection themselves.

22.3 Problems with the Public Provision of Public Goods

Learning Objective 22.3: Describe the problem of under-provision of public goods.

While the case of fire protection may seem straightforward, other public goods can be both difficult to evaluate in terms of the value they provide to the public and difficult to provide even given the policy tools available to governments.

In order to value public goods, you must look beyond the market valuation. Because of the presence of free ridership, the market will undervalue public goods. Alternatively, governments can rely on surveys, but these types of surveys are often poor because it is very hard to judge the value to an individual of public good. An individual might be able to answer how much they would be willing to pay for a proposed new park in their neighbourhood, but how much is the police protection they enjoy worth? Without knowing what life would be like in the absence of a police force, that is a very difficult question to answer. Other things for which individuals lack enough information to value correctly could include clean air and drinking water, national defense, and public education.

Another way to both value and to potentially provide public goods is through a popular vote. This seems to be a reasonable solution on the surface, but upon examination, it is clear that the ability of such a system to provide public good rests pivotally on the median voter.

Consider the following example: suppose a town on a river is considering building a bridge over the river. To keep the analysis simple, let’s assume a simplified world where there are five residents of the town and the bridge costs exactly $1000 to construct. The bridge is worth different amounts to each resident depending on factors such as income, how close they live to the bridge, how often they anticipate using the bridge, etc. The following table, Table 22.3.1, lists each resident and their maximum willingness to pay for a bridge which is a measure of the monetary value to them of the bridge.

Table 22.3.1: Resident’s Willingness to Pay for a New Bridge

Resident	Willingness to Pay
A	$500
B	$350
C	$175
D	$150
E	$125
TOTAL	$1300

Note that the total value to the society of the new bridge is $1300, which is well more than the cost of $1000 and so from a social welfare perspective, the bridge should be built – the community will see a net benefit from doing so. Suppose the town proposes a tax of $200 on each resident, which would net exactly the $1000 needed to build the bridge. When put to a vote, this proposal will fail because residents C, D and E will all vote no: the $200 they are being asked to pay is greater than their individual benefit. Note that the pivotal voter in this is resident C. If resident C’s willingness to pay were $200 or more, they would vote yes. C is the median voter, half way from the top and bottom and the construction of the bridge will rest crucially on their valuation relative to the individual cost.

It is also worth noting that other means of provision in this case are also problematic. Voluntary contributions would fall prey to the free rider problem as C, D and E all know that their contributions are not needed provided the others contribute fully and will therefore withhold. A toll would have to raise the $1000 cost, and thus would be the equivalent of the $200 tax. In this case the ‘voting’ would happen by use: only A and B would pay $200 to use it and the toll revenues would fall far short of the cost of the bridge.

If these willingnesses to pay were closely related to income, then charging a tax as a percentage of income might work, but if they have more to do with proximity, work travel patterns and so on, this approach would fail as well. So how do public goods get provided in most cases? Out of general funds from the government. By packaging together a whole host of public goods including roads, parks, schools, libraries, public safety and the like, governments can average out individual differences related to preferences and create broad support for the funding of these activities.

 

SUMMARY

Review: Topics and Related Learning Outcomes

22.1 What is a Public Good?

Learning Objective 22.1: Describe the two key features of a public good.

22.2 The Free-Rider Problem

Learning Objective 22.2: Explain how public good lead to overuse.

22.3 Problems with the Public Provision of Public Goods

Learning Objective 22.3: Describe the problem of under-provision of public goods.

Learn: Key Terms and Graphs

Terms

Public Goods

Rival Goods

Exclusive Goods

Private Goods

Supplemental Resources