2.3.2
Note

The Public-Goods Problem

2.3.2 Market failure 2.3.3 Micro policies

Idea

The free market fails to provide public goods at all. Because a public good is non-excludable and non-rivalrous in consumption, no profit-maximising producer is willing to supply it — which is why public-good provision is sometimes called a complete market failure.

Mechanism

Three linked reasons explain the non-provision:

  • Free-rider problem. Because the good is non-excludable, once it is provided any consumer can enjoy it without paying. Since everyone can free-ride, no rational consumer chooses to pay.

  • Lack of price signals. With no one willing to pay, there are no price signals to register demand, so a profit-maximising producer has no basis or incentive to supply.

  • Zero user charge. Because the good is non-rivalrous, the marginal cost of serving one more user is zero — once an army exists, defending an extra resident costs nothing. The allocatively efficient price (where P=MCP = MC) is therefore zero, and no profit-maximising producer will supply at a zero price.

The remedy is direct provision by the government with full subsidy: the government funds and supplies the good itself, as with national defence and street lighting.

Considerations

A neutral catalogue of the limits on direct provision:

  • Lack of information. Direct provision works only if the government can determine the allocatively efficient quantity. With no price signals to reveal true demand, over- or under-estimation is likely, and either fails to maximise welfare.

  • Opportunity cost of a limited budget. Provision draws on a budget with many competing microeconomic and macroeconomic uses, so it carries an opportunity cost.

  • Political factors. A government seeking re-election may divert funds from public goods towards more visibly popular policies such as subsidies and transfers.

A common error is to conflate the marginal cost of serving an additional user (zero, by non-rivalry) with the marginal cost of producing an additional unit of the good (not zero) — the cost of one more streetlight is positive, but the cost of one more person benefiting from an existing streetlight is zero.