The consequences of missing markets for public goods

Overview

Consequences of the free rider problem for firms, consequences for government of public goods being non-excludable and consequences for third parties.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Analyse the consequences for consumers when a good with public-good characteristics is left entirely to the market.

   Model answer

   Consumers who would collectively have valued the good above its cost receive none of it, so they lose the whole of the potential consumer surplus rather than merely part of it. They may substitute towards inferior private alternatives, such as buying individual security measures instead of benefiting from policing, which duplicates spending and costs more in total. Poorer households are affected most, since they are least able to afford private substitutes, so the loss is unevenly distributed.

2. 2

   What are the consequences of the free rider problem for firms?

   Model answer

   Firms cannot capture revenue from a non-excludable output, so they do not enter the market and the potential producer surplus is never earned. Where a related good can be made excludable they divert resources into that instead, which distorts what gets produced. Firms also lose indirectly, because they operate in an economy without the roads, defence, flood protection and basic research that public goods provide, so their own costs are higher and their markets smaller than they would otherwise be.

3. 3

   Explain the consequences for government of public goods being non-excludable.

   Model answer

   Government becomes the provider of last resort, since only it can compel payment through taxation and so bypass free riding. That creates a spending commitment funded by taxes, which themselves distort incentives elsewhere in the economy. It must also decide how much to provide without a market price to guide it, relying on estimated valuations that may be wrong in either direction. And it carries political responsibility for a quantity and quality that no market test can validate.

4. 4

   Evaluate the view that government provision of public goods is always preferable to leaving them to the market.

   Model answer

   In support, the market supplies pure public goods in negligible quantities because charging is impossible, so funding through taxation is the only route to anything approaching the optimum, and the welfare gain can be large. Against, the state has no price signal revealing how much people want, so it may over-provide or under-provide, and tax-funded provision involves compulsion and administrative cost. Where a good is only quasi-public and exclusion is technically feasible, charged or private provision may work better. The case for state provision is therefore strongest for pure public goods and weakest for impure ones.

5. 5

   Why does the absence of a market price make it hard to decide how much of a public good to supply?

   Model answer

   In an ordinary market the price consumers pay reveals what the marginal unit is worth to them, and the provider expands until that value equals marginal cost. For a public good nobody pays a price, and stated valuations are distorted by the incentive to understate. The provider therefore has to estimate total willingness to pay across the whole population by other means, such as surveys or political processes, and those are far less reliable than observed purchases.

6. 6

   Analyse the consequences for third parties, including future generations, of under-provision of flood defences.

   Model answer

   Households and firms on the flood plain face repeated damage, higher insurance premiums and, in the worst cases, property that cannot be insured at all, which depresses land values. Those effects fall on people who took no part in any decision about the defences. Because a defence wall lasts for decades, the burden also falls on future residents who inherit the absence of protection and on future taxpayers who fund emergency repair rather than cheaper prevention. The costs of under-provision therefore reach well beyond the current period.

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