Allocation of Resources · 4 question types
Past paper frequency (2018 to 2024)
This topic accounts for approximately 11% of your exam marks.
Externalities and market failure corrective policies are increasingly tested; particularly in evaluate questions since 2020.
Some goods are unusual because of two properties the market cannot price. These are public goods.
A public good has two key features:
Non-rival. One person's consumption does not reduce the amount available to others. Walking past a street light does not stop anyone else from using it.
Non-excludable. Once provided, it is impossible (or too costly) to prevent non-payers from using it. A lighthouse warns every passing ship regardless of which shipping company has paid.
Classic examples: national defence, street lighting, lighthouses, public flood defences, clean air, public parks (in many cases).
Both properties are required. A good that has only one of them is not a public good.
The combination of non-rival and non-excludable creates the free-rider problem: a private firm trying to sell a public good cannot stop people who refuse to pay from consuming it. Rational consumers therefore wait for someone else to pay and then use the good for free. Knowing this, the firm cannot collect enough revenue to cover costs, so it does not produce the good at all.
The free market either massively under-provides public goods or fails to provide them entirely. This is called a missing market.
The standard solution: the government provides public goods directly, funded through general taxation. Everyone pays through tax, and the free-rider problem is solved because no one can opt out of the tax.
This solution has its own trade-off: providing the good requires tax revenue, which has an opportunity cost (the tax money could have funded a hospital, a road, or a tax cut for households).