Market Failure & Externalities

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.

Why public goods are under-provided in the free market

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. The non-provision of public goods is one of the consequences of market failure the syllabus names directly: socially valuable goods like defence and street lighting would simply not exist if left to private firms. This outcome is called a missing market.

Government provision of public goods

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).