Public Goods & Private Goods Author: Geoff Riley Last updated: Sunday 23 September, 2012 Introduction Public

goods provide an example of market failure resulting from missing markets. To understand this it is helpful first to discuss what is meant by a private good or service. Private Goods A private good or service has three main characteristics: 1. Excludability: Consumers of private goods can be excluded from consuming the product by the seller if they are not willing or able to pay for it. For example a ticket to the theatre or a meal in a restaurant is clearly a private good. Another example is the increasing use of pay-per-viewas a means of extracting payment from people wanting to watch exclusive coverage of sporting events on television or the payment required to travel on a toll-road or toll-bridge. Another example of a private good is the use of subscription-based services on the internet. Some newspapers provide the bulk of their news stories on the internet as a quasi public good such as The Guardian www.guardian.co.uk. Others are developing an alternative business model where users can only access premium services through password-protected parts of a web site that require payment from consumers examples include The Economist www.economist.com and the Financial Timeswww.ft.com. Excludability gives the service provider (the seller) the chance to make a profit from producing and selling the product. As we shall see, with public goods, such excludability does not exist. When goods are excludable, the owners can exercise property rights. Rivalry: With a private good, one person's consumption of a product reduces the amount left for others to consume and benefit from - because scarce resources are used up in producing and supplying the good or service. If you order and then enjoy a pizza from Pizza Hut, that pizza is no longer available to someone else. Likewise driving your car on a road uses up road space that is no longer available at that time to another motorist. The greater the volume of traffic on the roads, the higher the likelihood of traffic congestion which has the effect of reducing the average speed and increasing the average journey time for each road user. Rejectability: Private goods and services can be rejected - if you don't like the soup on the college or school menu, you can use your money to buy something else! You can choose not to travel on Virgin Rail on a journey to the North West and go instead by coach, or you can choose not to buy a season ticket for your local soccer club and instead use the money to finance a subscription to a local health club. All private goods and services can be rejected by the final consumer should their tastes and preferences change.

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Private and Public Goods a question of exclusion Le Shuttle is a private good the service is excludable, rival in consumption and rejectable. But not all providers of public goods make a profit. EuroTunnel is facing large losses and even bigger debts! Characteristics of Public Goods As one might expect, the characteristics of pure public goods are the opposite of private goods:

Non-excludability: The benefits derived from the provision of pure public goods cannot be confined to only those who have actually paid for it. In this sense, non-payers can enjoy the benefits of consumption at no financial cost to themselves this is known as the free-rider problem and it means that people have a temptation to consume without paying! Non-rival consumption: Consumption of a public good by one person does not reduce the availability of a good to everyone else therefore we all consume the same amount of public goods even though our tastes and preferences for these goods (and therefore our valuation of the benefit we derive from them) might differ

Examples of Public Goods There are relatively few examples of pure public goods. Examples of public goods include flood control systems, some of the broadcasting services provided by the BBC, public water supplies, street lighting for roads and motorways, lighthouse protection for ships and also national defence services. Example: Policing a public good? To what extent is our current system of policing an example of a public good? Some (but not all) aspects of policing might qualify as public goods. The general protection that the police services provide in deterring crime and investigating criminal acts serves as a public good. But resources used up in providing specific police services mean that fewer resources are available elsewhere. For

example the use of police at sporting events or demonstrations and protests means that police resources have to be diverted from other policing duties. The police services must make important decisions about how best to allocate their manpower in order to provide the most effective policing service for the whole community. Private protection services (including private security guards, privately bought security systems and detectives) are private goods because the service is excludable, rejectable and rival in consumption and people and businesses are often prepared to pay a high price for exclusive services. A good recent example of this has been the use of private security firms in post-war Iraq where up to 15,000 workers are said to have been working for private businesses protecting installations, coalition buildings and convoy protection. Public goods and market failure Pure public goods are not normally provided at all by the private sector because they would be unable to supply them for a profit. Thus the free market may fail totally to provide important pure public goods and under-provide quasi public goods (see below). It is therefore up to the Government to decide what output of public goods is appropriate for society. To do this, it must estimate the social benefit from the consumption of public goods. Putting a monetary value on the benefit derived from street lighting and defence systems is problematic. The electoral system provides an opportunity to see the public choices of voters but elections are rarely won and lost purely on the grounds of government spending plans and the turnout at elections continues to fall.

The air waves a public good or a quasi public good? The airwaves used by mobile phone companies, radio stations and television companies are essentially owned by the government of a particular country. Do they count as a pure public good? Normally the answer would be yes. One persons use of the airwaves rarely reduces the extent to which other people can benefit from utilising them. But when demand for mobile phone services is high at peak times, the airwaves become crowded and as a result access to the networks can become slow. In this sense the airwaves can be treated a crowded nonpure public good. The government also controls the issue of licences needed to operate mobile phone services using the airwaves in the UK. In 2000, they auctioned off five licences for 3rd generation mobile phone services and raised 22 billion in doing so. Quasi-Public Goods Most public goods are non-pure public goods these are also known as quasi-public goods. The main reason is that we can find ways and means of excluding some groups from consuming them! A quasi-public good is a near-public good i.e. it has many but not all the characteristics of a public good. Quasi public goods are:

Semi-non-rival: up to a point, extra consumers using a park, beach or road do not reduce the amount of the product available to other consumers. Eventually additional consumers reduce the benefits to other users. Beaches become crowded as do parks and other leisure facilities. Semi-non-excludable: it is possible but often difficult or expensive to exclude non-paying consumers. E.g. fencing a park or beach and charging an entrance fee; building toll booths to charge for road usage on congested routes

The diagram below is one way of illustrating the different characteristics of public and private goods.

The BBC as a public good Broadcasting is a good example of a public good. Let us remind ourselves of the three main characteristics of a public good. Firstly it is non-rival, meaning that the consumption of a public good or service by one individual does not preclude consumption by another individual. Secondly, consumption is non-excludable. This means that consumption by one individual makes it impossible to exclude any other individual from having the opportunity to consume. Effectively the cost of providing a pure public good to an extra user is zero, and this implies that, in order to achieve allocative efficiency, the charge for the product should be zero. Of course, in this situation, private sector businesses are unlikely to consider providing pure public goods because they will not be able to make any profit at a zero price, and many consumers can take a free ride on such goods because of non-excludability. The provision of pure public goods is therefore a cause of market failure. Left to the free market, public goods are underprovided and under-consumed leading to a loss of social welfare. At the moment, around 23 million households in Britain pay an annual licence fee. All of these people arestakeholders in the debate about the future funding of the BBC and the vast majority use one or more BBC services at least once a week. The fee is a means of providing collective payment for a public good. We know that there are fee-dodgers who try to take a free-ride by avoiding payment, but there are well established although costly means to enforce the licence fee and take non-payers to court. Of course the BBC is now facing huge competition from broadcasters such as Sky who are able to exclude people from their services through the use of subscription-based services. Skys financial muscle continues to grow. The case for government intervention in the case of public goods

The non-rival nature of consumption provides a strong case for the government rather than the market to provide and pay for public goods. Many public goods are provided more or less free at the point of use and then paid for out of general taxation or another general form of charge such as a licence fee. State provision may help to prevent the under-provision and under-consumption of public goods so that social welfare is improved.

Public bads A public bad is the opposite of a public good it provides disutility or dis-satisfaction to people when consumed and therefore reduces our economic welfare. A good example to look at would be the disposal of household and commercial waste. People are normally prepared to pay a price for their household waste to be collected and disposed of in a safe and non-polluting way. But if waste was changed for according to how much had been generated, then some people would find an incentive to dump their waste on other peoples property and thereby avoid direct charges. The economics of waste is it a public bad? Waste is now a major economic problem. As a nation, the UK generates over 430 million tonnes of waste each year, the majority coming from municipal, industrial and commercial sources. Each household is estimated to produce over 500 kg of waste per person each year and we throw away nearly a tonne of waste each over the course of twelve months! Waste is a nuisance good that has a negative effect on our welfare. From unsightly waste products to the costs of clearing up and disposing of waste, there are many private and external costs arising from the mountain of detritus that comes from our homes every day. But how much are we prepared to pay for waste collection and disposal? The current situation is that local authorities have a legal responsibility to collect household waste once per week, the private sector market does not provide the bulk of waste collection services for households although they have a role to play in providing waste services for businesses and other larger organisations. Household waste collection is nearly always done free at the point of collection. This raises questions of equity and efficiency and also the issue of whether there are better ways of providing incentives for us to create less waste as our living standards improve. Why should a large family that fills many wheelie bins every week pay the same as a single householder who creates just one or two bags worth of rubbish? Can economists come up with good ideas to reduce waste and to give people the right incentives to dispose of their waste in an environmentally friendly way? Public Goods When the market fails to provide certain goods and services, there is a clear case for government intervention. The nature of public goods Public goods are services which must be provided collectively for two main reasons:

Non-excludability - the goods cannot be confined to those who have paid for it Non-rivalry in consumption - the consumption of one individual does not reduce the availability of goods to others

Examples of pure public goods include flood control systems, street lighting and national defence. A flood control system, such as the Thames Barrier, cannot be confined to those who have paid for the service. Also, the consumption of the service by one household will not reduce its availability to others. If left to the free market mechanism, no public goods would be provided and, as a result, there would be a clear market failure. No individual consumer would pay for a product that could be consumed for free if another household decided to purchase it. Quasi-public goods: These are products that are essentially public in nature, but do not exhibit fully the features of non-excludability and non-rivalry. The road network in the UK is currently available to all, but could be made excludable via a system of electronic road pricing. There is also non-rivalry in consumption, but only up to an extent. Once the road becomes congested there is rivalry in consumption. Environmental public goods: An example of an environmental public good is public open space, which nobody would provide on their own, even though everybody benefits from it being available. Street lighting is another example of a public good. The Air-Waves a Quasi Public Good The airwaves are essentially owned by the government of a particular country. Do they count as a pure public good? Normally the answer would be yes. One persons use of the airwaves rarely reduces the extent to which other people can benefit from utilising them. But when demand for mobile phone services is high at peak times, the airwaves become crowded and access to the networks provided by the main mobile phone companies can become slow. In this sense the airwaves can be treated a crowded non-pure public good. The government controls the issue of licences needed to operate mobile phone services using the airwaves in the UK. In 2000, they auctioned off five licences for 3rd generation mobile phone services and raised 22 billion in doing so. The government was using the auction process to ration the airwaves through a licence system. Although the government has monopoly control in the sense that it

controls the issue of licences, it did not set the market price. This was determined by the auction process, and the fact that at the end of a bidding war, the major mobile phone companies were prepared to pay such a high price for a licence to allow them to operate in the market, is evidence of the private benefit (or anticipated future profit) that the companies expected to make from selling 3rd generation contracts to customers. The fact that these telecoms companies may have greatly misjudged the actual market demand for third generation mobile phone services is not the result of the auction process itself. The government decided that the income from the sale of these licences would be used to repay a slice of the national debt, providing a bonus for current and future generations in terms of reducing the annual interest payments on government debt. Finding an Equilibrium Allocation of Public Goods that Maximises Social Welfare Finding the socially efficient level provision of public goods is a hugely difficult process. First we must seek a valuation of the willingness and ability of consumers to pay for public goods which involves estimating the individual demand curves for each consumer and then aggregating to find the market demand curve a reflection of the social marginal benefit (or valuation) that consumers place on each extra unit of a public good that is made available. In the diagram below we consider a non-pure public good whose marginal cost of supply does rise gently as output is increased. If the market fails to provide a sufficient quantity of a public good, then there is a loss of economic (social) welfare.

Case Study: The BBC as a public good Broadcasting is a good example of a public good. Let us remind ourselves of the three main characteristics of a public good. Firstly it is non-rival, meaning that the consumption of a public good or service by one individual does not preclude consumption by another individual. Secondly, consumption is non-excludable. This means that consumption by one individual makes it impossible to exclude any other individual from having the opportunity to consume. Effectively the marginal cost of providing a pure public good to an extra user is zero, and this implies that, in order to achieve allocative efficiency, the charge for the product should be zero. Of course, in this situation, private sector businesses are unlikely to consider providing pure public goods because they will not be able to make any profit at a zero price, and many consumers can take a free ride on such goods because of non-excludability. The provision of pure public goods is therefore a cause of market failure. Left to the free market, public goods are under-provided and under-consumed leading to a loss of social welfare. Traditional analogue broadcasting differs from encrypted digital broadcasting in the sense that digital broadcasters can now exclude non-payers using set-top boxes. But even when Britain moves fully to digital when the analogue signal is turned off in a few years, the broadcasting services will continue to be completely non-rival and it is this that really matters in the context of the services that the BBC provides. One extra person consuming programmes on BBC1 or BBC2 has no effect at all on the ability of people to consume other services provided by the BBC. Paying for a public good - the licence fee debate

At the moment, around 23 million households in Britain pay an annual licence fee. All of these people are stakeholders in the debate about the future funding of the BBC and the vast majority use one or more BBC services at least once a week. The fee is a means of providing collective payment for a public good. We know that there are fee-dodgers who try to take a free-ride by avoiding payment, but there are well established although costly means to enforce the licence fee and take non-payers to court. According to research undertaken by the BBC as part of the Charter Review, on rough estimates, about 17 million households value BBC television, radio and internet services at more than the current licence fee of 122. These are gainers from the existence of the BBC. In contrast, the study finds that 6 million people value the BBC at less than the current licence fee. These are losers they are paying more than the utility that they get and many such people may resent having to pay the licence fee when they have paid for theirBSkyB subscription and have already deserted the BBC for other digital or commercial channels. The BBC study estimates that the net consumer surplus created by the BBC is well over 2bn/year, or % of GDP. The most likely groups to think the licence fee represents good value for money for their household are those aged over 60 and those in the higher AB social groups. Groups more likely to think the fee represents poor value for money are those with multi-channel television access, people aged 31-45, people in the C2DEs social groups and younger people of Black or Asian origin. People in C2DE social groups are far more likely to have an income below the median, and therefore the question of raising the licence fee becomes important because a sharp rise in its level would affect peoples ability to pay. For millions of people, the value that they derive from the BBCs output does exceed the price they currently have to pay via the licence fee. Would they be happy to pay a significantly higher fee in the future? Much would depend on the quality and range of broadcasting that the BBC is able to deliver. Assuming a constant range, reliability and quality of services, a large rise in the BBC licence fee would reduce total consumer surplus. The BBC study estimates that if the fee was raised by forty per cent from 122 to 170, up to four million people would no longer value BBC services as much as the higher compulsory fee, consumer surplus would be reduced and the BBCs services might end up being under-consumed. This, in a nutshell, is the argument against the introduction of a subscription-based system for funding the BBC. It would exclude several million people from consuming their services and would probably result in a net loss of social welfare. Criticisms of the licence fee Opponents of the licence fee argue that 1. It is a regressive form of taxation everyone pays the same flat charge, regardless of their disposable income, the number of televisions they own or the extent to which they watch television in general and BBC services in particular As fewer people watch the BBC, the case for a licence fee diminishes. Indeed as technology develops, it become even harder to sustain a compulsory licence fee when people have moved predominantly toalternative sources of information through the internet, digital channels, broadband and their mobile phones The costs of collection and evasion are high including 150 million per year chasing licence-fee evaders

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What are the alternatives for funding the BBC?

Moving to a subscription base system (technology may allow this in the future). Allowing advertising and sponsorship of programmes similar to the ITV model. Greater emphasis on selling BBC programmes overseas through BBC Worldwide and sales of DVDs to generate increased revenue for the BBC. Funding the BBC entirely through direct taxation and scrapping the licence fee. A tax on the revenues of other commercial broadcasters to part-fund the BBCs services reflecting the public service nature of much of the BBCs output.

Of these alternatives, introducing advertising is least preferred among people surveyed. A sizeable majority of viewers (over sixty per cent according to a recent MORI poll) regard advertising as an intrusion to their enjoyment of programmes, and few think that the BBC should move to this form of finance. And there are worries that the total size of the TV advertising market is not large enough to absorb the entry of the BBC as a supplier of advertising slots. It might well damage the financial viability of ITV for example. In any case, advancing technology now allows viewers to skip advertising when they have pre-recorded programmes.

On the whole, there is a preference for keeping the licence fee (a system of funding used in many other countries) although there are concerns among older groups about their ability to pay for it. But without a sizeable increase in its value, there is little doubt that BBC revenues will soon be overtaken permanently by Sky and this will damage the BBCs ability to bid for live television events including the rights for sports such as soccer, cricket and golf. Public Goods and the Free Rider Problem Consumers have an incentive to not reveal their willingness and ability to pay for public goods if they believe that they will be expected or required to contribute to financing the public good accordingly by the government. After all, if the public good is supplied, it will be available to them just as it would be to anyone else because pure public goods are non-excludable. This is the essence of the free rider problem: the incentive which consumers have to avoid contributing to financing public goods in proportion to their valuation of such good. Good examples to use include TV licence dodgers and people who choose to evade the Council Tax but who still receive local authority services. Another example might be a group of residents in a block of flats who all stand to benefit from the refurbishment of an adjacent playground or better lighting and security systems, but who individually might try to avoid payment and benefit once the improved amenities are in place. Given the nature of the free rider problem, public goods are often financed through some form of enforcement, notably the compulsory nature of the TV licence fee, management fees for residents living in blocks of accommodation or the signing of international treaties on the environment.

In economic terms, a public good is a produced good or service that is widely available to consumers. In defining a public good, the item will usually be referred to as non-rivalous, non-excludable, or both. The identification of an item as a public good is normally for purposes of analysis, since it is very hard to find goods created for sale to consumers that do not match this criteria. When a public good is said to be non-rivalous, that simply means that the item remains widely available for consumption by all consumers, even when one consumer had engaged in consumption of the good. Non-rivalous goods can be thought of as easily renewed, or so plentiful that the consumption by one consumer in no way inhibits consumption by others. An example would be an ear of corn picked from a cornfield. While the one ear has been consumed, there are still many other ears of corn that are available for consumption. A public good is also often classed as being non-excludable. This means that just about anyone can make use of the good in some manner, essentially making that public good universal. Public services are a good example of non-excludable goods, since anyone can receive benefit from the presence of a police force or a fire department, regardless of their condition or economic status. There are a few basic examples of products that do not meet the basic definition of a publicgood. One has to do with obtaining professional services, such as those of a doctor or lawyer. When an individual makes an appointment with either of these professionals, he or she is effectively buying the time of that professional. That same time cannot be consumed by any other individual, thus making the duration of the appointment excludable and rivaled. In like manner, many drugs are limited when it comes to consumer access, with some requiring a prescription by a qualified medical professional. The fact that some are excluded from access to those drugs means that medications of this type are considered excludable and rivaled, and thus not a public good. Over time, advances in technology have created new types of public goods. The electric powered street light is an example of a public good that became common in the early years of the twentieth century. Since its light was available for anyone to enjoy as they walked down a street, the device met the criteria of being non-excludable and non-rivaled. Today, products such as software packages are often classified as public goods. This is particularly true with products such as free software that is widely available to anyone who wishes to use it, with no barriers of cost or economy to inhibit the consumption.

public goods
The government spends billions of pounds each year on public goods. To understand the nature of these goods more clearly, and why the government is left to provide these for people throughout the economy, we must consider the characteristics of private goods Private Goods A private good has three main characteristics: Excludability: Consumers can be excluded from consuming the product if they are not willing to pay for it (for example - a ticket to the theatre or a meal in a restaurant) Rivalry: One person's consumption of a product reduces the amount available for other people to consume - because scarce economic resources are used up in producing and supplying the good or service Rejectability: Private goods and services are rejectable - if you don't like the look of the soup on the college menu, you can reject the chance to consume it and use your money to buy something else. Characteristics of public goods The characteristics of pure public goods are the opposite of private goods. They are services which are clearly in demand, but which must be provided collectively by the Government for two main reasons: Non-excludability - goods cannot be confined to those who have paid for it. In this sense, non-payers can take a free ride and enjoy the benefits of consumption Non-rivalry in consumption - consumption by one person does not reduce the availability of a good to others. Examples of public goods Examples of public goods include flood control systems, street lighting and national defence. Public goods (in fact most of them are services!) are not normally provided by the private sector in an economy. Partly this is because of the free-ride problem. The Free Rider Problem The "free rider" principle says that you cannot charge an individual a price for the provision of a non-excludable good because somebody else would gain the benefit from consumption without paying anything. Consider the case of the provision of traffic wardens and safety signs on roads. One person's benefit from these services is not unique other motorists benefit from the service as well - but they cannot be stopped and asked to pay for the benefits they derive. Public goods and market failure Why is there market failure with public goods? The main reason is that private sector producers will not supply public goods to people because they cannot be sure of making an economic profit. This is due to the characteristics of public goods outlined earlier. Consumers can take a free ride without having to pay for the good or service. The obvious solution is that these goods are provided collectively by the government, and then financed through taxation of individual households and businesses.

What are the sources of market failure?

I. Public Goods a public good is one, which if provided to one consumer, is freely available to all consumers. Ex. - Street lighting, parks, roads, etc,. This means no private firm is able to make a profit from providing such goods. Therefore, government should ensure that such goods are provided at the socially desired level. II. Income Distribution The market will not necessarily ensure equitable distribution of incomes. This may motivate government to introduce policies to redistribute wealth through measures, i.e., income taxes and social security benefits. III. Monopoly The operations of monopoly or natural monopoly often result in misuse of market power and inefficient allocation of resources, which reduce community welfare. For this reason, governments generally regulate monopoly and enforce laws preventing cartels. This type is a major rationale for a comprehensive competition policy. IV. Externalities An externality arises when an activity confers a benefit (like the benefit of education or immunization) or imposes a cost (pollution) on a third party, without the cost or benefit being included in the market price of that activity. V. Information Asymmetries In theory, buyers and sellers in a competitive market have complete knowledge about a product or service characteristics and quality. Information asymmetries between producers and consumers can lead to market failure and reduce community welfare. Market Failures and Externalities Principle of Economics #7: Governments can sometimes improve market outcomes. Markets do many things well. With competition and no externalities, markets will allocate resources so as to maximize the surplus available. However, if these conditions are not met, markets may fail to achieve the optimal outcome. This is also known as "market failure". Externalities In previous analysis, we assumed that all goods consumed or produced have been private, in the sense that one individuals consumption or production of a good does not affect the other. When our actions impact on those not directly involved, an externality exists. As one individual's behaviour increases or decreases, another's satisfaction or profit changes as well. It can have a positive or negative effect on a third-party not directly involved with the buyer or seller of the transaction. These costs (or benefits) are not included in the cost curve faced by the decision makers. Examples of externalities:

A smoker annoys others with second hand smoke. A gardener delights a neighbour with his beautiful garden. A pulp mill pollutes the air and water in town. A perfume wearer gives a friend an allergic reaction.

Negative Externalities When economic agents not directly involved, negative externalities can exist, such as pollution. A free market tends to over-produce the good which produces a negative externality, and under produce those with positive externality. If we include costs borne by everyone, then we get social costs, which are the total costs of production no matter who bears them. We say that the total cost is equal to private costs plus external costs. Negative externalities result in a lower free-market output. In order to make the market produce the optimal amount, we must impose a tax. This is called "internalizing the externality", and forces those involved to account for external costs. There are also externalities in "consumption", when consumption has costs for persons other than those actually consuming the product. Examples of these are cigarettes and second-hand smoke, and drinking alcohol and car accidents. Positive Externalities Not all externalities are negative. Some create benefits to those not directly involved. Such is the case with "technology spillover", where new inventions benefit those beyond the inventors.

Some have argued that governments should subsidize research and development, since it will have positive externalities to everyone else. Another method is to allow patents to give monopoly rights to new inventions for a period of time, and encourage such activity. Without this method, there could be an under investment in research. Positive externalities in production means that social cost is less than private cost, and more of the good should be produced than will occur in a free market. There may also be positive externalities in consumption, such as education. In this case, the social value is greater than the private value Solution to Externalities Externalities lead to an inefficient quantity of production and consumption. This can be remedied by either private arrangements or public policy. Externalities can be dealt with by: 1. 2. 3. 4. Moral codes and social sanctions Voluntary organizations - charitable groups, lobby groups Internalization - when activities with complementary externalities are merged into one firm, thus eliminating the externality Contracts - parties through negotiation can agree as to how to regulate the externality

Coase Theorem If parties can bargain without cost over the allocation of resources, then the private market can always solve the problem of externalities. It can allocate resources efficiently, irrespective of how the law assigns responsibility for damages. Earlier before Coase, it was argued that the source of the externality should be penalized. It is now recognized that the party that can deal with the externality at least cost should do exactly that.