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Subject ECONOMICS

Paper No and Title 7 - Theory of Public Finance

Module No and Title 6 - Private Goods, Public Goods, and Merit Goods

Module Tag ECO_P7_M6

ECONOMICS PAPER No. 7: TITLE Theory of Public Finance

MODULE No.6 : Private Goods, Public Goods, and Merit
Goods
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Concept of Public Goods and Private Goods
3.1 Definition of Public Good and Private Good
3.2 Optimal provision of Private Good
3.3 Optimal provision of Public Good
4. Concept of Merit Goods

5. Summary

ECONOMICS PAPER No. 7: TITLE Theory of Public Finance

MODULE No.6 : Private Goods, Public Goods, and Merit
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1. Learning Outcomes
After studying this module, you shall be able to

 Understand the concept of public goods, private goods and merit goods.
 Distinguish between these different types of goods and categorize various goods that we
see in the economy into these groups.
 Analyze the rationale behind different public policies of the government regarding the
provision of public goods and merit goods.

2. Introduction

Concept of Different Types of Goods

Previously, we have discussed why the government in various economies is the primary provider
of several essential goods and services like highways, education, unemployment insurance, while
the provision of other goods and services such as clothing, entertainment is generally left to the
private companies? The concept of private goods, public goods and merit goods provides the
rationale behind this allocation function of the government in a country. Generally speaking,
public goods include all those goods and services provided by the public sector and all those
goods left to be provided by the private market are categorized as private goods. In order to
understand the difference between these goods, we need to know the underling characteristics of
them.

3. Concept of Public Good and Private Good

3.1 Definition of Public Good and Private Good

Goods and services that are either not supplied at all or supplied by a less than optimal amount in
the private markets are usually provided through the public sector in an economy. So, what is the
difficulty of providing them through the private sector? To understand this, we need to know the
concept of “Free-rider problem” in economics. The following example will help to understand
the idea.

Suppose, the residents of an apartment building in Delhi need a garbage collection service. If they
opt for a private service to pick up the trash regularly, the cost of this service has to be financed
by a voluntary fee paid by each resident of that building. Now, the problem is since this is
voluntary, several residents can refuse the pay their share of trash collection fee and continue to
throw garbage with a hope that their neighbors will pay and they will enjoy the free service at
other’s cost. This is an example of classic Free-rider problem.

ECONOMICS PAPER No. 7: TITLE Theory of Public Finance

MODULE No.6 : Private Goods, Public Goods, and Merit
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Therefore, Free-rider problem states that when an investment
has a personal cost but a common benefit, people tend to underinvest or shirk from their share.
Goods that suffer from this Free-rider problem are known in economics as the Public Goods.

Public Good can be categorized as either a pure public good or an impure public good. Pure
public goods are characterized by two traits:

 Non-rival in consumption
 Non-excludable

Non-rival in consumption implies one individual’s consumption of a good does not affect
another’s opportunity to consume the good. Similarly, non-excludable means individuals
cannot deny each other the opportunity to consume a good. These conditions for pure
public goods are fairly strong which are met by very few goods in reality. For example:
national defense of a country is a classic example of pure public good. National defense
is non-rival because if I live next to your house, then my consumption will not diminish
your national protection in any way. Similarly, national defense is non-excludable
because if an area is under national protection then every house in that neighborhood
receives same protection. There is no way government can exclude me if I live in that
neighborhood from others. Other examples of pure public good include lighthouses, and
firework displays. Therefore, goods that are perfectly non-rival in consumption and
non-excludable are called pure public goods.

Most of the public goods that we see frequently are usually known as impure public
goods. Goods that satisfy the two above-mentioned public good conditions (non-rival in
consumption and non-excludable) to some extent, but not fully are called impure
public goods.

The following table (Table 6.1) shows all possible combinations of public goods based on
the two characteristics.

Table-6.1: Pure and impure public goods, private good

Is the good rival in consumption?

Is the good Yes No
Yes Private Good Impure Public Good
Excludable?
(Example: Ice-cream) (Example: Cable TV)
No Impure Public Good Pure Public Good

(Example: Crowded side-walk) (Example: National defense)

ECONOMICS PAPER No. 7: TITLE Theory of Public Finance

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From the above table, we can see that there are two types of impure public goods.

Some public goods are excludable but non-rival in consumption. For example: Cable
television is an example of such impure public good. The cable company can refuse to
provide you the connection, so it is excludable. But, once you have the cable connection,
you can enjoy the same shows and programs as others. Your enjoyment of cable
television will not reduce the enjoyment of anybody else’s, so it is non-rival in
consumption.

Other types of public goods are rival but non-excludable in nature. For example: walking
on a crowded side-walk will be the case of such public good. When we walk on a crowed
side-walk, we reduce the enjoyment of each other’s walking as we have to struggle
against even more foot traffic, so it is rival in consumption. But, no city or town can
exclude anybody from walking on a crowded side-walk, so it is non-excludable in nature.

Therefore, from table 6.1, it implies that when a public good is both non-rival and non-
excludable, it is a pure public good. When a public good is either rival but non-
excludable or excludable but non-rival, it is an impure public good.

From the table, we can see, goods that are both rival and excludable in consumption are
called pure private good. For example, Ice-cream is a private good. It is completely rival
in consumption because if you buy an ice-cream cone, I cannot have that ice-cream cone.
It is also perfectly excludable because if you don’t want to sell ice-cream to me, you can
do that.

3.2 Optimal Provision of Private Good

In order to determine the optimal provision of public goods, we need to understand the
mechanism of the private goods market and compare it with the public good allocation
principle. The most important aspect of the public good allocation is that pure public
goods are consumed collectively or jointly without exclusion. On the other hand, as we
have discussed before, private goods are subject to exclusion principle. As a result, when
a public good is supplied in an economy, it is consumed in equal amounts by all
consumers whereas for a private good, an individual can be excluded or prevented from
its consumption if he doesn’t pay a price for it. The following discussion of private good
provision will help us to revisit the pricing mechanism for such good and understand its
market demand.

ECONOMICS PAPER No. 7: TITLE Theory of Public Finance

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Figure 6.1

Let us consider figure 6.1 above representing the market equilibrium of a pure private
good, such as bread. The horizontal axis measures the quantity demanded of bread and
the vertical axis measures the price of bread. Let, W reflects the total market quantity
supplied for bread. Suppose the society has two consumers, A and B. Let Wa and Wb
represent the quantities of private good consumed by A and B respectively. Therefore, W
must be equal to the summation of Wa and Wb . Since, bread is a pure private good, from
our previous discussion we know that it must be rival in consumption and excludable.
That means, if consumer A uses more of good W, consumer B must use less under the
condition of rivalry. Moreover, a consumer who does not voluntarily pay the price of
bread is unable to consume the good at all. For example, if market supply of bread is 20
units and consumer A consumes 15 units of bread, then only 5 units remain for consumer
B. Therefore, assuming the total production to be 20 units, for a pure private good, W:

W  Wa  Wb Or

20 = 15 + 5 in this case.

Figure 6.1 demonstrates the allocation of private good in graphical terms. Here, Wa and
Wb represent the individual demand curves for bread of consumer A and consumer B

ECONOMICS PAPER No. 7: TITLE Theory of Public Finance

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respectively. The market demand curve W for bread, the
dotted line in the figure, is derived by the horizontal summation of the two individual
demand curves under the condition of exclusion principle along with divisibility of a pure
private good. S is the market supply curve of bread. The intersection of market demand
and supply curves at point x results in the equilibrium quantity determined in the market
at 20 units with a price of 50 cents per unit. At this price, 15 units of bread is demanded
by consumer A and 5 units is demanded by consumer B as reflected from their individual
demand curves.

Therefore, in case of a pure private good, the total demand of the good is the horizontal
summation of the individual demands. In another words, a pure private good is divisible
between consumers. This implies that market works better to provide the pure private
good as for such a good the efficiency condition: Marginal benefit (MB) = Marginal
cost (MC) holds for each consumer. We can verify that from the above diagram. In figure
6.1, the vertical distance under each consumer’s demand curve at their chosen quantity
measures the marginal benefit they receive from private good consumption. Therefore, at
equilibrium x, both the marginal benefits derived by person A in consuming 15 units and
by person B in consuming 5 units are equal to the marginal cost of 50 cents. This is an
efficient solution as MB = MC for each consumer. So, in case of pure private good:

MBa  MC For consumer A

MBb  MC For consumer B

3.3 Optimal Provision of Public Good

Now we can discuss the optimal condition for providing a pure public good in a society
and compare it with the private good provision principles. Let us consider figure 6.2
representing the demand for a pure public good, such as National defense. Let us assume,
Z reflects the total quantity of pure public good. We have the same two consumers A and
B with Z a and Z b levels of consumption of the public good respectively. As discussed
before, a pure public good like national defense is non-rival and non-excludable in
consumption. Therefore, it is not divisible among consumers. Once supplied at a given
level, this good is jointly consumed equally by all consumers in a society. Assuming the
total supply of pure public good Z to be 20 units, both consumer A and B will consume
20 units of the good. In other words, if the good is supplied to one of the consumers, it
must also be supplied at the same level to the other consumer. So, for both consumers,
the equations are:

Z = Z a and Z = Z b

ECONOMICS PAPER No. 7: TITLE Theory of Public Finance

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Figure 6.2

Figure 6.2 represents the demand for pure public good in graphical terms. The horizontal
axis measures the quantity demanded of public good and the vertical axis measures the
price of public good Z. Z a and Z b represent the individual demand curves respectively
for consumer A and B. The market demand curve Z for pure public good is derived by
the vertical summation of the two individual demand curves in case of indivisible pure
public good where exclusion principle does not apply. Consumer A and B each
individually consumes the total quantity (20 units) of the pure public good. S denotes the
supply curve of public good. The equilibrium is achieved at point y where market
demand curve Z intersects the supply curve S. The equilibrium supply of public good is
20 units with a price of 50 cents per unit. As observed from the diagram, in case of pure
public good, individual consumers are not able to vary the quantities of the good that can
be purchased at a particular market price. Instead, both consumers must consume the
entire public good provided (20 units here) equally regardless of the price they are willing
to pay for that particular quantity of the good. As we can see from figure 6.2, consumer A
would be willing to pay 35 cents and consumer B 15 cents per unit for 20 units of the

ECONOMICS PAPER No. 7: TITLE Theory of Public Finance

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public good if a pricing mechanism as same as in the case
of private good could be worked out.

The phenomenon of different consumers willing to pay different prices for the
consumption of a particular quantity of public good can be better understood if we
consider the marginal benefit and marginal cost of public good consumption. As before,
the vertical distance under each consumer’s demand curve at their chosen quantity
measures the marginal benefit they receive from public good consumption in figure 6.2.
The marginal benefit to each consumer in this case (35 cents to consumer A and 15 cents
to consumer B) sum up to the marginal cost of 50 cents as determined at point y in the
diagram. Therefore, in case of pure public good, the efficiency condition is to set the
marginal cost equal to the sum of marginal benefits rather than setting it equal to each
individual’s marginal benefit. So, we have the following:

MBa  MBb  MC Or

0.35 + 0.15 = 0.50 for pure public good.

Therefore, comparing the efficiency of public and private good provision, we see two
significant distinctions. Firstly, the key feature of the private good’s market equilibrium
is that consumers demand different quantities of the good at same market price. So, in
private market, we horizontally sum the individual demands of consumers to get the
market demand of the private good. On the other hand, the key feature of the public good
market is that whatever amount of the public good is provided must be consumed equally
by all consumers. That is each person is forced to choose a common quantity of the
public good. So, in public good’s market, we vertically sum the individual demands of
consumers to get the social value of the public good. Secondly, in case of private good,
the marginal benefit received from the good for each consumer is equal to the marginal
cost of production ( MB  MC for both A and B). On the other hand, for public good, the
social efficiency is maximized when the sum of individual marginal benefits equals the
marginal cost ( MBa  MBb  MC ).

4. Concept of Merit Goods

4.1 Definition

So far, we have classified economic goods into categories of private and public good
based on their consumption characteristics-joint or private. Goods that have higher degree
of joint or collective consumption characteristic are usually provided by the public sector
and those goods with lower degree of joint consumption can be supplied by the private
sector. But, there can be exception to this tendency as we may notice in a society.

ECONOMICS PAPER No. 7: TITLE Theory of Public Finance

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Sometimes, the public sector may decide to actively
participate in the allocation of certain economic goods which are essentially private
goods-rival and excludable in consumption-and therefore can be otherwise supplied by
the private sector. These economic goods are considered by the government as
meritorious or important as they generate large social benefits for every individual and
the society. Examples of such goods and services are education, healthcare, job training
program, public library and others. For these goods, the government thinks that
everybody in a society should consume a certain level of these goods irrespective of their
ability to pay for those goods and also believes that if left to the private sector alone,
these goods will be under provided. These governmentally supplied or heavily subsidized
private goods are called the Merit goods in economics. In other words, merit goods are
those goods and services with large social benefits which the government feels that
people will under consume if left to private market alone and which ought to be
subsidized or to be provided free of cost so that everybody can consume it regardless of
their ability to pay for the good.

Merit goods are under provided or supplied at a less than optimal level by the private
sector because the private market for such goods suffers from market failure that is the
equilibrium outcome of the private market does not maximize social efficiency. There are
two main reasons for this market failure:

Firstly, consumption of merit goods generate large positive externalities which means
social marginal benefit (SMB) from merit goods consumption exceeds the private
marginal benefit (PMB) that is SMB>PMB. For example, we can think about education.
An individual receives private benefit from education through higher productivity,
income and better job in his or her life but others in the society also gains in terms of
social benefit to get an educated, enlightened and responsible citizen. Therefore,
consumption of education does not only creates benefit for that person but also for others
in the society which is not accounted for in the private market equilibrium.

Secondly, people suffers from imperfect information regarding the consumption of merit
goods. Government feels that individuals may not act in their own best interest partly
because they don’t have complete information about the long term benefits of merit
goods. Let’s take the example of education again. Education is a long term investment
decision for children. The costs of education are paid in the current period but the
benefits from education in terms of higher productivity, income, greater occupational
mobility, better employment opportunities could be received in distant future.
Sometimes, people are unaware of these long term benefits of education for their children
and therefore, under consume it. Also, the equity ground is another argument for the
public provision of merit goods. Families with low income do not have the ability to pay
for their children’s education even when they know the benefits of education. Therefore,
subsidized or free education from government can help them to attain that desired level.

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Therefore, merit goods can be provided both privately and
publicly as we can see both private and public schools, hospitals, health insurance and
other services to coexist in a society.

5. Summary
 This module explains the concept of public good, private good and merit good and the
differences between them. Public goods suffer from free-rider problem.
 Pure public good can be identified by two criteria : non-rival in consumption and non-
excludable in consumption. Violation of any one criteria leads to an impure public good.
When none of the above criteria holds, we get the usual private good.
 Comparison between private and public good markets reveals that for private market,
goods are divisible so people demand different quantities at a given market price. The
market demand is constructed by horizontal summation of individual demand curves.
Also, the private market is efficient meaning marginal benefit to every consumer is equal
to the marginal cost of the good.
 In public good market, everybody consumes a given level of public good equally. So, we
have joint or indivisible consumption in this case. The market demand curve is generated
by vertical summation of individual demand curves. Here, sum of the individual marginal
benefits equals the marginal cost of the good.
 Goods that are essentially private in consumption characteristics but provided publicly
due to large positive externalities and imperfect information concerning them are called
merit goods. Due to the merits and importance associated with them, government feels
that everybody in a society should consume these goods even if they are not able to pay
for them.

ECONOMICS PAPER No. 7: TITLE Theory of Public Finance

MODULE No.6 : Private Goods, Public Goods, and Merit
Goods