2.

0 PUBLIC GOODS AND PUBLIC UTILITY

General objective

By the end of the lesson the learner should be able to explain the issues pertaining to public
goods and public utility
Specific objectives:
By the end of the lesson the learner should be able to
describe a public good
explain the characteristics of public goods and private goods
explain free rider problem and its solutions
explain the causes of market failure and the solutions

2.1 Introduction

A public good is a good that is non rival and non-excludable. Non-rivalry means that consumption
of the good by one individual does not reduce availability of the good for consumption by others;
and non-excludability that no one can be effectively excluded from using the good.

In the real world, there may be no such thing as an absolutely non-rivaled and non-excludable
good; but economists think that some goods approximate the concept closely enough for the
analysis to be economically useful.

For example, if one individual visits a doctor there is one fewer doctor's visit for everyone else,
and it is possible to exclude others from visiting the doctor. This makes doctor visits a rivaled
and excludable private good. Conversely, breathing air does not significantly reduce the amount
of air available to others, and people cannot be effectively excluded from using the air. This
makes air a public good, albeit one that is economically trivial, since air is a free good.

Non-rivalness and non-excludability may cause problems for the production of such goods.
Specifically, some economists have argued that they may lead to instances of market failure,
where uncoordinated markets driven by parties working in their own self interest are unable to
provide these goods in desired quantities. These issues are known as public goods problems, and
there is a good deal of debate and literature on how to measure their significance to an economy,
and to identify the best remedies. These debates can become important to political arguments about
the role of markets in the economy. More technically, public goods problems are related to the
broader issue of externalities.

2.2 Theory of Private and Social /Public Goods

Private goods
This refers to those goods and services that satisfy individual wants and have the characters tics of
rivalry and exclusiveness. These goods can be produced by the free market policy mechanism.
Private goods are rival in consumption i.e. their consumption by a person reduces the amount
available to others. Also all those who want to pay the market price for them will consume them
and those who do not want to pay will be excluded from their use. In this case private goods are
subject to the principal of exclusion. Example of private goods relate to food, clothing, shelter,
transportation, communication etc.

Characteristics of private goods

1. They are rivalrous in consumption.

2. They are subject to exclusion principal

3. They satisfy individual wants.

4. The can be produced through free market pricing mechanism.

5. They are divisible in so far as their use is concerned

6. Marginal cost of providing a private good to an extra consumer is always positive

Public goods
They refer to those goods and services which are jointly and equally consumed by many people at
the same time and their consumption by one person does not alter availability for another person
.e.g. defence
These goods may not be produced by the free market pricing mechanism because those persons
who do not want to pay for the price can not be prevented from the consumption of those goods
and services i.e. public goods and services have a feature of non-rivalry in consumption and non-
excludability and as a result would not be provided in the free market.

Characteristics of public goods

i. They are non rivalrous- i.e. the quantity that a person consumes does not affect the quantity
that other can consume. No one has exclusive right over the consumption of good.

ii. They are non-excludable i.e. if one person consumes the goods it is not possible to prevent
others from consuming it.

iii. The goods are of collective consumption.

iv. These goods may not be produced through the free market mechanism

v. They are indivisible

vi. The consumption of a public good is always joint and equal, thus public goods are always
produced and supplied by the society to meet its collective wants for increasing social
welfare.

vii. Public goods create externalities or divergences between social and private benefits.

Differences between private and public goods

i. Public goods satisfy social wants while private goods satisfy individual wants.

ii. Public goods are non-rival in consumption while private goods are rivalrous.

iii. Public goods are non-exclusive whereas private goods permit exclusion.

iv. Public goods cannot be provided by the free market pricing mechanism while, private
goods are priced in the market
 v. The marginal cost of providing a private good to an extra consumer is positive, while
in the public good it is zero.

The efficient level of production of a private good is achieved when the marginal benefit and the
marginal cost are equal. However with a public good, we must ask how much each person values
an additional unit of output and how to add them to the marginal cost of production

Further considerations on the types of goods

Excludable Non-excludable

Common goods
Private goods (Common-pool
Rivalrous food, clothing, cars, resources)
personal electronics fish stocks, timber, coal,
national health service

Club goods Public goods

Non-rivalrous cinemas, private parks, free-to-air television, air,
satellite television national defense

A good which is rivalrous but non-excludable is sometimes called a common pool resource. Such
goods raise similar issues to public goods: the mirror to the public goods problem for this case is
sometimes called the tragedy of the commons. For example, it is so difficult to enforce restrictions
on deep sea fishing that the world's fish stocks can be seen as a non-excludable resource, but one
which is finite and diminishing.

The definition of non-excludability states that it is impossible to exclude individuals from

consumption. Technology now allows radio or TV broadcasts to be encrypted such that persons
without a special decoder are excluded from the broadcast. Many forms of information goods have
characteristics of public goods.
For example, a poem can be read by many people without reducing the consumption of that good
by others; in this sense, it is non-rivalrous. Similarly, the information in most patents can be used
by any party without reducing consumption of that good by others. Creative works may be
excludable in some circumstances, however: the individual who wrote the poem may decline to
share it with others by not publishing it.

Copyrights and patents both encourage and inhibit the creation of such non-rival goods by
providing temporary monopolies, or, in the terminology of public goods, providing a legal
mechanism to enforce excludability for a limited period of time. For public goods, the "lost
revenue" of the producer of the good is not part of the definition: a public good is a good whose
consumption does not reduce any other's consumption of that good.The economic concept of
public goods should not be confused with the expression "the public good", which is usually an
application of a collective ethical notion of "the good" in political decision-making.

Another common confusion is that public goods are goods provided by the public sector. Although
it is often the case that Government is involved in producing public goods, this is not necessarily
the case. Public goods may be naturally available. They may be produced by private individuals
and firms, by non-state collective action, or they may not be produced at all.

Collective goods

Collective goods (or social goods) are defined public goods that could be delivered as private
goods, but are usually delivered by the government for various reasons, including social policy,
and finances from public funds like taxes.

Examples

Common examples of public goods include: defense and law enforcement (including the system
of property rights), public fireworks, lighthouses, clean air and other environmental goods, and
information goods, such as software development, authorship, and invention.

2.3 The Free Rider Problem

Public goods provide a very important example of market failure, in which market-like behavior
of individual gain-seeking does not produce efficient results. The production of public goods
results in positive externalities which are not remunerated. If private organizations don't reap all
the benefits of a public good which they have produced, their incentives to produce it voluntarily
might be insufficient. Consumers can take advantage of public goods without contributing
sufficiently to their creation. This is called the free rider problem, or occasionally, the "easy rider
problem" (because consumer's contributions will be small but non-zero).

The free rider problem depends on a conception of the human being as homo economicus: purely
rational and also purely selfish -extremely individualistic, considering only those benefits and costs
that directly affect him or her. Public goods give such a person an incentive to be a free rider.

For example, consider national defense, a standard example of a pure public good. Suppose homo
economicus thinks about exerting some extra effort to defend the nation. The benefits to the
individual of this effort would be very low, since the benefits would be distributed among all of
the millions of other people in the country. There is also a very high possibility that he or she could
get injured or killed during the course of his or her military service.

On the other hand, the free rider knows that he or she cannot be excluded from the benefits of
national defense, regardless of whether he or she contributes to it. There is also no way that these
benefits can be split up and distributed as individual parcels to people. The free rider would not
voluntarily exert any extra effort, unless there is some inherent pleasure or material reward for
doing so (for example, money paid by the government, as with an all-volunteer army or
mercenaries).

In the case of information goods, an inventor of a new product may benefit all of society, but
hardly anyone is willing to pay for the invention if they can benefit from it for free.
Possible solutions to the free rider problem

a) Assurance contracts

An assurance contract is a contract in which participants make a binding pledge to contribute to

building a public good, contingent on a quorum of a predetermined size being reached. Otherwise
the good is not provided and any monetary contributions are refunded.

A dominant assurance contract is a variation in which an entrepreneur creates the contract and
refunds the initial pledge plus an additional sum of money if the quorum is not reached. (The
entrepreneur profits by collecting a fee if the quorum is reached and the good is provided.) In
game-theoretic terms this makes pledging to build the public good a dominant strategy: the best
move is to pledge to the contract regardless of the actions of others.

b) Coasian solution

The coasian solution, named for the economist Ronald Coase and unrelated to the Coase theorem,
proposes a mechanism by which potential beneficiaries of a public good band together and pool
their resources based on their willingness to pay to create the public good. Coase (1960) argued
that if the transaction costs between potential beneficiaries of a public good are sufficiently low,
and it is therefore easy for beneficiaries to find each other and pool their money based on the public
good's value to them, then an adequate level of public goods production can occur even under
competitive free market conditions. However, Coase (1988) famously wrote:

"The world of zero transaction costs has often been described as a Coasian world. Nothing could
be further from the truth. It is the world of modern economic theory, one which I was hoping to
persuade economists to leave."

In some ways, the formation of governments and government-like communities, such as

homeowners’ associations can be thought of as applied instances of practicing the coasian solution
by creating institutions to reduce the transaction costs.
A similar alternative for arranging funders of public goods production, which is especially
applicable to information goods, is to produce the good but refuse to release it to the public until
some form of payment to cover costs is met.

Author Stephen King, for instance, authored chapters of a new novel downloadable for free on his
website while stating that he would not release subsequent chapters unless a certain amount of
money was raised. Sometimes dubbed holding for ransom, this method of public goods production
is a modern application of the street performer protocol for public goods production. Unlike
assurance contracts, this relies on social norms to ensure (to some extent) that the threshold is
reached and partial contributions are not wasted.

c) Government provision

If voluntary provision of public goods will not work, then the obvious solution is making their
provision involuntary. This saves each of us from our own tendency to be a free rider, while also
assuring us that no one else will be allowed to free ride. One frequently proposed solution to the
problem is for governments or states to impose taxation to fund the production of public goods.
This does not actually solve the theoretical problem because good government is itself a public
good. Thus it is difficult to ensure the government has an incentive to provide the optimum amount
even if it were possible for the government to determine precisely what amount would be optimum.
These issues are studied by public choice theory and public finance.

Sometimes the government provides public goods using "unfunded mandates". An example is the
requirement that every car be fit with a catalytic converter. This may be executed in the private
sector, but the end result is predetermined by the state: the individually involuntary provision of
the public good clean air. Unfunded mandates have also been imposed by the U.S. federal
government on the state and local governments, as with the Americans with Disabilities Act, for
example.

d) Subsidies and joint products

A government may subsidize production of a public good in the private sector. Unlike government
provision, subsidies may result in some form of a competitive market. The potential
for cronyism (for example, an alliance between political insiders and the businesses receiving
subsidies) can be limited with secret bidding for the subsidies or application of the subsidies
following clear general principles. Depending on the nature of a public good and a related subsidy,
principal agent problems can arise between the citizens and the government or between the
government and the subsidized producers; this effect and counter-measures taken to address it can
diminish the benefits of the subsidy.

Subsidies can also be used in areas with a potential for non-individualism: For instance, a state
may subsidize devices to reduce air pollution and appeal to citizens to cover the remaining costs.

Similarly, a joint-product model analyzes the collaborative effect of joining a private good to a
public good. For example, a tax deduction (private good) can be tied to a donation to a charity
(public good). It can be shown that the provision of the public good increases when tied to the
private good, as long as the private good is provided by a monopoly (otherwise the private good
would be provided by competitors without the link to the public good).

e) Privileged group

The study of collective action shows that public goods are still produced when one individual
benefits more from the public good than it costs him to produce it; examples include benefits from
individual use, intrinsic motivation to produce, and business models based on selling complement
goods. A group that contains such individuals is called a privileged group. A historical example
could be a downtown entrepreneur who erects a street light in front of his shop to attract customers;
even though there are positive external benefits to neighboring nonpaying businesses, the added
customers to the paying shop provide enough revenue to cover the costs of the street light.

The existence of privileged groups may not be a complete solution to the free rider problem,
however, as underproduction of the public good may still result. The street light builder, for
instance, would not consider the added benefit to neighboring businesses when determining
whether to erect his street light, making it possible that the street light isn't built when the cost of
building is too high for the single entrepreneur even when the total benefit to all the businesses
combined exceeds the cost.
An example of the privileged group solution could be the Linux community, assuming that users
derive more benefit from contributing than it costs them to do it. For more discussion on this topic
see also Coase's Penguin.

Another example is those musicians and writers who create music and writings for their own
personal enjoyment, and publish because they enjoy having an audience. Financial incentives are
not necessary to ensure the creation of these public goods. Whether this creates the correct
production level of writings and music is an open question.

f) Merging free riders

Another method of overcoming the free rider problem is to simply eliminate the profit incentive
for free riding by buying out all the potential free riders. A property developer that owned an entire
city street, for instance, would not need to worry about free riders when erecting street lights since
he owns every business that could benefit from the street light without paying. Implicitly, then, the
property developer would erect street lights until the marginal social benefit met the marginal
social cost. In this case, they are equivalent to the private marginal benefits and costs.

While the purchase of all potential free riders may solve the problem of underproduction due to
free riders in smaller markets, it may simultaneously introduce the problem of underproduction
due to monopoly. Additionally, some markets are simply too large to make a buyout of all
beneficiaries feasible - this is particularly visible with public goods that affect everyone in a
country.

g) Introducing an exclusion mechanism (club goods)

Another solution, which has evolved for information goods, is to introduce exclusion mechanisms
which turn public goods into club goods. One well-known example is copyright and patent laws.
These laws, which in the 20th century came to be called intellectual property laws, attempt to
remove the natural non-excludability by prohibiting reproduction of the good. Although they can
address the free rider problem, the downside of these laws is that they imply private monopoly
power and thus are not Pareto-optimal.
h) Social norms

If enough people do not think like free-riders, the private and voluntary provision of public goods
may be successful. A free rider might litter in a public park, but a more public-spirited individual
would not do so, getting an inherent pleasure from helping the community. In fact, one might
voluntarily pick up some of the existing litter. If enough people do so, the role of the state in using
taxes to hire professional maintenance crews is reduced. This might imply that even someone
typically inclined to free-riding would not litter, since their action would have such a cost.

Public mindedness may be encouraged by non-market solutions to the economic problem, such as
tradition and social norms. For example, concepts such as nationalism and patriotism have been
part of most successful war efforts, complementing the roles of taxation and conscription. To some
extent, public spiritedness of a more limited type is the basis for voluntary contributions that
support public radio and television. Contributions to online collaborative media like Wikipedia
and many other projects utilising wiki technology can also be seen to represent an example of such
public spiritedness, since they provide a public good (information) freely to all readers.

Groups relying on such social norms often have a federated structure, since collaboration emerges
more readily in smaller social groups than in large ones. This explains why labor unions or charities
are often organized this way.

2.4 Market failure

This refers to the circumstances under which the market fails to allocate resources efficiently i.e.
it exists where the production or use of the goods and services by the market is not efficient. The
market failures can be viewed in scenarios where individual pursuit of pure self interest leads to
results that are not efficient i.e. that can be improved from societal point of view.

Causes of market failures

There are four main causes:

Market power: Agents in the market can gain market power, allowing them to block other
mutually beneficial gains from trades from occurring. This can lead to inefficiency due to
imperfect competition, which can take many different forms such as monopolies, cartels or
monopolistic competition. In a monopoly, for example, the monopolist will use his/her market
power to restrict output below the quantity at which the marginal social benefit is equal to the
marginal social cost of the last unit produced so as to keep the prices and the profits high.

Externalities: the actions of the agents can have externalities which are innate to the methods of
production or other conditions important to the market eg when a firm is producing papers, it
absorbs labour, capital and other inputs. It must pay for these in the appropriate markets and these
will be reflected in the market price for paper products. If the firm also pollutes the environment
and atmosphere while producing paper products and it is not forced to pay for this resource, then
this cost will not be borne by the firm but by the society. Hence the market price for paper products
will fail to incorporate the full opportunity cost to the society of producing paper products. In this
case the market equilibrium in the paper industry will not be optimal. Therefore the marginal social
cost of the last unit produced will exceed its marginal social benefit.

Public goods: some markets can fail due to the nature of certain goods e.g. existence of public
goods. A public good is one whose consumption or use by one individual does not reduce the
amount available to others e.g. city park, defense, law and order, ocean or lake fishing e.t.c. Public
goods have two characteristics i.e. they are non-excludable and non-rivalrous. A good is non-
excludable if it can be consumed by anyone. It is non-rivalrous, if no one has an exclusive right
over its consumption. Its benefit can be provided to an addition consumer at zero marginal cost.
Thus public goods, being both non-excludable and non-rivalrous are not sold in a free market like
private goods.

Equity: the issue here is that the distribution of goods and services generated by the market may
not be fair. This is due to inequitable distribution of income.

Market failure, the rationale for government intervention / measures to correct market
failure

1. Externalities
If pollution costs are external, firms will produce too much of a polluting good.

The goal of the goverment should be to discourage production and consumption activities
that impose high external costs on society. This can be accomplished by:

Regulation- passing legislation that address the problem

Altering markets incentives- this can be altered via emission changes. An emission charge
is a fee that is imposed on polluters based on the quantity of pollution.

2. Market power

This is the ability to alter the market price of a good or service. The goal of government
policy should be to prevent or dismantle concentration of market power. This can be done
through the relevant legislation.

3. Public goods

These goods should be provided by some public authority. As the benefits of public goods
are indivisible, the state should make people share the cost of public goods so that everyone
is made better off. Due to the free rider problems some services such as defense should be
provided free to every user and can be provided by government through taxes.

4. Equity

Government intervention may be needed to redistribute income if the market fails to reflect
our notions of fairness. This can be done through transfer of payments such as social
security, welfare and unemployment benefits.