H2 Economics Essay Practice – Essay Model

Date: 26 December 2009

Topic: Market Failure
Written by Kevin

Why must public goods be provided by the government? [12]

Public goods are goods which features the unique properties of being non-rivalry and non-excludability at the
same time. Non-rivalry refers to the fact that these goods are not depleted by their ‘consumption’. In other
words, when a user makes use of the good, it does not deprive another user of using it. Non-excludability
refers to the fact that it is impossible or too costly to exclude non-paying users from using the goods. Street
lights exemplify these two properties of public goods; once it is provided, any additional users using it doesn’t
diminish its value to existing users and at the same time, it’s hard to exclude non-paying people from using it –
tourist who don’t contribute to the taxes that might be spent on building the street lights can use them all the
same. As a result, the goods suffer from free-ridership.

The implications of the two unique properties of being non-rivalry and non-excludable is that the private
markets would not provide any public goods at all. As the goods are non-rivalry, the marginal cost of provision
of the good to every additional user is virtually zero. The allocative efficient price for these goods is effectively
zero. At the same time, being non-excludable, firms would have to incur extremely high cost or even find it
absolutely impossible to prevent non-paying users from enjoying the goods. Take the case of a national
defense system, a firm providing it would not be able to extract money from the citizens of the country once
the system is in place. Since the entire nation or geographical area the system is capable of defending will be
protected, there is no way to prevent non-paying users from being protected unless they are able to levy a
charge on anyone entering their area of protection.

The difficulty of compelling users to pay for the usage of these goods and preventing non-paying users from
using it ultimately prevents firms from making any sort of profits from the market. No firms would want to
produce goods or provide services where free-ridership is going to be rampant. Such a market thus would not
exist naturally; as such, public goods presents a case of complete market failure where the market fails to
provide goods that may have a ready demand.

Many of these public goods, however, are essential to the well-being and development of the society and
therefore are valuable socially. These public goods satisfy important collective needs. Street lighting, public
roads, public parks and benches, national defense and police force, are all socially beneficial goods that ensure
the growth and stability of an economy and thus have to be provided somehow. Without the participation of
private firms, the market for these goods is absent and will thus emerge only as a result of government
provision. The government is the only body which would have the authority and resources to collect taxes
from citizens and residents of the country to pay for these public services.

The provision of the public goods by the government would be more complex than their provision by the
market; without paying consumers or firms supplying the goods, there will not be price signals or coincidence
of supply and demand to determine the quantity of public goods to be supplied. The government will
therefore be required to assess the social benefit and the social cost for each level of output of the public good
and assure that an allocative efficient outcome can be achieved by balancing the cost and benefits of provision.
Although the eventual quantity of output dictated by the government would probably not coincide perfectly
with an allocative efficient equilibrium if a perfect market had existed for these public goods, it would raise
social welfare above the level where these goods are not provided at all.

Public goods must be provided by the government because of their unique properties of being non-rivalry and
non-excludable prevents the emergence of a market for these goods. Yet the nature of these goods is such
that they satisfy a collective need of the society and is beneficial to the economy at large. The provision of
these goods must therefore fall on the government who has the resources and authority to obtain the financial
resources for production of these goods.

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Is it justifiable for the government to provide goods that are not classified as public goods? [13]

Public goods are by definition the goods that are non-rivalry and non-excludable and therefore provided by the
government. The government, however, provides many other goods that are not classified as public goods.
The provision of these goods is often based on the fact that they present other forms of market failure such as
market imperfections and the presence of externalities. As long as the government’s intervention in the free
market is able to raise the welfare gained by the society, it is justified for the government to provide the goods
that are not classified as public goods.

Public goods are not the only source of market failure. The presence of externalities for some goods results in
partial market failure since there is a divergence of private and social cost or benefits. In the case of merit
goods such as vaccines, education and healthcare, when the free market is left on their own, they will be
under-consumed as the participants of the market would only account for their private benefits and ignore the
social benefits. Getting vaccinated for a disease would not only prevent yourself from getting infected but also
reduce the risk of those close to you; at a societal level, the risk of infection spreading would be reduced. As a
result of the positive externalities present in the case of such goods, the social marginal benefit is higher than
the private marginal benefit as shown in the diagram below.

[Diagram of a positive externality, showing the typical market equilibrium and the social efficient equilibrium;
label the different equilibriums and the intersections of the axes]

As demonstrated in the diagram, without any government intervention, the free market will attain equilibrium
at point ‘E’, where the private cost and benefit intersects. The quantity supplied by the market will be less than
the social efficient equilibrium, point ‘SE’, thus the good is under-produced. To allow the market to attain the
socially efficient equilibrium, the government might choose to offer a subsidy to the producers that is equal to
the external marginal benefit so that the positive externality is internalized. Alternatively, in an event when the
market equilibrium output is far below the socially optimal quantity, the government can choose to make up
for the shortfall by providing the good. Such might be the case for healthcare and education where a subsidy
would take too long to propagate down the market and benefit the society as quickly as government provision.
The government will still charge a price for providing these goods so that they can cover their cost of provision
at least partially; the price they charge would be the one corresponding to the socially efficient equilibrium in
order to ensure an efficient allocation. This price may or may not cover the cost of government provision
totally.

For other goods or services, the government may be providing them as a result of inherent market
imperfections that require the government to nationalize the industry or control the production wholly to
ensure that the welfare of the society is maximized. In the case of telecommunication services in developing
countries, private firms are often unable to secure the amount of funding necessary to build the infrastructure
required to provide such services or that the risk of failure is so huge it deters private investors from starting
the firm. At the same time, once the firm is established with the necessary investments made, the marginal
cost of running the firm is very low because it is a natural monopoly and the market equilibrium would
compromise the welfare of the consumers. As a result, the government might choose to provide the service
themselves by forking out the necessary resources to start the firm and then run the services, providing the
socially optimal output and charging the socially optimal price.

Provision of non-public goods might also be justified under unique circumstances of emergency when the free
market is unable to provide the good or service in a timely manner. In the case of a world-wide epidemic
where the risk of infection spreading is extremely high, the market cannot be depended upon for the
production and propagation of a vaccine or cure when it is discovered. Time lags involved in establishing
contractual agreements, sourcing for suppliers and securing distribution networks will take too long and result
in unnecessary human sacrifices. Under such circumstances, it would be prudent for government to intervene;
by taking over the production of the vaccine and distribution.

Of course, there are situations where it might not be justifiable for governments to provide goods that are not
classified as public goods. In the case of markets which are already well established by governments, such as
public transport or energy generation, the case of continued government provision might be very weak. Since
the economy would already be capable of producing these goods and with proper regulation in place, they
could ensure that pricing do not compromise the welfare of society. An example is the case for electricity

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generation market in Singapore, where the government deregulated the market and left electricity generation
to private firms while focusing on the aspect of the industry where market failure occurs, such as electricity
distribution where the natural monopoly results in compromise of consumer welfare if left to the free market.

In general, in cases of merit goods and the goods in markets where market imperfections reduces consumer
welfare, government provision is justified as long as they are able to raise the welfare of the general society to
a level higher than if the market was left on its own.

Copyrights © 2009 Erpz.net, Kevin. 3