Definitions

consumption good

Public good

In economics, a public good is a good that is non-rivaled and non-excludable. This means, respectively, that consumption of the good by one individual does not reduce availability of the good for consumption by others; and 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 eats a cake, there is no cake left for anyone else, and it is possible to exclude others from consuming the cake; it is a rivaled and excludable private good. Conversely, breathing air neither significantly reduces the amount of air available to others, nor can people be effectively excluded from using the air. This makes it a public good, but one that is economically trivial, as air is a free good. A less trivial example is the exchange of MP3 music files on the internet: the use of these files by any one person does not restrict the use by anyone else and there is little effective control over the exchange of these music files.

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 are unable to provide these goods in desired quantities. These spanner issues are known as public goods problems, and there is a good deal of debate and literature on how significant they are, and on what their solutions might be. 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.

Terminology, and types of public goods

Paul A. Samuelson is usually credited as the first economist to develop the theory of public goods. In his classic 1954 paper The Pure Theory of Public Expenditure, he defined a public good, or as he called it in the paper a "collective consumption good", as follows:

...[goods] which all enjoy in common in the sense that each individual's consumption of such a good leads to no subtractions from any other individual's consumption of that good...

This is the property that has become known as Non-rivalness. In addition a pure public good exhibits a second property called Non-excludability: that is, it is impossible to exclude any individuals from consuming the good.

The opposite of a public good is a private good, which does not possess these properties. A loaf of bread, for example, is a private good: its owner can exclude others from using it, and once it has been consumed, it cannot be used again.

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 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; however, an unencrypted broadcast is still non-excludable.

Many forms of creative works 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.

Challenges to Adam Smith's Market for Public Goods

Some argue that a potential failure of a market-based 'system,' as outlined by Adam Smith, is that alone it may be unable to provide necessary public goods. Proponents of the failed market-based view suggest that the collective must do something together to provide these goods. For example, some argue that the defense of a country will never be adequately provided for without a draft or a significant tax.

A more detailed critique against Smith's when applied to public education is that he developed his theory at a time when education was limited, provided only by private funding, and was not seen as a valuable input to public good. At that time, only labor was considered a valuable input. Today, it is possible, however, to discriminate and measure different degrees of human input. Some conspiracy theorists might espouse a view that politicians and academicians persist in furthering these outmoded ways of thinking to preserve economic hegemony of important wealthy economic players. However, it is more likely that the challenge in determining the relative values among various public goods plays a larger role. It is possible that perceived Public goods can have negative externalities effects instead of positive ones. For example, pollution or political corruption may be negative effects that show some of the same non-excludability and non-rivalness properties.

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.

The theoretical concept of public goods does not distinguish with regard to the geographical region in which a good may be produced or consumed. However, some theorists (such as Inge Kaul) use the term global public good to mean a public good which is non-rival and non-excludable throughout the whole world, as opposed to a public good which exists in just one national area. Knowledge has been held to be an example of a global public good.

Collective good

Collective goods (or social goods) are defined as 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.

''Note: Some writers have used the term public good to refer only to non-excludable pure public goods. They may then call excludable public goods club goods.

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. Some goods (such as orphan drugs) require special governmental incentives to be produced, but can't be classified as public goods since they don't fulfill the above requirements (Non-excludable and non-rivalrous.)

The provision of a lighthouse has often been used as the standard example of a public good, since it is difficult to exclude ships from using its services. No ship's use detracts from that of others, however, since most of the benefit of a lighthouse accrues to ships using particular ports, lighthouse maintenance fees can often profitably be bundled with port fees (Ronald Coase, The Lighthouse in Economics 1974). This has been sufficient to fund actual lighthouses.

Technological progress can create new public goods. The most simple examples are street lights, which are relatively recent inventions (by historical standards). One person's enjoyment of them does not detract from other persons' enjoyment, and it currently would be prohibitively expensive to charge individuals separately for the amount of light they presumably use. On the other hand, a public good's status may change over time. Technological progress can significantly impact excludability of traditional public goods: encryption allows broadcasters to sell individual access to their programming. The costs for electronic road pricing have fallen dramatically, paving the way for detailed billing based on actual use.

There is some question as to whether defense is a public good. Murray Rothbard argues, "'national defense' is surely not an absolute good with only one unit of supply. It consists of specific re­sources committed in certain definite and concrete ways—and these resources are necessarily scarce. A ring of defense bases around New York, for example, cuts down the amount possibly available around San Francisco. Jeffrey Rogers Hummel and Don Lavoie note, "Americans in Alaska and Hawaii could very easily be excluded from the U.S. government's defense perimeter, and doing so might enhance the military value of at least conventional U.S. forces to Americans in the other forty-eight states. But, in general, an additional ICBM in the U.S. arsenal can simultaneously protect everyone within the country without diminishing its services.

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, there will be insufficient incentives to produce it voluntarily. 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).

For example, consider national defense, a standard example of a pure public good. A purely rational person (also known as homo economicus) is an individual who is extremely individualistic, considering only those benefits and costs that directly affect him or her. Public goods give such a person incentive to be a free rider.

Suppose this purely rational person 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

Dominant assurance contracts

Assurance contracts are contracts in which participants make a binding pledge to contribute to a contract for building a public good, contingent on a quorum of a predetermined size being reached. Otherwise their money is 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. In game theory 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.

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."

A similar alternative for arranging funders of public goods production is to produce the public good but refuse to release it into 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 threatening not to 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.

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.

Government provision

If voluntary provision of public goods will not work, then the obvious solution is making their provision involuntary. (Each of us are saved from our own individualistic short-sightedness, i.e. our tendency to be a free rider, while also being assured 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 were it possible for the government to determine precisely what amount would be optimum (see also resource allocation mechanisms 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.

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).

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 businesses that aren't paying from the street light, the added customers to the paying shop provide enough revenue to cover the costs of the street light.

The existence of privileged groups is not a complete solution to the free rider problem, however, as underproduction of the public good can 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.

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.

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 solve the free rider problem, the downside of these laws is that they imply private monopoly power and thus are not Pareto-optimal. For example, in the United States, the patent rights given to pharmaceutical companies encourage them to charge high prices (above marginal cost), to advertise to convince patients to nag their doctors to prescribe the drugs.

Likewise, copyright provides an incentive for a publisher to act like The Dog in the Manger, taking older works out of print so as not to cannibalize revenue from the publisher's own new works. The laws also end up encouraging patent and copyright owners to sue even mild imitators in court and to lobby for the extension of the term of the exclusive rights in a form of rent seeking.

This near-ubiquitous problem arises, because the underlying marginal cost of giving the good to more people is low or zero, but, because of the limits of price discrimination those who are unwilling or unable to pay a profit-maximizing price do not gain access to the good.

Joseph Schumpeter claimed that the "excess profits," or profits over normal profit, generated by the copyright or patent monopoly will attract competitors that will make technological innovations and thereby end the monopoly. This is a continual process referred to as "Schumpeterian creative destruction", and its applicability to different types of public goods is a source of some controversy. The supporters of the theory point to the case of Microsoft, for example, which has been increasing its prices (or lowering its products' quality), predicting that these practices will make increased market shares for Linux and Apple largely inevitable.

If the costs of the exclusion mechanism are not higher than the gain from the collaboration, club goods can emerge naturally. James M. Buchanan showed in his seminal paper that clubs can be an efficient alternative to government interventions.

A nation can be seen as a club whose members are its citizens. Government would then be the manager of this club. This is further studied in the Theory of the State.

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 (e.g. see Dunbar's number). This explains why labor unions or charities are often organized this way.

Efficient production levels of public goods

A public good is provided efficiently at the level where the combined marginal rate of substitution of all individuals is equal to the marginal rate of transformation. (The marginal rate of substitution is the ratio at which an individual is willing to exchange a private good for a public good, the marginal rate of transformation are the units of a private good which the society has to give up in order to produce one unit of a public good).

Regardless of the method of providing public goods, the efficient level of such provision is still being subjected to economic analysis. For instance, the Samuelson condition calculates the efficient level of public goods production to be where the ratio of the marginal social cost of public and private goods production equals the ratio of the marginal social benefit of public and private goods production.

See also

References

For example, Gravelle and Rees: The defining characteristic of a public good is that consumption of it by one individual does not actually or potentially reduce the amount available to be consumed by another individual.

  • Ronald Coase (1974). "The Lighthouse in Economics". Journal of Law and Economics 17 (2): 357–376.

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