Market Failure: What Does It All Mean?
Part III: Public Goods

Marc Law and Jason Clemens

In our April Fraser Forum article, we discussed how externalities can lead to economic inefficiency. Negative externalities are costs that are not priced by the free market system. When there is a negative externality (for instance, pollution), the free market tends to result in “over--provision” or “too much” pollution.

National defense is a public good because it secures all members of a community from attack. It is impossible to prevent any member of the community from “consuming” the benefits of ... [it]; the moment it is available to one person ... it is available to everyone.

A positive externality, in contrast, is a benefit that is not priced by the market. When there are positive externalities (for instance, when parkland raises the aesthetic quality of the surrounding neighbourhood), the free market will lead to “under--provision” of certain goods (“too little” parkland). Externalities arise because the price system is unable to capture all the costs and benefits of economic exchange.

Closely related to positive externalities is the concept of a public good. A public good is defined as a good or service that is non--ex--cludable in consumption.¹ In other words, a public good is a good characterized by the fact that the supplier of the good cannot exclude anyone from benefitting from it. Once a public good is provided to one person, it is available to all. Hence, the defining quality of a public good is that it is unfeasible (or prohibitively costly) for the producer to restrict individuals from consuming it.² A public good, therefore, involves positive externalities since it generates benefits that cannot be captured by the producer of the good.

National defense as a public good

The traditional example of a public good is national defense. National defense is a public good because it secures all members of a community from attack. It is impossible to prevent any member of the community from “consuming” the benefits of national defense; the moment it is available to one person in the community, it is available to everyone. In other words, national defense is non--excludable in consumption.

Like most public goods, national defense is characterized by what economists call the “free rider problem.” Because no individual can be excluded from “consuming” the benefits of national defense once it is provided, no individual has an incentive to contribute voluntarily to its provision. As a result of this free rider problem, the market will tend to underproduce public goods such as national defense. It is thus that many economists recommend that public goods be supplied (or at least financed) by the state. Hence, the existence of public goods has traditionally been used as a rationale for government intervention in economic affairs.³

Transactions costs and public goods

In our discussion of externalities, we noted that transactions costs—the costs associated with finding a partner for exchange, negotiating contracts, monitoring contractual performance, and so on—are the ultimate cause of externalities. Transactions costs prevent people from engaging in mutually beneficial exchanges. In the absence of transactions costs, all externality problems would be internalized, and the free market system would be efficient.

Similarly, transactions costs are the reason why the free market will result in the under--provision of public goods. To show why this is the case, let us return to the example of national defense. If it were possible to induce each person to voluntarily contribute their true valuation for national defense, then the market would tend to produce the right amount of military services. That is, if we could overcome the “free rider problem,” then the community, through the market system, would purchase the “right” amount of national defense.

However, because the transactions costs of doing so are prohibitively high—it would be extraordinarily costly to get all members of the community together and induce each person to truthfully state their valuation for the military—we cannot do this. In other words, the transactions costs that we would have to incur to eliminate the free rider problem would be enormous. Thus, at the heart of the public goods problem is the problem of transactions costs.¹ Because it is expensive to get people together, negotiate contracts, and enforce contractual performance, it is difficult to overcome the problem of free riding. As a result of this, the free market system tends to result in the under--provision of public goods.

Private versus public provision of public goods

Of course, the fact that the free market will tend to under--produce public goods does not mean that it will fail to produce them at all. Nor, for that matter, does it mean that government will be able to produce the “efficient” amount of public goods either. Efficiency in the provision of public goods would require the supplier of the public good to be able to observe each individual's marginal valuation for the public good.² That is, the supplier of the public good would have to be able to observe how much each person values or is willing to pay for the provision of the public good. Because this information is, in general, unavailable to anyone, including the government, there is no reason to suppose that public goods will be provided any more efficiently by the public sector than by the private sector.³ As David Friedman notes, only an all--knowing “bureaucrat--god” would be able to supply the “right” amount of a public good.⁴

Furthermore, there are many instances when the private sector does manage to produce public goods successfully. Consider, for instance, radio broadcasting. Radio broadcasts are a public good in that once a radio station starts broadcasting, its programming is available free of charge to anyone with a radio. In the absence of signal scrambling, no person with a radio can be excluded from listening to a broadcast. Interestingly, however, radio broadcasting is provided largely by the private market. What makes private radio broadcasting possible is that broadcasters are able to “tie--in” radio programming with another public good, i.e., advertising. By selling advertising time to commercial companies, it is possible for private radio stations to finance their broadcasts without charging listeners for their consumption.⁵ Hence, the free market is often able to come up with ways that enable private producers to profitably supply public goods.

Another example of a public good that can be provided successfully by the private sector is lighthouses. Traditionally, most economists believed that lighthouses were an example of a public good which could only be provided by government.⁶ Clearly all ships benefit from lighthouses. However, because most economists could not imagine a mechanism by which sailors could be induced to pay for the services of lighthouses, it was thought that the lighthouse was a public good which could only be provided by the state. This view was unchallenged until Ronald Coase did an historical study of lighthouses in the United Kingdom and found that, contrary to the popular view, a large number of lighthouses prior to the 1830s were provided privately.¹ Lighthouse owners obtained patents from the Crown empowering them to build lighthouses and levy tolls on ships presumed to have benefitted from the lighthouse. Tolls were collected at ports by agents of the lighthouse. The historical evidence therefore indicates that it is possible for the private sector to profitably supply lighthouses. The fact that certain economists have trouble imagining how the free market might supply certain public goods is therefore no reason to suppose that the market cannot produce them.  )

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Last Modified: Wednesday, October 20, 1999.