Public good (economics)

In economics, a public good is a good that is hard or even impossible to produce for private profit, because the market fails to account for its large beneficial externalities. By definition, a public good possesses two properties:

Non-rivalrous — its benefits fail to exhibit consumption scarcity; once it has been produced, everyone can benefit from it without diminishing other's enjoyment.
Non-excludable — once it has been created, it is very difficult to impossible to prevent access to the good.

"Pure" public goods possess these properties absolutely. Because pure public goods are rare (though they include such important cases as national defense and the system of property rights), in common parlance among economists "public goods" usually refers to impure public goods or those confined to particular localities. A public good is for society as a whole (the public), while a "collective good" is merely for a sub-set of society.

A pure public good is the opposite of a private good, i.e., a good that can easily be divided into parts to sell on the market, because it is excludable and rivalrous. 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 free market is highly unlikely to produce the optimum amount of any public good. Such important goods like national defense will be underproduced due to the free rider problem. In practice, this problem is solved by government intervention and state provision of public goods. These solutions are not without their own critics, however, since some argue that this can lead to too many resources being allocated to a public good's production. In the case of national defense, this is the alleged problem of the military-industrial complex. Also, centralized governments are not the only substitute for markets: in theory, tradition and decentralized democracy might play a similar role.

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.

Examples of Public Goods

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 fulfil 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 and no ship's use detracts from that of others. However, since in some cases, most of the benefit of a lighthouse accrues to ships using particular ports, lighthouse maintenance fees can profitably be bundled with port fees (Ronald Coase, 1974). This has been been sufficient to fund some actual lighthouses as club goods. Nevertheless, since port fees are much like taxes, this example does not go against the theory of public goods.

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. On the other hand, technological progress can also create new public goods. The simplest examples are street lights: they are relatively recent inventions (by historical standards), one person's enjoyment of them does not detract from other persons' enjoyment, and it is impossible to charge individuals separately for the amount of light they presumably use.

Subtypes of Public Goods

One of the most common ways of looking at goods in economics, illustrated in the table below, is the classic division based on:

whether there is competition involved in obtaining a given good
whether it is possible to exclude a person from consumption of a given good

	Excludable	Non-excludable
Rivalrous	Private goods eg. food, clothing, parking spaces	Common-pool resources eg. fish stocks, timber
Non-rivalrous	Club goods eg. cinemas, software, private parks	Public goods eg. free-to-air television, air, national defense

Sometimes, club and common goods are included in the broad definition of public goods. There are always some goods that can be argued to belong in more than one of the above categories.

Common goods should not be confused with another subtype of public goods: the collective goods (also known as social goods), which are defined as goods that could be delivered as private goods, but are delivered instead by the government for various reasons (usually social policy).

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. Because no private organisation can 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 free-rider (also known as homo economicus) is an individual who is extremely individualistic, considering benefits and costs that affect only him or her. Suppose this individual 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. Further, there is a very high possibility that he 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. So the free rider would not voluntarily exert any extra effort, unless there is some inherent pleasure or material reward for doing so (such as, for example, money paid by the government, as with an all-volunteer army or mercenaries).

Finally, 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

Dominant Assurance Contracts

Assurance contracts are contracts in which participents 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 entrepeneur 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 pleding to the contract 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 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 eachother 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.

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 goverments 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 is saved from our own individualistic short-sightedness, our tendency to be a free rider.) One general solution to the problem is for governments or states to impose taxation to fund the production of public goods. The difficulty is to determine how much funding should be allocated to different public goods, and how the costs should be split (see resource allocation mechanisms, public finance). Ideally, these decisions should be made democratically following advice informed by economic theory.

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

A government may subsidize production of a public good in the private sector. Unlike government provision, subsidies may result in some form of 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.

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 of 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, since 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.

Legislated exclusion

Another solution, which has evolved for information goods, is to create intellectual property laws, such as copyright or patents, covering the public goods. These 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, to sue even mild imitators in court, and to lobby for the extension of patent rights. (See 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 (including both arbitrage and a lack of incentives to provide cheap, high quality copies to those with little ability to pay), those who are unwilling or unable to pay a profit-maximising price, do not get access to the good.

Joseph Schumpeter claimed that the "excess profits" 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), and predict that these practices will make increased market shares for Linux and Macintosh largely inevitable.

Non-individualism

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, a public-spirited person 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 a free-rider would not litter, since his or her action would have such an obvious cost.

Public spirit may be encouraged by non-market solutions to the economic problem, such as tradition and decentralized democracy. The centralized government may play only a supporting role here.

In turn, this kind of public spirit – involving nationalism, patriotism, or national chauvinism or sometimes religious or ethnic unity – has 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 TV. 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.

Efficient production levels of public goods

Regardless of the method of attaining public goods production, the efficient level of such production is still susceptible 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.

External sources

Coase, Ronald (1974), The Lighthouse in Economics, Journal of Law and Economics 17 (2), 357–376