MARKET FAILURE

Classification of Public Goods 

One approach to classify goods so as to establish taxonomy of different types of goods is to concentrate on the non rival and non excludable characteristics of public goods. The following table presenting the taxonomy of goods will help us understand the classification of goods. 

	Excludable	Non-excludable
Rivalrous	A Private goods food, clothing, cars	B Common resources such as fish stocks, forest resources, coal
Non-rivalrous	C Club goods, cinemas, private parks, satellite television	D Pure public goods such as national defence

•  Goods in category A are rival in consumption and are excludable. These are also known as pure private goods. 
•  Goods in category D which are characterized by both non-excludability and non-rivalry properties are called pure public goods. A pure public good is non 
•  -rival as well as non- excludable. The benefit that an individual gets from a pure public good does not depend on the number of users. The clarity of your radio reception, for example, is generally independent of the number of other listeners. Knowledge is another non-rivalrous good. Once something has been discovered, one person's use of that knowledge does not preclude others from applying the same knowledge. But, this is not the case with most private goods. 
•  Consumption goods that fall in category B are rival but not excludable. Common resources would come under this (explained in section 2.4.6 below) Let us take another example. Bees from the hives of different bee keepers collect nectar from the nearby orange garden. The blossom is rival as the nectar collected for one hive is unavailable to another. Even so, it may be inconceivable to try to deny any particular honey bee access i.e. the situation is non-excludable. The examples include public parks, public roads in a city etc. 
•  Goods in category C are non rival in consumption but are excludable. A toll booth may exclude vehicles unless payment is made. Yet, if the road is not congested, one car may utilize it with no loss of benefit even though the other cars are also consuming the road service. Similarly, admission to a cinema, swimming pool, music concert etc. has potential for exclusion, but if there is no congestion, each individual admitted may consume the services without subtracting from the benefit of others. A good example of this is DTH cable TV service or Digital goods. The consumption of these is non-rival in nature but exclusion of houlseholds who do not pay is feasible. 

Pure and Impure Public Goods 

• The concept of pure public good is often criticized by many who point out that such goods are not in fact observable in the real world. They argue that goods which perfectly satisfy non rivalness and non-excludability are not easy to come across. 
• For example, if the government provides law and order or medical care, the use of law courts or medical care by some individuals subtracts the consumption of others if they need to wait. As another example, we may take defence. If armies are mostly deployed in the northern borders, it may not result in the same amount of protection to people in the south. 
• There are many hybrid goods that possess some features of both public and private goods. These goods are called impure public goods and are partially rivalrous or congestible. Because of the possibility of congestion, the benefit that an individual gets from an impure public good depends on the number of users. 
• Consumption of these goods by another person reduces, but does not eliminate, the benefits that other people receive from their consumption of the same good. For example, open- access Wi-Fi networks become crowded when more people access it. Impure public goods also differ from pure public goods in that they are often excludable.
•  An example of an impure public good would be cable television. It is non-rivalrous because the use of cable television by other individuals will in no way reduce your enjoyment of it. The good is excludable since the cable TV service providers can refuse connection if you do not pay for set top box and recharge it regularly. 

We have seen above that impure public goods only partially satisfy the two public good characteristics of non-rivalry in consumption and non-excludability. The possibility of exclusion from the use of an impure public good has two implications. 

1. Since free riding can be eliminated, the impure public good may be provided either by the market or by the government at a price or fee. If the consumption of a good can be excluded, then, the market would provide a price mechanism for it. 

2. The provider of an impure public good may be able to control the degree of congestion either by regulating the number of people who may use it , or the frequency with which it may be used or both. 

Two broad classes of goods have been included in the studies related to impure public goods. 

1. Club goods; first studied by Buchanan 

2. Variable use public goods; first analyzed by Oakland and Sandmo 

• Examples of club goods are: facilities such as swimming pools, fitness centres etc. These goods are replicable and, therefore, individuals who are excluded from one facility may get similar services from an equivalent provider. 
• Variable use public goods include facilities such as roads, bridges etc. Once they are provided, everybody can use it. They can be excludable or non excludable. If they are excludable, some people can be discouraged from using it frequently by making them pay for its consumption. In doing so, the frequency of usage of the public good can be controlled. Since they are not replicable, the facility should be accessible to all potential users. Why should we exclude the enjoyment of roads, bridges etc of some people? The reason is the possibility of congestion due to large number of vehicles and the potential reduction of benefit to the users. 

Quasi Public Goods (Mixed Goods) 

• This second approach to classification of impure public goods focuses on the mix of services that arise from the provision of the good. 
• For example, if one gets inoculated against measles, it confers not only a private benefit to the individual, but also an external benefit because it reduces the chances getting infected of other persons who are in contact with him. You can observe here that the external effect associated with the consumption of a private good may have the characteristics of a public good. 
• Similarly, education will improve the individual’s earning potential and at the same time, it may facilitate basic research creating nonrival non excludable knowledge and information which are public goods. 
• Other examples of benefits to the society through education are improvement in decision making behaviour, provision of a screening device for the labour market to determine the quality of labour and better cultural environment and heritage for future generations. For example, other things remaining the same, the students pursuing the chartered accountancy programme will have a demand curve for the programme at various prices. This reflects the private benefits which the students believe they would enjoy as a result of this education.
•  These may be viewed as ‘private return’ on education and they depend in part on the income differential that students expect during their working life as a result of chartered accountancy education. However, there are likely other benefits such as, the possible addition which you may make to accounting knowledge and practices, the consultancy services you give to others, the policy recommendations that you may be able to put forth for a better tax or budgeting system etc. to mention a few. 
• These have the characteristics of public good as everyone in the society can consume them without reducing the amount available for consumption by others. Obviously, your demand curve for the CA programme did not incorporate all these external effects. 
• The quasi-public goods or services, also called a near public good (for e.g. education, health services) possess nearly all of the qualities of the private goods and some of the benefits of public good. It is easy to keep people away from them by charging a price or fee.
•  However, it is undesirable to keep people away from such goods because the society would be better off if more people consume them. This particular characteristic namely, the combination of virtually infinite benefits and the ability to charge a price results in some quasi-public goods being sold through markets and others being provided by government. As such, people argue that these should not be left to the market alone.
•  Markets for the quasi public goods are considered to be incomplete markets and their lack of provision by free markets would be considered as inefficiency and market failure. 

Common Access Resources 

• Common access resources or common pool resources are a special class of impure public goods which are non-excludable as people cannot be excluded from using them. These are rival in nature and their consumption lessens the benefits available for others. 
• This rival nature of common resources is what distinguishes them from pure public goods, which exhibit both non-excludability and non-rivalry in consumption. They are generally available free of charge. Some important natural resources fall into this category. 
• Since price mechanism does not apply to common resources, producers and consumers do not pay for these resources and therefore, they overuse them and cause their depletion and degradation. This creates threat to the sustainability of these resources and, therefore, the availability of common access resources for future generations. 
• Economists use the term ‘tragedy of the commons’ to describe the problem which occurs when rivalrous but non excludable goods are overused, to the disadvantage of the entire world. 

Examples of common access resources are fisheries, common pastures, rivers, sea, backwaters biodiversity etc. The earth’s atmosphere is perhaps the best example. Emissions of carbon dioxide and other greenhouse gases have led to the depletion of the ozone layer endangering environmental sustainability. Although nations are aware of the fact that reduced global warming would benefit everyone, they have an incentive to free ride, with the result that nothing positive is likely to be done to correct the problem. . 

Global Public Goods 

• There are several public goods benefits of which accrue to everyone in the world. These goods have widespread impact on different countries and regions, population groups and generations. These are goods whose impacts are indivisibly spread throughout the entire globe. 
• The WHO delineates two categories of global public goods namely, final public goods which are ‘outcomes’, (e.g. the eradication of polio) and intermediate public goods, which contribute to the provision of final public goods.( e.g. International Health Regulations aimed at stopping the cross-border movement of communicable diseases and thus reducing cross-border health risks). 
• Similarly, the World Bank identifies five areas of global public goods which it seeks to address: namely, the environmental commons (including the prevention of climate change and biodiversity), communicable diseases (including HIV/AIDS, tuberculosis, malaria, and avian influenza), international trade, international financial architecture, and global knowledge for development. The distinctive characteristic of global public goods is that there is no mechanism (either market or government) to ensure an efficient outcome. 

The Free Rider Problem 

• We may be unfamiliar with the jargon ‘free riding’ but it is a familiar phenomenon in our day to day life. You might have noticed that when students are required to do a group project, some group members tend to escape the work and make others do the entire work. Those who escape assignment ‘free ride’ on the efforts of others. 
• The incentive to let other people pay for a good or service, the benefits of which are enjoyed by an individual is known as the free rider problem. In other words, free riding is ‘benefiting from the actions of others without paying’. A free rider is a consumer or producer who does not pay for a nonexclusive good in the expectation that others will pay. 
• Public goods provide a very important example of market failure, in which the self interested behaviour of individuals does not produce efficient results. We shall now see how free riding is applicable in the case of public goods. Consumers can take advantage of public goods without contributing sufficiently to their production. The absence of excludability in the case of public goods and the tendency of people to act in their own self interest will lead to the problem of free riding. If individuals cannot be excluded from the benefit of a public good, then they are not likely to express the value of the benefits which they receive as an offer to pay. 
• In other words, they will not express to buy a particular quantity at a price. Briefly put, there is no incentive for people to pay for the good because they can consume it without paying for it. There is an important implication for this behaviour. If every individual plays the same strategy of free riding, the strategy will fail because nobody is willing to pay and therefore, nothing will be provided by the market. Then, a free ride for any one becomes impossible. 
• On account of the free rider problem, there is no meaningful demand curve for public goods. If individuals make no offers to pay for public goods, then the profit maximizing firms will not produce them. 

In fact, the public goods are valuable for people. If there is no free rider problem, people would be willing to pay for them and they will be produced by the market. As such, if the free-rider problem cannot be solved, the following two outcomes are possible: 

1. No public good will be provided in private markets 

2. Private markets will seriously under produce public goods even though these goods provide valuable service to the society. 

INCOMPLETE INFORMATION 

Complete information is an important element of competitive market. Perfect information implies that both buyers and sellers have complete information about anything that may influence their decision making. However, this assumption is not fully satisfied in real markets due to the following reasons. 

• Often, the nature of products and services tends to be highly complex e.g. Cardiac surgery, financial products (such as pension products mutual funds etc). 
•  In many cases consumers are unable to quickly / cheaply find sufficient information on the best prices as well as quality for different products. Sometimes they misunderstand the true costs or benefits of a product or are uncertain about the true costs and benefits. 
•  People are ignorant or not aware of many matters in the market. Generally they have inaccurate or incomplete data and consequently make potentially ‘wrong’ choices / decisions. 

Information failure is widespread in numerous market exchanges. When this happens misallocation of scarce resources takes place and equilibrium price and quantity is not established through price mechanism. This results in market failure. 

Asymmetric Information 

• Asymmetric information occurs when there is an imbalance in information between buyer and seller i.e. when the buyer knows more than the seller or the seller knows more than the buyer. This can distort choices.
•  For example, the landlords know more about their properties than tenants, a borrower knows more about their ability to repay a loan than the lender, a used-car seller knows more about vehicle quality than a buyer and some traders may possess insider information in financial markets. These are situations in which one party to a transaction knows a material fact that the other party does not. This phenomenon, which is sometimes referred to as the ‘lemons problem’, is an important source of market failure. With asymmetric information, low-quality goods can drive high-quality goods out of the market. 

Adverse Selection and Moral Hazard 

• Adverse selection is a situation in which asymmetric information about quality eliminates high-quality goods from a market. 
• One example of adverse selection is that of health insurance. The people who are most likely to purchase health insurance are those who are most likely to use it, i.e. people with unhealthy life styles and those with underlying health issues. The insurance company being aware of this raises the average price of insurance cover. This prices healthy consumers out of the market as healthy people will be unwilling to pay such high premium. The result is that only high risk individuals buy insurance. This is a market failure. 
• Another example is the used car market i.e. the ‘market for lemons’. The owner of a car knows much more about its quality than anyone else. The buyer’s willingness to pay for any particular car will be based on the ‘average quality’ of used cars. Anyone who sells a ‘lemon’ (an unusually poor car) stands to gain. The market becomes flooded with lemons. Eventually the market may offer nothing but lemons. The good-quality cars disappear because they are kept by their owners or sold only to friends. Briefly put, buyers expect hidden problems in items offered for sale, leading to low prices and the best items being kept off the market.
• Moral hazard is opportunism characterized by an informed person’s taking advantage of a less-informed person through an unobserved action. It arises from lack of information about someone’s future behavior. Moral hazard occurs when an individual knows more about his or her own actions than other people do. This leads to a distortion of incentives to take care or to exert effort when someone else bears the costs of the lack of care or effort. 
• When someone is protected from paying the full costs of their harmful actions, they tend to act irresponsibly, making the harmful consequences more likely. Moral hazard occurs when a party whose actions are unobserved can affect the probability or magnitude of a payment associated with an event. For example: the insured consumers are likely to take greater risks, knowing that a claim will be paid for by the insurance company. The more of one’s costs that are covered by the insurance company, the less a person cares whether the doctor charges excessive fees or uses inefficient and costly procedures as part of his health care.
•  This causes insurance premiums to rise for everyone, driving many potential customers out of the market. This became a big issue in India when the health insurance providers and big private hospitals came in conflict and the issue was resolved by putting in place a ‘third party administration’ to settle the medical claims. 

Asymmetric information, adverse selection and moral hazard affect the ability of markets to efficiently allocate resources and therefore lead to market failure because the party with better information has a competitive advantage. 

CONCLUSION 

Markets, do not always lead to efficiency. When there is a market failure, the market outcomes may be inefficient and government intervention can improve society’s welfare. Government can ensure economic efficiency by providing the necessary legal and regulatory system that facilitates efficiency and /or it can intervene to correct specific market failures.