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. 

MARKET FAILURE

INTRODUCTION 

Before we go into the subject matter of market failure which is the focus of this unit, we shall examine two familiar events that are in some way connected with the phenomenon of market failure

Case I

Sarva Shiksha Abhiyan (SSA) is a centrally sponsored scheme implemented by the Government of India in partnership with the state governments, for universalising good quality elementary education for all children in the 6-14 age groups in a time- bound manner. Through this programme, the government aims to provide opportunity for children to learn about and master their natural environment in order to develop their potential intellectually, spiritually as well as materially. The ultimate objective is to bring in social, regional and gender quantity. 

Nearly everyone believes that providing basic education to all citizens is an important responsibility of the government. This is the reason why education is almost entirely administered and extensively financed by government. 

Questions

Why do you think governments should intervene to provide education?

What do you think the outcome will be if it is left to private entrepreneurs?

Case II

In November 2016, the Central Pollution Control Board (CPCB), the nation’s apex pollution  control  body,  has come up with the ‘Guidelines For Environmentally Sound Management (ESM) of End- of - Life Vehicles (ELVs)’ with the recommendation that the Union Environment Ministry draft  the  necessary legislative framework for the sector considering the growing concern about the health and environmental hazards posed by them. CPCB advocates disposing of  such vehicles in an environmentally friendly manner and recommends a system of “shared responsibility” involving all stakeholders—the government, manufacturers, recyclers, dealers, insurers and consumers.

The central board has called  for periodic  review of  the registration of all  vehicles by transport offices so that the environment is not harmed by the continued use of polluting vehicles as well as initiation of a massive awareness campaign aimed at sensitizing stakeholders like consumers about the environmental hazards posed by ELVs.

The above case is an example of how government departments and specifically constituted bodies address different issues to sustain our environment.

Question

Since citizens should ideally know the need for clean environment, why should governments interfere with the system?

THE CONCEPT OF MARKET FAILURE 

• The general belief is that markets are amazingly competent in organizing the activities of an economy as they are generally efficient and capable of achieving optimal allocation of resources.
• However, there are exceptions to this. Under certain circumstances, ‘market failure’ occurs, i.e. the market fails to allocate resources efficiently and therefore, market outcomes become inefficient. 
• Market failure is a situation in which the free market leads to misallocation of society's scarce resources in the sense that there is either overproduction or underproduction of particular goods and services leading to a less than optimal outcome.
• The reason for market failure lies in the fact that though perfectly competitive markets work efficiently, most often the prerequisites of competition are unlikely to be present in an economy.
•  Market failures are situations in which a particular market, left to itself, is inefficient. We shall first try to understand why markets fail and later, in the subsequent unit, proceed to identify the role of government in dealing with market failure. 
• We need to appreciate the fact that there are two aspects of market failures namely, demand-side market failures and supply side market failures. Demand-side market failures are said to occur when the demand curves do not take into account the full willingness of consumers to pay for a product.
•  For example, none of us will be willing to pay to view a wayside fountain because we can view it without paying. Supply-side market failures happen when supply curves do not incorporate the full cost of producing the product. For example, a thermal power plant that uses coal may not have to include or pay completely for the costs to the society caused by fumes it discharges into the atmosphere as part of the cost of producing electricity. 

WHY DO MARKETS FAIL? 

The pertinent question here is why do markets fail? There are four major reasons for market failure. They are: 

• Market power, 
• Externalities, 
• Public goods, and 
• Incomplete information 

We shall discuss each of the above in detail. 

Market Power 

• Market power or monopoly power is the ability of a firm to profitably raise the market price of a good or service over its marginal cost. Firms that have market power are price makers and therefore, can charge a price that gives them positive economic profits.
•  Excessive market power causes the single producer or a small number of producers to produce and sell less output than would be produced in a competitive market. Market power can cause markets to be inefficient because it keeps price higher and output lower than the outcome of equilibrium of supply and demand.
•  In the extreme case, there is the problem of non existence of markets or missing markets resulting in failure to produce various goods and services, despite the fact that such products and services are wanted by people.
•  For example, the markets for pure public goods do not exist. 

Externalities 

• We begin by describing externalities and then, proceed to discuss how they create market inefficiencies. As we are aware, anything that one individual does, may have, at the margin, some effect on others.
•  For example, if individuals decide to switch from consumption of ordinary vegetables to consumption of organic vegetables, they would, other things equal, increase the price of organic vegetables and potentially reduce the welfare of existing consumers of organic vegetables.
•  However, we should note that all these operate through price mechanism i.e. through changes in prices. The price system works efficiently because market prices convey information to both producers and consumers.
•  However, sometimes, the actions of either consumers or producers result in costs or benefits that do not reflect as part of the market price. Such costs or benefits which are not accounted for by the market price are called externalities because they are “external” to the market. 

In other words, there is an externality when a consumption or production activity has an indirect effect on other’s consumption or production activities and such effects are not reflected directly in market prices. The unique feature of an externality is that it is initiated and experienced not through the operation of the price system, but outside the market. Since it occurs outside the price mechanism, it has not been compensated for, or in other words it is uninternalized or the cost (benefit) of it is not borne (paid) by the parties. 

• Externalities are also referred to as 'spillover effects', 'neighbourhood effects' 'third-party effects' or 'side-effects', as the originator of the externality imposes costs or benefits on others who are not responsible for initiating the effect. 
• Externalities may be unidirectional or reciprocal. Suppose a workshop creates earsplitting noise and imposes an externality on a baker who produces smoke and disturbs the workers in the workshop, then this is a case of reciprocal externality. If an accountant who is disturbed by loud music but has not imposed any externality on the singers, then the externality is unidirectional.
•  Externalities can be positive or negative. Negative externalities occur when the action of one party imposes costs on another party. Positive externalities occur when the action of one party confers benefits on another party. 

The four possible types of externalities are: 

• Negative production externalities 
• Positive production externalities
•  Negative consumption externalities ,and 
• Positive consumption externalities 

Negative Production Externalities 

• A negative externality initiated in production which imposes an external cost on others may be received by another in consumption or in production.
•  As an example, a negative production externality occurs when a factory which produces aluminum discharges untreated waste water into a nearby river and pollutes the water causing health hazards for people who use the water for drinking and bathing. Pollution of river also affects fish output as there will be less catch for fishermen due to loss of fish resources.
•  The former is a case where a negative production externality is received in consumption and the latter presents a case of a negative production externality received in production. The firm, however, has no incentive to account for the external costs that it imposes on consumers of river water or fishermen when making its production decision. 
• Additionally, there is no market in which these external costs can be reflected in the price of aluminum. 

Positive production externalities 

• A positive production externality initiated in production that confers external benefits on others may be received in production or in consumption. Compared to negative production externalities, positive production externalities are less common. 
• As an example of positive production externality received in production, we can cite the case of a firm which offers training to its employees for increasing their skills. The firm generates positive benefits on other firms when they hire such workers as they change their jobs. 
• Another example is the case of a beekeeper who locates beehives in an orange growing area enhancing the chances of greater production of oranges through increased pollination. A positive production externality is received in consumption when an individual raises an attractive garden and the persons walking by enjoy the garden. These external effects were not in fact taken into account when the production decisions were made. 

Negative consumption externalities 

• Negative consumption externalities are extensively experienced by us in our day to day life. Such negative consumption externalities initiated in consumption which produce external costs on others may be received in consumption or in production.
•  Examples to cite where they affect consumption of others are smoking cigarettes in public place causing passive smoking by others, creating litter and diminishing the aesthetic value of the room and playing the radio loudly obstructing one from enjoying a concert.
•  The act of undisciplined students talking and creating disturbance in a class preventing teachers from making effective instruction and the case of excessive consumption of alcohol causing impairment in efficiency for work and production are instances of negative consumption externalities affecting production. 

Positive consumption externalities 

• A positive consumption externality initiated in consumption that confers external benefits on others may be received in consumption or in production.
•  For example, if people get immunized against contagious diseases, they would confer a social benefit to others as well by preventing others from getting infected. Consumption of the services of a health club by the employees of a firm would result in an external benefit to the firm in the form of increased efficiency and productivity. 
• Having discussed the nature of externalities in production and consumption, we shall now examine how externalities cause inefficiency and market failure. Before we attempt this, we need to understand the difference between private costs and social costs.
•  Private cost is the cost faced by the producer or consumer directly involved in a transaction. If we take the case of a producer, his private cost includes direct cost of labour, materials, energy and other indirect overheads.
•  As we have mentioned above, firms do not have to pay for the damage resulting from the pollution which they generate. As a result, each firm’s private cost would be the direct cost of production only which does not incorporate externalities. 
• Social costs refer to the total costs to the society on account of a production or consumption activity. Social costs are private costs borne by individuals directly involved in a transaction together with the external costs borne by third parties not directly involved in the transaction. 

The presence of externalities creates a divergence between private and social 

Social Cost = Private Cost + External Cost

costs of production. When negative production externalities exist, social costs exceed private cost because the true social cost of production would be private cost plus the cost of the damage from externalities. If producers do not take into account the externalities, there will be over-production and market failure. Applying the same logic, negative consumption externalities lead to a situation where the social benefit of consumption is less than the private benefit. 

• Externalities cause market inefficiencies because they hinder the ability of market prices to convey accurate information about how much to produce and how much to consume. Given that externalities are more often negative, we shall focus on them. 
• A market exchange assumes that the participants have total control over every aspect of their product and that the prices (or fees) they charge represent the full cost of production plus profit. As a matter of fact, the producers of products with extensive negative externalities are not fully accountable for the full cost of their production which includes private as well as social costs. Recall our earlier case of the aluminum factory which causes pollution of river water.
•  As a matter of fact, the prices of aluminum tend to reflect only the private costs of the producer. Since externalities are not reflected in market prices, they can be a source of economic inefficiency. Production remains efficient only when all benefits and costs are paid for. 
• Negative externalities impose costs on society that extend beyond the cost of production as originally intended by the producer. Without government intervention, such a producer will have no reason to consider the social costs of pollution. When firms do not have to worry about the negative externalities associated with their production, the result is excess production and unnecessary social costs. The problem, though serious, does not usually float up much because: 

The society does not know precisely who are the producers of harmful externalities 

Even if the society knows it, the cause-effect linkages are so unclear that the negative externality cannot be unquestionably traced to its producer. 

The problem can be explained with the help of the figure below: 

Figure 2.2.1 

Negative Externalities and Loss of Social welfare 

• The equilibrium level of output that would be produced by a free market is Q1 at which marginal private benefit (MPB) is equal to marginal private cost (MPC).
•  Marginal social cost (MSC) represents the full or true cost to the society of producing another unit of a good. It includes marginal private cost (MPC) and marginal social cost (MSC).
•  Assuming that there are no externalities arising from consumption, we can see that marginal social cost (Q1S) is higher than marginal private cost (Q1E). Social efficiency occurs at Q2 level of output where MSC is equal to MSB. Output Q1 is socially inefficient because at Q1, the MSC is greater than the MSB and represents over production.
•  The shaded triangle represents the area of dead weight welfare loss. It indicates the area of overconsumption. Thus, we conclude that when there is negative externality, a competitive market will produce too much output relative to the social optimum. This is a clear case of market failure where prices fail to provide the correct signals. 

PUBLIC GOODS 

Paul A. Samuelson who introduced the concept of ‘collective consumption good’ in his path-breaking 1954 paper ‘The Pure Theory of Public Expenditure’ is usually recognized as the first economist to develop the theory of public goods. A public good (also referred to as collective consumption good or social good) is defined as one which all enjoy in common in the sense that each individual’s consumption of such a good leads to no subtraction from any other individuals’ consumption of that good. 

Before we go on to discuss the distinguishing features of public goods and how they differ from private goods, it is pertinent to first understand the characteristics of private goods. 

Characteristics of Private Goods 

• Private goods refer to those goods that yield utility to people. Anyone who wants to consume them must purchase them. 
• Owners of private goods can exercise private property rights and can prevent others from using the good or consuming their benefits. 
• Consumption of private goods is ‘rivalrous’ that is the purchase and consumption of a private good by one individual prevents another individual from consuming it. In other words, simultaneous consumption of a rivalrous good by more than one person is impossible. 
• Private goods are ‘excludable’ i.e. it is possible to exclude or prevent consumers who have not paid for them from consuming them or having access to them. In other words, those who want to consume private goods must buy them at a price from its sellers. Excludability necessitates that consumers of private goods send the right signals in the market. A buyer of a private good is forced in a transaction to reveal what he or she is willing to pay for a good or a service. 
• Private goods do not have the free rider problem. This means that the private godds will be available to only those persons who are willing to pay for it. 
• Private goods can be parceled out among different individuals and therefore, it is possible to refer to total consumption as the sum of each individual’s consumption. Therefore, the market demand curve for a private good is obtained by horizontal summation of individual demand curves 
• All private goods and services can be rejected by the consumers if their needs, preferences or budgets change. 
• Additional resource costs are involved for producing and supplying additional quantities of private goods.

• Since buyers can be excluded from enjoying the good if they are not willing and able to pay for it, consumers will get different amounts of goods and services based on their desires and ability and willingness to pay.
•  Therefore, whenever there is inequality in income distribution in an economy, issues of fairness and justice tend to arise with respect to private goods. Normally, the market will efficiently allocate resources for the production of private goods.

Characteristics of Public Goods 

• Public goods yield utility to people and are products (goods or services) whose consumption is essentially collective in nature. No direct payment by the consumer is involved in the case of pure public goods. 
• Public good is non-rival in consumption. It means that consumption of a public good by one individual does not reduce the quality or quantity available for all other individuals. When consumed by one person, it can be consumed in equal amounts by the rest of the persons in the society. That is, your consumption of a public good in no way interferes with its consumption by other people. For example, if, you eat your apple, another person too cannot eat it. But, if you walk in street light, other persons too can walk without any reduced benefit from the street light. 
• Public goods are non-excludable. Consumers cannot (at least at less than prohibitive cost) be excluded from consumption benefits. If the good is provided, one individual cannot deny other individuals’ consumption. Provision of a public good at all by government means provision for all. For example, national defence once provided, it is impossible to exclude anyone within the country from consuming and benefiting from it. 
• Public goods are characterized by indivisibility. For example, you can buy chocolates or ice cream as separate units, but a lighthouse, a highway, an airport, defence, clean air etc cannot be consumed in separate units. In the case of public goods, each individual may consume all of the good i.e. the total amount consumed is the same for each individual. 
• Public goods are generally more vulnerable to issues such as externalities, inadequate property rights, and free rider problems. 
• Once a public good is provided, the additional resource cost of another person consuming the goods is ‘zero’. A good example is a Lighthouse near a sea shore to guide the ships. Once the beacon is lit, an additional ship can use it without any additional cost of provision. 
• Public goods are generally divided into two categories namely, public consumption goods and public factors of production. 
• A few examples of public goods are: national defence, highways, public education, scientific research which benefits everyone, law enforcement, lighthouses, fire protection, disease prevention and public sanitation. 
• A unique feature of public goods is that they do not conform to the settings of market exchange. The property rights of public goods with extensive indivisibility and nonexclusive properties cannot be determined with certainty. Therefore, the owners of such products cannot exercise sufficient control over their assets. For example, if you maintain a beautiful garden, you cannot exercise full control over it so as to charge your neighbours for the enjoyment which they get from your garden.
•  As a consequence of their peculiar characteristics, public goods do not provide incentives that will generate optimal market reaction. Producers are not motivated to produce a socially-optimal amount of products if they cannot charge a positive price for them or make profits from them. As such, though public goods are extremely valuable for the well being of the society, left to the market, they will not be produced at all or will be grossly under produced. 

Now that we have understood the difference between private goods and public goods, we shall examine the implications of these characteristics on the production, supply and use of these goods. As mentioned above, ideally competitive markets have sufficient incentives to produce and supply private goods. Because of the peculiar characteristics of public goods such as indivisibility, non excludability and nonrivalry, competitive private markets will fail to generate economically efficient outputs of public goods. That is why public goods are often (though not always) under-provided in a free market economy.

Clarification Regarding GST Book and more

Hello,

This is clarification regarding GST Book as many students asked various questions, hope this resolve their doubts.

1. Is this is 2 books?
No. It is only 1 book with includes relevant provisions and Flowcharts.

2. Is it amended?
Yes. Till date all amendments include. And for future amendments stay connected with blog. It is advisible to students whose exams on head, visit only in week ends and look and cover all amendments if any.

3. How to deal with Future amendments, if any?
Don't worry. Space at back of Flowcharts is provided for Self Note. After reading this book, your brain automatically create flow charts > helps in clearing amendment (provisions) > helps in other subject preparations too.

4. Can i use for Self Study?
Yes, definitely. As Commerce Gurukul Team aim to help students how can't afford or lack time or don't won't Coachings > REFER these Books > thats why it is STUDENT FRIENDLY. So, it reach to each pocket.

5. What if I have any Query/Questions?
Don't worry again. As there is Various Commerce Gurukul Telegram Groups where students post query and helps eachother Or in case of extreme Experts too help there.

6. Can i get immediate answer of query/questions and/or personal attention for my preparation?
Yes. But in that case you have to register with the Team. Where they will guide you.

7. How can i guided by team?
Team will talk to you to know few thing, like- Your goals, social problems, why you sitting in exam, etc. They psycologically understand you and fix your schedule which help to cover your course in due time and number of time revisions. You will have to fill everyday schedules to update team about your progress  > in case u lost in way > they help you.

Don't worry WE ARE HERE TO CREATE YOUR FUTURE, Secrecy is completely maintained.

There are many students registered but not sincere BUT those sincere cleared there exams as like CA-Finals in their first attempt.

8. When i get book?
As exams includes recent amendments 2nd lot booking/more bookings have to done in advance. On advance booking you will get book only at price you register with new amendment BUT in case no booking New price is applicable and DELIVERY of books in FIFO Basis.


FOR MORE QUESTIONS YOU ARE FREE TO ASK WE ARE HAPPY TO HELP YOU.

DREAM BIG......

LETS BRING A REVOLUTION WHERE EACH ONE TEACH ONE.

Commerce Gurukul Team

FISCAL FUNCTION

INTRODUCTION

The following are a few headlines which appeared recently in the leading business dailies:

1. Crop worry: Centre scraps import duty on wheat to ease supply and check  prices

2. Monetary Policy panel members voted unanimously for a rate cut

3. A fortified mid -day meal gets underway at Karnataka’s government schools

4. Government to spend ` 60,000 crores more on rural jobs

5. Government looking at subsidizing Smart phones to boost digital payments

6. No service tax on credit, debit card transactions up to ` 2,000

Each of the above statements represents a proactive response on the part of the government to achieve certain objectives in the interest of the economy and the society.

What exactly is the government planning to accomplish by the above measures?  On close examination, we can find that the first two steps are intended to control potential rise in prices; the next two seek to bring in welfare to the underprivileged sections of the society by ensuring equity and fairness and the remaining two are meant to provide incentives to promote the production/ use of resources in a socially desirable direction. The government does not expect the economic  variables underlying the above mentioned phenomena to function automatically; rather it intervenes to direct them to function in particular directions. Such intervention on the part of the government is based on the belief that the objective of the economic system and the role of government is to improve the wellbeing of individuals and households.

We have experienced in our day to day life that though governments at various levels impose many rules and regulations in the economy, some matters still go unregulated. Similarly, most of the goods and services that we consume are provided to us by private producers, but certain goods and services are provided exclusively by the government. For a variety of reasons, we believe  that governments should accomplish some activities and should not do others. The purpose of this lesson is to examine the economic functions of the government and to understand why the government should invariably perform them.

THE ROLE OF GOVERNMENT IN AN ECONOMIC SYSTEM

We shall first consider why an economic system should be in place. The basic economic problem of scarcity arises from the fact that on account of qualitative as well as quantitative constraints, the resources available to any society cannot produce all economic goods and services that its members desire to have. Therefore, an economic system should exist to answer the basic questions such as what, how and for whom to produce and how much resources should be set apart to ensure growth of productive capacity. The modern society, in general, offers three alternate economic systems through which the decisions of resource reallocation may be made namely, the market, the government and a mixed system where both markets and governments simultaneously determine resource allocation.

Adam Smith is often described as a bold advocate of free markets and minimal governmental activity. However, Smith saw an important resource allocation  role for government when he underlined the role of government in national defence, maintenance of justice and the rule of law, establishment and maintenance  of highly beneficial public institutions and public works which the market may fail to produce on account of  lack of sufficient profits. Since the 1930s, more specifically  as a consequence of the great depression, the state’s role in the economy has been distinctly gaining in importance and therefore, the traditional functions of the state as described above, have been supplemented with what is referred to as economic functions (also called fiscal functions or public finance function).While there are differences among different countries in respect to the nature and extent of government intervention in economies, all governments are still expected to play a major role. This comes out of the belief that government intervention will invariably influence the performance of the economy in a positive way.

Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the three branch taxonomy of the role of government in a market economy. Musgrave believed that, for conceptual purposes, the functions of government are to be separated into three, namely, resource allocation, (efficiency), income redistribution (fairness) and macroeconomic stabilization. The  allocation and distribution functions are primarily microeconomic  functions,  while stabilization is a macroeconomic function. The allocation function aims to correct the sources of inefficiency in the economic system while the distribution role ensures that the distribution of wealth and income is fair. Monetary  and  fiscal policy, the problems of macroeconomic stability, maintenance of high levels of employment and price stability etc fall under the stabilization function. We shall  now discuss in detail this conceptual three function framework of the responsibilities of the government.

THE ALLOCATION FUNCTION

Resource allocation refers to the way in which the available factors of production are allocated among the various uses to which they might be  put.  It determines how much of the various kinds of goods and services will actually be produced in    an economy. One of the most important functions of an economic system is the optimal or efficient allocation of scarce resources so  that the  available resources are put to their best use and no wastages are there.

As we know, the private sector resource allocation is characterized by market supply and demand and price mechanism as determined by consumer sovereignty and producer profit motives. The state’s allocation, on the other hand, is accomplished through the revenue and expenditure activities of governmental budgeting. In the real world, resource allocation is both market determined and government determined.

A market economy is subject to serious malfunctioning in several basic respects. There is also the problem of nonexistence of markets in a  variety  of situations. While private goods will be sufficiently provided by the market, public goods will  not be produced in sufficient quantities by the market. Why do markets fail to give right answers to the question as to what goods should be produced and in what quantities? In other words, why do markets generate misallocation of resources?

Efficient allocation of resources is assumed to take place only in perfectly competitive markets. In reality, markets are never perfectly competitive. Market failures which hold back the efficient allocation of resources occur  mainly due to  the following reasons:

·   Imperfect competition and presence of monopoly power in different degrees leading to under-production and higher prices than would exist under conditions of competition. These distort the choices available to consumers  and reduce their welfare.

·   Markets typically fail to provide collective goods which are, by their very nature, consumed in common by all the people.

·   Externalities which arise when the production and consumption of a good or service affects people and they cannot influence through markets the decision about how much of the good or service should be produced e.g. pollution.

·   Factor immobility which causes unemployment and inefficiency

·   Imperfect information, and

·  Inequalities in the distribution of income and wealth.

According to Musgrave, the state is the instrument by which the needs  and concerns of the citizens are fulfilled and therefore, public finance is connected with economic mechanisms that should ideally lead to the effective and optimal allocation of limited resources. This logic, in effect, makes it necessary for the government to intervene in the market to bring about improvement in social welfare. In the absence of appropriate government intervention, market failures  may occur and the resources are likely to be misallocated by too much production  of certain goods or too little production of certain other goods. The allocation responsibility of the governments involves suitable corrective action when private markets fail to provide the right and desirable combination of goods and services. Briefly put, market failures provide the rationale for government’s allocative function.

You might have noticed that in many cases, the government can provide us with goods and services that we cannot produce on our own or buy at a price from the market. For example, the government establishes property rights and makes the necessary arrangements for enforcing contracts through provision of law enforcement and courts. Goods which involve externalities that are not met by the market require intervention by the government for corrective measures. Merit  goods which are greatly beneficial to the society also fall under the purview of provision by the government. These interventions do not imply that markets are replaced by government action. In its allocation role, the government acts as a complement rather than as a substitute to the market system in an economy.

The resource allocation role of government’s fiscal policy focuses on the potential for the government to improve economic performance through its expenditure and tax policies. The allocative function in budgeting determines who and what will be taxed as well as how and on what the government revenue will be spent. It is concerned with the provision of public goods and the process by which the total resources of the economy are divided among various uses and an optimum mix of various social goods (both public goods and merit goods). The allocation function also involves the reallocation of society’s resources from private use to public use.

A variety of allocation instruments are available by which governments can  influence resource allocation in the economy. For example,

·   government may directly produce the economic good(for example, electricity and public transportation services)

·   government may influence private allocation through incentives and disincentives (for example, tax concessions and subsidies may be given for the production of goods that promote social welfare and higher taxes may be imposed on goods such as cigarettes and alcohol)

·   government may influence allocation through its competition policies, merger policies etc which will affect the structure of industry and commerce ( for example, the Competition Act in India promotes competition and prevents anti-competitive activities)

·   governments’ regulatory activities such as licensing, controls, minimum wages, and directives on location of industry influence resource allocation

·   government sets legal and administrative frameworks, and

·   any of a mixture of intermediate techniques may be adopted by governments

Maximizing social welfare is one of the primary and most commonly manifest reasons for government intervention in the market.  However,  it is also possible  that instead of eliminating market distortions, sometimes governments may contribute to generate them. The possible sources of this type of government failures are inadequate information, conflicting objectives and administrative costs involved in government intervention.

REDISTRIBUTION FUNCTION

You might have noticed that over the past decades there has been tremendous expansion in economic activities which has generated enormous increase in aggregate output and wealth. However, the outcomes of this growth have not spread evenly across the households. A major function of present-day governments therefore involves changing the pattern of distribution of income from what the market would offer to a more egalitarian one. The distribution responsibility of the government arises from the fact that, left to the market, the distribution of income and wealth among individuals in the society is likely to be  skewed and therefore  the government has to intervene to ensure a more desirable and just distribution.

The distributive function of budget is related to the basic question of for whom should an economy produce goods and services. As such, it is concerned with the adjustment of the distribution of income and wealth so as to ensure distributive justice namely, equity and fairness. The distribution function also relates to the manner in which the effective demand over the economic goods is divided among the various individual and family spending units of the society. Effective demand is determined by the level of income of the households and this  in  turn determines the distribution of real output among the population.

The distribution function of the government aims at:

·   redistribution of income to achieve an equitable distribution of societal output among households

·   advancing the well-being of those members of the society who suffer from deprivations of different types

·   providing equality in income, wealth and opportunities

·   providing security for people who have hardships, and

·   ensuring that everyone enjoys a minimal standard of living

·   A few examples of the redistribution function (or market intervention for socio- economic reasons) performed by governments are:

·   taxation policies of the government whereby progressive taxation of the rich is combined with provision of subsidy to the poor households

·  proceeds from progressive taxes used for financing public services, especially those that benefit low-income households (example, supply of essential food grains at highly subsidized prices to BPL households)

A few examples of the redistribution function (or market intervention for socio- economic reasons) performed by governments are:

· taxation policies of the government whereby progressive taxation of the rich is combined with provision of subsidy to the poor households

· proceeds from progressive taxes used for financing public services, especially those that benefit low-income households (example, supply of essential food grains at highly subsidized prices to BPL households)

· employment reservations and preferences to protect certain segments of the population,

· regulation of the manufacture and sale of 

certain products to ensure the health and well-being 

of consumers, and

· special schemes for backward regions and for the vulnerable sections of the population

In modern times, most of the egalitarian welfare states provide free or subsidized education and health-care system, unemployment benefits, pensions and such  other social security measures. There is, nevertheless, an argument that  in  exercising the redistributive function, there exists a conflict between efficiency and equity. In other words, governments’ redistribution policies which interfere with producer choices or consumer choices are likely to have efficiency costs or deadweight losses. For example, greater equity can be achieved through high rates of taxes on the rich; but high rates of taxes could also act as a disincentive to work, and discourage people from savings and investments and risk taking. This in turn  will have negative consequences for productivity and growth of the economy. Consequently, the potential tax revenue may be reduced and the scope for government’s welfare activities would get seriously limited. As such, an optimal budgetary policy towards any distributional change should reconcile the conflicting goals of efficiency and equity by exercising an appropriate trade off between them. In other words, redistribution measures should be accomplished with minimal efficiency costs by carefully balancing equity and efficiency objectives.

STABILIZATION FUNCTION

The theoretical rationale for the stabilization function of the government is derived from the Keynesian proposition that a market economy does not automatically generate full employment and price stability and therefore the  governments  should pursue deliberate stabilization policies. Business cycles are natural phenomena in any economy and they tend to occur periodically.  The  market system has inherent tendencies to create business cycles. The market mechanism     is limited in its capacity to prevent or to resolve the disruptions caused by the fluctuations in economic activity. In the absence of appropriate corrective intervention by the government, the instabilities that occur in the economy in the form of recessions, inflation etc. may be prolonged for longer periods causing enormous hardships to people especially the poorer sections of society. It is also possible that a situation of stagflation (a state of affairs in which inflation and unemployment exist side by side) may set in and make the problem more intricate.

The stabilization issue also becomes more complex as the increased international interdependence causes forces of instability to get easily transmitted from one country to other countries This is also known as contagion effect”.

The stabilization function is one of the key functions of fiscal policy and aims at eliminating macroeconomic fluctuations arising from suboptimal allocation. As you might recall, the economic crisis that engulfed the world in 2008 and the more recent euro area crisis have highlighted the importance of macroeconomic stability and has, therefore, revived interest in countercyclical fiscal policy.

The stabilization function is concerned with the performance of the aggregate economy in terms of:

·         labour employment and capital utilization,

·         overall output and income,

·         general price levels,

·         balance of international payments, and

·         the rate of economic growth.

Government’s fiscal policy has two major components which are important in stabilizing the economy:

·         an overall effect generated by the balance between the resources the government puts into the economy through expenditures and the resources it takes out through taxation, charges, borrowing etc.

·         a microeconomic effect generated by the specific policies it adopts.

Government’s stabilization intervention may be through monetary policy as well as fiscal policy. Monetary policy has a singular objective of controlling the size of money supply and interest rate in the economy which in turn would affect consumption, investment and prices. Fiscal policy for stabilization purposes attempts to direct the actions of individuals and organizations by means of its expenditure and taxation decisions. On the expenditure side, Government can choose to spend in such a way that it stimulates other economic activities. For example, government expenditure on building infrastructure may  initiate a  series  of productive activities. Production decisions, investments, savings etc can be influenced by its tax policies.

We know that government expenditure injects more money into the economy and stimulates demand. On the other hand, taxes reduce the income of people and

therefore, reduce effective demand. During recession, the government increases its expenditure or cuts down taxes or adopts a combination of both so that aggregate demand is boosted up with more money put into the hands of the people. On the other hand, to control high inflation the government cuts down its expenditure or raises taxes. In other words, expansionary fiscal policy is adopted to alleviate recession and contractionary fiscal policy is resorted to for controlling  high inflation. The nature of the budget (surplus or deficit) also has important implications on a country’s economic activity. While deficit budgets are  expected  to stimulate economic activity, surplus budgets are thought to slow down economic activity. Generally government’s fiscal policy has a strong influence on the performance of the macro economy in terms of employment, price stability, economic growth and external balance.

There is often a conflict between the different goals and functions of budgetary policy. Effective policy design to meet the diverse goals of government is very difficult to conceive and to implement. The challenge before any government is  how to design its budgetary policy so that the pursuit of one goal does not jeopardize the other.

CONCLUSION

We have discussed the need for and rationale of government intervention to improve social welfare by enhancing stability, efficiency and fairness. However, we should also understand that when we say that the market-generated allocation of resources is imperfect, it does not necessarily imply that the government is always infallible and at all times capable of correcting the failures of the market. Governments are likely to commit serious errors in its attempt to correct market failure. For example, in certain cases the costs incurred by government to deal with some market failure could be greater than the cost of the market failure itself. Moreover, just as individuals, governments too have only imperfect information,  and hence can commit mistakes. It is also possible that individuals may use government as a mechanism for maximizing their self-interest. Moreover, governments may not always be unbiased and benevolent.