The Mixed Economy » Market Failure and Public Goods

When markets get it wrong

Usually, prices guide a market. If people want more of something, the price rises and firms supply more. Resources move to where they are wanted. When this works well, resources are used efficiently. This means scarce resources are shared out in the best way, so that the right goods and services are made in the right amounts.

But markets do not always work well. Sometimes the market produces too much of something, too little of something, or nothing at all. This topic is examined on Paper 1 (Microeconomics and Business Economics).

Key terms:

• Market failure: when the free market fails to allocate resources efficiently, so the best possible outcome for society is not reached.
• Inefficient allocation of resources: when scarce resources are not used in the best way, for example when too many or too few resources go into making a good.
• Public good: a good that is non-excludable and non-rival, so the private sector will not normally provide it.
• Non-excludable: once the good is provided, nobody can be stopped from using it, even if they do not pay.
• Non-rival: one person using the good does not reduce the amount left for other people.
• Free rider: a person who gets the benefit of a good without paying for it.

Why governments might need to step in

If a market fails, resources are wasted. Society could be better off if they were used differently. Because the market will not fix the problem by itself, the government may decide to intervene.

So the main reason for intervention is to correct a misallocation of resources and improve the outcome for society. The exact policies governments use are covered in later lessons, and one major cause of market failure is covered in Externalities: Social Costs and Benefits. This lesson looks at one clear cause: public goods.

Private goods and public goods

Think about a bar of chocolate. If you do not pay, you do not get it (it is excludable). And if you eat it, nobody else can eat it (it is rival). This is a normal private good, and the market is good at providing it.

Now think about a street light. Public goods have two features:

Good	Can people be stopped from using it?	Does one person's use reduce it for others?	Type
Bar of chocolate	Yes	Yes	Private good
Street lighting	No	No	Public good
National defence	No	No	Public good

National defence protects everyone in a country, whether or not they pay taxes. Protecting one more person does not mean there is less protection for anyone else.

The free rider problem

Imagine a private company wants to put up street lights in a town and charge for them. Nobody can be stopped from using the lights, so many people think, "Why should I pay? I can use them anyway." These people are free riders.

1. People can enjoy the good without paying.
2. So few people choose to pay.
3. The firm cannot earn enough money to cover its costs.
4. So no private firm will provide the good, or it will provide far too little.

This is a clear market failure. The good would benefit everyone, but the free market does not supply it. Resources are not allocated efficiently, because society goes without something it wants.

That is why public goods are usually provided by the government. It pays for them with money raised from taxes, so everyone helps to pay, and everyone can use them. Examples include street lighting and national defence.

Exam-style question

The town of Harlow Bay has no street lighting on its coast road. A private company says it will not build lights there because it could not charge drivers or walkers to use them.

(a) Define the term 'market failure'. [2 marks]

(b) Identify two features of a public good. [2 marks]

(c) Explain why the free rider problem means the market may not provide street lighting. [4 marks]