Public Goods
6/23/08
The United States, as well as most of the industrialized world, has a capitalistic system of allocating resources to its citizens via prices and relative scarcity. Over the last two centuries since Adam Smith wrote The Wealth of Nations we have seen relative success in capitalistic markets where the consumer's valuations of individual goods determines price, quantity demanded and quantity supplied. One of the most important tenets in economics is that a good's price should its reflect relative scarcity, both in final products and in factor markets. "For market prices to produce an efficient allocation of resources, it is necessary that the full cost of using each resource is borne by the person or firm that uses it." (Mansfield 503) But there are also some areas in which we experience market failures- places where markets are unable to allocate goods and services to those consumers whose preferences and valuations choose them. One type of market failure occurs when byproducts of market transactions affect, either positively or negatively, parties not directly involved in that specific market. Another type occurs when as individuals we have an incentive not to pay for something that we can receive anyway. In this article, I plan to show that given purely self-interested individuals the creation of public goods via government intervention is the most effective way to control the amount of externalities that occur in the marketplace. I will also describe many ways our government can intervene more effectively.
These two types of market failures are by no means rare or unimportant. One of the chief economic functions of our government is to provide these goods and services or to create artificial incentives, usually through the enactment of laws, to change the amount of byproducts firms produce. Also, as voting constituents in a democracy, it is imperative that we choose which goods and services should be provided by the government, and how important each byproduct of the market is and how we should deal with it. According to Hobbes, even the reason mankind chose to live in a society instead of the perfectly competitive state of nature is based on people giving up their individual rights for the benefit of the group as a whole (Hobbes 17).
The first type of market failure occurs when externalities are produced during normal market operations of certain goods and services. Externalities occur when a third party is affected by the transactions of others. The externality produced is not sold or bought in a market scenario under natural conditions. We will see that it is possible for the government to artificially create a market to try to match the individual and social costs. These externalities can be either positive or negative, and they can also vary in the mode by which they occur- through production or through consumption. This matrix gives some examples (from Mansfield 483):
Production Consumption
Positive: General training for workers Maintained lawn
Negative: Pollution Envy of another's gain.
Under a perfectly competitive model, individual and social costs coincide. But when externalities are present in the actions of either agent, the social value differs from the value to the individual. For example, in a negative externality like smokestack pollution, the individual producer does not account for the marginal social cost of dirtier air into his prices. In this case, the cost of dirtier air is an externality that is not included in the price- and that creates a distortion because dirty air is a social cost that profit-maximizing firms have no incentive to decrease. From this we see that there will be more pollution if we ignore this externality than if we are able to force firms to more accurately account for these costs.
The second of these market failures is allieviated by creating a public good. A public good is a good or service that is difficult or impossible to be restricted to one paying individual or group without being provided for everyone nearby in the same amount whether or not the others pay. Public goods are usually able to be used by one person while it is still possible for another to use it at the same time. This is differentiated from the private goods that we usually identify with, where the producers or firms are able to restrict use to paying customers only. Since it is not in our individual interest to obtain these public goods, we will wait for it to be in someone else's best interest to provide the good or service, and then use it ourselves. This is the free-rider problem, and it is an example of individuals acting rationally, yet as a group they achieve irrational ends. Professor Sullivan's example of the small town of Piermont having the desire to rely on the big town of Hanover to cut its pollution is an example of this. "Thus, when benefits are indivisible, each individual is always motivated to evade his share of the cost of producing them." (Downs 4)
A good becomes a public good when we select an outside agent, usually our government, to provide the good for everyone and to have involuntary taxes levied on the consumers to pay for it. The reason we would prefer this to normal market allocation is that these goods are not in our individual interest to obtain, yet with which society as a whole is better off. Thus society as a whole will convene to decide which goods and services ought to be provided through the government. Examples of public goods include roads, parks, sidewalks, clean water and clean air.
Some important set questions to be asked in setting governmental policy concerning public goods and externalities are: Why do markets fail? What are the consequences of these failures, and what are possible solutions? If these can be answered accurately, our government can truly reflect our beliefs and goals by controlling the effects of externalities.
Markets fail because it is either difficult or impossible for people to receive or produce the amount of goods that would be in accord with their valuations. These goods and services are not allocated by the desires of the participants. When this occurs, consumers may desire a good, like defense against hostile countries, but are unable to afford it. But the key here is that even if one consumer were able to afford it, the market would still fail because his neighbors would receive benefits from something that they didn't pay for. No one would have an incentive to purchase nuclear arms because one's neighbors would receive positive externalities; that is, given purely self-interested individuals, national defense must become a public good for it to exist at all. Here we see a need for the government to provide a public good, national defense, and its relation to an externality, his neighbors protection, in that if the good weren't public, rational individuals wouldn't obtain national defense, which is certainly a good.
Another example of rational individual thought becoming a socially unacceptable condition is given by Anthony Downs. Downs looks at well-informed voting; specifically, the individual returns and costs to voting. His famous conclusion: "it is irrational for most citizens to acquire political information for purposes of voting." (Downs 4)
The consequences of a failed market, before external intervention, are that society as a whole would have too little (or none) of those goods or conditions that each individual would consider vitally important: national defense, streets free of snow and litter, a well-informed electorate, and even education itself. A major reason the federal government subsidizes education is that the benefit from a well-educated society is greater than the benefit one gets individually in the job market. Conversely, society would have too much of the goods or conditions that each individual would consider undesirable, like pollution. Obviously, society would be worse off in many ways without external intervention.
The one objection to this intervention is that most capitalistic societies are based on laissez-faire economics, which means "to leave alone". This is the belief that non-interventionism works best, and it is certainly well-founded, given both economic theory on competition (how can bureaucrats know the benefits and costs of installing a electrostatic precipitator in a smokestack?) and the current sentiment on the success of government projects.
The two most popular solutions to the problem of market failures are direct regulation and effluent fees (Varian 556). Direct regulation occurs when the government simply chooses the amount of either the public good or the externality produced. For example, mandatory education or the heavily regulated medicinal industry are two areas of direct regulation. Effluent fees are generally ways of dealing with externalities. These fees are levied by the community in accord with the amount of the externality produced by each agent. Originally meant only for pollution control (hence the name), these fees (or the converse, rebates) could be applied to the gain from a neat lawn or a rebate for conducting basic scientific research. Of these two proposals, effluent fees are superior because they are cheaper to enact and create an incentive to reduce (or increase) an externality. (Mansfield 508)
Another solution is for an agent to internalize all of these social costs. A popular example of internalizing externalities is when a paper mill that pollutes in a river and a fishery (which makes less money with high pollution) merge. This has the effect of eradicating the externality, or at least causing it to be accounted for in the pricing of the goods. "It is always rational to perform any act if its marginal return is larger than its marginal cost." (Downs 3) Before the merger, the marginal cost of producing pollution was zero. Now the merged paper mill must incur the "social" cost of producing pollution. This will cause the profit-maximizing amount of the negative externality to be reduced to a socially optimum amount. Once again private, individual costs coincide with social costs. Although this seems to be the best solution, there are several practical problems with this "internalization"; using our example, what about the other fisheries nearby? Or the millions of people that drink the water? Obviously, this solution is limited.
The final solution I would like to look at was developed by Gordon Tullock, in which we try to find the optimal size of government that will use both economies of scale and the internalization of externalities by the government. When we combine the two desired goals, we choose the size of government to be at the point where the combined costs are at a minimum. Also, Tullock looked at what size of government units individuals want. The conflict was between small government units where one can easily obtain what one wants but inefficient because of the many units that must work together, and large government units where we have efficiency but less representation. As usual, a compromise between the two is optimal.
Now we can look at ways in which the government can emulate the more efficient capitalist-market scheme. The key relationship between public goods and externalities is the distinction between social and individual optimality, and the method of deciding policy to achieve "agreed-upon ends" throughout society. This is distinct from achieving "efficiency" throughout society because efficiency is usually not the only desired outcome. For example, equity issues like minimum wage are also considered important. When we look at ways the government can mimic the free-market system, we see that if each producer is able to bargain with each consumer on the amount of the externality, we can again revert back to looking at marginal costs and marginal benefits. We will see that each consumer will compare the marginal benefit of a little cleaner air, for example, with the marginal cost paid to the producer for installing more efficient machinery. Here we have market-place bargaining for a lack of pollution and this market operates just like the market any other good.
In conclusion, I have shown that given self-interested individuals our government is necessary to provide goods that would not appear in the private sector. I have also examined the relationship between public goods and externalities and ways that economists and government officials can work together to increase social welfare by eliminating the free-rider problem.