We saw in the previous section that externalities can lead to markets not providing the socially efficient amount of a good at the optimal price. Either too much or too little of the good is produced, or it is offered at too high or too low a price, leading to a market failure. The presence of externalities is one cause of market failure. This section looks at two other causes of market failure that arise when no individual or firm is able to claim ownership of a product. These goods and services are called public goods and common property resources.

Pure public goods are nonrival in consumption, and exhibit nonexcludability. Nonrivalry means that the consumption of a good or service by one person does not reduce the utility of that good or service to others. Nonexcludability means that it is not possible to exclude some consumers from using the good or service once it has been provided.

By way of contrast, a can of Coke is a rival product. When you drink a can of Coke, no one else can drink that same can. Airline flights exhibit excludability—one must either buy a ticket or obtain an award ticket to board the plane, even if empty seats are available. But consider a lighthouse. Once it is built and in operation, all ships can see the lighthouse and use the light to avoid obstacles. One captain’s use of the lighthouse does not prevent another from using it, nor can a ship realistically be excluded from using the lighthouse’s services. Hence, the lighthouse is a public good. Other examples of public goods include national defense, accumulated knowledge, standards such as a national currency, protection of property rights, vaccinations, mosquito spraying, and clean air. Table 2 provides a taxonomy of private and public goods.

Consumers cannot be excluded from a public good once it is provided; therefore, they have little incentive to pay for the good in question. Instead, most will essentially be free riders. Think of the lighthouse again. If you have a ship and cannot be excluded from the benefits the lighthouse provides, why should you contribute anything to the lighthouse’s upkeep? But if everyone took this position, there would be no support for the lighthouse, and it would go into decline. With free riders, private producers cannot hope to sell many units of a good, and thus they have no incentive to produce it. Private markets will therefore fail to provide public goods, even if the goods are things everyone would like to see produced. This is why the government or special interest groups must get involved in the provision of products and services that have significant public good characteristics.

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Assessing the public’s demand for public goods is clearly different from that of private goods where we found market demand by horizontally summing private demands. But the fact that once a public good is supplied, no one can be excluded from consuming it, and one person’s consumption does not affect another’s, plays a crucial role. Figure 3 provides a solution to finding the demand for public goods.

Figure 3 shows demand for a public good by two different consumers. Individual A wants none when the price is $40 and is willing and able to buy 40 units when the price approaches zero. Individual B wants none when the price is $60 and only is willing to buy 30 units when the price nears zero. Because each consumer can consume any given amount of a public good at the same time, the total demand for a public good is found by summing the individual demands vertically. To see why, consider when both individuals demand 20 units. This is the point at which the two demand curves cross, and both are willing to pay $20 for 20 units. Thus, total willingness-to-pay for 20 units is $40. The total demand for the public good in Figure 3 is shown by the heavy line labeled D_{Public Goods} and is the vertical summation of individual demands.

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Notice how this differs from our discussion of market demand curves for private goods. For private goods, others could be excluded from consuming any good we bought; therefore, demands were horizontally summed. In contrast, with public goods, exclusion is not possible; therefore, both individuals can consume the good simultaneously, and market demand is found by summing vertically. Market demand for public goods is really a willingness-to-pay curve, because the government will have to provide the good and levy taxes to pay the cost.

Providing the optimal amount of public goods is easy in theory and is illustrated in Figure 3. The supply of public goods is equal to the marginal cost curve (S = MC) shown in the figure. Just like the competitive market equilibrium we covered earlier, optimal allocation is where MC = P, and in this instance, it is 20 units of the good at a total price of $40 (point e). In this example, the taxes are split equally between individuals A and B. Determining how much tax each person should (or would be willing to) pay is hampered by the fact that once the public good is provided, no one can be excluded; therefore, individuals will be unwilling to reveal their true preferences for the good because it might mean that they would have to pay a higher tax.

In reality, providing public goods such as national defense involves the political process. This means that politicians, bureaucrats, special interest groups, and many others generate the decisions on how much of any particular public good to provide. Since the demand for a public good represents the benefits to society and the supply curve represents society’s costs, equating marginal benefits and marginal costs yields the optimal amount. But estimating the demand (benefits) from public goods and their costs can be a complex process. Most people desire the benefits of a strong military, but few enjoy paying the taxes required to pay the cost. Because people cannot be excluded from the good once provided, they have little incentive to reveal their true preferences, making this type of market failure difficult to overcome.

Commonly held resources are subject to nonexclusion but are rival in consumption. The market failure associated with such resources is often referred to as the “tragedy of the commons.”3 The tragedy here is the tendency for commonly held resources to be overused and overexploited. Because the resource is held in common, individuals race to “get theirs” before others can grab it all.

3 Garrett Hardin, “The Tragedy of the Commons,” Science 162, 1968, pp. 1243–1248.

One example of commonly held resources giving rise to problems involves oil fields. Oil reservoirs often span the subsurface property of many landowners. Because oil reservoirs are regarded as common property, each landowner has an incentive to drill as many wells as possible and to pump out oil as rapidly as possible. Having too many wells pumping too quickly, however, reduces the oil field’s water and gas pressure, thus reducing the total recoverable oil from the reservoir. Each owner’s decision to drill a well therefore imposes an external cost on the other owners of land over the reservoir. At one point, this problem grew so severe that it resulted in passage of the 1935 Connally “Hot Oil” Act. This act restricted drilling, regulated the number and location of oil wells, and capped pumping rates.4

4 Daniel Yergin, The Prize (New York: Simon & Schuster), 1991.

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Road congestion is another illustration of the “tragedy of the commons.” Figure 4 shows a market for usage of a road that is fully used and is right at the tipping point before becoming congested. In Figure 4, demand for driving on this road is D₀, and the marginal cost to use the road—gas, time, and auto expenses—is initially MC₀. Equilibrium is at point e, with Q₀ miles per day driven. Consumer surplus is area P₀ae for the typical driver.

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Now assume that a new driver begins using the road. This increases the marginal cost of driving to MC₁ for everyone, because the tipping point has been passed, and the road is now congested. Consumer surplus shrinks because of overuse of the commons. Note that the new driver did not take these external costs into consideration; the driver assumed that the marginal cost would be equal to MC₀, not MC₁.

Possible solutions to common property resource problems involve establishing private property rights, using government policy to restrict access to the resource, or informal organizations that restrict each user’s benefits from the resource. Reduced congestion, for example, could be achieved by raising the tax on gasoline, subsidizing bus or rapid transit travel, or privatizing roads and allowing the owners to charge tolls.

The optimal provision of public goods, whether pure public goods or common property resources with significant public goods characteristics, is a significant challenge faced by society. Individuals tend to act in their self-interest when using public goods without contributing to their provision (free riding) or overusing a resource without considering the impact of such use on others. Another example of a public good that has risen to the forefront of policy debate is environmental policy, which we turn to next.

Among the most contentious recent issues has been the expansion of health care access with the Affordable Care Act (ACA) in 2010. Although health care services are guaranteed by the government to those serving in the military along with veterans, those over the age of 65 with Medicare, and those who fall below certain income limits that qualify for Medicaid, most Americans rely on the private insurance market for their health care services. Much of this insurance is paid for by employers of full-time workers. But part-time workers, self-employed workers, and unemployed persons must find health care coverage on their own, often at high prices, especially when individuals are deemed by insurance companies to be high-risk. Consequently, in 2010, about 1 in 6 Americans did not have health care insurance.

One problem with private health care provision and private insurance markets is asymmetric information, when one party knows more about a situation than another. For example, individuals know more about their daily health habits than private insurers, and might try to hide unhealthy habits. Doctors know more about medical conditions than their patients, leading some to order excessive medical tests or prescribe more expensive treatment options than what might be necessary. A consequence of asymmetric information is an increase in the cost of health care resulting from inefficiencies in delivering health care, which leads to higher insurance prices that become unaffordable to many. Addressing the problem of asymmetric information requires greater transparency in medical records to prevent patients and doctors from exploiting information to their advantage. Otherwise, it may lead to greater escalation in the cost of health care, as the following example shows.

Suppose that consumers with bad habits (such as poor eating habits, lack of exercise, aggressive driving, or a penchant for high-impact sports) fail to disclose this information. This leads to insurance companies underestimating risk and setting premiums too low, causing losses. Because insurance companies do not always know who is failing to disclose information, premiums are raised on all customers who share the characteristics of those with risky behaviors. The rise in premiums causes some to drop coverage (especially young healthy people), making the insurance pool even weaker. Because asymmetric information exacerbates the problem of less healthy people seeking health insurance and healthy people forgoing it, the private insurance market becomes less sustainable, leading insurance providers to take more drastic actions, such as restricting coverage to anyone who might be deemed high-risk.

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Because of the growing number of Americans who either did not qualify for insurance or chose not to purchase it, the ACA was passed in 2010, though not without tremendous controversy and subsequent attempts by Congress to eliminate it. The aim of the ACA is to reduce the percentage of Americans without health care coverage. This is accomplished through many rules, such as preventing insurance companies from refusing customers due to preexisting conditions (such as a previous bout of cancer that would have previously disqualified a person from obtaining affordable insurance), removing lifetime limits on coverage, providing subsidies to make insurance more affordable, and requiring all Americans to buy insurance or face a tax penalty at the end of the year (commonly known as the individual mandate). From 2010 to 2016, the uninsured rate fell from 16% to 11%.

The ACA remains controversial because of the individual mandate that forces all consumers to buy insurance, even if they do not want it. Mandated health care has many characteristics of public goods, something that all persons have access to and a service that one cannot opt out of no matter why.

Why would a government force its citizens to buy health insurance? First, like other public goods, it is subject to the free rider problem. Those without health insurance often use hospital emergency rooms for illnesses and accidents because many laws prevent caregivers such as hospitals from denying emergency care, regardless of ability to pay. The cost is borne by caregivers, who pass this on in the form of higher prices for everyone else. Second, much like other public goods such as clean air, fire department services, or elementary education, health care provides societal benefits such as improved productivity and earlier diagnosis of severe illnesses, which allows for greater treatment options and lower costs.

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The ACA is likely to remain unpopular among many for some time. This is common whenever a debate ensues on the best approach to providing public goods. In the long run, however, once consumers become accustomed to the benefits created by the ACA, they will be less likely to accept those same benefits being taken away.