What’s the difference between installing a new bathroom in a house and building a municipal sewage system? What’s the difference between growing wheat and fishing in the open ocean?

These aren’t trick questions. In each case there is a basic difference in the characteristics of the goods involved. Bathroom fixtures and wheat have the characteristics necessary to allow markets to work efficiently. Public sewage systems and fish in the sea do not.

Let’s look at these crucial characteristics and why they matter.

Goods like bathroom fixtures or wheat have two characteristics that, as we’ll soon see, are essential if a good is to be efficiently provided by a market economy.

When a good is both excludable and rival in consumption, it is called a private good. Wheat is an example of a private good. It is excludable: the farmer can sell a bushel to one consumer without having to provide wheat to everyone in the county. And it is rival in consumption: if I eat bread baked with a farmer’s wheat, that wheat cannot be consumed by someone else.

But not all goods possess these two characteristics. Some goods are nonexcludable—the supplier cannot prevent consumption of the good by people who do not pay for it. Fire protection is one example: a fire department that puts out fires before they spread protects the whole city, not just people who have made contributions to the Firemen’s Benevolent Association. An improved environment is another: the city of London couldn’t have ended the Great Stink for some residents while leaving the river Thames foul for others.

Nor are all goods rival in consumption. Goods are nonrival in consumption if more than one person can consume the same unit of the good at the same time. TV shows are nonrival in consumption: your decision to watch a show does not prevent other people from watching the same show.

Because goods can be either excludable or nonexcludable, rival or nonrival in consumption, there are four types of goods, illustrated by the matrix in Figure 17-1:

There are, of course, many other characteristics that distinguish between types of goods—necessities versus luxuries, normal versus inferior, and so on. Why focus on whether goods are excludable and rival in consumption?

As we learned in earlier chapters, markets are typically the best means for a society to deliver goods and services to its members; that is, markets are efficient except in the case of the well-defined problems of market power, externalities, or other instances of market failure. But there is yet another condition that must be met, one rooted in the nature of the good itself: markets cannot supply goods and services efficiently unless they are private goods—excludable and rival in consumption.

To see why excludability is crucial, suppose that a farmer had only two choices: either produce no wheat or provide a bushel of wheat to every resident of the county who wants it, whether or not that resident pays for it. It seems unlikely that anyone would grow wheat under those conditions.

Yet the operator of a municipal sewage system faces pretty much the same problem as our hypothetical farmer. A sewage system makes the whole city cleaner and healthier—but that benefit accrues to all the city’s residents, whether or not they pay the system operator. That’s why no private entrepreneur came forward with a plan to end London’s Great Stink.

The general point is that if a good is nonexcludable, self-interested consumers won’t be willing to pay for it—they will take a “free ride” on anyone who does pay. So there is a free-rider problem. Examples of the free-rider problem are familiar from daily life. One example you may have encountered happens when students are required to do a group project. There is often a tendency for some group members to shirk, relying on others in the group to get the work done. The shirkers free-ride on someone else’s effort.

Because of the free-rider problem, the forces of self-interest alone do not lead to an efficient level of production for a nonexcludable good. Even though consumers would benefit from increased production of the good, no one individual is willing to pay for more, and so no producer is willing to supply it. The result is that nonexcludable goods suffer from inefficiently low production in a market economy. In fact, in the face of the free-rider problem, self-interest may not ensure that any amount of the good—let alone the efficient quantity—is produced.

Goods that are excludable and nonrival in consumption, like on-demand movies, suffer from a different kind of inefficiency. As long as a good is excludable, it is possible to earn a profit by making it available only to those who pay. Therefore, producers are willing to supply an excludable good. But the marginal cost of letting an additional viewer watch an on-demand movie is zero because it is nonrival in consumption. So the efficient price to the consumer is also zero—or, to put it another way, individuals should watch movies up to the point where their marginal benefit is zero.

But if Netflix actually charges viewers $4 for on-demand movies, viewers will consume the good only up to the point where their marginal benefit is $4. When consumers must pay a price greater than zero for a good that is nonrival in consumption, the price they pay is higher than the marginal cost of allowing them to consume that good, which is zero. So in a market economy goods that are nonrival in consumption suffer from inefficiently low consumption.

Now we can see why private goods are the only goods that can be efficiently produced and consumed in a competitive market. (That is, a private good will be efficiently produced and consumed in a market free of market power, externalities, or other instances of market failure.) Because private goods are excludable, producers can charge for them and so have an incentive to produce them. And because they are also rival in consumption, it is efficient for consumers to pay a positive price—a price equal to the marginal cost of production. If one or both of these characteristics are lacking, a market economy will not lead to efficient production and consumption of the good.

Fortunately for the market system, most goods are private goods. Food, clothing, shelter, and most other desirable things in life are excludable and rival in consumption, so markets can provide us with most things. Yet there are crucial goods that don’t meet these criteria—and in most cases, that means that the government must step in.