Goods may be classified according to whether or not they are excludable and whether or not they are rival in consumption.
Free markets can deliver efficient levels of production and consumption for private goods, which are both excludable and rival in consumption. When goods are nonexcludable or nonrival in consumption, or both, free markets cannot achieve efficient outcomes.
When goods are nonexcludable, there is a free-rider problem: some consumers will not pay for the good, consuming what others have paid for and leading to inefficiently low production. When goods are nonrival in consumption, they should be free, and any positive price leads to inefficiently low consumption.
A public good is nonexcludable and nonrival in consumption. In most cases a public good must be supplied by the government. The marginal social benefit of a public good is equal to the sum of the individual marginal benefits to each consumer. The efficient quantity of a public good is the quantity at which marginal social benefit equals the marginal cost of providing the good. Like a positive externality, marginal social benefit is greater than any one individual’s marginal benefit, so no individual is willing to provide the efficient quantity.
One rationale for the presence of government is that it allows citizens to tax themselves in order to provide public goods. Governments use cost-benefit analysis to determine the efficient provision of a public good. Such analysis is difficult, however, because individuals have an incentive to overstate the good’s value to them.
A common resource is rival in consumption but nonexcludable. It is subject to overuse, because an individual does not take into account the fact that his or her use depletes the amount available for others. This is similar to the problem of a negative externality: the marginal social cost of an individual’s use of a common resource is always higher than his or her individual marginal cost. Pigouvian taxes, the creation of a system of tradable licences, or the assignment of property rights are possible solutions.
Artificially scarce goods are excludable but nonrival in consumption. Because no marginal cost arises from allowing another individual to consume the good, the efficient price is zero. A positive price compensates the producer for the cost of production but leads to inefficiently low consumption. The problem of an artificially scarce good is similar to that of a natural monopoly.