Why Markets Can Supply Only Private Goods Efficiently

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.

Goods that are nonexcludable suffer from the free-rider problem: many individuals are unwilling to pay for their own consumption and instead will take a “free ride” on anyone who does pay.

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.

PITFALLS: MARGINAL COST OF WHAT EXACTLY?

PITFALLS

MARGINAL COST OF WHAT EXACTLY?
In the case of a good that is nonrival in consumption, it’s easy to confuse the marginal cost of producing a unit of the good with the marginal cost of allowing a unit of the good to be consumed. For example, Netflix incurs a marginal cost in making an on-demand movie available to its subscribers that is equal to the cost of the resources it uses to produce and broadcast that movie. However, once that movie is being broadcast, no marginal cost is incurred by letting an additional family watch it. In other words, no costly resources are “used up” when one more family consumes a movie that has already been produced and is being broadcast.
This complication does not arise, however, when a good is rival in consumption. In that case, the resources used to produce a unit of the good are “used up” by a person’s consumption of it—they are no longer available to satisfy someone else’s consumption. So when a good is rival in consumption, the marginal cost to society of allowing an individual to consume a unit is equal to the resource cost of producing that unit—that is, equal to the marginal cost of producing it.

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.

!worldview! ECONOMICS in Action: From Mayhem to Renaissance

From Mayhem to Renaissance

Life during the European Middle Ages—from approximately 1100 to 1500—was difficult and dangerous, with high rates of violent crime, banditry, and war casualties. According to researchers, murder rates in Europe in 1200 were 30 to 40 per 100,000 people. But by 1500 the rate had been halved to around 20 per 100,000; today, it is less than 1 per 100,000. What accounts for the sharp decrease in mayhem over the last 900 years?

Think public goods, as the history of medieval Italian city-states illustrates.

The emergence of institutions to maintain law and order—public goods—allowed for a move away from the war and brutality that marked the Middle Ages and toward a new era.
Ivy Close Images/Alamy

Starting around the year 900 in Venice and 1100 in other city-states like Milan and Florence, citizens began to organize and create institutions for protection. In Venice, citizens built a defensive fleet to battle the pirates and other marauders who regularly attacked them. Other city-states built strong defensive walls to encircle their cities and also paid defensive militias. Institutions were created to maintain law and order: cadres of guards, watchmen, and magistrates were hired; courthouses and jails were built.

As a result, trade, commerce, and banking were able to flourish, as well as literacy, numeracy, and the arts. By 1300, the leading cities of Venice, Milan, and Florence had each grown to over 100,000 people. As resources and the standard of living increased, the rate of violent deaths diminished.

For example, the Republic of Venice was known as La Serenissima— the Most Serene One—because of its enlightened governance, overseen by a council of leading citizens. Owing to its stability, diplomatic prowess, and prodigious fleet of vessels, Venice became enormously wealthy in the fifteenth and sixteenth centuries.

Also through stability, high literacy, and numeracy, Florence became the banking center of Italy. During the fifteenth century it was ruled by the Medici, an immensely wealthy banking family. And it was the patronage of the Medici to artists such as Leonardo da Vinci and Michelangelo that ushered in the Renaissance.

So Western Europe was able to move from mayhem to Renaissance through the creation of public goods like good governance and defense—goods that benefited everyone and could not be diminished by any one person’s use.

Quick Review

  • Goods can be classified according to two attributes: whether they are excludable and whether they are rival in consumption.

  • Goods that are both excludable and rival in consumption are private goods. Private goods can be efficiently produced and consumed in a competitive market.

  • When goods are nonexcludable, there is a free-rider problem: consumers will not pay producers, leading to inefficiently low production.

  • When goods are nonrival in consumption, the efficient price for consumption is zero. But if a positive price is charged to compensate producers for the cost of production, the result is inefficiently low consumption.

17-1

  1. Question 17.1

    Classify each of the following goods according to whether they are excludable and whether they are rival in consumption. What kind of good is each?

    1. Use of a public space such as a park

    2. A cheese burrito

    3. Information from a website that is password-protected

    4. Publicly announced information on the path of an incoming hurricane

  2. Question 17.2

    Which of the goods in Question 1 will be provided by a competitive market? Which will not be? Explain your answer.

Solutions appear at back of book.