DP Economics SL 2.9 Market Failure: Public Goods

DP Economics SL 2.9 Market Failure: Public Goods - Full notes

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DP Economics SL | 2.9 Market Failure: Public Goods

DP ECONOMICS · UNIT 2: MICROECONOMICS

2.9

Market Failure: Public Goods

Full notes for SL · IB-style

Contents

1	Rivalry and excludability
2	Public goods and the free-rider problem
3	Classifying goods: private, public, club and common pool
4	Quasi-public goods and the role of technology
5	How public goods are provided
6	Rivalry and excludability: applied
7	The free-rider problem in detail
8	Quasi-public goods
9	Technology changing goods
10	Government provision
11	Contracting out and public–private partnerships
12	Deciding how much to provide
13	Global public goods
14	Public goods versus merit goods
15	Opportunity cost of public goods
16	Mixed review: worked problems
17	Additional exam-style practice
18	Public goods and inequality
19	Evaluating government provision
20	Case study: national defence
21	Case study: open-source software and knowledge
22	Diagram: missing market
23	Common misconceptions and links
24	Exam-style question with markscheme
25	Check your understanding
26	Summary and topic map

These are full teaching notes. Read each section in order, try the Think about it question before you read on, and do every Quick check before moving to the next section.

Before you start

Rate yourself on each statement now, and again after you've worked through the notes. Shade R (not yet), A (getting there) or G (confident).

I can…	R	A	G
define rivalry and excludability
explain why public goods are non-rivalrous and non-excludable
explain the free-rider problem and why it leads to a missing market
classify goods as private, public, club or common pool resources
explain quasi-public goods and how technology can change a good's type
evaluate different ways of providing public goods

There is no additional HL content in 2.9. SL and HL students study the same material.

Guiding questions

Why will no private firm build a lighthouse? Why do governments provide national defence and street lighting? How has technology turned some public goods into goods people can be charged for?

How this topic is examined

Public goods are a standard source of short Paper 2 questions (define a public good, explain the free-rider problem) and of Paper 1 essays on market failure and the role of government.

The key skill is precision: public goods are defined by two characteristics, non-rivalry and non-excludability, not by who provides them. Examiners penalize answers that call schools or hospitals 'public goods' just because the government provides them.

Command term	What the examiner wants
Define	the precise meaning, ideally in the IB wording, in one or two sentences
Draw / Sketch	a fully labelled diagram with every axis, curve, equilibrium and change labelled
Explain	a causal chain linked to economic theory, usually supported by a diagram
Analyse	break a situation into its parts and trace the effects of each
Evaluate / Discuss	weigh up arguments, question assumptions and reach a justified conclusion using real-world examples

How to use these notes

Each section teaches one part of the syllabus in full. You'll see these boxes throughout; each has one job:

Box	What it's for
Think about it	a question to get you thinking before a section; the answer comes in the section
Key point	the one idea you must not forget
Common mistake	an error examiners see every year, and how to avoid it
In the real world	where the economics shows up outside the classroom
Try this	something quick you can do yourself to test the idea
Worked example	full solutions with IB-style marks (M1 method, A1 answer, R1 reasoning)
Quick check	short questions to test yourself at the end of each section

1 Rivalry and excludability

Two questions sort every good: can one person's use reduce another's, and can non-payers be kept out?

Think about it

If you eat a sandwich, nobody else can eat it. If you look at a fireworks display, does that stop anyone else from seeing it?

Economists classify goods using two characteristics.

Rivalry. A good is rivalrous if one person's consumption reduces the amount available for others. A sandwich, a litre of petrol and a seat on a crowded train are rivalrous: if you use them, someone else cannot. A good is non-rivalrous if one person's consumption does not reduce the amount available to others. A radio broadcast, a lighthouse beam or national defence can be enjoyed by one more person without anyone else getting less.

Excludability. A good is excludable if it is possible to prevent people who have not paid from consuming it. A cinema can check tickets; a shop can refuse to hand over goods until they are paid for. A good is non-excludable if it is impossible, or very costly, to stop people from benefiting once it is provided. A firework display lights up the whole sky; flood defences protect every house behind them.

Key point

Rivalry asks: does my use reduce yours? Excludability asks: can non-payers be kept out? Every classification in this topic follows from these two questions.

Quick check

1. Define a rivalrous good.

2. Define a non-excludable good.

3. Is a cinema seat excludable? Is it rivalrous?

Answers: 1. one person's use reduces availability to others 2. non-payers cannot easily be prevented from benefiting 3. excludable and rivalrous

2 Public goods and the free-rider problem

If people can benefit without paying, few will pay, and the market won't supply the good.

Think about it

A town needs a new flood barrier costing $10 million. If it is funded by voluntary donations, how much do you think would be raised? Why?

A public good is a good that is both non-rivalrous and non-excludable. Classic examples are national defence, lighthouses, street lighting, flood defences, public fireworks displays and basic scientific knowledge.

Because a public good is non-excludable, people can benefit from it whether or not they pay. Each individual therefore has an incentive to let others pay and enjoy the good for free. This is the free-rider problem. A free rider is someone who benefits from a good without paying for it.

Because so many people free ride, private firms cannot charge enough people to cover their costs, so they will not produce the good at all, even though society values it highly. The market for the good is missing. This is a market failure: the market produces zero, while the socially optimal quantity is positive.

Non-rivalry adds a further point. Even if a firm could exclude non-payers, it would be inefficient to do so: once a lighthouse is built, letting one more ship see it costs nothing. Charging a price would stop some ships using a light that costs nothing extra to provide.

Figure 1. A survey shows how few people would pay voluntarily for public goods.

WORKED EXAMPLE 1 Explaining the free-rider problem

Explain why a private firm would not supply street lighting in a residential area. [4]

Solution

Street lighting is non-excludable: residents cannot be prevented from benefiting once it is installedR1

so each resident has an incentive to free ride on others' paymentsR1

the firm cannot collect enough revenue to cover its costs and make a profitR1

so the market does not provide it: a missing market, even though society values itR1

Common mistake

Explaining the free-rider problem using rivalry. Free riding comes from non-excludability: you can benefit without paying because you cannot be excluded.

Quick check

1. Define a public good.

2. What is a free rider?

3. Why does the free-rider problem lead to a missing market?

Answers: 1. non-rivalrous and non-excludable 2. someone who benefits without paying 3. firms cannot charge enough people to cover costs

3 Classifying goods: private, public, club and common pool

Two characteristics, four types of good.

	Excludable	Non-excludable
Rivalrous	Private goods: food, clothes, cars, haircuts	Common pool resources: fish in the sea, groundwater, forests
Non-rivalrous	Club goods: streaming subscriptions, toll roads (uncongested), private parks	Public goods: national defence, lighthouses, street lighting

Private goods are rivalrous and excludable. The market supplies them well, because firms can charge for them and each unit is used by one consumer.

Common pool resources are rivalrous but non-excludable. You met them in 2.8: because they cannot be protected by charging, they tend to be overused.

Club goods are non-rivalrous but excludable. A streaming service can show the same film to one more subscriber at almost no extra cost (non-rivalrous), but it can lock out non-payers with a password (excludable). Markets can supply club goods, through subscriptions.

Public goods are non-rivalrous and non-excludable. They tend to be underprovided or not provided at all by markets, because of free riding.

Common mistake

Calling something a public good because the government provides it. State schools and public hospitals are rivalrous (a place taken by one student or patient cannot be used by another) and excludable. They are better described as merit goods.

Quick check

1. Classify: a toll motorway with little traffic.

2. Classify: fish in international waters.

3. Why are state schools not public goods?

Answers: 1. club good 2. common pool resource 3. they are rivalrous and excludable

4 Quasi-public goods and the role of technology

Many real goods have some, but not all, of the features of a public good.

Pure public goods are rare. Many goods have some of the characteristics of a public good; these are called quasi-public goods.

A road is a good example. On an empty road, one more driver does not slow anyone else, so it is non-rivalrous; and it is hard to charge every user, so it is largely non-excludable. But in rush hour, one more car adds to congestion and slows everyone down, so the road becomes rivalrous. With toll booths or electronic road pricing, drivers can be charged, so the road becomes excludable.

Technology can change the nature of a good. Television broadcasts were once non-excludable: anyone with an aerial could watch. Encryption and subscription services made broadcasts excludable, turning them into club goods that private firms can supply profitably. Electronic road pricing systems, such as those in Singapore and London, make roads excludable and allow congestion charges.

In the real world

Singapore introduced electronic road pricing in 1998: drivers are charged automatically when they pass gantries at busy times. The charge varies with traffic levels, turning a congested road, a rivalrous good, into one with a price that reflects scarcity.

Quick check

1. Define a quasi-public good.

2. How does congestion change the nature of a road?

3. Give an example of technology making a good excludable.

Answers: 1. a good with some but not all public good characteristics 2. it becomes rivalrous 3. encrypted TV / electronic road pricing

5 How public goods are provided

If the market won't provide them, someone else must, and someone must pay.

Because the market fails to provide public goods, they are usually provided by the government and paid for by taxation. Taxes are compulsory, so free riding is not possible: everyone contributes.

Direct provision. The government produces the good itself: armed forces for defence, government-employed staff maintaining street lighting.

Contracting out. The government pays private firms to produce the good, such as hiring a private company to build and maintain flood defences. The good is still financed by taxes, but production may be more efficient.

Public–private partnerships (PPPs). A private firm finances, builds and often operates a project, such as a road or bridge, and the government pays it over many years or allows it to charge users. PPPs bring private finance and expertise, but long contracts can be expensive and inflexible.

Providing public goods always involves an opportunity cost: tax revenue spent on defence or flood barriers cannot be spent on health or education, or returned to households. Governments also face the problem of deciding how much to provide. Because people can free ride, they have no reason to reveal how much they truly value the good, so it is hard to measure demand.

Method	Advantages	Disadvantages
Direct provision	guaranteed supply; accountability to voters	may be inefficient; political influence
Contracting out	private sector efficiency and expertise	monitoring costs; risk of poor quality
Public–private partnership	private finance; shared risk	can be costly long term; complex contracts

Key point

Public goods are provided by governments and funded by taxes because taxation removes the free-rider problem. The cost is the opportunity cost of other spending.

Quick check

1. Why are public goods funded by taxation?

2. What is a public–private partnership?

3. Why is it hard to decide how much of a public good to provide?

Answers: 1. taxes are compulsory, so no free riding 2. a private firm finances and builds a project with government payments or user charges 3. people do not reveal their true valuation

6 Rivalry and excludability: applied

Classifying real goods.

A good is rivalrous if one person's use reduces availability for others; excludable if people can be prevented from using it unless they pay. Applying both tests classifies goods.

Good	Rivalrous?	Excludable?	Type
pizza	yes	yes	private
national defence	no	no	public
streaming service	no	yes	club
ocean fish	yes	no	common pool
uncongested road	no	no (unless tolled)	public / quasi-public

WORKED EXAMPLE 2 Classifying (standard)

Classify a toll bridge that is rarely congested.

Solution

Non-rivalrous (uncongested) but excludable (toll)R1

Club goodA1

7 The free-rider problem in detail

Why markets fail to provide.

Because public goods are non-excludable, people can benefit without paying, so they have no incentive to pay voluntarily. Firms cannot earn revenue, so the market under-provides or fails to provide the good at all (a missing market).

WORKED EXAMPLE 3 Street lighting (exam level)

Explain why street lighting would not be provided by a free market.

Solution

Non-excludable: cannot charge each userR1

Free riders mean firms cannot earn revenueR1

Missing market despite social benefitR1

8 Quasi-public goods

Partly public.

Quasi-public goods have some characteristics of public goods but not all: roads (non-excludable unless tolled, rivalrous when congested), beaches, parks. Congestion can make them rivalrous.

Quick check

1. Why can a road become rivalrous?

Answers: 1. when congested, each extra car slows others

9 Technology changing goods

From public to excludable.

Technology can make previously non-excludable goods excludable: encrypted TV broadcasts, electronic road pricing, paywalls on news websites. This allows private provision but may reduce access.

In the real world

Singapore introduced electronic road pricing in 1998, charging drivers to use congested roads, effectively turning roads into an excludable good at peak times.

Quick check

1. How did encryption change TV broadcasting?

Answers: 1. made it excludable: only subscribers can watch

10 Government provision

Direct supply.

Governments provide public goods directly (defence, police, flood defences) financed by taxation. This solves the free-rider problem because everyone pays through taxes.

WORKED EXAMPLE 4 Financing (standard)

How does tax finance overcome free riding?

Solution

Payment is compulsory for all taxpayersR1

Provision does not depend on voluntary paymentR1

11 Contracting out and public–private partnerships

Private firms delivering public services.

Governments may pay private firms to provide public goods (contracting out) or partner with them (PPPs) to build infrastructure. This may increase efficiency but can be costly in the long term and reduce accountability.

Quick check

1. Give one advantage and one risk of public–private partnerships.

Answers: 1. private expertise and efficiency; high long-term costs to taxpayers

12 Deciding how much to provide

Cost–benefit analysis.

Without market prices, governments use cost–benefit analysis to decide whether to provide a public good: estimate total social benefits (including non-market values) and costs over time; proceed if benefits exceed costs.

WORKED EXAMPLE 5 CBA (exam level)

Outline one difficulty in using cost–benefit analysis for a flood defence.

Solution

Hard to value benefits such as avoided risk to life or environmentR1

Uncertain future events; choice of discount rateR1

13 Global public goods

Benefits for everyone.

Some public goods are global: climate stability, disease eradication, scientific knowledge. No single country has enough incentive to provide them, so international cooperation and organizations (WHO, IPCC) are needed.

Quick check

1. Why is global vaccination a global public good?

Answers: 1. reducing disease spread benefits all countries; non-rivalrous and hard to exclude

14 Public goods versus merit goods

Different reasons for provision.

Public goods are defined by non-rivalry and non-excludability. Merit goods (education, healthcare) are rivalrous and excludable but underconsumed due to positive externalities or information failure. Governments provide or subsidize both, for different reasons.

Common mistake

Calling education a public good. It is excludable and rivalrous (class sizes); it is a merit good.

Quick check

1. Classify: a public hospital service.

Answers: 1. merit good (rivalrous and excludable)

15 Opportunity cost of public goods

Choices in the budget.

Spending on public goods has an opportunity cost: money spent on defence cannot be spent on health or education. Governments must prioritize using political and economic criteria.

Quick check

1. State the opportunity cost of increasing defence spending.

Answers: 1. the forgone spending on other services, or lower taxes

16 Mixed review: worked problems

Bringing the ideas together.

WORKED EXAMPLE 6 Mixed problem (exam level)

Explain why lighthouses are often cited as public goods, and how they have been financed.

Solution

Non-rivalrous and non-excludable for passing shipsR1

Historically financed by port charges or governmentR1

17 Additional exam-style practice

Paper 1 and Paper 2.

WORKED EXAMPLE 7 Paper 1 part (a) (exam level)

Explain why the free market fails to provide public goods. [10]

Solution

Define public goods: non-rivalrous, non-excludableR1 R1

Free-rider problem; no revenue for firmsR1 R1

Missing market; examplesR1

18 Public goods and inequality

Who benefits?

Public goods benefit everyone, but some groups may benefit more (well-lit wealthy neighbourhoods). Fair provision considers distribution, especially for public infrastructure in poorer regions.

Quick check

1. Why might public good provision affect inequality?

Answers: 1. provision may be unevenly distributed across regions or groups

19 Evaluating government provision

Government failure risks.

Government provision may suffer from inefficiency (lack of competition), political bias, and difficulty measuring demand. Evaluating provision involves comparing alternatives and outcomes.

Quick check

1. What is government failure?

Answers: 1. when intervention leads to a less efficient outcome than before

20 Case study: national defence

The classic public good.

Defence protects everyone in a country at once (non-rival) and cannot exclude residents (non-excludable). It is financed by taxation; debates centre on how much to spend relative to other priorities.

Quick check

1. Why can a private firm not sell defence to individuals?

Answers: 1. those who do not pay would still be protected (free riders)

21 Case study: open-source software and knowledge

Digital public goods.

Knowledge and open-source software are non-rivalrous; once shared freely they are non-excludable. Patents and copyright make knowledge temporarily excludable to reward innovation.

Quick check

1. Why do patents exist?

Answers: 1. to make knowledge excludable for a time, giving innovators an incentive

22 Diagram: missing market

Representing public goods.

A public good can be shown with a demand curve (social benefit) but no market supply because firms cannot charge. The welfare loss is the entire area of potential surplus that is not realized.

WORKED EXAMPLE 8 Missing market (standard)

What area represents the welfare loss of a missing market?

Solution

The whole potential community surplus that would exist if providedR1

23 Common misconceptions and links

Students often think…	Actually…
public goods are goods provided by the government	they are defined by non-rivalry and non-excludability
free riding comes from non-rivalry	free riding comes from non-excludability
public goods and common pool resources are the same	common pool resources are rivalrous
roads are always public goods	they are quasi-public; congestion makes them rivalrous

How 2.9 connects to the rest of the course

Topic	Connection
2.8 Externalities and common pool resources	another cause of market failure; rivalry contrasted
2.7 Role of government	direct provision and taxation
3.5 Fiscal policy	government spending on public goods
4.7 Sustainable development	global public goods such as climate stability

24 Exam-style question with markscheme

Try this under exam conditions (about 15 minutes) before reading the markscheme.

Figure 2. Spending on public goods in a country.

Text A. The country plans to spend more on flood defences as storms become more severe. A private company proposed building the defences in return for a fee from residents, but most residents refused to pay.

(a) Define public good. [2]

(b) Explain why most residents refused to pay the private company. [4]

(d) Explain one way the government could provide the flood defences. [2]

Markscheme

Part	Answer	Marks
(a)	non-rivalrous	A1
	and non-excludable	A1
(b)	flood defences are non-excludable	R1
	residents benefit whether or not they pay	R1
	free-rider problem	R1
	private firm cannot earn enough revenue: missing market	R1
(c)	resources diverted from other uses	R1
	e.g. less health or education spending, or higher taxes	A1
(d)	direct provision / contracting out / PPP funded by taxes	A1
	taxation removes free riding	R1

Examiner's comments. In (b), many answers said residents 'could not afford it'. The question is about incentives: non-excludability means paying gives no extra benefit.

25 Check your understanding

Section A: multiple choice

1. A public good is

A. non-rivalrous and non-excludable B. rivalrous and excludable C. provided only by government D. free of charge

2. The free-rider problem arises because

A. goods are too expensive B. governments overprovide C. people can benefit without paying D. firms are monopolies

3. Which is a pure public good?

A. a mobile phone B. national defence C. a cinema ticket D. fish in the ocean

4. A streaming subscription service is

A. a public good B. a common pool resource C. a private good D. a club good

5. Public goods are an example of

A. excess demand B. a missing market C. a positive externality only D. monopoly

6. A road becomes rivalrous when

A. it is congested B. it is empty C. tolls are introduced D. it is new

7. Governments usually fund public goods through

A. user charges only B. advertising C. selling shares D. taxation

8. Which is a common pool resource rather than a public good?

A. street lights B. national defence C. ocean fish stocks D. lighthouses

Section B: structured

9. Explain the two characteristics of a public good, using a lighthouse as an example. [4]

10. Explain why public goods are an example of market failure. [4]

11. Explain how technology can turn a public good into a club good. [3]

Answers

1. A 2. C 3. B 4. D 5. B 6. A 7. D 8. C

9. Non-rival: one ship using the light does not reduce it for others; non-excludable: ships cannot be stopped from seeing it.

10. Non-excludability leads to free riding; firms cannot cover costs; missing market; society values the good so this is allocative inefficiency.

11. e.g. encryption makes TV broadcasts excludable; subscriptions can be charged; private firms can supply.

26 Summary and topic map

Idea	Remember
Rivalry	one person's use reduces others'
Excludability	non-payers can be kept out
Public good	non-rivalrous and non-excludable
Free rider	benefits without paying
Missing market	market supplies nothing although society values the good
Club good	non-rivalrous, excludable
Quasi-public good	some public good features; e.g. roads
Provision	taxation; direct, contracted or PPP

Before the exam, make sure you…

•define public goods by both characteristics
•link free riding to non-excludability
•never call schools or hospitals public goods
•mention opportunity cost when evaluating provision

Public Goods on one page

Cover this page with a sheet of paper and try to rebuild it from memory. Whatever you can't recall is what to revise next.

Figure 3. Topic map for Public Goods.

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