On several occasions, I have had to correct a serious misconception on public goods and why their associated prices are zero in the free market with students.
So I thought it best to share more on it and remedy with appropriate explanations.
As these students’ stories go…
Public goods are goods that exhibit the properties of non-excludability and non-rivalry.
A non-excludable product is one where non-paying customers are not able to consume it.
And a non-rivalrous product, is one where its consumption by one consumer reduces the ability of another consumer to consume it.
So far so good. But then…
At this point, many students will then make mention that due to the above properties, there is no expressed demand due to the tendency for consumers to free-ride, causing the market price to be zero.
Since suppliers respond to prices for output decisions, a zero market price will mean that suppliers will not produce that good at all, causing market failure through allocative inefficiency.
While the outcome is certainly true (i.e. public goods do not get produced by the free market), the explanation is not entirely correct.
And I had to write and share this post, because precise explanation:
- Ultimately separates the best students from the others;
- Avoids unnecessary marks attrition in exams.
It is instructive therefore to revisit and scrutinise the concepts of non-excludability and non-rivalry.
Excludability is the ability to exclude
A “non-excludable” product, is one where non-paying customers are able to consume it.
For example, it is extremely difficult, if not impossible to restrict consumption to non-excludable goods, such sunlight, lighthouses and public roads.
There are many other examples around us, and some were more controversial than others.
In 2014, there was a huge outcry after a student was fined by the court by what many considered to be a minor infarction in Singapore.
Her alleged crime was in utilising an available power socket at the MRT station to charge her handphone.
I bet you didn’t know that it is actually a criminal offense to use electrical points in the MRT station for your own use. Well now you know!
The general public’s outcry over the incident illustrated a key point: Non-excludability gives rise to free ridership because consumers will not be willing to pay for the right to consume the good, simply because there is no need to.
As noted by lawyer Vijai Parwani: “Power sockets are ubiquitous. If one is left in the open, it is not unreasonable for a person to assume that it can be used, especially if it’s in a public area and it is not under lock and key.”
Since it is not possible to exclude non-paying consumers from enjoying the product, non-excludable goods will tend to exhibit zero demand in the free market, causing the free market price of the good to be zero.
Left to market forces, no profit-maximising sellers will produce the good since the revenue made from selling the good will be zero.
Rivalry reduces the ability of others to consume.
A “non-rivalrous” good or service is one where its consumption by one consumer does not reduce the ability of another consumer to consume it.
For example, the consumption of non-rivalrous goods such as sunlight, lighthouses and public roads by one consumer does not diminish the ability of other consumers to consume these goods.
Marginal cost refers to the additional cost incurred when an additional unit of the good is produced.
In the case of a non-rivalrous good, the marginal cost of the good is zero, since no additional cost is needed to ensure the consumption of every next unit of the good.
From a societal perspective therefore, the socially optimal price of the good should be zero, since the marginal cost of the good is zero.
Non-rivalry does not lead to zero price.
Because students often gloss over the details when studying Economics (I was guilty of that too), they tend to associate both non-excludability and non-rivalry as combined factors that result in zero price.
This is not true.
To understand why, we first note that goods need not be simultaneously non-excludable and non-rivalrous. In particular, let’s first explore goods that are excludable, but non-rivalrous (a.k.a club goods).
Assuming away congestion as a troublesome possibility, examples of such goods include cable TV, toll roads and even international treaties such as NATO.
As analysed earlier, non-excludability results in free ridership, which causes demand, and hence the market price, to be zero.
But things are less straightforward with non-rivalry.
As we saw earlier, non-rivalry causes the marginal cost of the product to be zero. Most of us should be familiar with its implication – the supply curve for the product should then be zero (and price too, by extension).
Yet, we observe that such goods often come with prices attached: Cable TV isn’t free of charge; toll roads are self-explanatory; and Donald Trump frequently calls out as NATO “too expensive”.
So what is going on?
Remember how we had earlier equated the marginal cost of producing a product to be the supplier’s supply curve?
Actually, it is more accurate if we look from the perspective of society, and qualify that the marginal cost of producing a product as borne by society.
Because it turns out that suppliers can apply a relatively novel concept (to traditional Economics, but absolutely common sense for many of us) called “Artificial Scarcity“.
Without boring you to death with details, it essentially explains that suppliers charge a price, because they can (since the products are excludable).
Non-rivalry, rather, implies that the socially optimal price for the product is zero.
This is an important distinction – students should be aware that non-rivalry is not the reason behind prices in public goods being zero. Non-excludability is the actual culprit.
Instead, non-rivalry causes the societal marginal cost for the product to be zero, implying that the socially optimal price for the product should be zero.
To go further, in the absence of government provisions, the presence of non-rivalrous products will therefore lead to allocative inefficiencies, since:
- At the socially optimal price of zero, the free market will not produce these goods anyway;
- If the free market does produce, the price is unlikely to be zero, which implies artificial scarcity.
Non-excludability causes free-ridership, causing prices to be zero since the expressed demand is zero.
Non-rivalry causes the marginal cost to be zero, causing the socially optimal price to be zero, necessitating government intervention to ensure allocative efficiency.
The combination of both factors ensures that public goods always cause market failure and there is need for government intervention for socially optimal outcomes.
Being precise in the explanation pays dividends and if you have learnt something from it…
Lend your support!
I hope that you have enjoyed reading this article of mine. I am giving my time to sharing my knowledge and every bit of support means a lot to me! Do drop me a comment or share this article on social media with your friends.
To find out more about my services as a JC Economics tutor, visit my website here.