Question

Explain the relationship between public finance and market failure.

Answer 1

Public finance is generally concerned with public good .It is a other way to speak public good . "Public goods" is a cause of market failure. The basic problem is that some goods have special characteristics which make it difficult for firms to make money by trying to produce and sell the goods. At the same time people often want these goods.

For instance, one defining characteristics of a public good is that a person's consumption of it will not make it unavailable for another person. This is known as non-rivalry in consumption. GPS signals have this property: My use of GPS signals will not prevent you from also using the signals. This is different from many other goods: If I drink a can of coke, you cannot drink the same can!

A second defining property of a public good is that once it is provided, nobody can be prevented from using it (non-excludable): Once GPS signals are provided, everybody can use the signal regardless of whether they pay for it or not.

A good with these properties (non-rivalry and non-excludability) will usually not be provided in the market because nobody can make profit from producing it. There are some exceptions to this. For instance, if the value of the good is very high to one person, it may still be provided since the person will pay for it even when it means that others will also enjoy it for free. It may also be possible to tie the good to other things which you can make money off. For instance advertisement to provide free TV content in the days when the signals were free. It could also be possible to provide these public goods outside the market by voluntary contribution and social shaming of people who do not contribute.

But in general, the two properties do create a situation in which people want something (and are willing to pay for it), but no firm will find it profitable to provide the good.

It is important to distinguish the definition of public goods used above, from the popular use of the term public goods. Health, education and so on are not public goods in the technical sense. It is perfectly possible to prevent people who do not pay from going to school. Also health services can often be restriced to those who pay. Defense is a slightly better example. Once it is provided in a country it is difficult to say that you are only going to defend those who (voluntarily) pay for it.

Some goods have only one of the properties. This also create market failures. For instance, goods that have zero marginal cost (non-excludable) should be provided a zero price, but this will not happen in a free market. Let’s say you could scramble GPS signals so that only those who pay for it will get it. Now you can make people pay for it, but technically charging a price for something that does not cost anything to provide additional units of, is not a good outcome.

In short, public goods cause market failure. People want the goods, but no firms will find it profitable to produce these goods because they can be enjoyed for free once they are provided and they cannot prevent this from happening. To provide these goods then, we must either rely on governments who can force people to pay (tax to finance the military), or voluntary associations based on social norms (which may or may not work in different situations).