Of course, this gives rise to another major reason for government intervention and regulation of the market system: to alter and affect the distribution of income and wealth which the market generates, and the distribution of the economic activity which goes with it over the territorial space of the community - geographical distribution - so that the less well off have a greater weight (more income and/or more say) in determining what is produced (and where) - the JUDGE function of governement. The Government as 'Judge' determines fair and just distributions of income, wealth, purchasing power, command over goods and services etc. However, economics has nothing to say about the exercise of this function, other than to point out that any practical re-distribution typically reduces the efficiency of the market system by distorting the economic signals encouraging people to economise on scarce resources and adopt the most productive and efficient systems.
Remember the two other key functions of government? Policeman - already implicit in the workings of the market system, since laws of contract and property rights are essential for markets to function. Pharmacist/Mechanic - regulation of imperfect competition and monopoly, Macroeconomic management.
For Public Goods, however, my use, consumption or enjoyment does not deny you the use, consumption or enjoyment of the good - we are not rivaling each other for the use of the good (or service), so they are non-rival in consumption. An example is a football game or theatre performance - where, if anything, the more people who are enjoying or watching the performance, the greater the enjoyment of each person. So, how might we think if the total demand for a football game or theatre performance? Instead of adding up the quantity (1 or the length or the performance, game) for each person, we need to add up the price each person is willing to pay for the performance - we add up individual demands vertically, up the price axis.
This example, however, illustrates that "non-rivalness" is not the only characteristic which separates public goods from private goods. In these cases, it is simple and easy to exclude people from the game or performance - we can stop people who have not paid from getting into the ground or theatre, and exclude them. For a public good, however, this is not possible - public goods are non-excludable as well as being non-rival. Examples include street lighting, lighthouses, national defence, public health (cleaner air, disease control etc., radio and TV broadcasts [though note here that it is possible, though expensive, to exclude people - or at least fine them if they do not have the appropriate receiver license), and, importantly, the natural (or urban) environment. There are also such things as public bads - pollution is the classic example, which we will deal with below.
The market problem of public goods and a possible solution.
Why is the non-excludable characteristic a problem? Because if private (non collective) companies or organisations cannot charge people for their use, how are they going to raise enough revenue to pay the costs of providing these public goods? They cannot, other than relying on charitable (altruistic) donations from people who care about these goods. So, a simple-minded economist (who believes that people only do things for their own narrow self-interest) might argue that these public goods can never be provided by a free market. An "economically rational" individual would not spend hard earned income on public goods, since s/he would reason that others will provide the good anyway, and cannot exclude him or her from consumption or enjoyment once they do, so there is no point in contributing - better to "free-ride" on other (less economically rational) peoples' charity. If everyone behaved like this, no-one would get any public goods.
There must be something wrong here, though. People do organise themselves to provide for at least some public goods. The lighthouses in the UK are run by Trinity House, which is an independent (private) organisation, paid for by contributions from mariners. The Royal National Lifeboat Institution (RNLI) is similarly a private charity supported solely by voluntary donations. Public service television stations in the US also exist and are succesful on the same principle. A lot of people are not quite so narrow-minded and stupidly selfish as the purely self-interested economically rational man - thank goodness.
Nevertheless, free-riding is a problem for many public goods. Unless everyone is forced to make a contribution (through taxes), the chances are that less of the public good will be provided than is socially optimal - that is, less than everyone is really willing to pay for the good, and hence a smaller or lower supply of the good than everyone really wants. Thus, many public goods are paid for and provided by the Government, through coercion on the public's (yours and my) behalf. What do we mean by socially optimal?
Imagine, as a simple case, two people (households) interested in getting streetlights put into their private street (of just two houses). Both households have their own ideas about how much they are willing to pay for this common (public) service. One household (the most interested) could discover how much streetlighting would cost, and realise that it alone was not willing to pay the full amount. It might then approach the other and ask for a contribution towards the total cost. What would be the outcome of such negotiations?
The following diagram explains this and shows how (honest) negotiation between people could provide for the right amount of the public good that people want. This diagram may look seriously off-putting - but it is really quite straightforward - spend a little time and thought following through the explanation in the boxes - just get your brains into gear! The outcome is that both households each contribute what they are willing to pay for street lights, and the combined amount is enough to cover the costs of supplying the amount (number) of streetlights that both households (collectively) are willing to pay for. This is socially optimal for this community of two households. If the costs were greater than the households willingness to pay, then too many street lights would be provided. If the costs were lower than the combined willingness to pay, then too few lights would be provided, since the users are willing to pay for more.
The major problems with this concept of voluntary collective negotiation for the supply of public goods should be obvious (with a little thought). The solution requires that all the people interested in and benefiting from the public good are fully committed to the idea of collective action, and recognise that the solution will not work if people free-ride. This might be expected amongst a relatively small and coherent community (such as mariners for lighthouses and the RNLI for instance). Otherwise, as with the Royal Society for the Protection of Birds (RSPB), which (among other things) buys or rents wildlife reserves for the conservation of birds and thus related environments - as public goods -with voluntary donations and subscriptions, the organisation must put up with the near-inevitability that there will be substantial free-riding. Although the RSPB can, of course, exclude all but it own members from particular wildlife reserves, the general public cannot be excluded from the general good of encouraging wildlife. The National Trust is another example, albeit helped by the Her Majesty's Treasury in that large estates or country houses etc. can be left to the National Trust in lieu of estate duties, which would otherwise accrue to the Treasury as taxes.
Although the formal logic of this solution suggests that each contributor will pay a different price according to their own willingness to pay, the difficulties with this differential solution in practice normally result in a standard contribution (membership fee, annual subscription etc.), though always allowing for the seriously altruistic or enthusiastic to contribute more if they like.
In some cases, it may be that a particularly rich or concerned member of the public might be prepared to pay for the public good on their own. This would follow from the above diagram if Dy intersected the supply curve (at C=MC=AC) - then the intersection would indacate the quantity Y would buy on his/her own, without support from the rest of the community. There is one classic case of this - the American media tycoon Ted Turner was so impressed with public service broadcasting (PSB, no adverts) that he bought his own PSB station in his home city of Atlanta. Once he had done so, of course, he was able to raise additional voluntary contributions from other residents, and thus extend the quality of the service. But this is a non profit making enterprise.
In general, however, for many public goods (National Parks, Environmentally Sensitive Areas, Areas of Outstanding National Beauty, national defence) it has been considered that the problem of free-riding is too great, and these public goods are provided by the Government and paid for out of general tax revenue, to which everyone is obliged to contribute according (roughly) to their means.
In addition, some public organisation (if not actual provision) can be justified on the grounds that there are substantial organisational and transactions costs associated with communities of people negotiating the common provision of a public good. These transactions costs are serious, and may well be reduced by government (i.e coerced or forced cooperative) action.
The issue here is that the market mechanism is capricious in the income (and wealth) distribution that it generates between people. The accidents of birth, personalities, family circumstances and local conditions all combine with the operation of the market system itself to ensure that incomes are never equal. Although most governments seek to rectify this somewhat with social security and progressive taxation systems (where the rich are supposed to pay more than the poor), the fact remains that some people will be richer than others, and thus have a generally greater willingness to pay. Social justice and equity demand, however, that some things are too important to be left to the market (even given that the poor are supported through income supplements of various sorts).
There are, however, some clear overlaps between merit goods and public goods. Some of our public goods (especially, perhaps, the natural environment in the form of National Parks etc.) are also considered to be merit goods. Our major merit goods (health, education) also have public good aspects - the better educated and the more healthy the population, the better-off everyone is, regardless of the indivudal level of health or education of each of us, simply because the economy and society is likely to work and perform better.
Nevertheless, it is helpful to keep the public good and merit good arguments separate when considering the problems of (for example) provision for conservation of the natural environment, or issues of the health and education services.
These external effects are important because they mean that market transactions do not account for all the benefits and costs of particular activities, so the outcome of markets cannot ensure a social optimum. They arise because of two major factors: first, transactions costs - the necessary transactions to account for the benefits and costs (to internalise the effect within a market mechanism) are difficult and expensive in time and effort; second, because the property rights to pretty countrysides or wildlife are unclear or contested - who owns the landscape or view, or the wildlife? Without clear ownership rights, there is no legitimate basis for the negotiations about rewarding benefits or compensating losses.
Take as an example the case of pollution of a river by some production system (a dairy farm, if you like). If the farmer can produce without regard to the pollution he causes, he will maximise his private profits, since pollution control will generally cost money and reduce margins. There is, then, some upper bound to the level of pollution that this production activity will cause. However, this level of pollution may well kill all the wildlife in the river, through atrophication. This damage will affect anglers, wildlife enthusiasts, water users downstream, ramblers etc., who value cleaner rivers and the benefits they enjoy from cleaner rivers.
We can picture the situation as in the following diagram.
The
point of private profit maximisation is Qm. At this point (and corresponding
production activity), the damage suffered by the river users and enjoyers
is very substantial. On the other hand, there is a level of production
and associated production practice which would eliminate the pollution
entirely (shown by the intersection of the MD curve with the horizontal
axis - implying in this illustration that some limited level and form of
dairy farming is of no harm to the river environment).
Suppose that the farmer owns the river, and is alive to the business opportunities of the river. It might be worth his while to find out how much people were prepared to pay for enjoying or using the river. The answer would be that they would only be prepared to pay for a cleaner and less polluted river. The marginal damage (MD) curve shows how much they would be prepared to pay for a cleaner river, reading this curve from right to left, since it shows the monetary equivalent of the damage they suffer from the polluted river. They would be prepared to pay up to this damage suffered to avoid it (prefering to pay less of course). The sensible farmer would then negotiate with the potential users, agreeing to take steps to reduce pollution so long as the price paid for a cleaner river were greater than the reduction of net revenue earned from the farming operation as a result of reducing pollution. This reduction is shown by the MC curve, again reading from right to left. The final agreement between farmer and user would be at Q* pollution, with a payment of T* per unit of cleaner river by the users to the farmer.
What if the farmer does not own the river? Suppose the river is owned by someone else, who is also concerned about its value to them and other users. In this case, these owners can require the farmer to take steps not to damage their resource, and to pay compensation to the owners if such damage occured. The compensation required by the owners is shown, again, by the MD curve (reading from left to right) - a little compensation for a small amount of pollution and a lot for a large amount. What would now be the farmer's best option? Think, before you read on.
The farmer increases his private net revenues the more pollution he causes, but at a reducing rate, as shown by the MC curve, left to right. But he is now required to pay for this pollution at an increasing rate, according to the MD curve, left to right. The profit maximising optimum for the farmer is now where the reducing marginal benefit of polluting (the MC curve) crosses the increasing marginal cost to him of polluting - the MD curve. Once again, the market equilibrium solution (the optimum) is at pollution level Q* and the farmer paying T* per unit of pollution to the owners for the priviledge of polluting the river.
Conclusions on externalities
Thus, according to these principles, there does exist a logic which would allow for negotiations between owners and beneficiaries of a resource and polluters or damagers of (in effect using up) this resource to agree on an appropriate transaction and contract which balances the interests of the producers and users - allowing some pollution, but preventing levels of pollution where the gain from additional pollution is less than the cost of this additional pollution.
The analysis also points up the often very serious difficulties with externalities. Three of the most important are as follows.
First, it is often very difficult to estimate the monetary equivalent of the damage caused by pollution (or equivalently, the value of cleaner environments - more diverse wildlife and and more valuable landscapes etc.). Voluntary donations to organisations such as the RSPB strongly suggest that there is a large demand amongst at least some of the general public for cleaner and more natural environments. It might be that, in particular circumstances, the MD curve in the above diagram lies everywhere above the MC curve, in which case the market (economic) optimum level of pollution would be zero (that level of production which does not damage the environment at all). In other cases, however, it could be that the actual willingness to pay exhibited by the general public for cleaner environments is simply insufficient to outweigh the indirect benefits of pollution (the value of the production and associated consumption). A case in point is traffic pollution - generally, the public is concerned to reduce this, but is not prepared to do without all the indirect benefits of traffic pollution. So we try to insist that research and development is devoted to making our "necessary" traffic cleaner, and penalising only those who cause excessive pollution, rather than everyone.
Second, there are often very considerable transaction and negotiation costs associated with getting everyone concerned with the problem together and reconciling their differences. Frequently this is because the externality has at least some of the properties of being also a public good - like better environments, cleaner air and rivers etc. But, even where this is not the case, the fact that the side-effect has not already been accounted for in market transactions and remains an externality itself implies that the costs and effort required to undertake the necessary transactions are too great to be worthwhile. Externalities are, therefore, an indication that the transactions necessary to take proper account of them are more costly than the benefits which might be obtained from carrying out the transactions. The existence of organisations like the RSPB illustrate the market response - try and develop institutions and organisations to reduce the transactions costs and negotiate collective agreements to reduce negative (bad) externalities and encourage positive (good) externalities.
Third, the ownership of the property rights on the natural resource is often contested. Who should pay for pollution depends on who owns the affected resource or property, as shown above - if the farmer owns the river, the beneficiaries of the clean river might end up paying for the clean river. If the farmer does not own the river, then he (or she) may be forced to apy for the damage the dairy does to someone elses property.
The notion that farmers should be subsidised (paid) to avoid polluting the natural environment impies that farmers own the natural environment. If they do not, then the implication is that farmers should be taxed (required to pay compensation) for any pollution they cause. The general presumption (outside agriculture) is that air, water, and even soil are common property - belonging to everyone - so the polluter pays principle applies. Should farmers be different, and if so, why? Thoughtfull and well argued Answers to me, please!
It is partly because of these difficulties, and also because the effects of pollution (or, more generally, environmental degradation) tend to be specific to particular locations and different between different locations and practices (that is, the effects are highly heterogeneous), that governments are asked (by their electorates, assisted by pressure groups) to intervene and find solutions to the externality problems. This analysis suggests that the appropriate solution is a system of pollution taxes or subsidies to avoid degradation. It can be shown that, under restrictive conditions, the tax/subsidy system is more efficient than regulation - blanket restrictions on levels of pollution and fines/penalties for contravention of the regulations (see here for a demonstration of this conclusion, and reasons why regulation might, nevertheless, be a preferable option in many cases, as is frequently observed in public opinion preferring regulation to taxes and subsidies).
As concerns over food security diminished, and people became richer and more leisured, so the demands for countryside and wildlife increased (witness the growth in membership and subscription to the environmental and wildlife pressure groups and action organisations like the RSPB). So, too, does public support for the policies of agricultural protection and subsidy diminish, leading to changes in the government (public) policies with these objectives, as well as to changes in market signals and thus responses of both the supply and the demand sides of the market. The growing demand for organic and environmentally freindly food production is having an effect in the market, encouraging more of these production practices, as well as generating pressure for government legislation and policies.
The market system, in spite of its apparent concentration on pure self-interest, does generate responses to changing circumstances and conditions and encourage socially acceptable solutions - albeit not nearly fast enough or effectively enough for some peoples' tastes. It is a serious mistake, though, to consider government or state action and management of the social and economic system as an alternative to the market system. Both require each other.
Markets need to take account of public opinions and values, or the public will find ways (through government or through their own purchasing and factor supply decisions) to make markets behave better. But governments (and the general public) need also to take account of the expressions of self-interest and self-determination as expressed in market transactions, otherwise their attempts at governance and regulation are quite likely to result in worse rather than better outcomes. Adam Smith's invisible hand is inevitably attached to the long arm of the law - to enforce market contracts and protect property rights, and also to try and correct the market-determined income and wealth distributions between people so that they accord more clearly with public perceptions of social justice.
The key difficulty, here, is that interference with the market distribution will tend to change incentives and market signals, and make the market work less well than if there is no interference. If income (and associated consumption) and profit are the only motivators of human activity, then this adverse effect on the market might be serious. However, there is both good reason and substantial evidence that people do things for reasons other then pure economic self-interest (though these other motivations and behaviours have not yet been incorporated into the economic models and pictures of behaviours).
For a more complete evaluation of the role of markets and governments (the state) in the countryside - see The Role of Markets in the Rural Economy.