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A public good is a good where one person's use does not reduce the amount available for others and where once the good is provided then no one can be excluded from using the good (Varian 1992). Classic examples in economics are national defense, clean air, and public parks. So that, if your house is protected from foreign invaders by the military, then my house must also be protected. And laws that limit pollution to provide more clean air for you will also provide more clean air for me. These are in contrast to private goods that are either used up when one person consumes them or where individuals not paying can be excluded from consuming the good. If I eat an apple then there is nothing left for you to consume, and if I build a swimming pool in my yard then I can exclude you from swimming in my pool. An apple and a swimming pool are examples of goods that are not public goods.
In the 1920s, A.C. Pigou proposed using taxes to punish providers of negative externalities and reward providers of positive externalities . An externality occurs when a cost is incurred (negative) or benefit enjoyed (positive) by an agent who did not produce or pay for the good (Parkin 2003). Pigovian taxes became the classical solution to the pollution problem and are credited with the elimination of lead pollution from the atmosphere in the 1980s (Ibid.). However, the government is usually not able to determine the costs imposed by an externality (Varian 1992).
In the 1960s, economist Ronald Coase hypothesized that the assignment of property rights would lead to an efficient solution to the externality problem. He articulated this idea in his Coase theorem which states that to whom the property rights are assigned does not matter if the transaction and negotiation costs are low (Parkin 2003). While Coase theorem has many applications in economics, it is not as useful in solving public good problems that nonprofit organizations address because either it is often not possible to assign and transfer property rights or the negotiation costs are too high. For example, how would the property rights of feeding the poor be assigned and how would a factory that pollutes negotiate with every person who is harmed by their pollution?
Burton Weisbrod later offered the first general economic theory of nonprofits, proposing that nonprofit organizations often produce more public goods than those provided by the
government. Yet, Jeffrey Weiss showed that this need not lead to a situation where a person can only be made better off by making another person worse off (i.e., Pareto optimal efficient ) if it is possible to exploit the free rider property (Hansmann 1987). A free rider is someone who does not pay for a good but is still able to consume the good because of the public nature of the good (Parkin 2003).
Unlike private goods, which the market will efficiently provide for sale in the amount individuals are willing purchase, public goods are not provided at an efficient level because of the free rider problem. A free rider is someone who does not pay for a good but is still able to consume the good because of its public nature (Ibid.). For example, even if I don't pay for national defense, my house will be protected from invaders if the military provides protections for my neighbor's house.
Government also will not provide an efficient amount of a public good because the government will provide an amount of the good determined by the median voter (Varian 1992). The median voter will underestimate the value of the good to take advantage of the free rider opportunity that a public good offers. For example, if everyone is asked to pay the amount they value national defense, everyone has an incentive to say they get no value from national defense because they will still be protected if everyone else pays. Since everyone wants to avoid paying, the median voter will say he or she gets less value from the good than is the actual case. The failure of both markets and government to provide an efficient amount of a public good is known as market failure.
Consider an example of a dark street with three houses. Each of the houses would like to have a streetlight. Say a light that would illuminate the entire street costs $100 and each homeowner values the light at $50. The light should be provided because it is worth $150 collective to the three homeowners and only costs $100. If two of the homeowners pay the $50 they value the light, the light will be provided and the other homeowner will be able to enjoy the light free of charge, as a free rider. However once the light is provided no one can be excluded from consuming the illumination, each homeowner would like the others to pay for it. In this case, each would say they don't value the light hoping that the other two will provide the light, so the market will not provide an efficient solution to the problem because of the public property of the light.
In this case, the government could provide a solution by forcing each homeowner to pay $33.33, instead of their stated value, and using the $100 to provide the light. If each homeowner pays $33.33 and receives $50 worth of consumption from the light, this is an efficient solution. However, if one homeowner values the light at $75 and each of the
other two at $25, then two of the homeowners would be made worse off by being forced to pay more than they value the light. This is not "Pareto efficient." The case would be worse if all three homeowners value the light at $25. In this case not providing a light would be the efficient solution, since it would cost $100 to provide $75 worth of light. Since the government will rely on the median voter to decide how much to force each to pay for the light, the voters will all underestimate the value they receive from the light. If they all claimed to not value the light, to take advantage of the free riding opportunity of the public good, then the government would not provide the light.
Ties to the Philanthropic Sector
In 1974, Burton Weisbrod proposed that public goods are often provided by nonprofit organizations because neither markets nor government have an incentive to provide an efficient amount of a public good because of the free rider problem (Hansmann 1987).
Consider the example of the streetlight in the previous section, but replace the public good streetlight with the public good of curing a disease. All members of a community would benefit from having a disease cured, but neither the market nor government will provide the efficient amount of research because of the free rider problem. In this case, nonprofit organizations will provide additional research funding above what the government will provide. Sometimes nonprofits will also lobby government to provide a good at a level above what the median voter is willing to pay. Examples of this are legislation to provide a higher amount of clean air and medical research that the median voter claims to want.
There are many examples of problems or wants where neither the market nor government will provide an efficient outcome. In these cases it falls on nonprofit organizations to provide the additional amount of the good or lobby government to do so. Public goods that nonprofit organizations provide extensively include care for the needy and elderly, environmental protection, medical research, and the arts.
Key Related Ideas
Externality: An externality occurs when a cost is incurred or benefit enjoyed by an agent who did not produce or pay for the good (Parkin 2003). If I have to breathe smoke from your cigarette then I am forced to pay part of the cost for you to smoke. This is an example of a negative externality. A positive externality would be if I enjoy the smell of cigarette smoke and am able to breathe your smoke without paying you to do so.
Free rider: Someone who does not pay for a good but is still able to consume the good because of the public nature of the good (Ibid.).
Market failure: When markets "fail to efficiently provide or allocate goods and services" (Wikipedia "Market"). The main reasons for this are public goods, externality, monopoly, and information asymmetry ("when one party to a transaction has better information than another"; Ibid.).
Median voter: Half of the population prefers more of a good and half prefer less of a good than the amount the median voter prefers (Varian 1992).
Pareto efficient: A situation in which no person can be made better off without making another person worse off (Nicholson 1992).
Important People Related to the Topic
- Ronald Coase: Winner of the 1991 Nobel Prize in economics. Developed Coase theorem, which hypothesized that private bargaining would lead to an efficient allocation of public goods if private property rights are assigned and transaction costs are minimal.
- Arthur Cecil Pigou: Suggested that the government could tax businesses that caused negative externalities. The Pigovian tax is the classical solution to the free rider problem.
- Burton Weisbrod: Offered the first general economic theory of nonprofit organizations. Claimed nonprofit organizations produce a residual amount of public goods above that which the government provides to satisfy the demand above what the median voter reveals.
Related Nonprofit Organizations
- American Cancer Society : The mission of the American Cancer Society is to eliminate cancer as a major health problem by eliminating cancer, saving lives, and diminishing suffering from cancer through research, education, advocacy, and service (ACS "About").
- American Heart Association : The mission of the American Heart Association is to reduce disability and death from cardiovascular disease and stroke (American Heart "About").
- March of Dimes : The mission of the March of Dimes is to prevent birth defects and infant mortality (March of Dimes "About").
Related Web Sites
- Foundation for Economic Education Web site provides access to articles on topics related to economics and private enterprise. The FEE mission is "to study the moral and intellectual foundation of a free society and to share its knowledge with individuals everywhere" (FEE "About FEE"). "Rethinking the Free Rider Problem" by political scientist James L. Payne gives an example of voluntary groups overcoming the free rider problem, at http://www.fee.org/vnews.php?nid=2444 . "The Ultimate Externality" by economist Donald J. Boudreaux explains how eliminating externalities may cause other externalities, at http://www.fee.org/vnews.php?nid=271 .
- Foundation for Research on Economics & the Environment (FREE) Web site provides "Trails and the Free Rider Problem" by Pete Geddes, at http://www.free-eco.org/articleDisplay.php?id=345 . The article examines the free rider problem associated with mountain trails in Montana.
Wikipedia, the Free Encylopedia Web site provides extensive definitions of terms. Free rider is defined at http://en.wikipedia.org/wiki/Free_rider_problem and public good at http://en.wikipedia.org/wiki/Public_good .
Bibliography and Internet Sources
American Cancer Society. "About the American Cancer Society." ACS. http://www.cancer.org/docroot/AA/content/
American Heart Association. "About Us: Mission." American Heart Association. http://www.americanheart.org/presenter.jhtml?identifier=10858.
Foundation for Economic Education. "About FEE." FEE. http://www.fee.org/vnews.php?sec=aboutfee .
Foundation for Research on Economics & the Environment (FREE). "Publications: Trails and the Free Rider Problem." FREE. http://www.free-eco.org/articleDisplay.php?id=345 .
Hansmann, Henry. "Economic Theories of Nonprofit Organizations." In The Nonprofit Sector: A Research Handbook edited by Walter W. Powell . New Haven, Conn.: Yale University Press, 1987.
March of Dimes. "About Us." March of Dimes. http://www.marchofdimes.com/aboutus/aboutus.asp.
Nicholson, Walter. Microeconomic Theory, Basic Principles and Extensions. Fort Worth, Texas: The Dryden Press, 1992.
Parkin, Michael. Microeconomics . Boston: Addison Wesley, 2003.
Varian, Hal. Microeconomics Analysis. New York: W. W. Norton & Company, 1992.
Wikipedia, the Free Encyclopedia. "Market Failure." Wikipedia. http://en.wikipedia.org/wiki/Market_failure .
This paper was developed by a student taking a Philanthropic Studies course taught at The Center on Philanthropy at Indiana University. It is offered by Learning To Give and The Center on Philanthropy at Indiana University.