A significant market failure is the failure to produce some goods and services, despite being needed or wanted. Markets can only form under certain conditions, and when these conditions are absent markets may struggle to exist. The most extreme case of a missing market is the case of pure public goods.
Pure public goods clearly provide a benefit to the consumer, but, for several reasons, are unlikely to exist in a market economy. Examples of pure public goods include national defence, the police service, and street lighting. Because markets for these goods are not likely to form they are called missing markets and are considered a special case where demand exists, but supply is absent.
Pure public goods
The market mechanism is likely to fail to supply pure public goods because entrepreneurs are unlikely to enter the market, given the impossibility of charging consumers at the point of consumption. Public goods have the following characteristics:
When a public good is supplied, it is impossible to exclude other individuals from deriving a benefit. For example, once street lighting is made available in an area, all passers-by can benefit, and no one can be denied access to it.
When a pure public good, such as street lighting, is consumed by one individual, the stock available for others does not diminish, as it would in the case of a private good. A pedestrian passing under a street light has no effect on the supply of lighting whatsoever. Non-diminishability is also known as the principle of non-rivalry. Because the stock of a public good does not diminish with use, consumers do not need to compete with each other to get access to them. For example, individuals do not need to queue to get access to street lighting.
Unlike a private good, consumers cannot reject a pure public good, and are forced to consume it. An individual cannot reject being defended by the armed forces of a country, nor can they reject the benefit of street lighting.
When combined, these three characteristics deter potential suppliers because it would be impossible to charge users at the point of use.
Why will suppliers not be able to charge?
Suppliers cannot charge at the point of consumption or use because of the free-rider problem. No one would pay because the first person to pay for supply creates a free supply for everyone else! No one can be excluded from the market and prevented from consuming, and hence they are encouraged to become free-riders.
Because of this, suppliers are not able to generate any revenue, or make a profit, so a necessary condition for the formation of a market is absent, namely the absence of a profit incentive. With no incentive, entry into the market is deterred, resulting in a missing market.
If we assume there is a limit to the formation and completion of markets, and a high probability that some markets might not exist at all, policy makers need to consider how demand can be satisfied. One of the roles of government is to allocate scarce resources to satisfy demand for public goods. There are several ways a governments can do this, including the following.
A government can take complete control over the initial planning, funding and operation of public goods like defence, policing and street lighting. Government can impose general taxes to pay for these services, rather than try to charge consumers directly.
With transport services, government can fund the building of the infrastructure, and contract-out the running and maintenance of the service to private firms, as with bridges, tunnels, motorways, and airports. Government is likely to fund the initial investment out of taxation, and it may be possible to charge consumers, if the free-rider problem can be solved. For example, tolls can be used to charge drivers wishing to use a motorway, and airports can charge landing fees to private airlines.