Some things are free, either because they occur naturally, such as beaches and mountains, or because they are provided by the government, such as military protection. From an economic standpoint, there is a problem in analyzing free goods, which are often referred to as public goods, since they are freely available to all. Buyers do not pay for public goods nor do sellers provide them, since they receive nothing for the provision, so there is a market failure by private markets in allocating resources to produce public goods. Therefore, a different economic analysis is necessary to determine how resources are allocated.
In distinguishing between private and public goods, it is useful to introduce 2 concepts: exclusion ability and rivalry in consumption.
Exclusion ability is the property whereby a person can be prevented from using that good. Obviously, private goods have this quality. If you buy food at the supermarket, then it is yours to eat. You can exclude everyone else from eating it. Rivalry in consumption is a quality where the use of the good diminishes the supply for others. If you chop down a tree on public land to supply your fireplace, then that is one less tree for everyone else. Fishing in the ocean reduces the number of fish for others.
A private good is both excludable and rivalry in consumption, a public good is neither. Some natural resources are another type of good which are rivalry in consumption, in that their consumption reduces the supply for others, but they are not excludable, such as the fish in the ocean.
Sometimes, a good can be excludable but is not rivalry in consumption, such as the products of a natural monopoly. For instance, software companies are natural monopolies in that they can supply the entire market for minimal marginal cost, yet they have the right to exclude its use.
These different qualities of goods are broad general descriptions, not bright line distinctions. For instance, many natural resources are excludable because their extraction requires the permission of the landowner. Some public goods are excludable, but often are not, such as public parking spaces and highways.
When a good is not excludable, then suppliers cannot charge for the benefit of the good because people can benefit regardless of whether they pay for it or not. For instance, fireworks are a common example of a good that is not excludable (and also not rivalry in consumption), so private suppliers will not provide it. With these types of public goods, people can save money by being free riders, who are people who can enjoy the benefit of a good without paying for it. This is the reason why most fireworks are paid for by local governments, since fireworks can be financed out of general tax revenue, which is collected from everyone. Likewise, national defense and public safety are provided by governments, since they are required for any modern economy but they cannot be economically provided by private parties.
Tragedy of the Commons
Most common resources are public goods because they are not excludable. However, they are rivalry in consumption, because their use diminishes the value or lessens the quantity available to others. This is best illustrated by the parable of the Tragedy of the Commons. In medieval times, people raised sheep and allowed them to graze on common land that was freely available to everyone. When the population was small, the land could replenish itself on its own. However, as the population grew, they needed more sheep, so eventually, the land was being grazed so much, that it could not replenish itself. Eventually, there was not enough common land to support the number of sheep.
The reason why this occurs is obvious – people will not protect what is not their own. Because anyone can use the land for grazing, no one has any incentive to regrow the grass, to protect it, or to limit the number of sheep grazing on it. Eventually, the government started to allow people to enclose a specific amount of land which they could claim as their own. So it became their duty to maintain their own land and they could exclude the use of their land by anyone else, a process that began in England during the 17th century.
The tragedy of the commons not only applies to land but also applies to many wild animals, such as elephants, which are often killed for their valuable ivory. However, the most important tragedy of the commons today is the harvesting of fish using huge nets pulled behind factory ships, where the fish are processed immediately after they're caught. Because the ships can catch a huge amount of fish, the fishing stock is being rapidly depleted to the point where they will be unable to repopulate under continued fishing pressure. Governments have responded to this tragedy by restricting the size of the fish that can be caught, by regulating the size of the holes in the fishing nets, establishing quotas that can limit the number of fish that can be caught, limiting the days that a vessel can fish, restricting fishing to specific seasons, and protecting the breeding grounds of threatened fish. Some governments, such as New Zealand, allow quota shares to be bought or sold, and quotas for halibut can be traded in the United States and Canada. In 1992, Canada banned cod fishing off the coasts of Newfoundland and Labrador to replenish the stock. However, no government controls the open oceans, making it difficult to establish a global policy.
In summary, the government uses several methods to provide public goods or to prevent the tragedy of the commons, such as granting property rights, so that people have an incentive to protect the value of the property; it can organize a system that uses market forces, such as the creation and trading of pollution permits or fishing quotas. The government can also actually pay for the public good, such as the military, which consumes the largest part of the United States budget.
The demand and supply of private goods is largely determined by the market, where demand is determined by the amount that people are willing to pay and the supply is determined by the price that sellers receive for their product. The private market provides pricing information, allowing the market to reach equilibrium when the marginal benefit to buyers equals the marginal cost of suppliers. Since there is no market for a public good, the government must do a cost-benefit analysis to determine if the good should be provided. The method for doing the cost-benefit analysis will depend on the project, but it probably will not be as accurate as market information, and, often, the supply of public goods is determined by those with political influence. Nonetheless, to determine what is socially optimal, the government should measure the public demand for a good, including the quantity desired, and how much it will cost to supply that quantity. As with private markets, the socially optimal quantity of a public good is when the marginal benefit equals the marginal cost.
A cost-benefit analysis can also be applied to the tragedy of the commons. Because the marginal cost of a common resource is zero, people will continue to consume the resource until their marginal benefit is zero. Hence, the resource is consumed, but not replaced. Therein lies the tragedy.