1) Free Rider Problem:
Since the provision of a public good is nonexclusive, everyone benefits once the public good is provided. Therefore individuals have no incentive to pay as much as the good is really worth to them. A consumer is able to behave as a free rider paying nothing for a good while anticipating that others will contribute.
Free rider problem makes it hard for a private market to provide public goods efficiently. It is generally easier to organize effective efforts to collect voluntary funding when the number of people involved in paying for a project is small because each person recognizes that his or her contribution is important. But, as the number of consumers of a public good gets larger, it is more likely that many consumers will act as free riders. Public intervention may be essential to ensure the provision of a socially beneficial public good. The government therefore often produces public good itself or subsidizes the companies that produce the good.
2) Optimal Output Decision of Public Good:
It’s hard to identify true preferences for the public good because many people will pretend that they don’t need that good not to incur any production costs.
Suppose we can easily identify the preferences.
For private goods, we can derive the market demand curve by horizontally adding up the individual demand curves. For public goods, however, we need to vertically add up the individual demand curves because everyone consumes same amount of public good compared to private goods consumed at the same price. The height of every demand curve implies the marginal benefit from public good.
Point F signify the socially optimal amount of public good (Q**). But OT is not the unit price of this public good in a market. OT means the marginal cost to produce Q** units to the market. At Q** units, we can charge OR and OS for A and B, respectively.
For private good, MBA = MBB = MC ........(i)
For public good ∑ MBi = MC .......(ii)
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