In an efficient market, firms can produce goods at the lowest possible cost while individuals can access the goods and services they desire, all while utilizing the least resources possible. A market can be said to be economically efficient if it has certain qualities:
- perfectly competitive
- mobile resources
- accurate and freely available information
- individuals directly receive the costs and benefits of their transactions
Market failure is the name for when a market is not efficient; that is, when it deviates from one or more of the above conditions. However, in reality no market is perfectly efficient. In general, minor inefficiencies do not dramatically effect society. But when society is adversely affected by economic inefficiency, such as when a monopoly firm raises prices to a point where people cannot afford a basic good, the government will sometimes intervene.
Consider the problem of externalities, the phenomenon of when a transaction occurs that affects people who were not directly involved. For example, when a coal plant producing electricity causes pollution, there is a transaction between the company and the resident who purchases the product. But if you live near the coal plant and suffer from asthma due to the smog it produces, you are encountering a negative externality. You had no choice in the transaction, but are experiencing its effects.
Externalities are an example of economic inefficiency, since those involved in the economic transaction do not bear the full costs of the transaction. In this case, governments can intervene by taxing the transaction and using the money to negate the harmful effects or to compensate those affected by the negative externality. Similarly, when a transaction produces positive externalities, efficiency is achieved when the government subsidizes the transaction. Education is an example of a transaction that has a positive effect on society.
Another case in which markets do not operate efficiently on their own is the market for public goods. Public goods are nonrival, which means that more than one (and sometimes many!) individual can use the good at one time. They are also nonexcludable, which means that their use cannot be prevented. For example, consider a beautiful fountain in a public park. The company that built the fountain cannot force people to pay money in order to enjoy it, since its in a public area; and since one person looking at the fountain doesn't prevent others from looking at it, it is a nonrival good.
Free markets will generally produce less than the optimal amount when a good is nonexcludable and nonrivalrous, which means that a government can make the market more efficient by producing the public good itself. By using tax revenue, governments can avoid the problem of free riders and produce an efficient quantity of public goods even when the free market cannot.
National Defense as a Public Good
National defense is a classic example of a good that is nonexcludable and nonrivalrous. It will be under-produced unless the government provides it.