Public Goods, Market Failure, and Voluntary Exchange

Abstract

The core of public economics traditionally addresses two situations of market failure: externalities and public goods. While externalities fit neatly into neoclassical economics, public goods proved substantially more difficult to pin down. An interesting thread in the story of public goods relates to the application of voluntary exchange theory—the idea that the revenue-expenditure process should be determined by the same fundamental laws and procedures that govern market prices in the private aspects of the economy. Driven by the changing political landscape of Europe and greater demand for responsive government, voluntary exchange theory emerged in the 1880s as a competitor to models that represented government as a monolithic decision maker. That voluntary exchange has faded out of the public finance literature belies the role it served launching the public goods debate of the 1950s. In this article, voluntary exchange is used as a vehicle to examine positions taken on the market failure engendered by public goods. What we see is that the discussion was less about the mechanics of voluntary exchange theory or solutions to public goods problems than it was about beliefs regarding the economic role of government and how to delineate the appropriate boundaries of public economics inquiry. This in turn was stimulated by the larger background context of the period, particularly the nexus of free markets and democracy.