Public Finance, Public Goods and the Public Sector

Why does a government exist in an economy at all? Most of what people consume is bought in markets: a person pays, receives the shoes or the meal, and nobody else gets them.

But a person cannot buy a share of national defence or of the light from a street lamp: if the defence force protects one citizen, it protects the others living next to him; if the lamp is lit, anyone passing benefits whether or not he paid. Goods like these are hard or impossible to sell, so a market will not supply them in the right quantity, or at all.

They are the reason for a public sector and the starting point of public finance, the study of how governments raise money, spend it and influence the economy by doing so.

This topic defines public finance and its subject matter (Bhatia’s five categories); describes the public sector in a mixed economy such as Nigeria, with its public services and public undertakings; distinguishes public from private provision, with pure public goods, quasi-public goods and merit goods, and the characteristics of public and private goods; explains the problem of public choice; and sets out the efficient provision of public goods, with Samuelson’s condition and the contrast between the demand for public and private goods, with worked figures.

The next topic is The rationale, functions and methods of government intervention in the economy.

This content was tested in May Diet, 2026, Question 4(a) (10 marks), which asked for two subdivisions of public goods and three characteristics each of public and private goods, and in May Diet, 2024, Question 7(a) (7½ marks), which asked for five categories of public finance. Read public sector audit: process, internal audit, assurance and INTOSAI first.

What public finance is

The term joins two ideas: public, the masses with their needs and desires, and finance, the mobilising and allocating of resources to achieve objectives. Public finance is the resource generation (revenue) and allocation (expenditure) functions of public authorities and their consequences for the economy. Writers define it in different ways:

• Musgrave: the complex financial problems that operate through the revenue and expenditure process of government. Because the public sector interacts with the private sector, the effects of spending and tax policy depend on how the private sector reacts, and the need for fiscal measures depends on how the private sector would perform without them.
• Buchanan: the study of the economic activity of government as a unit.
• Hyman: the field of economics that studies government activities and the alternative means of financing government expenditure.
• Dalton: the income and expenditure of public authorities and the adjustment of one to the other.
• Bhatia: the financial problems and policies of government at different levels, and inter-governmental financial relations.

The five categories of public finance (Bhatia)

1. The theory of revenue: the sources of revenue open to government (taxation, non-tax revenue and others), the advantages and disadvantages of each and the principles that govern them. Taxation is the most important and deserves special treatment.
2. The theory of expenditure: an important tool for policy makers to allocate resources, redistribute income and wealth, stabilise prices and employment and achieve the optimum growth rate. Through public expenditure government contributes to the financial flows of the economy, regulates the patterns of demand and supply and carries out welfare programmes.
3. Financial administration: the budget, its formulation and execution, and government accounting, auditing and the other financial operations of public authorities.
4. Economic growth and stabilisation: the main focus of government policy; public finance is concerned that scarce resources are used prudently to achieve growth and stability.
5. Federal finance: fiscal federalism requires the assignment of expenditure and revenue responsibilities among the tiers of government, with the challenges and possible solutions of inter-governmental financial flows.

The public sector in a mixed economy

It is not possible for everybody to take part in decision making, so some are appointed, elected or selected to decide for the masses. These representatives are commonly called government, which in some cases operates through a body called the public sector.

How far government is involved in economic activity varies with the economic and political philosophy of each country: in some the public sector dominates, in others it is hardly noticeable. In a mixed economy such as Nigeria, the public and private sectors work together for growth and development.

The public sector is the segment of the economy whose activities, economic and non-economic, are under the control and direction of the state.

In Nigeria it covers public services (defence, law and order, and infrastructure such as roads, railways, water, electricity grids, bridges, telecommunications, education and health) and public undertakings (for example the ports authority, the railway corporation, the national petroleum company, the standards organisation, the food and drug regulatory agency, research institutions, health and educational institutions, the Central Bank, the Bank of Industry and the Securities and Exchange Commission).

It is characterised by collective ownership of resources used mainly for the welfare of citizens and the maintenance of government machinery, and by the near absence of an ownership title, which makes transfer of ownership and control difficult. Its output is commonly called public goods.

The private sector is the other segment, controlled by non-governmental economic units such as individuals and households. Resources are privately owned and used to maximise profit, and the ownership title makes it possible to exchange goods and services.

Public versus private provision

Goods and services are of two broad kinds: public goods and private goods. Public goods are subdivided into:

Subdivisions of public goods

• Pure public goods: perfectly non-rival in consumption and non-excludable. Examples: defence and street lighting.
• Quasi-public goods: goods with some characteristics of both private and public goods: partially non-rivalrous and partially non-excludable. Examples: roads, tunnels and bridges. Markets for them are inefficient, though a private firm could supply some roads, bridges and tunnels if a charging system solved the free-rider problem.
• Merit goods: a concept introduced by Musgrave: goods judged to be of great value to an individual or to society, which people should have on the basis of need rather than ability and willingness to pay. They are goods and services that government believes people will under-consume, and which should be subsidised or provided free at the point of use. Examples: education and health care.

Characteristics of public goods

1. Non-rival consumption: consumption by one person does not reduce the benefit available to others. Street lighting, defence and policing benefit everyone, whether or not they pay tax.
2. Non-excludability: once provided for one, the same quantity and quality is available to all, and dividing the output into units for individuals is not desirable even if it were possible. Consumption does not depend on payment, so there is room for free riders, which makes provision through the market impossible.
3. Zero marginal cost: additional demand does not force government to supply more, at least in the short run: more vehicles on a road or bridge need no immediate expansion and cost society nothing extra.
4. The sum of marginal benefits equals marginal cost: since all consume from the same supply, efficiency requires that the sum of the marginal benefits of all consumers equal the marginal cost.

Characteristics of private goods

These are the opposite:

1. Rivalrous consumption: what one person consumes is unavailable to another (a pair of shoes worn by one person cannot be worn at the same time by another).
2. Excludability: consumers must pay before enjoying the benefit. If supply to a particular consumer cannot be limited, no price can be charged and the market fails.
3. Positive marginal cost: more consumers need more output, which costs more, and producers expand to make extra income.
4. Marginal benefit equals marginal cost for each consumer: each consumer pays the same unit price but buys a different quantity, so efficiency requires each consumer’s marginal benefit to equal marginal cost.

Public goods and public choice

Where a good is non-rival and non-excludable, a consumer has little choice whether to consume it. The quality available under the existing terms, and an individual’s preferences, will not materially change it. A person may even be forced to consume a public good that has a negative value for him.

Streets, for example, may become congested thoroughfares that reduce the convenience of residents and shoppers, who must cope whether they like it or not. This is why public goods are provided through collective choice, by voting and budgeting, and not by individual purchase.

Efficient provision of public goods

For a private good, each consumer decides how much to buy at a given market price. Individual demand curves show willingness to pay for each quantity, and the market demand is found by adding them horizontally: for each price, the total quantity demanded.

For a public good there is only one level of output and consumers are willing to pay different prices for each level, so the market demand is found by adding the individual demand curves vertically: for each possible output, the total amount that consumers together are willing to pay.

An efficient allocation requires producing the public good as long as society’s total willingness to pay is greater than the marginal cost, which is Samuelson’s condition: an allocation is efficient if the sum of the marginal benefits equals the marginal cost.

Worked example. Three households value street lighting with marginal benefits (in naira millions) of: A, 40 − 2Q; B, 30 − Q; C, 20 − Q, where Q is the number of lamp posts in thousands. The vertical sum is 90 − 4Q, and the marginal cost is ₦50m per thousand. Setting 90 − 4Q = 50 gives Q = 10: at 10 thousand posts the marginal benefits are A 20, B 20 and C 10, which sum to 50 and equal the marginal cost.

At 8 posts the sum is (40 − 16) + (30 − 8) + (20 − 8) = 24 + 22 + 12 = 58, above the cost, so more should be provided; at 12 the sum is 16 + 18 + 8 = 42, below the cost, so too many are provided. Contrast with a private good: at a price of ₦20m, A buys (40 − 20) ÷ 2 = 10, B buys 30 − 20 = 10 and C buys 20 − 20 = 0, so the market demand, added horizontally, is 20 units; for a public good the same people would together pay a total price of 50 for the 10th unit.

Because no household has a reason to reveal its true willingness to pay when it can free ride, the market would supply less than 10, perhaps none, and that is why government provides the good and finances it by tax.

The ideas in more depth

Why free riders defeat the market

If a firm built a lighthouse and tried to charge each passing ship, it could not stop ships that did not pay from using the light. Knowing this, no ship would volunteer to pay, and the firm would not build it. Yet the lighthouse is worth more than it costs.

Taxation solves the problem by making everyone pay, whether or not they would have chosen to, and public provision delivers a good that the market would not.

Why merit goods are not public goods

Education is rival (a place in a class is occupied by one pupil) and excludable (schools can charge fees). It is not a public good. It is provided or subsidised because government judges that people will under-consume it if left to their own means, and that society benefits when more people are educated. The reason is a value judgement about need, not a feature of the good itself.

Why quasi-public goods can sometimes be run by the private sector

A toll road, a bridge with a toll or a tunnel can be made excludable by charging, and congestion makes the use rival at busy times. Where a charging system works, private firms can provide them under concessions, which is why such goods sit between the pure public good and the private good.

Sources and references

• Musgrave and Musgrave, Public Finance in Theory and Practice; Samuelson on the theory of public expenditure; Bhatia on the subject matter of public finance.

These points are stated as at 5 November 2026.

Worked examples

1. Solve.
   90 − 4Q = 50, so Q = 10.

1. Add horizontally.
   10 + 10 + 0 = 20 units.

1. Compare. 58 exceeds 50, so more should be provided.

How to answer in the exam

• Define the term, give the two tests (rivalry and excludability) and an example.
• Give each subdivision with its example and the reason it fits.
• Contrast public and private goods point by point, ideally in a table.
• For categories of public finance, name the five and explain each in a sentence.

Common mistakes in the exam

• Treating education and health as pure public goods.
• Adding public good demand curves horizontally.
• Forgetting zero marginal cost and the free-rider problem.
• Listing only three of Bhatia’s five categories.
• Saying that private goods are non-excludable.
• Confusing the public sector with government departments alone.

Quick revision

• Public finance: revenue and expenditure of public authorities; five categories.
• Public goods: non-rival, non-excludable; pure, quasi-public, merit.
• Efficiency: sum of marginal benefits equals marginal cost; vertical summation.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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