The second source of market failure is in markets for public (or social) goods, which are also called collective goods. A public good is a good that benefits everyone in the society.
The Characteristics of Public Goods
To be called a public good, a good must exhibit two traits: there must be no way to exclude anyone from consuming it (nonexcludability), and one persons consumption of the good must not diminish another persons ability to consume the good (nonrivalry). Classic examples of public goods are lighthouses and the national defense. There are some problems that are associated with the providing of these particular goods, though.
Suppose the government decided that anyone who wanted to benefit from national defense would therefore have to pay for it. What would be the incentive to pay? The problem is that people would recognize that there is no way the government could prevent them from benefiting from the national defense if they did not pay for it. As a result, many people would consume the service (take advantage of national defense) without paying for it. This situation is called the free-rider problem.
If many people want to consume a good, but very few are willing to pay for it, then there will not be enough of the good produced. The same could hold true for the lighthouse. A lighthouse provides a beacon of light that is projected from dangerous waters and is seen by ships. Again, the problem is that no ship would want to pay to fund the lighthouse, since they will benefit when others pay to fund the lighthouse. Furthermore, since so many boats depend on the lighthouse, each individual ship captain feels that his or her contribution to the lighthouse fund will not make a difference in the production of the service.
This problem is called the drop-in-the-bucket problem. Since the producer of the good does not get enough money to pay for all of the goods used due to these two problems, the good will therefore get underproduced.