# 5. Why Is the Provision of Public Goods Important?

Only the public sector can supply public goods efficiently (and in adequate quantities). Social returns for public goods are higher than private social returns due to positive externalities not captured through prices. This provides the rationale for public intervention to provide certain goods and services, since markets under-provide them. When supplied in a cost-effective way, public goods can generate higher returns than investments in private inputs because they create positive externalities in the economy as a whole. The public sector has the capacity to collect individual contributions, can capture economies of scale, and will access funding and manage risk better than farmers. Therefore it is better suited to supply public goods and services.

There are trade-offs between the provision of public goods and subsidization of private inputs. Governments that heavily subsidize private goods do so at the expense of deepening investment in public goods that have much higher returns. Investments in rural roads, irrigation, extension services or research are the main drivers of agriculture productivity.<sup>17</sup> Agricultural public goods also have a multiplier effect and generate positive externalities for society as a whole. Governments can significantly improve the quality of public expenditure in agriculture by shifting the composition of spending towards the provision of public goods and services, and away from private goods subsidization.

In certain instances, providing subsidies to private inputs may be desirable as a way of correcting for market failures, such as imperfect information, high transaction costs, or missing credit markets. The challenge for governments then is to identify the root of the market failure and seek to increase productivity by designing their subsidy program in a manner that corrects for the market failure (e.g. encouraging incremental use of inputs by groups that would under-utilize inputs in the absence of the subsidy). However, caution should be taken to avoid distorting the relative prices of agricultural inputs and encouraging their inefficient use.

Fertilizer subsidies are justifiable from an economic standpoint if they establish the foundations for a sustainable private sector-led input market. They can improve efficiency in the agriculture sector if they are able to:

- Develop a previously constrained or non-existent fertilizer market.  That is, by offsetting high initial distribution costs until the market expands, economies of scale are realized and prices decline.

- Encourage technology adoption and diffusion by reducing the initial risk and costs of learning new technologies.

- Overcome constraints in credit markets, where farmers tend to use below optimal levels of fertilizers because of imperfect rural credit or insurance markets.

- Compensate for taxes or output price controls that make fertilizer financially unprofitable, when the removal of such taxes or price controls is not feasible.

- Generate positive environmental externalities by reducing deforestation and soil erosion.

The government should assess whether there are market failures that warrant the subsidization of inputs and whether this is the most cost-effective way to address them. In Indonesia’s case, after three decades of fertilizer subsidies, it is debatable whether this subsidy is still necessary to develop a fertilizer

> 17 Spending on public goods is likely to have higher returns than private goods, as discussed in the policy note Agriculture Public Spending and Growth, Indonesia Public Expenditure Review, World Bank.

**19**