WHY DOES GOVERNMENT MAKE PUBLIC POLICY? To provide public goods/services •pure private goods •pure public goods and the free-rider problem •merit goods To counter the problem of externalities To deal with the problems of adverse selection and moral hazard Externalities • A positive externality exists when all of the social benefits associated with the production and consumption of a good or service are not captured by the private market. When a positive externality exists the private market produces a less-than socially optimal level of output. There is too little production. Government usually attempts to increase the level of output by subsidizing the production of the good or service or by providing the good or service itself. An example of a good/service with positive externalities is childhood immunizations (public health benefits). • A negative externality exists when all of the social costs associated with the production and consumption of a good or service are not captured by the private market. When a negative externality exists the private market produces a more-than socially optimal level of output. There is too much production. Government usually attempts to decrease the level of output by placing regulations or taxes on the production or consumption of the good or service. An example of a good/service with negative externalities is motor vehicles (pollution). Adverse Selection and Moral Hazard • Adverse selection is the tendency for people to enter into agreements in which they can use private information (information that is known only to themselves because it is too costly for anyone else to obtain) to their own advantage and to the disadvantage of the less informed party. •Moral hazard exists when one of the parties to an agreement has an incentive after the agreement is made to act in a manner that brings additional benefit to himself or herself at the expense of the other party (it is too costly for the injured party to monitor the actions of the advantaged party). EXAMPLE: Health Care Insurance Adverse selection exists in health insurance because there is a tendency for people who know they have a greater chance than average of falling ill to be the ones most likely to buy health insurance. Moral hazard is the tendency for people who are covered by insurance to use more health care services or to be less careful about avoiding health risks than they otherwise would.