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.