Lecture Notes: Social Insurance, Externalities, and Public Goods

Introduction

• Focus: Market failures, social insurance, externalities, and public goods.
• Tone: The lecture will be dense with economics content, but engaging.

Market Failures and Government Intervention

• Markets vs. Government:
  • Markets are innocent until proven guilty.
  • Government actions are suspect until justified.

Justifications for Government Intervention

1. Redistribution:
   • Interest in redistributing resources for a fairer outcome.
   • Public equilibrium may not be optimal based on distribution views.
2. Market Failure:
   • Types of market failures:
     • Market Power: Monopolists affecting prices.
     • Externalities: Unaccounted costs or benefits impacting others.
     • Public Goods: Inefficiency in private market production.
     • Missing Markets: Asymmetric information leading to underprovision (especially in insurance).
3. Paternalism:
   • Government intervenes in cases where individuals may not act in their best interests.

Externalities

• Definition: Effects of actions by one party that impact others without compensation.
• Types:
  • Negative Externalities: Lead to overproduction (e.g., pollution).
  • Positive Externalities: Lead to underproduction (e.g., education).

Addressing Externalities

• Internalizing Externalities:
  • Private negotiations (Coase Theorem) can resolve externalities if conditions allow.
  • When conditions fail, government intervention may be necessary.

Coase Theorem

• Summary: If property rights are assigned and transaction costs are low, parties can negotiate to an efficient outcome.
• Example: Paper mill and fishermen scenario illustrating the effects of pollution.

Market Model of Externalities

• Negative Production-Based Externality Model:
  • Private MC vs. Social MC reflects additional costs due to externalities.
  • Taxing the producer can equalize private MC and social MC, achieving efficiency.

Policy Instruments for Externalities

1. Taxation: Forces firms to internalize externalities by reflecting true social costs.
2. Quantity Regulation: Sets a limit on pollution but may ignore varying costs across firms.
3. Cap and Trade: Permits allow trading to achieve efficient outcomes based on marginal costs of abatement.

Public Goods

• Characteristics: Non-excludable and non-rival.
• Examples: National defense, public parks.
• Free Rider Problem: Individuals benefit without contributing, leading to underprovision in private markets.

Government Role in Public Goods

• Government typically provides public goods when private markets fail.
• Challenges: Accurate measurement of benefits and costs is crucial for effective provision.

Social Insurance

• Definition: Insurance against adverse events (e.g., unemployment, disability).
• Key Programs:
  • Unemployment Insurance (UI)
  • Disability Insurance
  • Social Security
  • Medicare

Expected Utility Model

• Concept: Individuals evaluate utility over uncertain outcomes, weighing the probability of good vs. bad states.
• Insurance Value: Individuals value insurance due to diminishing marginal utility of consumption.
• Actuarial Fair Premium: Premium reflecting risk (probability of an event) and payout.

Risk Aversion

• Risk aversion leads individuals to prefer certainty over uncertain outcomes, influencing insurance demand.
• Individuals may buy insurance even at a premium above actuarially fair pricing due to their risk aversion.

Adverse Selection

• Definition: High-risk individuals are more likely to purchase insurance, skewing the risk pool.
• Equilibria:
  • Pooling Equilibrium: Low and high-risk individuals buy insurance together due to risk aversion.
  • Separating Equilibrium: Only high-risk individuals purchase insurance, leading to market inefficiency.

Conclusion

• Next Steps: Review covered topics for further discussion and practice problems in the next class.
• Discussion: Explore current tax policies and implications for social insurance and public goods.