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The Four Questions of Public Finance: When Should The Government Intervene in The Economy?

This document discusses the four key questions of public finance: when should the government intervene in the economy, how might it intervene, what is the effect of interventions, and why governments choose to intervene as they do. It uses the health insurance market as an example of government intervention. There are two main reasons for intervention: market failures, which cause inefficient market outcomes, and redistribution. Market failures occur when problems prevent markets from maximizing efficiency, such as when supply and demand are not equal. Governments intervene to address market failures and redistribute resources in a way that the free market does not.

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289 views1 page

The Four Questions of Public Finance: When Should The Government Intervene in The Economy?

This document discusses the four key questions of public finance: when should the government intervene in the economy, how might it intervene, what is the effect of interventions, and why governments choose to intervene as they do. It uses the health insurance market as an example of government intervention. There are two main reasons for intervention: market failures, which cause inefficient market outcomes, and redistribution. Market failures occur when problems prevent markets from maximizing efficiency, such as when supply and demand are not equal. Governments intervene to address market failures and redistribute resources in a way that the free market does not.

Uploaded by

penelopegerhard
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We take content rights seriously. If you suspect this is your content, claim it here.
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CHAPTER 1 WHY STUDY PUBLIC FINANCE?

1.1
The Four Questions of Public Finance
n the simplest terms, public finance is the study of the role of the govern-
I ment in the economy. This is a very broad definition. This study involves
answering the four questions of public finance:
public finance The study of
the role of the government in
the economy.

four questions of public


 When should the government intervene in the economy?
finance When should the
 How might the government intervene? government intervene in the
economy? How might the
 What is the effect of those interventions on economic outcomes? government intervene? What is
 Why do governments choose to intervene in the way that they do? the effect of those interventions
on economic outcomes? Why do
In this section, we explore these four questions within the context of a spe- governments choose to inter-
cific example: the market for health insurance, in which individuals pay a monthly vene in the way that they do?

premium to insurance companies, in return for which insurance companies


pay the individuals medical bills if they are ill.This is only one of many markets
in which the government is involved, but it is a particularly useful example,
since health care spending is the single largest and fastest growing part of the
U.S. governments budget.

When Should the Government Intervene in the Economy?


To understand the reason for government intervention, think of the economy
as a series of trades between producers (firms) and consumers. A trade is efficient
if it makes at least one party better off without making the other party worse
off. The total efficiency of the economy is maximized when as many efficient
trades as possible are made.
The fundamental lesson of basic microeconomics is that in most cases the
competitive market equilibrium is the most efficient outcome for societythat is, it is the
outcome that maximizes the gains from efficient trades. As discussed in much
more detail in Chapter 2, the free adjustment of prices guarantees that, in
competitive market equilibrium, supply equals demand. When supply equals
demand, all trades that are valued by both producers and consumers are being
made. Any good that consumers value above its cost of production will be
produced and consumed; goods that consumers value at less than their cost of
production will not be produced or consumed.
If the competitive market equilibrium is the most efficient outcome for soci-
ety, why do governments intervene in the operation of some of these markets?
There are two reasons why governments may want to intervene in market
economies: market failures and redistribution.
Market Failures The first motivation for government involvement in the
economy is the existence of market failures, problems that cause a market market failure Problem that
economy to deliver an outcome that does not maximize efficiency. Through- causes the market economy to
deliver an outcome that does
out this book, and in particular in Chapters 517, we discuss a host of market not maximize efficiency.
failures that impede the operation of the market forces you learned about in

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