3. 1. Incentives: How People Make
People respond to incentives
Something that induces a person to act
Buyers - consume less
Sellers - produce more
Change costs or benefits
Change people’s behavior
4. Incentives for Firms
First Law of Supply:
the higher the market price the greater the
quantity supplied by each firm
6. Rational choice: How People Make
Rational people think at the margin
Systematically & purposefully do the best they can
to achieve their objectives
Small incremental adjustments to a plan of action
Rational decision maker – take action only if
Marginal benefits > Marginal costs
7. What government’s can do in disaster?
The challenge for government in disaster response and relief
is determining when it should take a “hands-on” role and
become actively involved, and when the goal of recovery is
best-served by stepping back in favor of other institutions
better suited to the task.
The rule of rational choice directs decision-makers to choose
the alternative with the greatest excess of benefits over costs.
This rule applies not only to private decision-makers but also
to government decision-makers:
Governments should undertake those activities for which the
expected benefits outweigh the expected costs.
instances benefits of government action
outweigh the costs include:
maintaining and enforcing the rule of law, and
providing public goods.
9. 3. Public goods and private goods
We consume many goods without paying:
parks, national defense, clean air & water.
When goods have no prices, the market forces that
normally allocate resources are absent.
The private market may fail to provide the socially
efficient quantity of such goods.
10. Important Characteristics of Goods
A good is excludable if a person can be prevented
from using it.
Excludable: a plate of pizza , wireless internet
Not excludable: FM radio signals, national defense
A good is rival in consumption if one person’s
use of it diminishes others’ use.
Rival: a plate of pizza
SSEE result sheet online
11. The Different Kinds of Goods
Private goods: excludable, rival in consumption
Example: food, pizza
Public goods: not excludable, not rival
Example: national defense
Common resources: rival but not excludable
Example: fish in the ocean
Natural monopolies: excludable but not rival
Example: cable TV
13. The Different Kinds of Goods
Public goods and common resources.
For both, externalities arise because something
of value has no price attached to it.
So, private decisions about consumption and
production can lead to an inefficient outcome.
Public policy can potentially raise economic
14. Public Goods
Public goods are difficult for
private markets to provide
because of the free-rider
Free rider: a person who
receives the benefit of a
good but avoids paying for it
If good is not excludable,
people have incentive to
be free riders, because
firms cannot prevent non-
payers from consuming
15. Public Goods
If the benefit of a public good exceeds the cost of
providing it, govt should provide the good and pay
for it with a tax on people who benefit.
Problem: Measuring the benefit is usually difficult.
Cost-benefit analysis: a study that compares
the costs and benefits of providing a public good
Cost-benefit analyses are imprecise, so the
efficient provision of public goods is more difficult
than that of private goods.
16. Some Important Public Goods
Knowledge created through basic research
17. Common Resources
Like public goods, common resources are not
Cannot prevent free riders from using
Little incentive for firms to provide
Role for govt: seeing that they are provided
Additional problem with common resources:
rival in consumption
Each person’s use reduces others’ ability
Role for govt: ensuring they are not overused
18. Public Goods vs Private Goods
(Pure) Public goods
Consumption properties of
Impure Public Goods:
Non-rival, but excludable
Impure Public Goods:
Non-excludable, but rival
Common fishing ground
19. What government can do
Economists distinguish between “public goods” and
“publicly-provided goods.” Both are paid for by government
spending of tax and other revenues.
Public goods are those that would not be provided by
private firms because they are non-rivalrous (consumption
by one person does not diminish consumption by others)
and non-exclusive (non-payers, or “free riders” cannot be
excluded), making them not profitable. National defense is
Many other publicly-provided goods might well be profitable
for private firms in the absence of government provision,
but we have, collectively, made a decision to pay for their
production with public funds. Public schooling is an
20. What government’s can do?
using military and police presence
to keep the peace, deter violence,
and protect property
When the rule of law is uncertain
and inconsistent, people and
businesses delay decisions about
whether to leave or return to the
disaster area, whether to try to re-
establish their businesses or give
them up, whether to move back or
maintaining the rules of the
game stabilizes social
institutions like schools and
Restoration of civil order
government can help to re-
establish the rule of law and
civil order by temporarily
altering the old rules of the
game to fit the needs of the
22. What government can do?
Role government institutions are well-suited is
providing the public goods that form the
infrastructure of a community.
In disasters, public goods may include such
activities as search-and-rescue operations and
The non-rivalrous, non-exclusive characteristics
of true public goods makes them subject to the
“free-rider” problem and thus not profitable for
23. Public choice theory
The branch of economics consisting of theory applied to
collective decisions and their processes and outcomes.
Public choice theory, also known as political economics,
is the study of the economics of political behavior — how
economic incentives and consequences affect voters,
legislators, and bureaucrats.
The democratic process is one in which, supposedly, the
preferences of the public are expressed through elected
24. simple assumptions of the theory
Voters are seen as customers and politicians as
Politicians produce decisions and outcomes which are ‘sold'
to the voters.
The ‘money' for which these political decisions are sold is
Voters, politicians are assumed to be rational utility
maximisers, aiming for their own personal gain.
In the simplest public choice models it is assumed that
politicians' utility is achieved through winning votes.
They are thus vote maximisers.
25. Public choice in voting
In a large election, the probability of one vote
changing the outcome is tiny.
In some elections, there are many candidates
Most voters do not spend much time and effort to
become well informed.
Ignorance breeds apathy.
26. The median voter
For a policy such as how much to spend on
parks, there is a spectrum of opinion.
27. The median rules
The median voter is the one at which half want
more spending and half want less.
In a two-party system, the candidates move
towards the median voter position.
Those at the tails (fringes) are ignored.
This can result in the tyranny of the majority.
29. PUBLIC CHOICE THEORY
In reality, government
preferences; rather the
governing is done by
bureaucrats, and so on.
These players have their
own objective functions
30. government leaders to favor special interests over general
Special interests have a big
stake in government
So they take a big interest in
When they give
Each member of the public
may lose only a little bit,
when a special interest gets
what it wants –
31. Public choice and disaster
political process lacks an effective
feedback loop from victims to the
decision-makers responsible for
allocating resources in a disaster.
No direct communication from
consumer (disaster victims) to
Instead, decision-makers have only
the (insufficient and mostly
incomplete) information that comes to
them through the political process.
32. Public choice and disaster
government disaster-relief activities are prone to
serve the wants and needs of politicians rather
than those of disaster victims.
The key insight of public choice theory is that
elected decision-makers’ pursuit of self-
interest is dependent upon their ability to gain
and remain in office.
when government relief efforts extend beyond
the immediate emergency, they tend to be
33. Government relief
Unelected government employees not motivated by profit have
little incentive to respond effectively to needs of disaster victims.
Loyal, hardworking, caring employees likely be commended to
follow procedures and criticized for taking risks – incentives
arguably ill-suited to disaster conditions.
Cost of government relief:
Friedman : incentive to get value for money is very high when
you spend your own money on yourself,
but that it falls when you spend your own money on someone
especially when you are spending other people’s money on
34. Moral Hazard
Moral hazard occurs
when a person (or
organization) that is
insulated from risk may
behave differently from
what he/she would if
he/she were fully
exposed to the risk.
Moral hazard occurs when the behavior of the insured
person changes in a way that rises costs for the insurer
because the insured person no longer bears the full
For example, because a person no longer bears the cost
of medical services, he/she has an incentive to demand
costlier and more elaborate medical service, which would
otherwise not be necessary.
Coinsurance, co-payments and deductibles
reduce the risk of moral hazard by increasing the
out-of-pocket costs of consumers, which
decreases their incentive to consume expensive
and unnecessary health care and medicine.
37. Moral hazard in disaster
Government programs to shelter people from disaster or to
help victims afterwards tend to be characterized by
escalating costs because they create moral hazards and
perverse “Good Samaritan” effects.
A moral hazard exists when people are shielded from
the full costs of risk, thereby creating an incentive for
them to engage in more risk-taking behavior. While
moral hazards occur in both the private and the public
sector, they are more likely to persist in public sector
Insurance is the classic example of an industry in the
private sector that is affected by moral hazards. At the
margin, insurance creates incentives for people to be less
careful because their losses are covered by insurance.