The Functions of Government

1) Providing a legal framework – markets work best when property rights are clearly assigned and protected and when contracts are enforced. Additionally, laws against criminal activity and negligent behavior characterize modern societies.

2) Promoting competition and regulating business – antitrust legislation was passed to prevent the formation of monopolies and the use of anticompetitive practices such as price-fixing. In certain cases, business firms are permitted to operate in a monopoly environment, but are subject to government regulations limiting the price they can charge. The purpose of such legal intervention into business practices is to avoid the inefficient outcome associated with imperfectly competitive markets. An important exemption is granted to firms eligible for patents, but these represent a temporary license to operate a monopoly and the resulting inefficiency is thought to be a small price to pay for new inventions.

3) Providing public goods – it is difficult to imagine firms profitably providing a product that is non-excludable since consumers could enjoy the benefits without paying. Because of the free rider problem, it is necessary for government to require each person to pay his or her fair share for public goods like national defense; otherwise, we would have no guarantee that they would be provided in sufficient quantity. For details, check out Public Goods.

4) Correcting externalities – government provides for education, public health, police and fire protection, roads and highways, and a host of other services because these services create external benefits. Government is also involved in environmental protection to correct the problem of external costs.

A positive externalities occurs when benefits spill over to third parties and negative externalities occur when costs spill over to third parties. For details, check out Positive Externalities and Education and Negative Externalities and the Environment.

5) Assisting families in poverty (redistributing income) – even if a market allocation is efficient, society’s notions of fairness or equity may require some assistance to those in need. Such programs include some cash assistance (TANF or Temporary Assistance for Needy Families), food stamps, Medicaid, and housing assistance. The progressive income tax system is also designed to help low-income families with the Earned Income Tax Credit (EITC). Government supports education partly to promote efficiency and partly to promote equity by creating opportunities for people to succeed in a market economy. For more information, see Income Distribution and Welfare.

6) Promoting economic growth and macroeconomic stabilization – macroeconomic policies are designed to pursue the goals of full employment, low inflation, and a healthy rate of economic growth. There is substantial debate among macroeconomists regarding the best way to achieve all three of these important goals.

7) "Social Insurance" - Social insurance programs have become the most important, the most expensive, and often the most controversial aspect of government domestic policy, not only in the United States but also in many other countries, including developing and industrial nations. In the United States, these programs include Social Security retirement, disability and survivor insurance, unemployment insurance, and Medicare health insurance for those age 65 and older.

Three characteristics of social insurance programs are of fundamental importance to the analysis of their actuarial status. First, because participation is essentially mandatory, social insurance programs can be assured of new entrants. Second, because such programs are operated by governments, program termination is usually not an important consideration when determining the program’s actuarial status. Third, social insurance is based on laws and regulations that can be changed (e.g., taxes or premiums may be increased or benefits decreased) without the consent of the participants.

Social insurance may include some or all of the following features:

1. a minimum level of participation is required to establish coverage;

2. a minimum or maximum level of protection is provided based on a concern to provide adequate benefits to most participants, i.e., based on the concept of social adequacy;

3. individual benefits need not bear a direct relationship to individual contributions, although benefits may increase somewhat with increased contributions or with increased participation to introduce some individual equity into the benefit formula; or

4. receipt of benefits is not restricted based on overall financial need.

Note, as well, another important characteristic of social insurance: the laws and regulations governing private insurance and pensions do not apply. Therefore, in most cases, the actuary practicing in the social insurance field must develop tests of financial adequacy for the program being evaluated. (
"Social Insurance," Actuarial Standard of Practice No. 32, Actuarial Standards Board, January 1998)

Social insurance may be provided by the government for a number of reasons (Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 12. Page 324. Page 328.):

1. To reduce the level of poverty among individuals.

  • This is also known as "redistribution" of wealth among the rich and the poor.
  • Social insurance is not a means-tested type of benefit provided by the government, but the very nature of this program tends to reduce the gap between rich and poor individuals.

2. To reduce the administrative costs.

  • The concept of economies of scale applies. For instance, unlike private organizations, the government is able to use fewer staff to manage the social security program, therefore, saving administrative costs.

3. To manage externalities.

  • The traditional motivation for government to intervene in social insurance markets is due to negative externalities. For instance, an under-insured person is more likely to get sick and raise the administrative costs of health care due to lack of health insurance. Government mandates automobile liability insurance to protect against external costs, so a similar rationale could be applied to other types of insurance.

4. Paternalism.

  • Paternalism can be viewed from a negative connotation, whereby the government may simply feel that individuals will not appropriately insure themselves against risks if government does not force them to do so. For instance, the government may feel the need to help individuals save their money for retirement because individuals may have poor savings habits.
  • On the other hand, paternalism can be viewed from a positive perspective, whereby the government feels compassionate toward individuals. For instance, the government may feel the need to help victims of fraudulent lending practices in the mortgage industry.

5. Adverse Selection.

  • Adverse selection is the fact that insured individuals know more about their risk level than insurers, and those most likely to have an adverse outcome are more likely to purchase insurance.
  • This is the most important reason for government intervention in the social insurance market. Because adverse selection can potentially cause the insurance to market to collapse.

Read more about two examples of social insurance,Social Security and Health Care.