Asymmetric Info Flashcards
Perfect Info
both purchasers and providers know who is high/low-risk
– each group is charged a price equal to the group’s probability of adverse event
– prices are actuarially fair for each group, everyone will buy full insurance
– no market failure
asymmetric info
a situation where purchasers and sellers differ in what they know
– a common phenomenon in insurance
Completely asymmetric info
extreme but can happen
Approach 1: Asking people their risk types
- ask people if they are low-/high-risk
- causes free-riding
- pricing structure is unsustainable
expected profit from the high-risk type
Premium from the high-risk type minus exp. payout to the high-risk type
Pooled price approach
the price that is actuarially fair for the population as a whole
Adverse Selection High-Risk Pooled Price
– less than their actuarially fair price: ρ < pH
→ The pooled price is a good deal. Buy full coverage
Adverse Selection Low-Risk Type Pooled Price
The pooled price is greater than their actuarially fair price: ρ > pL
→ The pooled price is a bad deal. Buy no or partial coverage
Adverse Selection
The phenomenon that the people who most want to buy insur. at the pooled price are those with a high risk of suffering the adverse event
Does Raising Prices Combat Adverse Selection?
Raising the price won’t necessarily solve adverse selection
– Instead, it can sometimes make the problem worse:
– If the price is higher, more low-risk individuals will drop out
⇒ The risk pool will be more strongly tilted toward the high-risk type
⇒ Avg. payouts will be even higher, and the insurer may again lose money
Unraveling EQ:
– adverse selection causes the market to collapse
– low-risk individuals drop out and do not buy insurance
– high-risk individuals buy full coverage at their actuarially fair price, pH
Conditions for Unraveling EQ
W/ two risk types, there are three conditions for the market to unravel:
1. sL small relative to sH
2. pH much larger than pL
3. Low-risk individuals are not very risk-averse
Pooling EQ conditions
- sL big relative to sH
- pH not much larger than pL
- Low-risk individuals are strongly risk-averse
Pooling EQ
– Adverse selection is not severe enough to distort the insurance market
– Everyone buys full insurance coverage at the pooled price
– all low-risk want to buy full coverage at the pooled price (No adverse selection)
Separating EQ
two distinct insurance options: (a) Full coverage at a high price & (b) Partial coverage at a low price
– Induce low-/high-risk to reveal their types via self-selection
– High-risk have strong demand for insurance; prefer (a)
– Low-risk have weak demand for insurance; prefer (b)
What do High-Risk individuals prefer
pooling eq
what do low-risk individuals prefer
prefer perfect info or prefer separating to unraveling
What can the gov do?
Mandate that everyone buy insurance or directly provide the insurance and fund it using tax revenue
– Creating the pooling equilibrium improves wellbeing for high-risk
Whether makes them better/worse off depends on:
- Their degree of risk aversion
- The nature of the eq. that would exist absent the policy
Actuarially Fair Premium
equals the insurer’s expected payout. It is the probability of the adverse event times the amount of the insurance benefit
Distributional Concerns of Private Insurance
– In the free market, high-risk have to pay a lot for private insurance
– If gov. provide the insurance, we can subsidize high-risk people
Externalities of Private Insurance
If someone lacks health ins. may not get treated for an infectious disease
Administrative Costs of Private Insurance
– Gov. sometimes has lower waste: 2% of claims paid for Medicare v. 12.4% for private insurance
– Private insurers spend on advertising; sometimes engage in predatory practices
– But gov.-provided insurance can have bureaucratic issues
Internalities of Private Insurance
people are bad at accounting for risk
⇒ may not buy enough insurance on their own
Samaritan’s Dilemma of Private Insurance
– Society often redistributes to people who suffer adverse events
– Can avoid footing the bill if force people to buy insurance
Insurance
Allows people to smooth consumption
→ Give up a little in the good state to maintain consumption in the bad state
Social Insurance
Deals with asymmetric info. ⇒ can ↑ access to insurance
Potentially deals with the other issues with private insurance:
– distributional concerns, externalities, admin. costs, internalities, Samaritan’s dilemma, etc.
cost of insurance
moral hazard
Forms of Moral Hazard
- Fewer precautions against an adverse event ex. Car insurance ⇒ drive less carefully
- Less effort on getting out of the adverse event ex. Unemploym. insurance ⇒ stay unemployed for longer
- Higher expenditures when suffering the adverse event ex. Health insurance ⇒ use too much healthcare
moral hazard
insurance can induce people to engage in harmful behaviors
— It reduces the incentives to avoid or remedy adverse events
imperfect monitoring
Insurers often can’t observe the behavior of beneficiaries
– why moral hazards exist
