EMI5- Asymmetric Information

Question 1

Define asymmetric information

Answer 1

Asymmetric information occurs when market information varies among agents in the market.

Question 2

Name the 2 ways in which asymmetrical information can cause market failure

Answer 2

• Adverse Selection

* Moral Hazard

Question 3

What is adverse selection?

Answer 3

When we cannot tell the high risk individual from the low risk individual and then the individual selects into the “wrong kind” of insurance”

Question 4

What will a high risk individual do if they are offered low risk insurance?

Answer 4

They will over-insure

Question 5

What will happen to the insurer if the dominant strategy is to claim to be low-risk?

Answer 5

The insurer will go out of business: the market fails

Question 6

What are the 2 main ways to try and solve the adverse selection problem?

Answer 6

• Pooling Equilibrium

* Separating Equilibrium

Question 7

• What is Pooling Equilibrium?

* Why does this still lead to market failure?

Answer 7

• Where the insurer offers a contract for the insurance which is an average of the 2 extremes (high/low risk insurance)
• Because high-risk individuals will still be able to over insure themselves at prices cheaper to what they should be paying, causing on average the insurer to make a loss.

Question 8

What is key in solving the adverse selection problem?

Answer 8

Contracts need to be incentive compatible – that is each risk type wants to buy the contract designed for them.

Question 9

• What is Separating Equilibrium?

* Why isn’t this Pareto efficient?

Answer 9

• Individuals are offered a take it or leave it between a point H on the low-risk indifference curve, or anywhere along the high risk indifference curve. High risk individuals choose fair insurance on the “correct indifference curve, and low risk people choose point H.
• This isn’t Pareto efficient as the low-risk individuals are not able to fully insure

Question 10

Give 2 other ways how Adverse Selection issue can be resolved

Answer 10

• Signalling from individuals to shows they’re higher quality- eg getting a degree to signal that they’re higher quality labour
• Screening from insurance providers eg they check your no claims bonus in order to gather more information about you as an individual.

Question 11

What is another way to try and resolve market failure in the case of asymmetric information, eg in the example of buying a car and not knowing how reliable it is.

Answer 11

The idea of warranties

Question 12

What is Moral Hazard?

Answer 12

This is when the hidden action of one agent is unobservable to another. Eg if a low risk person get’s fully insured, they may then change their behaviour to that of a high risk individual, which is an action hidden from the insurance providers, causing market failure.

Question 13

What are solutions to moral hazards

Answer 13

No claims discounts- to try and see how risky a person really is.