+ Information, Risk, and Insurance Chapter 16 + Chapter Outline n  The Problem of Imperfect Information and Asymmetric Information n  Insurance and Imperfect Information + Imperfect information and asymmetric information n  Asymmetric information: where both parties involved in an economic transaction have an unequal amount of information (one party knows much more than the other) n  n  E.g Buying a used car Imperfect information: either the buyer, the seller, or both, are less than 100% certain about the qualities of what is being bought and sold + Imperfect vs asymmetric Imperfect Information Asymmetric Information n  buyers and/or sellers not have all of the necessary information to make an informed decision about the price or quality of a product n  one party, either the buyer or the seller, has more information about the quality or price of the product than the other party n  “Lacking” n  “Unequal” + Lemons – Used Car Market n even with imperfect information, prices still reflect information n used cars are more expensive on some dealer lots because the dealers have a trustworthy reputation to uphold (signal) n individual seller has no reputation to defend (Craigslist) + Imperfect information – Labor markets n  How can a potential employer screen for certain attributes, such as motivation, timeliness, ability to get along with others, and so on? 1.  Trade schools and colleges to pre-screen candidates 2.  Only interview a candidate with a degree and, sometimes, a degree from a particular school 3.  View awards, a high grade point average, and other accolades as a signal of hard work, perseverance, and ability 4.  References for insights into key attributes such as energy level, work ethic, and so on + Imperfect information - impacts n Equilibrium Price and Quantity n  Thin markets (few buyers and sellers) as each is hesitant due to uncertainty as opposed to thick markets (many buyers and sellers) n Price as a signal of quality n  E.g Expensive restaurants + Imperfect Information - Fixing n  Product n  Reputation, guarantees, warrantees, and service contracts n  Guarantees assure quality (promised) n  Warranty – promise to fix defect over a limited time n  Service Contract – pay extra to assure repairs n  Labor n  quality assurance Markets occupational licenses and certifications to assure competency; probationary periods n  Financial n  n  Markets cosigners and collateral Federal Trade Commission – against advertisers making false claims as truth + Insurance and Imperfect Information Section 16.2 + Insurance n  Insurance: a method that households and firms use to prevent any single event from having a significant detrimental financial effect n  Premiums: Regular payments made by households or firms with insurance n  Based on probability of event occurring Pooled and paid out to those affected by the covered event if it occurs n  E.g Health insurance, Life insurance, Auto insurance etc n  + How insurance works n  100 people insured; three risk groups; three possible outcomes n  Total damage = (60 × $100) + (30 × $1,000) + (10 × $15,000) = $600 + $30,000 + $150,000 = $186,000 n  If each of the 100 drivers pays a premium of $1,860 each year, the insurance company will collect the $186,000 needed to cover the costs of the accidents that occur Average premiums and average insurance payouts must be approximately equal n  approximately equal + How insurance works n  Risk group: a group that shares roughly the same risks of an adverse event occurring n  Insurance companies often classify people into risk groups, and charge lower premiums to those with lower risks n  If could classify people according to risk group, then each group can be charged according to its expected losses – high risk, pay higher premiums + Imperfect information in insurance markets n  Moral Hazard : when people engage in riskier behavior with insurance than they would if they did not have the insurance n  E.g with car insurance, drivers drive less careful than without n  Cannot be eliminated, but insurance companies can attempt to reduce it: 1.  2.  3.  4.  n  Monitor behavior to manage risk – security system lowers premiums Deductibles - amount that the insurance policyholder must pay out of their own pocket before the insurance coverage starts paying Copayment - policyholder must pay a small amount Coinsurance - insurance company covers a certain percentage of the cost When faced with copays and deductibles, studies find reduction in moral hazard (less consumption of covered service) + Moral Hazard – health insurance n  Fee – for – service: medical care providers are paid for the services they provide and are paid more if they provide additional services n  n  n  Traditional way of providing health care in the US Lately more shift to health maintenance organizations (HMOs) Health Maintenance Organization (HMO) provides healthcare that receives a fixed amount per person enrolled in the plan—regardless of how many services are provided n  Consumer still has incentive to demand more services; provider has incentive to limit it + Adverse Selection n  Adverse selection - the problem in which the buyers of insurance have more information about whether they are highrisk or low-risk than the insurance company does n  Asymmetric information problem for insurers n  E.g With $1860 premium cost from previous example, only high risk group will get insurance (expected loss greater than $1850, while others have expected cost less than $1860, so insurance company can not pool risk, i.e take from lower risk and pay to higher risk n  May refuse high risk individuals, or offer insurance at very high rates – as was the case with healthcare in US before 2010 + Affordable Care Act 2010 n  If insurance premiums are set at actuarially fair levels, people end up paying an amount that accurately reflects their risk group, certain people will end up paying a lot or not offer it to those with pre-existing conditions – not allowed under ACA n  High premiums – not all get insurance (adverse selection) – mandated now (50+ employees must offer insurance) n  State insurance exchanges – for competition of plans n  Paid for by higher taxes, annual fees on providers + Review Questions + Review Questions n  Q6 What are some of the ways a seller of goods might reassure a possible buyer who is faced with imperfect information? n  n  Q7 What are some of the ways a seller of labor (that is, someone looking for a job) might reassure a possible employer who is faced with imperfect information? n  n  Solution: Offering warrantees or a period of time in which to return the product for a full refund might correct for the buyer’s lack of information Solution: The worker may offer to work for a trial period for little or no wages so that the employer can verify his value before signing a longterm contract Q8 What are some of the ways that someone looking for a loan might reassure a bank that is faced with imperfect information about whether the loan will be repaid? n  Solution: People looking for loans typically have to show evidence of a steady income or the possession of collateral, such as a property owned, so that the bank can be assured of collecting on its loan + Review Questions n  Q 11 What is an actuarially fair insurance policy? n  n  Q 12 What is the problem of moral hazard? n  n  Solution: An actuarially fair policy is one in which the average benefits paid out equal the average cost to the policy holder Solution: Moral hazard is the observation that people behave in more risky ways when the cost of risky behavior is decreased Q 13 How can moral hazard lead to insurance being more costly than was expected? n  Solution: When people are insured, they engage in more risky behavior, leading to higher costs for the insurer and thus higher premiums for the policy holder + Problem - # 24 Imagine that 50-year-old men can be divided into two groups: those who have a family history of cancer and those who not For the purposes of this example, say that 20% of a group of 1,000 men have a family history of cancer, and these men have one chance in 50 of dying in the next year, while the other 80% of men have one chance in 200 of dying in the next year The insurance company is selling a policy that will pay $100,000 to the estate of anyone who dies in the next year n  a If the insurance company were selling life insurance separately to each group, what would be the actuarially fair premium for each group? n  b If an insurance company were offering life insurance to the entire group, but could not find out about family cancer histories, what would be the actuarially fair premium for the group as a whole? n  c What will happen to the insurance company if it tries to charge the actuarially fair premium to the group as a whole rather than to each group separately? + Solution n  a For the high risk group, the premium would be the probability of dying 0.02 times the benefit payment $100,000 = $2,000 For the low risk group this would be 0.005 x $100,000 = $500 n  b We weight the premiums for the two groups by frequency in the population and add the results together $2,000 x 0.2 + $500 x 0.8 = $800 n  c The high risk group will recognize that they are getting a good deal, since $800 is less than their actuarially fair rate of $2,000, so they will enroll in high numbers Meanwhile, the low risk group will be less likely to enroll, since the rate is higher than their actuarially fair rate of $500 This adverse selection problem will cause the insurance company to either lose money or have to raise rates still higher  ... family history of cancer and those who not For the purposes of this example, say that 20% of a group of 1,000 men have a family history of cancer, and these men have one chance in 50 of dying in... exchanges – for competition of plans n  Paid for by higher taxes, annual fees on providers + Review Questions + Review Questions n  Q6 What are some of the ways a seller of goods might reassure... Q7 What are some of the ways a seller of labor (that is, someone looking for a job) might reassure a possible employer who is faced with imperfect information? n  n  Solution: Offering warrantees