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16.E: Information, Risk, and Insurance (Exercises)

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    16.1 The Problem of Imperfect Information and Asymmetric Information

    Many make economic transactions in a situation of imperfect information, where either the buyer, the seller, or both are less than 100% certain about the qualities of what they are buying or selling. When information about the quality of products is highly imperfect, it may be difficult for a market to exist.

    A “lemon” is a product that turns out, after the purchase, to have low quality. When the seller has more accurate information about the product's quality than the buyer, the buyer will be hesitant to buy, out of fear of purchasing a “lemon.”

    Markets have many ways to deal with imperfect information. In goods markets, buyers facing imperfect information about products may depend upon money-back guarantees, warranties, service contracts, and reputation. In labor markets, employers facing imperfect information about potential employees may turn to resumes, recommendations, occupational licenses for certain jobs, and employment for trial periods. In capital markets, lenders facing imperfect information about borrowers may require detailed loan applications and credit checks, cosigners, and collateral.

    16.2 Insurance and Imperfect Information

    Insurance is a way of sharing risk. People in a group pay premiums for insurance against some unpleasant event, and those in the group who actually experience the unpleasant event then receive some compensation. The fundamental law of insurance is that what the average person pays in over time cannot be less than what the average person gets out. In an actuarially fair insurance policy, the premiums that a person pays to the insurance company are the same as the average amount of benefits for a person in that risk group. Moral hazard arises in insurance markets because those who are insured against a risk will have less reason to take steps to avoid the costs from that risk.

    Many insurance policies have deductibles, copayments, or coinsurance. A deductible is the maximum amount that the policyholder must pay out-of-pocket before the insurance company pays the rest of the bill. A copayment is a flat fee that an insurance policy-holder must pay before receiving services. Coinsurance requires the policyholder to pay a certain percentage of costs. Deductibles, copayments, and coinsurance reduce moral hazard by requiring the insured party to bear some of the costs before collecting insurance benefits.

    In a fee-for-service health financing system, medical care providers receive reimbursement according to the cost of services they provide. An alternative method of organizing health care is through health maintenance organizations (HMOs), where medical care providers receive reimbursement according to the number of patients they handle, and it is up to the providers to allocate resources between patients who receive more or fewer health care services. Adverse selection arises in insurance markets when insurance buyers know more about the risks they face than does the insurance company. As a result, the insurance company runs the risk that low-risk parties will avoid its insurance because it is too costly for them, while high-risk parties will embrace it because it looks like a good deal to them.


    1. For each of the following purchases, say whether you would expect the degree of imperfect information to be relatively high or relatively low:

    1. Buying apples at a roadside stand
    2. Buying dinner at the neighborhood restaurant around the corner
    3. Buying a used laptop computer at a garage sale
    4. Ordering flowers over the internet for your friend in a different city
    2. Why is there asymmetric information in the labor market? What signals can an employer look for that might indicate the traits they are seeking in a new employee?
    3. Why is it difficult to measure health outcomes?

    4. Why might it be difficult for a buyer and seller to agree on a price when imperfect information exists?

    5. What do economists (and used-car dealers) mean by a “lemon”?
    6. What are some ways a seller of goods might reassure a possible buyer who is faced with imperfect information?
    7. What are some ways a seller of labor (that is, someone looking for a job) might reassure a possible employer who is faced with imperfect information?
    8. What are some ways that someone looking for a loan might reassure a bank that is faced with imperfect information about whether the borrower will repay the loan?
    9. What is an insurance premium?
    10. In an insurance system, would you expect each person to receive in benefits pretty much what they pay in premiums or is it just that the average benefits paid will equal the average premiums paid?
    11. What is an actuarially fair insurance policy?
    12. What is the problem of moral hazard?
    13. How can moral hazard lead to more costly insurance premiums than one was expected?
    14. Define deductibles, copayments, and coinsurance.
    15. How can deductibles, copayments, and coinsurance reduce moral hazard?
    16. What is the key difference between a fee-for-service healthcare system and a system based on health maintenance organizations?
    17. How might adverse selection make it difficult for an insurance market to operate?
    18. What are some of the metrics economists use to measure health outcomes?

    19. You are on the board of directors of a private high school, which is hiring new tenth-grade science teachers. As you think about hiring someone for a job, what are some mechanisms you might use to overcome the problem of imperfect information?

    20. A website offers a place for people to buy and sell emeralds, but information about emeralds can be quite imperfect. The website then enacts a rule that all sellers in the market must pay for two independent examinations of their emerald, which are available to the customer for inspection.
    1. How would you expect this improved information to affect demand for emeralds on this website?
    2. How would you expect this improved information to affect the quantity of high-quality emeralds sold on the website?
    21. How do you think the problem of moral hazard might have affected the safety of sports such as football and boxing when safety regulations started requiring that players wear more padding?
    22. To what sorts of customers would an insurance company offer a policy with a high copay? What about a high premium with a lower copay?

    23. Using Exercise 16.20, sketch the effects in parts (a) and (b) on a single supply and demand diagram. What prediction would you make about how the improved information alters the equilibrium quantity and price?

    24. Imagine that you can divide 50-year-old men into two groups: those who have a family history of cancer and those who do 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.
    1. If the insurance company were selling life insurance separately to each group, what would be the actuarially fair premium for each group?
    2. 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?
    3. 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?
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