Information and Advertising

Lemons and Insurance Insurers have incomplete information on the quality of those seeking insurance. Some may be creampuffs Others may be lemons. What does that do to the market. Assume we have 9 people, with expected expenditure levels varying from 0 to M.

Idea Insured know how healthy they are but insurers DON’T. Insurers only know that the AVERAGE person would have expenditures of how much? A> $1,000. Why?

Equilibrium price? Suppose an auctioneer calls out a price of $0 for insurers. All 9 people will seek insurance. Why? How many will be offered insurance? A> None. Because sellers only know that the mean expenditure level is $1,000. So you have 9 buyers, no sellers.

Equilibrium price? (2) $0 doesn’t work. Suppose auctioneer calls out a price of (1/2)* M. 5 people will continue to seek to buy insurance. Why? The HEALTHIEST people withdraw, because the insurance will cost them more than it is worth to them. Average expected expenses rise from (1/2)*M to (3/4)*M. Thus, the higher premiums drive out the healthier people, and a functioning market MAY not appear for otherwise insurable health care risks.

WHY? When potential sellers know only the average quality of those they are insuring, then the market prices will tend too high for the best health care risks. High quality insurance risks are driven out of the market by lemons. KEY -- Buyers have information. Sellers DON’T.

Adverse Selection This problem is called ADVERSE SELECTION! Does it mean that we don’t have insurance markets? Obviously not. In health insurance markets, patients may not be covered for “pre-existing conditions Premiums for individual policies may be based on other information that insurers use to predict expenditures, SUCH AS age, employment status, and occupation

The Principal:Agent Problem This problem occurs when a patient (the principal) must hire and provider (agent) who will decide how much service is needed. The PERFECT agent acts in accordance with the principal’s “best” interests. What if providing more services provides more income for the agent? Who monitors the agent.

Supplier-Induced Demand One example of the principal-agent problem is SID. Does having more physicians mean that more care is prescribed? Why, or why not? There are some who would argue that “managed care” organizations may monitor the agents.

Another example: contingency fees Some cases are handled on a contingency basis, like medical malpractice. Attorney collects a fee, typically 1/3 IF they win. What are marginal benefits, marginal costs? Attorney hours Dollars Marginal Benefits Marginal Costs 2/3 Marginal Benefits 1/3 Marginal Benefits

Another example: contingency fees What is the consumer’s optimum? Attorney hours Dollars Marginal Benefits Marginal Costs 2/3 Marginal Benefits 1/3 Marginal Benefits What is the attorney’s optimum? Point B. Why? Point A. Why? B A

Advertising Does a perfect competitor advertise? Does a monopolist advertise. Who advertises, then? Answer > A competitor with some monopoly power.

Total Rev. Let’s Review Monopolistic Firms Downward sloping demand. Why? Quantity Dollars Tot. Cost AC MC Demand MR Downward sloping MR. Why? Profit maximizing output? PROFIT

Total Rev. Then what? Entry. Why? Quantity Dollars Tot. Cost AC MC TR Demand MR Demand shifts. MR shifts. Profit maximizing output? PROFIT D’ MR’