Asymmetric Information Topic 6 Asymmetric Information

Outline for this Topic Asymmetric Information Adverse Selection Definition Signaling in the market for goods: The Case of Warranties Moral Hazard Inducing optimal level of care in the insurance market: The Case of Deductibles

Asymmetric Information We will examine the problems raised by differences in information, i.e., asymmetries in information, in markets for goods and services For example, in the market for used cars, the seller of the used car probably has a pretty good idea of the quality of the car. In contrast, the buyer might not be able to determine whether the car is a good car or a “lemon”

Asymmetric Information (cont.) The assumption that both parties of the market (i.e., buyers and sellers) are perfectly informed about the quality of the goods or services to be traded holds if the verifiability of the quality is possible If it is not costly to tell which items are high-quality goods and which are low-quality goods, then the price of the goods will simply adjust to reflect the quality differences. Under uncertainty, the consumer is concerned with the probability distribution of getting different consumption bundles of goods But if information about quality is costly to obtain, then it is not longer plausible that buyers and sellers have the same information about the goods involves in transactions

Adverse Selection The problem of adverse selection occurs when one side of the market cannot observe the “type” or quality of the good or service on the other side of the market (i.e., a hidden-type problem)

Adverse Selection and Signaling Seminal work by George Akerlof (“The Market for Lemons: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics, 1970; Nobel Prize in Economics, 2001) Low-quality used cars crowd-out high-quality used cars items because of the asymmetry of information Even though the price at which buyers are willing to buy good cars exceeds the price at which sellers are willing to sell them, no such transaction will take place because of asymmetry of information (i.e., there is a market failure)

Adverse Selection and Signaling (cont.) Owners of good cars have the incentive to try to convey the fact that they have a good car to potential purchasers They choose actions that signal the quality of their cars One sensible signal would be for the owner of a good car to offer a warranty A warranty will signal good quality as long as only the sellers of good items can afford to offer it

Adverse Selection and the Insurance Market Under unobservable “types” of clients, insurance companies cannot base their rates on the average incident of health problems in the population They can only base their rates on the average incidence of health problems in the group of potential purchasers Note that people who want to purchase a health insurance the most are the ones who are likely to need it the most, and thus rates must reflect this disparity

Adverse Selection and the Insurance Market (cont.) In such a situation it is possible that everyone can be made better off by REQUIRING the purchase of insurance that reflects the average risk in the population The high-risk people are better-off because they can purchase insurance at rates that are lower than the actual risk they face The low-risk people can purchase insurance that is more favorable to them than the insurance offered if only high-risk people purchased it

Adverse Selection and the Insurance Market (cont.) For instance, it is common the case that employers offer health plans to their employees as part of the package of fringe benefits The insurance company can base its rates on the averages over the set of employees and is assured that all employees must participate in the program, thus eliminating adverse selection (i.e., selection of only high-risk types of clients)

Moral Hazard The problem of moral hazard occurs when one side of the market cannot observe the “actions” of the other side of the market (i.e., a hidden-action problem) We will refer to the actions that affect the probability that some event occurs as “taking care”

Moral Hazard and the Insurance Market When it sets its rates, the insurance company has to take into account the incentives that the consumers have to take an appropriate amount of care If not insurance is available, consumers have an incentive to take the maximum possible amount of care because the consumer bears the full cost of his/her actions But if a consumer can insure his/her property, then incentives to take care are reduced In the extreme case, where the insurance company completely reimburses the individual for his/her damage, the individual has no incentives to take care, i.e., a moral-hazard problem occurs

Moral Hazard and the Insurance Market (cont.) If the amount of care is observable, then there is no moral-hazard problem: the insurance company can base its rates on the amount of care taken In these cases, the insurance firm attempts to discriminate among users depending on the choices they have made that influence the probability of damage

Moral Hazard, Insurance Market and Deductibles In case of unobservable amount of care, full-insurance will generate too little care because individuals do not face the full costs of their actions, i.e., a moral-hazard problem Insurance companies will include “a deductible” in their policies, i.e., an amount that the insured party has to pay in any claim By making consumers pay part of a claim, the insurance companies can make sure that consumers always have an incentive to take some care