Microeconomics Insurance Problem
Nakita Heitmann
The majority of government revenue earned is not spent on explicitly redistributive programs, such as those discussed in previous lectures about efficiency and equity. In fact, the majority of government revenue earned is devoted to social insurance. Social insurance is designed to insure individuals against risk in cases where the private market may not effectively provide such insurance. In this lecture, we will begin to learn about the role of social insurance.
This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.
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A second form of asymmetric information leading to market failure involves the hidden attributes (characteristics) of a good or product. When you want to purchase a used car, for example, the seller knows the quality of the vehicle. But you do not. This attribute of the car is hidden from the prospective buyer. Hidden attributes can cause a problem known as adverse selection.
The problem of hidden attributes occurs when some characteristic of a product or service being exchanged is not known to all parties. An example is that the individual purchasing health insurance knows their own health status, but the insurance company does not.
The term adverse selection refers to the problem faced by parties to an exchange in which the terms offered by one party will cause some exchange partners to drop out. An example is the problem of asymmetric information in insurance: if the price is sufficiently high, the only people who will seek to purchase medical insurance are people who know they are ill (but the insurer does not). This will lead to further price increases to cover costs.
The economist George Akerlof was the first to analyse this problem in 1970. Initially, his paper on the subject was rejected by two economics journals for being trivial. Another returned it, saying that it was incorrect. Thirty-one years later, he was awarded the Nobel Prize for his work on asymmetric information. Akerlof and co-author Robert Shiller give a simple explanation of the so-called market for lemons in this book: George A. Akerlof and Robert J. Shiller. 2015. Phishing for Phools: The Economics of Manipulation and Deception. Princeton, NJ: Princeton University Press.
If prospective buyers were able to observe the quality of every car, then buyers would approach each seller and bargain over the price, and by the end of the day all of the cars (except for the entirely worthless one) would be sold at a price somewhere between their true value and half the true value. The market would have ensured that all mutually beneficial trades took place.
The day after that, the owner of the third-best car will not be willing to sell either. And so it goes on. One by one, owners of higher-quality cars drop out of the market until, at some point next week, only the totally worthless car will remain. No one other than the owner of a lemon would be willing to sell it.
Again, we have a problem of adverse selection, and potentially a missing market. Healthier people (like higher-quality cars) are priced out of the market; many people will be uninsured. It is a market that could allocate insurance efficiently if health information were symmetrical and verifiable (ignoring for the moment the problem of whether everyone would want to share their health data). It could provide benefits to both insurance company owners and people who wanted to insure themselves. Not having such a market is Pareto inefficient.
Construct a table like the one in Figure 10.12 to analyse the possible market failures associated with the decisions below. In each case, identify which markets or contracts are missing or incomplete.
Hidden actions are a serious problem in insurance and credit markets because uncertainty and risk play a central role in the outcome from an insurance policy or loan. The chance of a bad outcome for the principal depends on unavoidable risks, but also on the actions of the agent.
You would like to be able to fully insure your car against the risks of theft and damage resulting from an accident. The insurance company is willing to provide insurance if the premium is not less than the amount it expects you will claim over the period of cover. For example, if the value of the car is V, and a policy provides full cover against theft in return for an insurance premium P:
Insurers typically place limits on the insurance they sell. For example, coverage may not apply (or may be more expensive) if someone other than the insured is driving, or if the car is usually parked in a place where cars are often stolen. These provisions can be written into an insurance contract.
A similar situation arises in the credit market, as described in Section 9.9. A bank (the principal) will be willing to make a loan to a borrower (agent) who wants to finance an investment project, if the bank expects the loan to be repaid in future. If repayment were guaranteed, then for a loan L at interest rate r, the amount repaid would be (1 + r) L. But lending is risky:
Though seemingly very different, hidden-action problems have an important feature in common with problems, such as pollution and public good provision, which were analysed in earlier sections. Here again, someone makes a decision that has external costs or benefits for someone else. The insured person or borrower (the agent) decides how much care to take. Taking care has an external benefit for the principal, but a private cost for the agent. The result is market failure.
What form does the market failure take? First, people without wealth or collateral are not able to undertake potentially profitable investment projects. And no-one can purchase full insurance. Both of these things would be possible if there were no asymmetries of information.
With some risks, an insurance market is missing altogether: governments provide cover against unemployment because private firms rarely do so. Getting a low grade in an important exam is a risk facing even the hardest-working student, but you are unlikely to be able to insure yourself against it.
In addition, market failure leads to an inequality of outcomes for rich and poor agents. The consequences of being unable to insure yourself against a loss are more serious for those who cannot afford to replace a stolen or damaged item.
This form of market failure arises particularly when wealth is very unequally distributed. Read Exercise 9.11 for how the Grameen Bank addressed this problem by making groups of borrowers jointly responsible for loan repayment, thereby giving them an incentive to work hard and take prudent decisions without the need for equity or collateral.
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