ECO 3343 Lecture 2: Micro theory notes- adverse selection and moral hazard

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aa666

28 Jul 2022

School

St. John's University

Department

ECO - ECONOMICS

Course

ECO 3343

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Document Summary

Adverse selection = the selection is bad for the one who selects. This problem is primarily recognized in connection with insurance. The probability that the insured against the event will occur. Calculated as the number of times a given event occurs in a total population. For example, one in a million 25-year-olds dies each year. One cannot know the probability of an individual event. No insurance on success of a new business. Three or four new businesses fall in 2 years. Insurance premium peas cost of given event plus profit. Fire insurance: certain percentages of homes burned down each year. Fire insurance paid by everyone allows insurance companies to pay for lost houses plus profits. Life insurance: statistical percentage of peopled the age 65 die each year. Insurance company pays off on policy of those that die and has profit left over. Smaller percentages of women age 65 die each year than men.

Related Questions

1) Insurance and social policy

You are making an app with a 5% chance of making a ton-load of money, and 95% chance of earning nothing. Your utility is the square root of income (Utility = Y^1/2); you will have $10,000,000^1/2 happiness if your app succeeds but 0^1/2 happiness if it fails.

a) (2 points) What is the expected value of your app? How much money can you expect to make? What is your utility at that income (if you know that your income will be the expected value of your app)?

Note that in EXCEL, the square root function is â=X^.5â for the number X

b) (1 point) What is your expected utility from your app? (Note: this is the weighted average of utility when the app succeeds and when it fails where the weight is the probability of success.)

c) (2 points) Why do people buy insurance? How can insurance companies profit? What happens to expected utility when people can buy insurance at a fair market price?

d) (2 points) What is moral hazard and what is adverse selection. How do these affect insurance markets? Give examples from the marketing of veterinary insurance. Would you expect markets with moral hazard and adverse selection to provide the optimal amount of veterinary insurance at an efficient price?

orangeeagle209

A health insurance company knows that there are two types of customers (smokers and non-smokers), each facing different health risks. The probabilities of getting sick and the healthcare costs in the case of illness for the two customer types is given in the table below.

Group	Healthcare costs	Probability of getting sick
Smokers	$1200	50%
Non-smokers	$1200	20%

Assume that each customer has a monthly income of $1600 and has a utility function given by U(x)=sqrt(x), where x is the remaining income after medical/health insurance expenses have been paid.

a. Explain the problem of âadverse selectionâ and the problem of âmoral hazard.â Give one example of a market in which adverse selection occurs and one example of a market in which moral hazard can be observed. What is the difference between the two information problems? Explain the consequences of adverse selection and moral hazard for the principal â agent relationship.

b. Discuss in detail the two ways (screening and signaling) in which the principal or the agent can try to resolve the problem of adverse selection. Give an example of screening and signaling and explain how the parties involved benefit from these strategies.

c. For the numerical example above construct the lotteries associated with the income that remains after healthcare expenses have been paid for smokers and for non-smokers (assuming agents do not have health insurance). Calculate the expected utility associated with the lotteries for smokers and non-smokers. Calculate the certainty equivalent of the two lotteries. What is maximum amount that smokers and non-smokers are willing to pay for full insurance? Calculate the actuarially fair health insurance premium for the two groups of customers (i.e. the expected healthcare costs).

dAssume the company cannot distinguish between smokers and non-smokers and offers a full insurance contract to all customers. How much should the company charge for the full insurance contract? Which customer group will purchase full insurance?

silverkangaroo356

13. Which of the following is true about adverse selection and moral hazard?

a. Adverse selection is a consequence of asymmetric information; asymmetric information is a consequence of moral hazard.

b. Insurance companies can eliminate adverse selection by charging deductibles and co-insurance, but charging deductibles and co-insurance increases the risk of moral hazard.

c. Adverse selection affects only the market for automobile insurance; moral hazard affects only the markets for health and life insurance.

d. Adverse selection refers to what happens at the time of entering into a transaction; moral hazard refers to what happens after entering into a transaction.

ECO 3343 Lecture 2: Micro theory notes- adverse selection and moral hazard

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