ECON 201 Chapter Notes - Chapter 5: Adverse Selection, Moral Hazard, Economic Equilibrium

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emeraldherring443

11 Apr 2018

School

Northwestern University

Department

Economics

Course

ECON 201

Professor

David Berger

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Document Summary

Health insurance: contract under which buyer agrees to make payments, or premiums, in exchange for the provider to pay some or all of the buyers medical bills. Asymmetric information: when one party in an economic transaction has less information than the other party. Adverse selection: the situation in which one party to a transaction takes advantage of knowing more than the other party to a transaction. Ex: this is a problem for firms selling health insurance policies because it results in people who are less healthy being more likely to buy insurance than people who are healthier. Ex: people who have health insurance make more doctors appointments or drive their. Ex: doctor order more lab tests, ceo flies in a private jet. Moral hazard: actions people take after they have entered into a transaction that make the other party to the transaction worse off cars more recklessly because they know they have insurance.

Related Questions

1. What is the reason for the existence of asymmetric information?

a. Asymmetric information exists when adverse selection leads to moral hazard.

b. Asymmetric information exists when one party to an economic transaction has less information than the other party.

c. Asymmetric information exists when parties to an economic transaction must pay different prices to obtain the same information.

d. Asymmetric information exists when people who have insurance change their actions because of the insurance.

More than 1.5 million vehicles collide with deer annually, killing hundreds of people and causing over $1 billion in vehicle damage. Some states, such as Michigan, attributed one in seven vehicle accidents to deer. Additional evidence indicates that many deer-related accidents go unreported.

The problem escalates in the fall of each year during deer mating season as more deer are on the move. While deer whistles and other vehicle warning systems appear ineffective in dealing with the problem, clearing brush in the road ditches to make deer more visible appears to help. Deer warning signs also appear to make drivers more vigilant and lower deer-vehicle collisions. What's the best advice? Drivers should be cautious when in deer country and when you see one deer there are likely others around.

Driving an insured vehicle in deer country could create a moral hazard problem. Since the insured knows the company will cover losses, it might make people less vigilant. While it may not be the case with automobile insurance, we do see people take more risks if they know they will not bear the entire burden of the possible negative outcome of their action.

1. What is the purpose of automobile insurance?

2. How does insurance encourage risky behavior?

3. If insurance companies did not cover deer/vehicle collisions or had a very high deductible, what should we observe?

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Freemont insurance sells homeowners insurance. In a recent financial review, managers discovered that company performance was lagging behind projections. They examined pricing and claims history in more detail and identified a group of about 20,000 homeowners insurance customers whose claims far exceeded the collected premiums. Members of the actuarial group, whose compensation was partially tied to the profitability of the policies they priced, were particularly frustrated.

a. Who is making the bad decision?

b. Does this group have enough information to make a good decision?

c. Does this group have an incentive to make a good decision?

d. Suppose moral hazard is at play. What is one thing that Freemont could do to reduce the problem of moral hazard?

e. Suppose adverse selection is at play. What is one thing that Freemont could do to reduce the problem of adverse selection?

The company hired a consultant to do a deep dive into the 20,000 customers whose claims far exceed the collected costs. The consultants noted that a significant number of these customers were far more likely to have had prior claims with their prior insurer. They took this information to the actuaries, but the actuaries said they were already taking into account the number of prior claims into their pricing.

f. How can we reconcile the fact that the actuaries were taking into account the number or prior claims into the pricing, but still underpricing these policies?

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ECON 201 Chapter Notes - Chapter 5: Adverse Selection, Moral Hazard, Economic Equilibrium

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