CH 12 Quiz
Asymmetric information important implications in insurance markets
1.) can cause adverse selection (makes it hard for insurance markets to provide actuarially fair insurance) 2.) can cause moral hazard
Moral hazard 2 types
1.) probabilities of adverse events increases because: -reduce caution-change the probability of adverse event. Build on a flood plain, for example 2.) overconsumption of health care -by people because insurance makes the price of care very low. More doctor visits, medicine, etc. -by providers: providers deliver/offer more services because you have insurance. Medical testing, MRI's, etc.
Suppose there are two regions of a state, one where car theft is high and the other where car theft is very low Assume that all drivers in the state are very risk averse when it comes to insurance against theft and that the insurance firms offer one premium rate to all drivers in that state. What kind of equilibrium will result?
This is an example of pooling equilibrium (all receive community-rated prices).
eligibility for benefits
does not depend on a person's income-not means tested
community rating
everyone in the insurance pool pays about the same insurance premium regardless of record, age, etc. -known as "community rating" and equilibrium characterized as "pooling equilibrium"
Other motivations for social insurance
externalities, administrative inefficiencies in the private insurance market, the desire for redistribution and paternalism
paternalism (definition)
for social security government insuring against people's lack of savings for retirement
government insurance vs private insurance companies
government has lower administrative costs because they have no need to earn profits
moral hazard (consumers alter their behavior because they have insurance)
government may intervene due to having health insurance can influence consumers' choices about health care consumption. Definition: an offsetting cost to the benefits of social insurance. By insuring individuals against adverse events, we may increase the incidence of these events among the insured *happens naturally when people are insured against adverse events* altering the probability of unfavored event
administrative costs
government-run Medicare has much lower administrative costs than private insurance
paternalism
governments may feel that people would choose to buy too little insurance for themselves or save too little for retirement. underestimate their risks or overestimate their risks
redistribution
governments may want to redistribute from healthy to sick or philosophy of pay when you are young and get benefits later in life
when is private insurance provision preferred?
in a market economy
experience rating
individuals' risks are priced into their policies (auto insurance) -equilibrium characterized as "separating equilibrium" -people placed into different risk pools -ex. automobile insurance premium prices based on accident record, violations, age, sex, type of car, etc
social insurance programs
insurance against adverse events. Health, inadequate retirement saving. Consumption smoothing is major concept in insurance. mandatory, contribution-based systems that tie the payout of benefits to the occurrence of a measurable event
Ironic feature of asymmetric information
it simultaneously motivates and undercuts the rationale for government intervention through social insurance
consumption smoothing
maintains consumption even if an expensive adverse event occurs
what eliminates the death spiral?
mandating that everyone purchase insurance and pay average premiums
amount of benefits received
means tested
what is the largest and fastest growing function of the government?
provision of social insurance against adverse events such as retirement, unemployment, injury, or illness
means-tested
refers to programs in which eligibility depends on the level of one's current income or assets
social insurance eligibility
related to work or having worked
merit good
social insurance generally in place to help lower-income groups gain access to insurance, income, healthcare
the consumption-smoothing benefits of social insurance are determined by...
the ability of individuals to use other forms of self-insurance to smooth their consumption
Fair insurance
the company pays out exactly the amount it collects in premiums (to cover extra expenses, insurance companies will have to charge insurance premiums larger than actuarially fair insurance)
major concepts in social insurance evaluation
the extent to which social insurance crowds-out private insurance or saving (known as self insurance) extent to which they discourage work or encourage retirement
what is the major motivation for government-provided social insurance?
the failure in private insurance markets caused by adverse selection. (remember adverse selection causes insurance markets to fail because imperfect information leads insurers to be unable to offer full insurance to different types of consumers
The more risk averse people are..
the more they are willing to pay for insurance. purchasing unfair insurance means people value consumption smoothing more than size of the expected loss
why is full insurance unlikely to be optimal?
the optimal social insurance benefit level trades off moral hazard costs against consumption-smoothing benefits
administrative inefficiencies
they can lead to market failure since not all people will be fully insured, as is optimal
If low-risk people have high risk aversion...
they will pay high risk premiums (amount willing to pay above fair insurance amount) and will buy insurance at more unfavorable rates
how to calculate expected value
(change of no problem)*(price of house)+(chance of fire)*($0)=$198,000
Excepted utility
-adverse event or accident occurs with probability -linear equation (probabilities sum to one) -line connects the expected utility of two uncertain events -falls on the line, where it falls depends on the probabilities
Insurers risks
-adverse selection for insurers -moral hazard for individuals and providers
Utility function
-has concave shape -the more concave the function is, the faster marginal utility diminishes
Adverse selection
-insurers need a normal distribution of risk to price insurance and keep it affordable suppose insurance is not mandatory: adverse selection: people with higher probabilities of losses are more likely to buy insurance -insurance draw clients on the riskier portion of the normal distribution of people
Health insurance
-patients who have health insurance pay little for visits to physicians and other providers moral hazard: name for tendency to over consume because the prices are low to patients who have third party payments doctors' visits -lack of transparency between patients' cost of care and effectiveness of care -asymmetric info among providers, insurance companies, and consumers
Why sell insurance?
-to make a profit -but to make profits, insurance company has to charge more in premiums than it pays out to cover losses
adverse selection
The fact that insured individuals know more about their risk level than does the insurer might cause those most likely to have the adverse outcome to select insurance, leading insurers to lose money if they offer insurance. Only those who feel the insurance is a good deal will buy it, which will be those in the high-expense group
pooling equilibrium
a market equilibrium in which all people buy insurance at a community-rated price (average price) *low-risk people subsidize high-risk people in a pooled equilibrium
separating equilibrium
a market equilibrium in which people in different risk pools purchase different insurance products
amount tested
amount of benefits received depends on income and generally means tested favors lower-income individuals
What drivers will be better off and what drivers will be worse off when insurance firms offer one insurance premium for all drivers instead of two different premiums in regions based on theft risk?
careful drivers would find this unfair because they are faced with the decision to buy insurance at the given cost or to not buy insurance at all (which usually ends up happening). They're paying all this money for such a small probability of getting hit. iMeanwhile, the careless consumers would view it as a good deal
How to make a pooled equilibrium charge workable?
company needs mandatory coverage to avoid adverse selection