CSM 405 Quiz 4

Examples of adverse selection

- A homeowner purchases a refrigerator that the seller knows has a history of leaking - Owners of used cars choosing to keep them rather than sell them at the low price that skeptical buyers are willing to pay - Buyers with low risk choosing to remain uninsured because the policies they are offered fail to reflect their true characteristics

examples of signaling

- Advertising, getting an education, gift giving, warranty - Magazine advertisements include the phrase "as seen on TV." - Graduates of highly-respected universities highlight that fact on their resumes

Examples of info asymmetry

- An employee knows more than his employer knows about his work effort - A borrower knows more than the lender about his ability to repay the loan - The seller of a 30-year-old house knows more than the buyer about the condition of the house - When an employee purchases group life insurance without taking a physical exam, she knows more about her health than does the insurance company

examples of screening

- An insurance company offers policies that feature different deductibles and different premiums - An unhealthy person would likely choose a medical insurance policy with a high premium and no deductible

moral hazard

- Arises when an agent who is imperfectly monitored tends to engage in dishonest or undesirable behavior - An employee lacks an incentive to promote the best interests of the employer, and the employer cannot observe the actions of the employee.

In examining the effects of social insurance, four types of moral hazard play a particularly important role.

- Reduced precaution against entering the adverse state. - Increased odds of entering the adverse state. - Increased expenditures when in the adverse state. - Supplier responses to insurance against the adverse state.

Moral hazard is costly for 2 reasons

- The adverse behavior encouraged by insurance lowers social efficiency because it reduces the provisions of socially efficient labor supply. - When social insurance encourages adverse events, which raise the cost of the social insurance program, it increases taxes and lowers social efficiency further.

solutions to moral hazard

- The employer pays his workers wages that are unusually high for the industry and region - The principal installs hidden cameras to monitor the agent's behavior - Requiring employees to provide itemized receipts for reimbursable expenses - Paying year-end bonuses rather than higher monthly earnings

Which of the following is not an example of a principal trying to solve the moral-hazard problem? a. the principal conducts an extensive interview of the agent b. the principal installs hidden cameras to monitor the agent's behavior c. the principal pays the agent efficiency wages d. the principal pays the agent a year-end bonus

A

Which of the following is not an example of signaling? a. screening b. advertising c. getting an education d. gift giving

A

Government action in cases of asymmetric information may not be an ideal solution because

- The government is itself an imperfect institution - The government rarely has more information than the private parties - The private market can sometimes deal with information asymmetries on its own

examples of moral hazard

- a person with car insurance drives recklessly - a pet-sitter being paid to walk a dog for one hour per day only walks the dog for 20 minutes per day

An actuarially fair premium is set equal to the insurer's: a. expected payout, assuming no administrative costs or profits. b. expected administrative costs, assuming maximum profits. c. desired amount of profit. d. total cost.

A

Effective signals a. convey useful information from informed parties to uninformed parties. b. impose little or no cost on the signaler. c. cannot be conveyed accurately when there is an information asymmetry. d. can be used by employers to alleviate the moral hazard problem in the workplace.

A

People buying insurance aim to shift consumption from periods when consumption is ___________ and marginal utility is relatively _____________ to periods when consumption is ____________. a. high; low; low b. high; low; high c. low; high; high d. low; high; low

A

Suppose that among a group of uninsured people, the only ones who want to buy health insurance are the ones who happen to enjoy jumping out of perfectly good airplanes. This is an example of: a. adverse selection. b. signaling. c. moral hazard. d. screening.

A

When one party is better informed about an economic situation than another party, economists describe the problem as one of a. asymmetric information. b. moral hazard. c. political economy. d. behavioral economics

A

pooling equilibrium

A market equilibrium in which all types of people buy full insurance even though it is not fairly priced to all individuals.

Separating equilibirum

A market equilibrium in which different types of people buy different kinds of insurance products designed to reveal their true types. (e.g., Coverage of $30,000 at $1,500 vs. coverage of up to $10,000 at $50)

An insurance premium that is set equal to the insurer's expected payout (p*expected costs)

Actuarially fair premium

A market equilibrium in which all types of individuals buy full insurance even though it is not fairly priced to all individuals is called a _________ equilibrium and occurs when all consumers are __________. a. pooling; not averse to risk b. pooling; risk averse c. separating; not averse to risk d. separating; risk averse

B

NOT ON QUIZ Consumers aim for ___________________ because of _________________. a. self-insurance; diminishing marginal utility b. consumption smoothing; diminishing marginal utility c. self-insurance; means-tested program benefits d. consumption smoothing; means-tested program benefits

B

Under realistic conditions, optimal social insurance systems should: a. not insure individuals against adverse events. b. partially, but not completely, insure individuals against adverse events. c. completely insure individuals against adverse events. d. prevent adverse selection.

B

Which of the following is an example of asymmetric information? a. When someone is applying for a job, the employer checks references to determine the previous work habits of the applicant. b. When an employee purchases group life insurance without taking a physical exam, she knows more about her health than does the insurance company. c. When someone is considering buying a used car from a dealership, the potential buyer requests documentation of the repair history of the car. d. All of the above are correct.

B

Which of the following is an example of screening? a. a man buys an expensive birthday present for his girlfriend b. an insurance company offers a policy with a high deductible c. the seller of a used motorcycle knows more about its true condition than a prospective buyer d. society supports long prison terms for corporate criminals

B

An unhealthy person would likely choose a medical insurance policy with a a. low premium and a high deductible. b. high premium and a high deductible. c. high premium and no deductible. d. The unhealthy person would choose not to be insured.

C

Screening occurs when a. an informed party acts to reveal his private information. b. an informed party acts to conceal his private information. c. an uninformed party acts to induce the informed party to reveal private information. d. one informed party acts to prevent another informed party from revealing private information.

C

Which of the following is not an example of moral hazard? a. a person with car insurance drives recklessly b. a pet-sitter being paid to walk a dog for one hour per day only walks the dog for 20 minutes per day c. a thief steals a car d. All of the above are examples of moral hazard.

C

Adverse selection is a. the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behavior. b. an action taken by an uninformed party to induce an informed party to reveal information. c. the failure of majority voting to produce transitive preferences for society. d. the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party.

D

In view of the possible need for government action in markets where asymmetric information is a problem, which of the following is a valid concern? a. The government rarely has more information than the private parties. b. Private markets can sometimes deal with information asymmetries on their own. c. The government is itself an imperfect institution. d. All of the above are valid concerns.

D

Information asymmetry refers to a. the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behavior. b. the tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party. c. an action taken by an informed party to reveal private information to an uninformed party. d. a difference in access to relevant knowledge.

D

Suppose you foresee two possibilities for your health: You will either develop Alzheimer's disease or will have nothing. These two possibilities are called: a. moral hazards. b. self-insurance. c. consumption. d. states of the world.

D

The reasons for government involvement in social insurance include all of the following EXCEPT: a. a potential adverse selection problem stemming from asymmetric information. b. a potential savings in decision-making and administrative costs. c. the paternalistic belief that some individuals will not engage in necessary planning. d. the adverse effect such involvement has on the distribution of income.

D

The state of Massachusetts requires all citizens to purchase medical insurance or face a monetary penalty when filing their taxes. The penalty is significantly less than the average annual insurance premium. Moreover, the state requires insurance companies to issue policies to anyone who applies, regardless of their health at the time of application. Which of the following examples describes the inherent adverse selection problem? a. Tricia purchases an insurance policy through her employer and visits her doctor for annual check-ups. b. Amber purchases insurance only after learning that she has cancer. c. Mike pays the penalty rather than purchasing insurance because it is cheaper for him than paying insurance premiums and he is generally in good health. d. Both b and c are correct.

D

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.

redistribution

Governments may want to redistribute from healthy to sick.

Why have social insurance?

Information asymmetry can lead to a key market failure (adverse selection)

• The extent to which individuals are more impacted by a negative change in income than by a positive change in income of the same magnitude • The extent to which individuals are willing to bear risk

Risk aversion

Adverse selection

The tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party

Externalities

Vaccines have positive spillovers; car crashes negative ones.

information asymmetry

When one party is better informed about an economic situation than another party •A difference in access to relevant knowledge

The fact that the 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

adverse selection

Suppose you are covered under health insurance or belong to a Health Maintenance Organization (HMO), and you are insured against all or most of the costs of visits to the doctor. As a result you are likely to make greater use of medical services of all kinds. This tendency of people with insurance to change their behavior in a way that leads to more claims against the insurance company is called a. adverse selection. b. moral hazard. c. screening d. signaling.

b

the translation of consumption from periods when consumption is high, and thus has low marginal utility, to periods when consumption is low, and thus has high marginal utility

consumption smoothing

Individuals know more about their underlying level of risk than do insurers

information asymmetry

Insurance is valuable because

it helps individuals' consumption across state of the world

Problem with insurance:

moral hazard

The problem that arises when one person performs a task on behalf of another person

moral hazard

An uninformed party acts to induce the informed party to reveal private information

screening

Actions by an informed party for the sole purpose of credibly revealing private information

signaling

the set of outcomes that are possible in an uncertain future

states of the world

Risk-averse people may

still want to buy some insurance even if it is not actuarially fair

If low-risk people have a high enough risk premium,

they will subsidize high-risk people in a pooling equilibrium.

effective signals convey..

useful information from informed parties to uninformed parties