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Asymmetric Information

Asymmetric Information

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Published by Carol Savia Peters

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Published by: Carol Savia Peters on Oct 02, 2012
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11/30/2012

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Asymmetric Information -
In the Health Insurance Market, buyers know more informationabout their own health problems than do potential insurance providers. With this betterinformation, buyers have an incentive to conceal their health problems in attempt to get a lowerinsurance premium. In other words, if insurance providers knew that a person had a history of heart problems, insurance providers could charge him or her higher rate. This informationaldisparity is often referred to as asymmetric information.Asymmetric information is a cause of market failure in many different arenas. One of the mostcommonly used examples is used and new cars. Although a new car may be worth $25,000 andthen the seller wishes to sell it almost immediately after purchase the value drops drastically.This is because buyers are wary that something may be wrong with the car even though the seller just decided they didn't want it anymore. In this case, the seller of the car has more informationthan the buyer and the buyer has to trust the seller to tell them all of the pertinent information inrelation to the car.The insurance market and the used cars are just some examples of how asymmetric informationaffects the economy and causes market failure. The real estate market is another example inwhich the seller has more information than the potential buyer. In this case, it is the previoushomeowner as well as the real estate agent who knows the most about the house or property inquestion.There are two basic models that describe information asymmetry and they are:
Adverse Selection-
Using the Health Insurance example from the first page, we can look at it adifferent way. With this informational asymmetry, insurance providers would charge one priceand hope to spread their costs across a diverse group of policy holders. Another way of lookingat this is that the insurance provider tries to use some of their large profits from low risk/goodhealth customers to subsidize their losses from high risk/poor health customers. However, wewill likely find the buyers in poor health purchase insurance while the healthy individuals findthat they are better off paying their smaller medical bills out of pocket. In this scenario, we findthat insurance providers would have a difficult time operating profitably. This is called adverseselection.When adverse selection occurs, too much of the low-quality product has entered the market thanthe high-quality product. This is best illustrated through the example of used cars once again. If we suppose that there are only two types of cars for sale, only ones in good quality and ones inbad quality, yet the buyer is unable to distinguish the difference between the two. Knowing thatthey have a 50 percent chance of buying a good quality car they will offer the median price to theseller, say for instance $7500 because the low-quality car is worth $5000 and the high-quality caris worth $10,000. If this happens then all of the sellers of low-quality cars will rush the marketto sell their products. So the market for high-quality cars will have dissipated, thus resulting in amarket failure, specifically adverse selection.
Moral Hazard-
Moral Hazard is a broad topic that addresses several areas within Economics. Itis defined as an adverse behavior that is brought on by allowing people to buy insurance for anadverse event. This entails when a person's behavior is hard to monitor and control and thuspayment to that person is based on incomplete information. This usually occurs in the insuranceand job markets. In the workplace, moral hazard is generally known as the principal-agent
 
problem. This is where the owner of a business (the principal) can't fully observe the productiveefforts of his employee or manager (the agent). Thus, a flat-rate of compensation foremployment, combined with the asymmetric information, can give the employee an incentive toshirk, or to not work as hard as he is capable of. He can follow his own best interest instead of fully pursuing the best interests of the owner by working diligently, as he will be paid the sameregardless of his performance.This is a problem within all areas of insurance and all of the different types of insurance that isoffered. People will buy the insurance and then feel falsely protected by it and act in a way thatis dangerous in general. For instance, if a person purchases fire insurance for his home, he mightnot be as careful to properly store flammable material or never use candles in the house, as hewas prior to obtaining insurance. Because of this, it may not be the best policy for governmentsto provide complete insurance for anything.This brings us to the relationship between moral hazard and unemployment insurance. Whenworkers are laid off or cannot find a job they may apply for unemployment insurance. In theUnited States, they are entitled to this for a limited time, while many countries in Europe allowthis collection of unemployment benefits to go on for an indefinite period of time. Because theseindividuals are receiving the benefits without doing the work they are less inclined to actuallyactively look for a job like they are supposed to. This creates a moral hazard because in thegovernment trying to help people without jobs they are actually giving them an incentive not tolook for another one. This is more of a problem in European countries and a reason why theyhave higher unemployment rates overall than the United States.
Market Failure -
At first, it may seem that the study of economics suggests that all goods andservices are efficiently provided for by the invisible hand. In other words, the correct number of goods and services will be provided and all shortages and/or surpluses will be resolved by wealthmaximizing individuals. Further, this will happen without government intervention. However, asimple look at the world around us will show that the government is quite involved in oureveryday market transactions. For example, in most states, the final purchase price of most goodsand services include a sales tax. Some goods like tobacco and alcohol have a further tax that maybe designed to alter people's behavior or "induce" them to do something more "socially"desirable. The existence of government intervention seems to suggest the invisible hand does notalways work; that the invisible hand does not always create the efficient outcome. Economistsrefer to this situation as market failure.In studying the sources of market failure (and how we may correct for the inefficiencies theycreate) economists typically look at three different categories. The categories are externalities,public goods, and imperfect information. When reviewing these pages, you will find that each of these topics are closely intertwined.
Externalities -
An externality is a result of market failure. The impact of an externality createscosts or benefits not reflected in the competitive market price. For example, the price that Lauraagrees to pay for George's house (my neighbor who likes to play loud, out of tune, guitar soloslate at night) does not include the benefit that I receive from no longer having George as myneighbor. Externalities are commonly referred to as "spillover" or "third-party" effects thatimpact parties beyond those considered in the decision making process of individuals or by the

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