Asymmetric Information - In the Health Insurance Market, buyers know more information about their own health problems

than do potential insurance providers. With this better information, buyers have an incentive to conceal their health problems in attempt to get a lower insurance 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 informational disparity is often referred to as asymmetric information. Asymmetric information is a cause of market failure in many different arenas. One of the most commonly used examples is used and new cars. Although a new car may be worth $25,000 and then 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 information than the buyer and the buyer has to trust the seller to tell them all of the pertinent information in relation to the car. The insurance market and the used cars are just some examples of how asymmetric information affects the economy and causes market failure. The real estate market is another example in which the seller has more information than the potential buyer. In this case, it is the previous homeowner as well as the real estate agent who knows the most about the house or property in question. 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 a different way. With this informational asymmetry, insurance providers would charge one price and hope to spread their costs across a diverse group of policy holders. Another way of looking at this is that the insurance provider tries to use some of their large profits from low risk/good health customers to subsidize their losses from high risk/poor health customers. However, we will likely find the buyers in poor health purchase insurance while the healthy individuals find that they are better off paying their smaller medical bills out of pocket. In this scenario, we find that insurance providers would have a difficult time operating profitably. This is called adverse selection. When adverse selection occurs, too much of the low-quality product has entered the market than the 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 in bad quality, yet the buyer is unable to distinguish the difference between the two. Knowing that they have a 50 percent chance of buying a good quality car they will offer the median price to the seller, say for instance $7500 because the low-quality car is worth $5000 and the high-quality car is worth $10,000. If this happens then all of the sellers of low-quality cars will rush the market to sell their products. So the market for high-quality cars will have dissipated, thus resulting in a market failure, specifically adverse selection. Moral Hazard- Moral Hazard is a broad topic that addresses several areas within Economics. It is defined as an adverse behavior that is brought on by allowing people to buy insurance for an adverse event. This entails when a person's behavior is hard to monitor and control and thus payment to that person is based on incomplete information. This usually occurs in the insurance and 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 productive efforts of his employee or manager (the agent). Thus, a flat-rate of compensation for employment, combined with the asymmetric information, can give the employee an incentive to shirk, 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 same regardless of his performance. This is a problem within all areas of insurance and all of the different types of insurance that is offered. People will buy the insurance and then feel falsely protected by it and act in a way that is dangerous in general. For instance, if a person purchases fire insurance for his home, he might not be as careful to properly store flammable material or never use candles in the house, as he was prior to obtaining insurance. Because of this, it may not be the best policy for governments to provide complete insurance for anything. This brings us to the relationship between moral hazard and unemployment insurance. When workers are laid off or cannot find a job they may apply for unemployment insurance. In the United States, they are entitled to this for a limited time, while many countries in Europe allow this collection of unemployment benefits to go on for an indefinite period of time. Because these individuals are receiving the benefits without doing the work they are less inclined to actually actively look for a job like they are supposed to. This creates a moral hazard because in the government trying to help people without jobs they are actually giving them an incentive not to look for another one. This is more of a problem in European countries and a reason why they have higher unemployment rates overall than the United States. Market Failure - At first, it may seem that the study of economics suggests that all goods and services 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 wealth maximizing individuals. Further, this will happen without government intervention. However, a simple look at the world around us will show that the government is quite involved in our everyday market transactions. For example, in most states, the final purchase price of most goods and services include a sales tax. Some goods like tobacco and alcohol have a further tax that may be 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 not always work; that the invisible hand does not always create the efficient outcome. Economists refer to this situation as market failure. In studying the sources of market failure (and how we may correct for the inefficiencies they create) 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 creates costs or benefits not reflected in the competitive market price. For example, the price that Laura agrees to pay for George's house (my neighbor who likes to play loud, out of tune, guitar solos late at night) does not include the benefit that I receive from no longer having George as my neighbor. Externalities are commonly referred to as "spillover" or "third-party" effects that impact parties beyond those considered in the decision making process of individuals or by the

transactions between parties. It is important to recognize that externalities can have a positive or a negative impact; economists typically classify externalities in this way Positive Externalities - A positive externality is a benefit transferred, or a positive "spill-over", to a party that was not a part of the original transaction or decision making process. Here is an example of a positive externality. Suppose homeowners spend $5000 in landscaping improvements to their property in hopes of increasing the market value of their home. These improvements will likely enhance the market value of neighbors' property even though they did not bear any portion of the improvement costs or participate in the decision to improve the yard. On a larger scale, another example of a positive externality is the benefit associated with the installation of scrubbers in producer's smokestacks. The people that live near the factory benefit from the scrubbers through cleaner air and better health even though they did not bear the cost of installing the scrubbers. Further, these positive benefits will likely "spill-over" to future generations not born yet; each scrubber installed in factories now will decrease the marginal environmental damage that future generations will face. Negative Externalities- George, my neighbor, enjoys serenading his girlfriend with loud, out of tune, electric guitar solos. While George and his girlfriend seem to enjoy the sound, I dislike the loss of sleep and the decrease in productivity at work the next morning. However, George does not bear the cost of my lost sleep and lower productivity at my job. My lost sleep and lower productivity is an example of a negative externality of George's guitar playing. An example on a larger scale. Consider a community in Malaysia that is home to a factory that produces goods to be sold in The United States and Europe. The final market price of these goods does not reflect the costs incurred by the community in the form of poorer air quality and poorer health. While the world is dazzled by China's impressive 10% per year growth in GDP, some have estimated that the cost of pollution in China is equal to 10% of GDP. In other words, when we account for the impact of pollution, China may not be growing after all. China, along with other developing nations, faces a difficult trade off between industrial economic growth and the well being of the environment. The reason for this is that limiting pollution typically increases the cost of production. This increased cost in production slows the economic growth that government officials in the developing world are so proud of. Because a lower level of pollution is a public good, we see developing nations under-invest in pollution control. Many developing nations are in competition for American and European factories; because pollution control increases the cost of doing business, we see an incentive for governments to be lenient in pollution reduction measures As we have stated, the final market price of many goods is not at the socially optimal level. The socially optimal price takes into account the benefit or damage caused by the "spillover" effect. Many remedies have been suggested for forcing buyers and sellers to "realize" the impact of externalities when negotiating price. Some of the suggested solutions use the private market while others argue for government policy

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