Self-Check Questions

16.2 Insurance and Imperfect Information

Insurance is a way of sharing risk. People in a group pay premiums for insurance against some unpleasant event, and those in the group who actually experience the unpleasant event then receive some compensation. The fundamental law of insurance is that what the average person pays in over time cannot be less than what the average person gets out. In an actuarially fair insurance policy, the premiums that a person pays to the insurance company are the same as the average amount of benefits for a person in that risk group. Moral hazard arises in insurance markets because those who are insured against a risk will have less reason to take steps to avoid the costs from that risk. Many insurance policies have deductibles, copayments, or coinsurance. A deductible is the maximum amount that the policyholder must pay out-of-pocket before the insurance company pays the rest of the bill. A copayment is a flat fee that an insurance policy-holder must pay before receiving services. Coinsurance requires the policyholder to pay a certain percentage of costs. Deductibles, copayments, and coinsurance reduce moral hazard by requiring the insured party to bear some of the costs before collecting insurance benefits. In a fee-for-service health financing system, medical care providers receive reimbursement according to the cost of services they provide. An alternative method of organizing health care is through health maintenance organizations (HMOs), where medical care providers receive reimbursement according to the number of patients they handle, and it is up to the providers to allocate resources between patients who receive more or fewer health care services. Adverse selection arises in insurance markets when insurance buyers know more about the risks they face than does the insurance company. As a result, the insurance company runs the risk that low-risk parties will avoid its insurance because it is too costly for them, while high-risk parties will embrace it because it looks like a good deal to them.

Self-Check Questions

1 . For each of the following purchases, say whether you would expect the degree of imperfect information to be relatively high or relatively low: a. Buying apples at a roadside stand b. Buying dinner at the neighborhood restaurant around the corner c. Buying a used laptop computer at a garage sale d. Ordering flowers over the internet for your friend in a different city 2 . Why is there asymmetric information in the labor market? What signals can an employer look for that might indicate the traits they are seeking in a new employee? 3 . Why is it difficult to measure health outcomes?

Review Questions

4 . Why might it be difficult for a buyer and seller to agree on a price when imperfect information exists? 5 . What do economists (and used-car dealers) mean by a “lemon”? 6 . What are some ways a seller of goods might reassure a possible buyer who is faced with imperfect information? 7 . What are some ways a seller of labor (that is, someone looking for a job) might reassure a possible employer who is faced with imperfect information? 8 . What are some ways that someone looking for a loan might reassure a bank that is faced with imperfect information about whether the borrower will repay the loan? 9 . What is an insurance premium?