ECON1002 Lecture Notes - Lecture 19: Adverse Selection, Unemployment Benefits, Perfect Competition
14 May 2019
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Department
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Market failures
•Assumptions of perfect markets (if met, the market will coordinate benefits/costs)
•Private goods
•No externalities
•No transaction costs
•Perfect competition
•imperfect information
Types of imperfect information
•Adverse selection: where one side of the market knows more than the other- the consumer
knows more then the producer or visa versa
•Moral Hazard: where an agent does not bear the cost of risks or purchases that they take/make-
they might bear some of the costs or all of the costs
•Principle–agent problem: where the incentives of the employer and employee do not align-
results in an inefficient outcome
•Note
: these often overlap
Adverse selection
•When one side of the market has more information than the other, this will result in inefficient
market outcomes
•Classic example: selling a used car—only the seller knows how bad it is. They are WTP more
then the car’s worth to them bc they are miss-informed of its quality
•Another classic example: unemployment insurance—only the worker knows how easily they
can find a job, how easily they might get fired bc they might be incompetent. Private markets
don’t usually provide unemployment insurance-bc they are concern a worker will deliberately
get fired to get the unemployment relief.
Adverse selection in health care
•Consider a population of 100 people where half the people have a high risk of a health incident
(25%) and half have a low risk (10%)
•An incident costs $100 to an insurer
•So the expected payout is:
(0.25% chance times*50 half the population *100 payout) + (0.1 10% chance times *50 half the
population times *100 payout) = 1250 + 500 = 1750
Note that the bulk of the cost is the high risk people (1250)
*Consumers know more then the producers and the producers is the health insurance
company
Continued:
•Assuming that the insurer does not know
who is high risk and low risk, the efficient premium
(charge) is:
Expected payout times population: 1750/100 = $17.50
•Note that for the high risk people their expected health care costs in a year is $100*0.25 = $25
è$17.50 is a good price for people to pay. Its a bargain for them- they get some consumer surplus
•But for low risk people it is $100*0.1 = $10 è$17.50 is expensive- the chances of me having an
accident are low, i’ll just gamble and don’t take the insurance in the hope i don’t get into an
accident.
-normative issue: should we have to finance other people. You can say eventually the young
people will be old so we should subsidise them. In a private market the young just won’t take out
insurance but this is inefficient because some people who would benefit from it don’t have it
-the distribution of costs is not very fair-most of costs comes from the high risk people.
-it is economically efficient because everyone is meeting costs but the low risk people are
subsidising the high risk people.
Moral hazard: happens when somebody is gambling with someone else’s money
•Arises when someone is gambling with somebody else’s money—stock-brokers, public servants
etc. you are using the taxpayers money or someone else’s so you don’t bear the risks of stuffing
up
•More formally, moral hazard is when someone does not bear or fully bear the risks and/or the
costs associated with their behaviour
•Important example: banks when they have “too big to fail” protection—banks know they can
take life-threatening risks (risks to its own viability) because the government will bail them out.
-happened during the GFC
Eg:loan waivers for farmers -creating a moral hazard
Moral hazard in health care
•If a health insurer covers your bills, then a doctor can overcharge you and you won’t care.
•For example, you may need a knee-replacement. You can get a cheap one that will allow you to
walk/work
•But you could also get a titanium knee that will allow you to ski. You never go skiing, but
you’re not paying
, so why not? In a commercial setting you wouldn’t get the titanium kee bc its
too expensive and you don’t need it
•Question: should a socialised medical service pay only for the cheap replacement or the
titanium kee? If you are a skier should they pay? What is the appropriate balance between private
co-balance eg: the state covers you for this and if you want extra you have to pay.
Moral hazard and preventative health: you do stuff not bc you have a health problem but
bc you want to avoid one
•If you have health insurance, whether public or private, you will be less inclined to invest in
preventative measures e.g. exercise, diet control
•Private insurance at least typically charges people higher premiums if they engage in ‘risky’
behaviours like smoking, extreme sports, overeating etc.
•But remember that people will always try to hide these risks from the insurer
Principle-Agent problems
•Sometimes a principle will employ an agent to act on their behalf
Document Summary
Market failures: assumptions of perfect markets (if met, the market will coordinate benefits/costs, private goods, no externalities, no transaction costs, perfect competition, imperfect information. Adverse selection: when one side of the market has more information than the other, this will result in inefficient market outcomes, classic example: selling a used car only the seller knows how bad it is. Private markets don"t usually provide unemployment insurance-bc they are concern a worker will deliberately get fired to get the unemployment relief. Note that the bulk of the cost is the high risk people (1250) *consumers know more then the producers and the producers is the health insurance company. Continued: assuming that the insurer does not know who is high risk and low risk, the efficient premium (charge) is: Expected payout times population: 1750/100 = . 50: note that for the high risk people their expected health care costs in a year is *0. 25 = .
