<< Chapter < Page Chapter >> Page >

Imperfect information is the cause of the moral hazard problem. If an insurance company had perfect information on risk, it could simply raise its premiums every time an insured party engages in riskier behavior. However, an insurance company cannot monitor all the risks that people take all the time and so, even with various checks and cost-sharing, moral hazard will remain a problem.

Visit this website to read about the relationship between health care and behavioral economics.

The adverse selection problem

Adverse selection refers to the problem in which the buyers of insurance have more information about whether they are high-risk or low-risk than the insurance company does. This creates an asymmetric information problem for the insurance company because buyers who are high-risk tend to want to buy more insurance, without letting the insurance company know about their higher risk. For example, someone purchasing health insurance or life insurance probably knows more about their family’s health history than an insurer can reasonably find out even with a costly investigation; someone purchasing car insurance may know that they are a high-risk driver who has not yet had a major accident—but it is hard for the insurance company to collect information about how people actually drive.

To understand how adverse selection can strangle an insurance market, recall the situation of 100 drivers who are buying automobile insurance, where 60 drivers had very low damages of $100 each, 30 drivers had medium-sized accidents that cost $1,000 each, and 10 of the drivers had large accidents that cost $15,000. That would equal $186,000 in total payouts by the insurance company. Imagine that, while the insurance company knows the overall size of the losses, it cannot identify the high-risk, medium-risk, and low-risk drivers. However, the drivers themselves know their risk groups. Since there is asymmetric information between the insurance company and the drivers, the insurance company would likely set the price of insurance at $1,860 per year, to cover the average loss (not including the cost of overhead and profit). The result is that those with low risks of only $100 will likely decide not to buy insurance; after all, it makes no sense for them to pay $1,860 per year when they are likely only to experience losses of $100. Those with medium risks of a $1,000 accident will not buy insurance either. So the insurance company ends up only selling insurance for $1,860 to high-risk drivers who will average $15,000 in claims apiece. So the insurance company ends up losing a lot of money. If the insurance company tries to raise its premiums to cover the losses of those with high risks, then those with low or medium risks will be even more discouraged from buying insurance.

Rather than face such a situation of adverse selection, the insurance company may decide not to sell insurance in this market    at all. If an insurance market is to exist, then one of two things must happen. First, the insurance company might find some way of separating insurance buyers into risk groups with some degree of accuracy and charging them accordingly, which in practice often means that the insurance company tries not to sell insurance to those who may pose high risks. Or second, those with low risks must be required to buy insurance, even if they have to pay more than the actuarially fair amount for their risk group. The notion that people can be required to purchase insurance raises the issue of government laws and regulations that influence the insurance industry.

Questions & Answers

what are two classical macroeconomics and what're their theories say about their equations?
AMARA Reply
what is the formula for calculating elasticity
aza Reply
mpp÷APP
Umar
what is elasticity of demand?
Rita Reply
hello
Osanday
hi
SHERO
Causes of economic growth
pierre Reply
What is elasticity of demand
pierre
What are the causes of economic growth
pierre
economic growth, establishment of industry, encourage of investor's, farm productivities, creation of institutions, construction of good road etc
Oyewale
elasticity of demand can be said to be the responsiveness of demand to a change in prices
fateemah
impact of collusion in the economy referring to inefficiencies illustrated by means of graph
nondumiso Reply
The Factor price will determine the choice of techniques to produce.Expantiate
dajan
what is elasticity of demand?
Etta Reply
state and explain two types of demand
Etta
Institution involved in money market
Gande Reply
what is Economics
Kwame Reply
Economic is the study of scarcity
Kolade
Economics is the study of a lot of things. It is split up into two areas of study, Microeconomics and Macroeconomics. Microeconomics is the study of an individual's choices in the economy and Macroeconomics is the study of the economy as a whole.
The
Economics is a science that studies human scarcity
Agnes
What is Equilibrium price?
Agnes
Equilibrium is the market clearing price. The point at which quantity demanded equals quantity supplied. The point at which the supply and demand curves intersect.
The
Equilibrium price*
The
Refers to the study of how producers use limited resources to satisfy human unlimited wants
Gatoya
why is economics important
Derrick Reply
What will you do as a consumer if you are not at equilibrium?
chukwu Reply
am new I will like to know about the graph relationship
Gloria Reply
comment on WTO principle on trading system. trade without discrimination
Omben Reply
optimize z=f(x,y)=6x²-9x-3xy-7y+5y²
Alex Reply
What is an indifference curve?
layla Reply
different levels of utilities of a person in a given set of bundles of goods
RAM
identify and quantify five social costs and social benefits of building a school
Mokgobo Reply
identify and quantity five social costs and social benefits of building a hospital
Mokgobo
short run vs long run
Jean
state the law of diminishing return?
Ibrahim
The Law of Diminishing (Marginal) Returns simply states that at some point in time a business/operation/etc.'s increased productivity will begin to decline.
The
For example, if a small pizza shop currently has 3 workers in the kitchen at any given time,and hiring 1 more worker will increase productivity, at some number of workers hired will the business see a decrease in productivity because the capital resources that the pizza shop has is not infinite.
The
Five social benefits of building a hospital, in my opinion and depending on where it's built, would be 1) Increased care for neighboring residents, 2) Potential jobs for individuals, 3) May decrease the travel time residents need to endure in order to reach the nearest hospital
The
4) May create work-study programs for individuals who aspire to be future Doctors, Nurses, Physicians, etc. 5) Assuming there are local pharmaceutical businesses nearby, the hospital may decide to purchase supplies local, increasing the business' sales. Thus, generating more income.
The
5 costs of building a hospital would be 1) Increased noise and waste pollution from service vehicles and hospital visitors, 2) May require large amounts of space, possibly jeopardizing nearby animal habitats, 3) May see an increase in traffic and possibly car accidents from frantic individuals
The
racing to see their injured friends, family members, etc. 4) Constructing a hospital and hiring staff is very expensive 5) To use funds, private or public, to finance the construction of a hospital cannot be used to fund any other projects. (The concept of opportunity costs.)
The
what is meant by inteference with the price mechanism operation?
Mugen
We use a Supply and Demand graph to illustrate at what price level will the market for a certain good or service be at equilibrium. If the price for a good or service is set too high, consumers will be less inclined to buy that product Thus, creating a surplus.
The
This surplus will eventually drive the price back down to it's equilibrium point. Similarly, if a price for a good or service is set too low, individuals would be more inclined to buy more of a certain product, creating a shortage. This shortage will cause sellers to drive the price back up to the
The
equilibrium point.
The

Get the best Principles of economics course in your pocket!





Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
Google Play and the Google Play logo are trademarks of Google Inc.

Notification Switch

Would you like to follow the 'Principles of economics' conversation and receive update notifications?

Ask