For this reason it is sometimes called a hidden

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Unformatted text preview: r to be inefficient, but one has to be careful when making this assertion in "the real world". In reality, we must ask the question, "inefficient relative to what?" The equilibrium in these markets will always be inefficient relative to the equilibrium with full information. However, this is of little (or no) help when we need to make policy decisions: if the participants in the industry find it too costly to collect more information then the government would likely find it too costly as well. The real question is to ask whether some sort of government intervention in the market could improve efficiency. In the case of hidden action, the answer is usually "no". If the government cannot observe the care taken by individuals, then it can do no better than the insurance companies. Of course, the government may have other tools at its disposal that are not available to the insurance company it could compel a particular level of care, and it could set criminal punishments for those that did not take due care. However, in most cases, the government can do no better than insurance companies can in markets with hidden action. Similar issues arise in the case of hidden information. We can imagine that if the government can compel people of all risk classes to buy insurance, it is possible for everyone to be made better off. That is, on the surface, this seems to justify government intervention here. On the other hand, there are costs to government intervention as well. Economic decisions made by governmental decree may not be as cost effective as those made by private firms. Just because there are government actions that can improve social welfare does not guarantee that those actions will be taken. Furthermore, there may be private solutions to the adverse selection problem. For example, if the seller of a good car can signal to the buyer that their car is a plum (by offering a 1 year warranty, or a money back guarantee if anything goes wrong within the first 6 months) then there are incentives for the buyer to believe the car is...
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This note was uploaded on 05/25/2010 for the course ECON 301 taught by Professor Sning during the Spring '10 term at University of Warsaw.

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