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Unformatted text preview: s widely across communities. In some areas there is a high probability that a bicycle will be stolen, and in other areas bike thefts are quite rare. Suppose that the insurance company decides to offer the insurance based on the average theft rate. What do you think will happen? ANSWER: The insurance company is likely to go broke quite quickly! Who is going to buy the insurance at the average theft rate? Not the people in the safer communities they don't need much insurance anyway. Instead, the people in the communities with a high incidence of theft will want the insurance they are the ones who need it. 327 But this means that the insurance claims will be made mostly in the communities with a higher theft rate than the average. Insurance prices that are based on the average theft rate will be a misleading indicator of the actual claims experience for the insurance company. The insurance company will not get an unbiased selection of customers rather they will get an adverse selection. In fact, the term "adverse selection" was first used in the insurance industry to describe this sort of problem. It follows that insurance pricing uses a "worst-case" forecast based on the fact that low risk customers will not purchase the policy. There is a very interesting literature in this field of economics that attempts to discuss the ideas of separating equilibria, pooling equilibria, and market signalling. Staying with the insurance industry, we can have another type of information problem known as moral hazard. While the terminology is somewhat strange the problem is not difficult to describe. Let's consider the bike theft issue again and suppose, for simplicity, that all of the consumers live in areas with identical theft rates, so there is no problem of adverse selection. On the other hand, the probability of theft may be affected by the actions of the bicycle owners. For example, if the bike owner do not bother to lock their bikes then the bicycle is much more likely to be stolen than if they use a sturdy lock. Let's refer to actions that affect...
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- Spring '10