MIT14_03F10_lec16

MIT14_03F10_lec16 - Lecture Note 16– Adverse Selection...

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Unformatted text preview: Lecture Note 16– Adverse Selection, Risk Aversion and Insurance Markets. 14.03/14003 Applied Microeconomic Theory and Public Policy, Fall 2010 David Autor, Massachusetts Institute of Technology November 21, 2010 1 Adverse Selection, Risk Aversion and Insurance Mar- kets • Risk is costly to bear (in utility terms). If we can defray risk through market mechanisms, we can potentially make many people better o¡ without making anyone worse o¡. • We gave three explanations for why and how insurance markets operate: 1. Risk pooling– Law of large numbers. 2. Risk spreading– Social insurance for non-diversi¢able risks. 3. Risk transfer (Lloyds of London)– Trading risk between more and less risk averse entities. • (Note: risk spreading does not generate Pareto improvements, but it may still be eco- nomically effi cient.) • There is an exceedingly strong economic case for many types of insurance. Effi cient insurance markets can unequivocally improve social welfare. • If the economic case for full insurance is so strong, why do we not see full insurance for: — Health — Loss of property: home, car, cash — Low wages 1 — Bad decisions: ∗ Marrying wrong guy/gal ∗ Going to the wrong college ∗ Eating poorly • Instead, we see: — Markets where not everyone is insured (health insurance, life insurance) — Incomplete insurance in every market where insurance exists at all: ∗ Deductibles ∗ Caps on coverage ∗ Tightly circumscribed rules (e.g., must install smoke detectors in house, must not smoke to qualify for life insurance). ∗ Coverage denied ∗ Insurance markets that don’t exist at all, even for major life risks Low earnings · Bad decisions · • Why are insurance markets incomplete? • Roughly 4 explanations: 1. Credit constraints: People cannot aFord insurance and hence must bear risk. Health insurance could be an example (i.e., if you already know you have an expensive disease, it may be too late to buy insurance). 2. Non-diversi¡able risk cannot be insured, e.g., polar ice cap melts, planet explodes. No way to buy insurance because we all face identical risk simultaneously. 3. Adverse selection—Individuals’private information about their own ‘riskiness’causes insurers not to want to sell policies to people who want to buy them. 4. Moral hazard (‘hidden action’)—Once insured, people take risky/costly actions that they otherwise would not. This makes policies prohibitively costly or simply not worth oFering (i.e, if I know that I’ ll drive like an idiot as soon as I have auto insurance, I may not want to be insured). 2 • The model that we’ ll develop in this lecture concerns adverse selection in insurance mar- kets. The basic notion of this model is that potential insured consumers may diFer in their risk pro¡les (that is, their expected costs), and, moreover, consumers may have some private information about their ‘riskiness’that is unknown to insurance companies (that is, insurance companies...
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This note was uploaded on 11/18/2011 for the course ECON 14.003 taught by Professor Davidautor during the Fall '10 term at MIT.

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MIT14_03F10_lec16 - Lecture Note 16– Adverse Selection...

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