Competitive equilibrium under Adverse Selection...

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  • Competitive equilibrium under Adverse Selection and Moral HazardIs there a role for government intervention?

    Eduard K. Bohm / Morten N. Ststad

    EC 426 - Public EconomicsLondon School of Economics

    16 October 2017

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 1 / 21

  • Content

    1 Moral hazard

    2 Adverse selection

    3 Government intervention

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 2 / 21

  • Moral hazard

    Moral hazard

    1 Moral hazard

    2 Adverse selection

    3 Government intervention

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 3 / 21

  • Moral hazard

    Definition

    Moral hazard

    The term moral hazard originated in the insurance literature. Itsmodern use in economics is understoodby economiststo describeloss-increasing behavior that arises under insurance.

    Rowell and Connelly (2012), A History of the Term Moral Hazard

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 4 / 21

  • Moral hazard

    Moral Hazard Theory I

    Consumer desires insurance

    Insurance leads to consumer being willing to take more risk

    Contract cannot specify consumer behavior

    Consumer takes more risk than is socially optimal

    Information asymmetry: Insurance contract cannot specify consumerbehavior

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 5 / 21

  • Moral hazard

    Figure: Schmieder et. al. (2012)E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 6 / 21

  • Moral hazard

    Moral Hazard - Theory II

    Krueger (2002) on unemployment benefits:

    More generous benefits will provide greater protection against risk, butwould likely generate larger distortionary effects. For example, generousUnemployment Insurance benefits insure workers against the earningslosses that accompany job loss, but also induce some workers to searchless intensively for a new job.

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 7 / 21

  • Moral hazard

    Moral Hazard UI Empirics I

    Gruber (1997): Benefit levels are too high (in the US)

    Parsons (1980) and Hurd and Boskin (1984): Benefit levels explainlower labor force participation

    Krueger (2010): Job search is inversely related to the generosity ofunemployment benefits

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 8 / 21

  • Moral hazard

    Moral Hazard - UI Empirics II

    Card and Riddell (1993, 1997), Riddell and Sharpe (1998), Riddell(1999) examines the timing of UI benefits increasing in Canadarelative to the US, and finds no robust relation to relativeunemployment rates

    Belot and Van Ours (2001, 2004): Uses variation of UI programsacross OECD countries to show that social insurance programs reduceunemployment rates

    Social cohesion, inequality. . .

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 9 / 21

  • Moral hazard

    Moral Hazard - UI Empirics III

    Sjoberg et al (2010):

    However, no clear consensus over the empirical evidence seems to havebeen reached. Nickell et al. (2005) and Nunziata (2002) found a highlysignificant positive correlation between unemployment benefits and theunemployment rate, Baker et al. (2004) found no clear relationship. Belotand van Ours (2001, 2004) have even suggested that the generosity ofunemployment benefits may be negatively correlated with unemployment.

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 10 / 21

  • Adverse selection

    Adverse selection

    1 Moral hazard

    2 Adverse selection

    3 Government intervention

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 11 / 21

  • Adverse selection

    Definition

    Adverse selection

    Situations where one side of the market cant observe the type orquality of the goods on other side of the market. For this reason it issometimes called a hidden information problem.

    H. Varian, Intermediate Microeconomics

    The fact that insured individuals know more about their risk level thandoes the insurer might cause those most likely to have the adverse outcometo select insurance, leading insurers to lose money if they offer insurance.

    J. Gruber, Public Finance and Public Policy

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 12 / 21

  • Adverse selection

    Adverse selection - Modelling I

    Nobel Prize in 2001 for Akerlof, Spence and Stiglitz awarded for work inthis area.

    The Market for Lemons (Akerlof, 1970), asymmetric information onsupply side of the market.

    Insurance markets are covered in Rothschild and Stiglitz (1976) in amodel with price-quantity contracts offered.

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 13 / 21

  • Adverse selection

    The Market for Lemons

    Q

    pS(p)D(p)

    Q

    p

    Q

    pS(p)D(p)

    Demand depends on expected quality in the market. Inefficient outcome(left) and market breakdown (right). Based on Akerlof (1970).

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 14 / 21

  • Adverse selection

    Adverse selection - Modelling II

    A more general and graphical model for insurance markets presented byEinav and Finkelstein (2011).

    Competitive insurance firm offering single contract

    Private information on policyholder, knows own risk

    Falling marginal cost representing adverse selection.

    Demand reflects risk aversion of consumers

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 15 / 21

  • Adverse selection

    Textbook model (EF)

    Textbook model in Einav, Finkelstein (2011). Falling marginal cost curvereflects self selection, efficiency is not achieved.

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 16 / 21

  • Adverse selection

    Adverse selection - Empirics

    Summarized briefly in Chetty, Finkelstein (2013), extensively in Cohen,Siegelmann (2009)

    Search for coverage-risk correlation

    Strong evidence in annuity markets, health insurance (Harvard)

    Policyholders use of information, advantageous selection

    Pending work: markets with social insurance

    Outcome (Theory and empirics)

    Leads to an inefficient market equilibrium or to a market breakdown

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 17 / 21

  • Government intervention

    Government intervention

    1 Moral hazard

    2 Adverse selection

    3 Government intervention

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 18 / 21

  • Government intervention

    General result

    Government intervention

    In general, there is a role for the government in markets with adverseselection, but not in those with moral hazard.

    In the former, government can prevent people from exiting the marketand enable an efficient outcome

    In the latter, it has no relative advantage when compared to a privateagent

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 19 / 21

  • Government intervention

    Objections

    Adverse selection

    Intervention counterproductive?

    AS market still efficient

    Gov. may be source

    Opposed effects

    Additional inefficiencies

    Moral hazard

    Intervention useful?

    Government to change theproblem

    Work programs, fire safetyadvertising

    Government-supplied insurancecan reduce (or increase?)incentives to cheat programs

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 20 / 21

  • Government intervention

    Thanks

    Thank you for the attention!

    E. Bohm / M. Ststad (LSE) Adverse Selection / Moral Hazard 16 October 2017 21 / 21

    Moral hazardAdverse selectionGovernment intervention