(More) Information

Lemons and Insurance

• Insurers have incomplete information on the quality of those seeking insurance.

• Some may be creampuffs• Others may be lemons.• What does that do to the

market.• Assume we have 9 people,

with expected expenditure levels varying from 0 to M. Let M = 2,000.

Expected Prob.0 0 0.1111111 0.222222 0.1111112 0.444444 0.1111113 0.666667 0.1111114 0.888889 0.1111115 1.111111 0.1111116 1.333333 0.1111117 1.555556 0.1111118 1.777778 0.1111119 2 0.111111

0

0.02

0.04

0.06

0.08

0.1

0.12

0.00 0.22 0.44 0.67 0.89 1.11 1.33 1.56 1.78 2.00

Pro

ba

bil

ity

Expected Medical Expenditues

Probabilities.

Prob.

Idea

• Insured know how healthy they are but insurers DON’T.

• Insurers only know that the AVERAGE person would have expenditures of how much?

• A> $1,000. Why?

Equilibrium price?

• Suppose an auctioneer calls out a price of $0 for insurers. All 9 people will seek insurance. Why?

• How many will be offered insurance?• A> None. Because sellers only know that the mean

expenditure level is $1,000. So you have 9 buyers, no sellers.

Equilibrium price? (2)

• $0 doesn’t work.

• Suppose auctioneer calls out a price of (1/2)* M = $1,000. 5 people will continue to seek to buy insurance. Why?

• The HEALTHIEST people withdraw, because the insurance will cost them more than it is worth to them.

• Average expected expenses rise from (1/2)*M to (3/4)*M, or from $1,000 to $1,500.

• Thus, the higher premiums drive out the healthier people, and a functioning market MAY not appear for otherwise insurable health care risks.

WHY?

• When potential sellers know only the average quality of those they are insuring, then the market prices will tend too high for the best health care risks.

• High quality insurance risks are driven out of the market by lemons.

• KEY -- Buyers have information. Sellers DON’T.

Example with ACA

• Biggest goal – Insure about 50 million people who do not have insurance.

• What happens if we make this voluntary?

• Healthiest ones may opt out.

• Ones with lowest insurance costs leave, and costs/person for all others will .

Adverse Selection

• This problem is called ADVERSE SELECTION!

• Does it mean that we don’t have insurance markets?• Obviously not.• In health insurance markets, patients may not be

covered for “pre-existing conditions”. ACA is preventing that.

• Premiums for individual policies may be based on other information that insurers use to predict expenditures,

• SUCH AS age, employment status, and occupation

The Principal:Agent Problem

• This problem occurs when a patient (the principal) must hire and provider (agent) who will decide how much service is needed.

• The PERFECT agent acts in accordance with the principal’s “best” interests.

• What if providing more services provides more income for the agent?

• Who monitors the agent.

Supplier-Induced Demand (SID)

• One example of the principal-agent problem is SID.

• Does having more physicians mean that more care is prescribed?

• Why, or why not?• There are some who would argue that

“managed care” organizations may monitor the agents.

Another example: contingency fees

• Some cases are handled on a contingency basis, like medical malpractice.

• Attorney collects a fee, typically 1/3

• IF they win.• What are marginal

benefits, marginal costs?

Attorney hours

Dol

lars

Marginal Benefits

Marginal Costs

2/3 Marginal Benefits (to plaintiff)

1/3 Marginal Benefits (to lawyer)

Another example: contingency fees

• What is the consumer’s optimum?

Attorney hours

Dol

lars

Marginal Benefits

Marginal Costs

2/3 Marginal Benefits

1/3 Marginal Benefits

• What is the attorney’s optimum?

• Point B. Why?

• Point A. Why?BA