Information, Risk, and Insurance
Purpose
In this chapter, you have learned that imperfect and asymmetric information can affect equilibrium prices and quantities in all markets and what can be done to reduce the impact of imperfect information. You have also learned about the problems that imperfect information causes in insurance markets and how insurance companies try to reduce the impact of imperfect information.
The first purpose of this exercise is for you to identify situations where imperfect information is a factor and to suggest ways in which the impact of imperfect information might be decreased. The second purpose is to identify the problems of adverse selection and moral hazard and explain what can be done to reduce their impact.
Directions
This exercise has two parts. In the first, you will identify situations where there is imperfect information, then indicate missing information from both the buyer's and the seller's perspective and suggest ways to increase the information available. In the second, you will determine if a situation is an example of adverse selection or moral hazard and suggest ways that these problems can be reduced.
Part 1 - Imperfect Information
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In the following table, for each situation with imperfect information, indicate the information that the buyer and/or the seller are missing and what can be done to increase the information available to either or both sides of the market.
In the last two rows, list two transactions where you were affected by imperfect information and indicate what you did, or could do in the future, to reduce the impact of imperfect information.
| Situation | Buyer | Seller | Ways to Reduce the Imperfect Information Problem |
|---|---|---|---|
| Buying a used car | (blank) | (blank) | (blank) |
| A doctor recommends knee replacement surgery for you | (blank) | (blank) | (blank) |
| Booking a hotel for a vacation in Canada | (blank) | (blank) | (blank) |
| Hiring someone to paint your house | (blank) | (blank) | (blank) |
| Hiring a lawyer to represent your small business | (blank) | (blank) | (blank) |
| (blank) | (blank) | (blank) | (blank) |
| (blank) | (blank) | (blank) | (blank) |
Part 2 - Adverse Selection and Moral Hazard
Indicate if the following situations are an example of adverse selection or moral hazard. Then, suggest a strategy that would reduce the problem.
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A university doesn't know if a student that they admit will remain in school, complete their program of study, and graduate.
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Most of the people buying health insurance are either sick, elderly, or both.
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If health insurance companies must insure everyone at the same low-cost premium, many people pursue careers in bull riding, ski jumping, and race car driving.
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Some people respond to credit card offers that promise very low interest rates and encourage balance transfers from other credit cards.
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People who have homeowner's insurance don't put new batteries in their smoke alarms.