Information, Risk, and
The Problem of Imperfect Information and Asymmetric
Insurance and Imperfect Information
Imperfect information and
Asymmetric information: where both parties involved in an
economic transaction have an unequal amount of information (one
party knows much more than the other)
E.g. Buying a used car
Imperfect information: either the buyer, the seller, or both, are
less than 100% certain about the qualities of what is being bought
Imperfect vs asymmetric
buyers and/or sellers do
not have all of the
necessary information to
make an informed decision
about the price or quality of
one party, either the buyer
or the seller, has more
information about the
quality or price of the
product than the other
Lemons – Used Car Market
with imperfect information, prices still
cars are more expensive on some dealer
lots because the dealers have a trustworthy
reputation to uphold (signal)
seller has no reputation to defend
Imperfect information – Labor
How can a potential employer screen for certain attributes, such
as motivation, timeliness, ability to get along with others, and so
Trade schools and colleges to pre-screen candidates.
Only interview a candidate with a degree and, sometimes, a
degree from a particular school.
View awards, a high grade point average, and other accolades
as a signal of hard work, perseverance, and ability.
References for insights into key attributes such as energy level,
work ethic, and so on.
Imperfect information - impacts
Price and Quantity
markets (few buyers and sellers) as each is
hesitant due to uncertainty as opposed to thick
markets (many buyers and sellers)
as a signal of quality
n E.g. Expensive
Imperfect Information - Fixing
Reputation, guarantees, warrantees, and service contracts
n Guarantees assure quality (promised)
n Warranty – promise to fix defect over a limited time
n Service Contract – pay extra to assure repairs
occupational licenses and certifications to assure competency;
cosigners and collateral
Federal Trade Commission – against advertisers making false
claims as truth
+ Insurance and Imperfect
Insurance: a method that households and firms use to prevent any
single event from having a significant detrimental financial effect.
Premiums: Regular payments made by households or firms with
Based on probability of event occurring
Pooled and paid out to those affected by the covered event if it occurs
E.g. Health insurance, Life insurance, Auto insurance etc.
How insurance works
100 people insured; three risk groups; three possible outcomes
Total damage = (60 × $100) + (30 × $1,000) + (10 × $15,000)
= $600 + $30,000 + $150,000
If each of the 100 drivers pays a premium of $1,860 each year, the
insurance company will collect the $186,000 needed to cover the
costs of the accidents that occur. Average premiums and average
insurance payouts must be approximately equal.
How insurance works
group: a group that shares roughly the same risks
of an adverse event occurring.
companies often classify people into risk
groups, and charge lower premiums to those with
could classify people according to risk group,
then each group can be charged according to its
expected losses – high risk, pay higher premiums
Imperfect information in insurance
Moral Hazard : when people engage in riskier behavior with
insurance than they would if they did not have the insurance.
E.g. with car insurance, drivers drive less careful than without
Cannot be eliminated, but insurance companies can attempt to
Monitor behavior to manage risk – security system lowers premiums
Deductibles - amount that the insurance policyholder must pay out of
their own pocket before the insurance coverage starts paying
Copayment - policyholder must pay a small amount
Coinsurance - insurance company covers a certain percentage of the
When faced with copays and deductibles, studies find reduction in
moral hazard (less consumption of covered service)
Moral Hazard – health insurance
Fee – for – service: medical care providers are paid for the
services they provide and are paid more if they provide
Traditional way of providing health care in the US
Lately more shift to health maintenance organizations (HMOs)
Health Maintenance Organization (HMO) provides
healthcare that receives a fixed amount per person enrolled
in the plan—regardless of how many services are provided
Consumer still has incentive to demand more services; provider
has incentive to limit it.
Adverse selection - the problem in which the buyers of
insurance have more information about whether they are highrisk or low-risk than the insurance company does.
Asymmetric information problem for insurers
E.g. With $1860 premium cost from previous example, only high
risk group will get insurance (expected loss greater than $1850,
while others have expected cost less than $1860, so insurance
company can not pool risk, i.e. take from lower risk and pay to
May refuse high risk individuals, or offer insurance at very high
rates – as was the case with healthcare in US before 2010
Affordable Care Act 2010
If insurance premiums are set at actuarially fair levels, people
end up paying an amount that accurately reflects their risk
group, certain people will end up paying a lot or not offer it
to those with pre-existing conditions – not allowed under
High premiums – not all get insurance (adverse selection) –
mandated now (50+ employees must offer insurance)
State insurance exchanges – for competition of plans
Paid for by higher taxes, annual fees on providers
Q6. What are some of the ways a seller of goods might reassure
a possible buyer who is faced with imperfect information?
Q7. What are some of the ways a seller of labor (that is,
someone looking for a job) might reassure a possible employer
who is faced with imperfect information?
Solution: Offering warrantees or a period of time in which to return the
product for a full refund might correct for the buyer’s lack of information.
Solution: The worker may offer to work for a trial period for little or no
wages so that the employer can verify his value before signing a longterm contract.
Q8. What are some of the ways that someone looking for a loan
might reassure a bank that is faced with imperfect information
about whether the loan will be repaid?
Solution: People looking for loans typically have to show evidence of a
steady income or the possession of collateral, such as a property owned,
so that the bank can be assured of collecting on its loan.
Q 11. What is an actuarially fair insurance policy?
Q 12. What is the problem of moral hazard?
Solution: An actuarially fair policy is one in which the average benefits
paid out equal the average cost to the policy holder.
Solution: Moral hazard is the observation that people behave in more
risky ways when the cost of risky behavior is decreased.
Q 13. How can moral hazard lead to insurance being more
costly than was expected?
Solution: When people are insured, they engage in more risky
behavior, leading to higher costs for the insurer and thus higher
premiums for the policy holder.
Problem - # 24
Imagine that 50-year-old men can be divided into two groups: those
who have a family history of cancer and those who do not. For the
purposes of this example, say that 20% of a group of 1,000 men have a
family history of cancer, and these men have one chance in 50 of dying
in the next year, while the other 80% of men have one chance in 200 of
dying in the next year. The insurance company is selling a policy that
will pay $100,000 to the estate of anyone who dies in the next year.
a. If the insurance company were selling life insurance separately to
each group, what would be the actuarially fair premium for each
b. If an insurance company were offering life insurance to the entire
group, but could not find out about family cancer histories, what
would be the actuarially fair premium for the group as a whole?
c. What will happen to the insurance company if it tries to charge the
actuarially fair premium to the group as a whole rather than to each
a. For the high risk group, the premium would be the probability
of dying 0.02 times the benefit payment $100,000 = $2,000. For
the low risk group this would be 0.005 x $100,000 = $500.
b. We weight the premiums for the two groups by frequency in
the population and add the results together. $2,000 x 0.2 + $500
x 0.8 = $800.
c. The high risk group will recognize that they are getting a
good deal, since $800 is less than their actuarially fair rate of
$2,000, so they will enroll in high numbers. Meanwhile, the low
risk group will be less likely to enroll, since the rate is higher
than their actuarially fair rate of $500. This adverse selection
problem will cause the insurance company to either lose money
or have to raise rates still higher.