Question 1

Expected utility theory predicts that individuals will fully insure in actuarily fair markets so long as their tastes are state-independent.How might adverse selection result in some individuals under-insuring?

Accepted Answer

Under adverse selection,a separating equilibrium will have the following feature: Low cost types will be offered a menu of insurance contracts that is actuarily fair but not complete -- i.e.full insurance will not be offered at rates that are actuarily fair for low cost consumers because this would draw high cost consumers into the market.

Question 2

Suppose a competitive market with adverse selection has settled into a pooling equilibrium where everyone is offered the same price.If firms then screen consumers,the outcome may and may not be more efficient.

Accepted Answer

If screening costs are low,then it is efficiency enhancing to screen; if they are too high then not.

Question 3

In a competitive separating equilibrium,low cost consumers of insurance will not fully insure because insurance rates offered to them are not actuarily fair.

Accepted Answer

Low cost consumers may not fully insure because,in a separating equilibrium,they are not offered a full menu of actuarily fair insurance policies.The zero profit condition still implies that competitive firms would offer actuarily air rates -- jut not the option of full insurance.

Question 4

In the presence of adverse selection (due to high and low cost consumers),firms will employ screens to get information about consumers so long as this leads to a more efficient competitive equilibrium.

Accepted Answer

Firms will employ screens so long as profit is maximized by employing screens -- it may result in more or less efficiency.

Question 5

Whenever there is adverse selection without signaling or screening,there will be a missing market.

Accepted Answer

If no attempt is made to uncover information,markets will be missing in the sense that either a pooling equilibrium emerges (with markets targeted at individual types missing)or,in a separating equilibrium,a restricted output choice is offered to low cost types in order to keep high cost types from buying in the low cost market.

Question 6

Adverse selection in insurance markets results in missing markets because people engage in riskier behavior once they are insured.

Accepted Answer

The tendency for people to behave differently when they are insured is moral hazard -- and adverse selection does not require moral hazard.

Question 7

Consider two types of rules that might govern an otherwise unregulated health insurance market: (1)Insurance companies can price-discriminate against the sick and old; (2)insurance companies cannot price discriminate against the sick and old.Explain why,in equilibrium,insurance may be very expensive for the sick and old regardless of which case we find ourselves in.

Accepted Answer

The answer of Consider two types of rules that might...

Question 8

Suppose a competitive market with adverse selection has settled into a pooling equilibrium where everyone is offered the same price.If full markets are re-established through signals,the new equilibrium will be more efficient than the original pooling equilibrium.

Accepted Answer

It depends on how costly it is to send signals.

Question 9

Whether or not a separating equilibrium exists in a competitive market with adverse selection depends on what fraction of consumers is of the high cost type and what fraction is of the low cost type.

Accepted Answer

Under a separating equilibrium,high cost types are not interested in buying low cost insurance (because only a restricted set of such policies is offered)-- nor are low cost types interested in buying high-priced insurance.What fraction of each type there is in the population is then irrelevant.

Question 10

Whenever there is adverse selection,there will be missing market.

Accepted Answer

If no attempt is made to uncover information,markets will be missing in the sense that either a pooling equilibrium emerges (with markets targeted at individual types missing)or,in a separating equilibrium,a restricted output choice is offered to low cost types in order to keep high cost types from buying in the low cost market.But if there are successful signals and/or screens,no markets might be missing.

Question 11

In a competitive market with high cost and low cost consumers (where firms are unable to tell consumer types apart),any screening costs incurred by firms will be passed on to low cost consumer but not to high cost consumers.

Accepted Answer

These costs have to be passed on to consumers because firms have to make zero profit in equilibrium.But they can't be passed on to high cost consumers -- because firms could always offer a price equal to the high MC and make at least zero profit.So they must be passed to low cost consumers.

Question 12

Regardless of whether or not screening or signaling occurs in markets with adverse selection,the equilibrium will always be less efficient than an equilibrium in the same competitive market if there were no asymmetric information.

Accepted Answer

In the absence of signals or screens,adverse selection gives rise to missing markets which in turn leads to inefficiency.Even if signals or screens re-establish these markets,they are costly -- and so overall surplus is lower because the cost of the signals or screens has to be covered.

Question 13

Explain the following statement: "In health insurance markets,moral hazard implies individuals will consume too much health care,whereas adverse selection implies too little health care will be consumed."

Accepted Answer

The answer of Explain the following statement: "In health insurance...

Question 14

If all consumers are willing to buy insurance at the zero-profit pooling price,there cannot be a separating equilibrium.

Accepted Answer

If the low cost consumers prefer a restricted policy at a lower price -- and if the high cost consumers prefer a separating but unrestricted high cost policy to the restricted low cost policy,a separating equilibrium will emerge despite the fact that all consumers would buy at the pooling price if that was all that was offered.

Question 15

In equilibrium,consumers will incur costs to signal their type (in markets with adverse selection)only if this results in a price that is lower than the pooling equilibrium price.

Accepted Answer

It is possible to have equilibria in which all consumers -- both high and low cost -- signal that they are low cost.Thus,no information is revealed and the pooling price remains.(This can happen when the cost of falsely signaling information is too low -- and when firms believe that no signal is equivalent to a signal of a high cost type.)

Question 16

If firms successfully gather information about consumers before offering them insurance,and if this leads to a separating equilibrium,efficiency is restored.

Accepted Answer

Not necessarily -- gathering information is itself costly,and even if it is successful and results in a separating equilibrium,the screening cost may be too high relative to the efficiency gain.

Question 17

If a pooling equilibrium exists in an insurance market,no separating equilibrium can exist.

Accepted Answer

The existence of a pooling equilibrium implies that low cost types prefer the pooled policy to a restricted low cost policy that high cost types would not buy.Thus,the fact that the pooling equilibrium exists implies that no separating equilibrium exists.

Question 18

A pooling equilibrium in insurance markets is inefficient because everyone buys too little insurance (relative to the efficient amount).

Accepted Answer

The pooling equilibrium is inefficient because high cost consumers buy too much and low cost consumers buy too little.

Question 19

Whether or not a pooling equilibrium exists in a competitive market with adverse selection depends on what fraction of consumers is of the high cost type and what fraction is of the low cost type.

Accepted Answer

The pooling equilibrium must offer insurance at zero-profit prices when everyone is buying at the same price.The pooling contract must furthermore be preferable to low cost consumers to a restricted lower-priced policy set at a benefit level that is sufficiently low to keep high cost types from demanding any at that price.These conditions are more likely to be satisfied when there are relatively few low-cost types.

Question 20

Firms that employ statistical discrimination in the labor market will earn higher profits in expectation than firms that do not discriminate (and have no effective screens).

Accepted Answer

Statistical discrimination is about using some information in the absence of full information -- and firms that statistically discriminate will outperform firms that use no information.

Quiz 22: Asymmetric Information in Competitive Markets