1. asymmetric infomation Define asymmetric information. Distinquish between hidd

Question

1. asymmetric infomation

Define asymmetric information. Distinquish between hidden characteristics and hidden actions. Which type of asymmetric information contributes to the principal agent problem?

2. The principal agent problem

Disscuss the nature of the principal agent problem. Determine which is the principal and which is the agent in each of the following relationships:

a. A firm that produces export goods and the export management company that helps market its goods overseas.

b. The management of a firm and its stockholders

c. A homeowner and the plumber hired to make repairs

d. A dentist and a patient

e. An employee pension management firm and the company using its services

3. Adverse selection and moral hazard

Describe the problems faced by health insurance companies as a result of adverse selection and moral hazard. How do insurance companies try to reduce these problems?

Explanation / Answer

Question 1 answers:

A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Potentially, this could be a harmful situation because one party can take advantage of the other party%u2019s lack of knowledge. Asymmetric information is when either the buyer or seller knows more about the good or service than the other party

asymmetric information means that sometimes, exchanges which would be beneficial to both parties do not happen

e.g. used car market - seller knows more about his car, seller might know car is really good, buyer willing to pay what seller is asking for if can be sure car is good, but not sure, so not willing to pay

buyer knows more than seller - insurance markets, some insurers won't sell insurance to particular buyers because can't be sure of their risk, even though buyers know they are very low risk.

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A hidden action is potentially voluntary. It's relevant when discussing moral hazard. For example, I get health insurance with $0 deductible. Then my "hidden action" is something that the insurer does not know, which is what I'm going to do with my body. If I intentionally decide to not care about my body, I've made a conscious decision to raise the expected costs to the insurer. Of course, I may choose to care about my body just as much, but with lower costs to having an unhealthy body, I'm inclined to be less careful with what I eat.

A hidden characteristic is intrinsic to an agent. It's relevant when discussing adverse selection. Suppose I got health insurance again, and there's no way for insurers to know whether I'm the healthy type or the sickly type. (Suppose there are two kinds of people). Then my health type is a hidden characteristic, and is relevant to the transaction but is withheld. As a result something that may be attractive to a sickly type (since his expected health costs are higher) may not be attractive to a healthy type. Here, no matter what I do, my health type is determined and unchangeable.

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2. PRINCIPAL AGENT PROBLEM ANSWER :

This problem is common in corporations, when the owners (principals) hire managers (agents) to run the company. The agents, however, might make decisions that benefit themselves (higher salaries, fringe benefits) that are unknown to and not in the best interests of the owners (profit).

The principal-agent problem also arises in the government, where citizens (principals) elect leaders (agents) to run the government. The agents in this case might seek personal benefits (higher salaries, lobbyist-paid vacations) that are unknown to and not in the best interests of the citizens (efficient, effective government).

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QUESTION 3 ANSWER :

Moral hazard is based on the idea that in any health insurance situation there exists an information asymmetry between the insurer and the insuree. Though this is present to some degree in all types of insurance, the asym­metry is more pronounced for health insurance. For instance, unless I tell my insurer that I have a family history of diabetes, it is very difficult, if not impossible, for the company to learn that information. I know more about my health status than my insurer ever will, which makes it hard to accurately assess my risk to the company. Since I have an incentive to hide any condi­tions that may raise my premium, this means that I will often pay premiums that do not reflect my actual liability. This information asymmetry is not as prevalent for something like car insur­ance, where the insurer has as much access to the relevant, objective infor­mation as I do.

Furthermore, even if my insurance company can by some means accu­rately assess my present risk, it has no way of controlling my health-related behavior in the future. This is where the problem of moral hazard becomes particularly problematic. Those who are insured tend to behave differently than those who are not, as insurance removes their financial liability for their actions. In the case of health in­surance, this means that once I am cov­ered by insurance, I am more likely to use services that I may not have used if I were paying for them out of pocket. I may go to the doctor more frequently and for more minor illnesses. Similarly, I may use services I once viewed as too expensive and unnecessary, such as mental health or dental services, solely because they are covered in my health insurance plan.

A second mechanism at work in health insurance is adverse selection. This refers to the idea that insurance companies actually have a disincentive to offer the best health plans. Since the people who are the most sick will want the plans that provide the most comprehensive coverage, it is logical that health plans with good benefits will attract a disproportionately ill set of consumers, such as the elderly and those with chronic conditions. Similar­ly, those who do not suffer from health problems, such younger populations, will avoid purchasing insurance or, if they do, will purchase only a minimal plan. These two things in combination mean that better, more comprehen­sive plans cost the insurance company more money in consumer payouts. Thus, insurance plans often put in place mechanisms to try to counteract this. These often take the form of deny­ing coverage to those with pre-existing conditions, not covering certain costly conditions, and limiting the amount they are willing to reimburse consum­ers for health expenses. These money-saving mechanisms make it hard for many people to get insurance, often leading to deadly consequences.

The problems of moral hazard and adverse selection are inherent in the health insurance system as it stands to­day. Yet this does not mean that there is nothing we can do to counteract them. Future policy should focus on regulating the types of benefits that health insurance companies must offer so that adverse selection does not pro­vide an incentive for a race to the bot­tom. We have already seen this hap­pen with Mental Health Parity, where the government mandated that health insurance companies cover mental and physical health services equally in an attempt to stop companies from avoid­ing covering consumers with mental ill­nesses.

Additionally, policy makers should work on lowering healthcare costs so that those diagnosed with an illness no longer face astronomical premium increases. This will reduce the incen­tive for consumers to conceal adverse health conditions from insurers, mak­ing it easier for insurers to assess the potential risk of each individual and charge them a premium that accu­rately reflects this risk. Lessening the information asymmetry between in­surers and the insured is a major step toward creating more efficient and stable health markets. Though these policy suggestions will not by them­selves eliminate negative economic mechanisms like moral hazard and ad­verse selection, they may be significant steps towards limiting their effects.
  

  

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