Adverse selection and moral hazard affect insurance markets. Adverse selection occurs when high-risk individuals are more likely to purchase insurance, leaving insurers with a riskier, costlier pool of policyholders. Moral hazard arises when insurance reduces incentives for careful behavior, raising costs. To address these issues, insurers offer different coverage options. High deductible plans with lower premiums alleviate moral hazard by requiring more out-of-pocket costs. A menu of prices also helps insurers distinguish between low and high-risk individuals, reducing adverse selection.

1. Adverse Selection and Moral
Hazard
May 10, 2013

2. Announcements
• If you haven’t gotten exam back – it’s now
with economics undergrad office
• Remember: homework due Monday morning!
• Class next Friday cancelled for Sun God.

3. Last Class
• Roles of information:
– show-rooming
– search / gambles
– asymmetric information & lemons

4. Learning Goals for Today
• Describe the two features of a credible signal.
• List many types of statistical discrimination.
• Compare and contrast adverse selection and
moral hazard.

5. How Do You Credibly Signal Quality?
• The lemons problem we just looked at could have been avoided if the
owners of good cars could have credibly signaled their quality.
• How do you credibly signal quality?
• In other words, what must be true about the signal itself for it to be
credible?

6. How Do You Credibly Signal Quality?
• The lemons problem we just looked at could have been avoided if the
owners of good cars could have credibly signaled their quality.
• How do you credibly signal quality?
Signal Must be Costly Signal cost lower when quality high
``costly to fake’’ ``not costly if truthful’’

7. Examples
1. How can people selling cars signal that their cars are high quality?
– Offer warranty.
– Costly, but less costly (on average) for people with good cars.
2. How can workers signal to employers that they are highly
motivated?
– High college GPA
– Costly, but less costly for highly motivated people.

8. Examples
3. How can sellers of any product signal that their product is high quality?
– Expensive advertising
– Costly, but less costly for good products that generate repeat sales.
4. How do real estate agents signal their ability to potential clients?
– Drive a nice car
– Costly, but less costly for successful (higher earning) agents.

9. Being seen driving an expensive car is a good
way for which professional to signal their
abilities?
A. carpenter
B. realtor
C. political officeholder
D. major league baseball player
E. there is more than one answer

10. Statistical Discrimination
• Statistical discrimination: the practice of making judgments about
the quality of people, goods and services based on the groups to
which they belong.
• In the presence of imperfect information, economic agents will
have an incentive to statistically discriminate.
• Examples

11. Which of the following is a solution to statistical
discrimination in hiring?
A. a minimum wage
B. punishing workers who are consistently late
C. federal guarantees for maternity leave
D. not hiring college grads with low grades

12. Adverse Selection
• Adverse selection: the pattern in which insurance tends to be
purchased by those who are most costly for companies to insure.
• Any situation in which informed buyers (or sellers) make purchasing
(or sales) decisions based on their unobservable characteristics in a
way that negatively affects those who are less uninformed .
• Leads to inefficient outcomes—markets can “unravel”.

13. Moral Hazard
• Moral hazard: the tendency for people to expend less effort
protecting those goods that are insured against damage or theft?
• Can increase the cost of insuring people—if it’s bad enough, moral
hazard could make it impossible for companies to profitably insure
people.
13

14. Clark just bought a new car and was required by
state law to purchase full insurance coverage.
The moral hazard problem suggests Clark will
A. usually try to find a save place to park his car to
avoid break-ins
B. be careful to lock his car always
C. drive carefully in traffic
D. park his car in his garage during bad weather
E. park outside regardless

15. In addition to mandatory insurance coverage, Clark purchases a
supplementary plan. Compared to the rate for the mandatory
plan, he probably pays
A. more
B. about the same given he is a male
C. about the same given he is over 30 years old
D. about the same given he shows his clean driving record

16. How Do Adverse Selection and Moral
Hazard Affect the Insurance Market?
• Insurance companies typically offer a menu of insurance prices.
– (a) High deductible, low premium: You cover first $1000 in
damages and pay $30 per month.
– (b) Low deductible, high premium: You cover first $500 in
damages and pay $50 per month.
• The deductible helps alleviate moral hazard.
• The price structure helps alleviate adverse selection by enabling the
insurance company to distinguish between good (a)and bad (b)
drivers.