The final module of the Power of Markets course begins by further exploring firm behavior in imperfectly competitive market settings: how firms with monopoly power can increase profits through price discrimination; and the price-output combinations we can expect firms to select in cases of monopolistic competition and oligopoly. We will also analyze monopolies from an efficiency perspective and look at the effects of imperfect information on firm and consumer behavior. We will next turn to exploring input markets and what determines the demand for an input by a firm, an industry, and the overall market. We will also look at the factors that affect input supply and how the supply of an input interacts with demand to determinant input prices. We will use input market theory to analyze institutions and government policies such as the NCAA sports cartel, the minimum wage, Social Security, and immigration. Finally, we will address the concept of market efficiency and what government can do to promote it as well as how government intervention may diminish it.
Adverse Selection and Moral Hazard
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From the course by University of Rochester
The Power of Markets III: Input Markets and Promoting Efficiency
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From the lesson
Week 10 - Monopolistic Competition and Oligopoly
Imperfect Information. The Efficiency Effects of Monopoly. Firm, Industry, and Market Demand for an Input.
Meet the Instructors
Mark ZupanProfessor of Economics and Public Policy
Simon School of Business
Welcome back to week ten of the Powers Markets course.
Last session we covered asymmetric information.
And in particular, where sellers had more information about the product than buyers.
And we looked at the used car market for, and, the labor market.
And to what extent even with MBA education, prospective students might want
a signal that they're a type A type of prospective employee, as opposed
to type B.
Today, in this session, we'll look at
problems where buyers have more information than sellers.
In particular, the problems that emerge of adverse selection and moral hazard.
We'll cover some examples as well as market forces that
can at least partially mitigate some of these market imperfections.
Adverse selection crops up in many markets healthcare insurance for one.
For example, if, if sellers of insurance can't perfectly distinguish
who are the high risk clients from the lower risk clients.
That you can't perfectly evaluate people's health, the precautions they take to
promote their health, an adverse selection problem may occur because if you charge
the same common price for health insurance, you're more likely to end
up drawing riskier clients who know
better about their health condition than insurers.
Now this is just the reverse of the lemons problem that we studied last time.
Except here it occurs on the buyers side.
Where will this process lead?
Potentially, we might end up with just high-risk
clients being offered insurance by insurance companies.
And the rates having to be adjusted upwards
as there are fewer low-risk, healthier clients that emerge.
Indeed one of the goals of the Affordable Care Act here
in the United States, Obamacare, was to provide universal healthcare coverage.
And so to be able to encapsulate an entire insurance market, the [UNKNOWN] of both
low risk and high risk individuals In terms of their health profiles.
And in that way, strive to lower the cost of providing insurance.
Now, there are ways the market responds to deal with the adverse selection problem.
And, and there are applications that we can point to,
where entirely bad buyers end up driving out good buyers.
A great case in point, is the blood market, where only 4% of
the blood that, for transfusion, nowadays, is provided by for-profit
firms, where people supply the blood in return for payment.
The discovery was, when you relied on price mechanisms to motivate
additional blood supply you ended up getting individuals who were more
likely to have diseases like hepatitis.
so, in this case, adverse selection, and adverse selection
can occur both on the buyer and the seller side, ended up driving out
people that could supply blood for prices and changed
the market dynamics so that individuals almost implied it on a pro bono basis.
Now, what are market responses to adverse selection?
You can place limits on the losses if
you're providing insurance for home ownership for example.
You may place limits on what you'll
compensate homeowners if their house should burn down.
To try to deal with the problem that homeowners that
have greater risks attached with their home are more likely
to be attracted to you as the seller. There are also group insurance
plans in the case of healthcare coverage where an insurer will offer a
certain health plan to an entire company and thereby be able to span a broader
range of both healthier, healthier insured individuals
and less healthy ones. You can offer or stipulate physical exams.
You can try to acquire more information about the riskiness of various profiles.
Moral hazard is another problem that crops up and
it shows up on the buyer side of the market.
As well as potentially on the seller side of the market.
Where you sell certain product, but then you can't fully control the actions the
buyers will take, once they acquire your product.
And through their actions, they may end up being a riskier consumer
that comes with a less profit opportunity to you as a seller.
A case in point, in the sub-prime loan market in the
2000s, if individuals at banks knew when they were taking on sub-prime loans that,
should everything start to deteriorate in the housing markets, and that the
value of these collateralized debt obligations,
these securitized assets that were repackaged and
sold by various financial institutions.
If their values started to deteriorate
because the housing market started to decline.
If sellers of these collatoralized debt obligations knew that
the federal government would would step in, it creates a moral hazard problem.
Because you're more likely to take riskier actions
knowing that you'll be bailed out in the future
by taxpayers.
And that's one of the big risks that'll keep on going in financial markets where
financial agents know that bailouts will be supported
by their governance, you'll see more risky behavior.
We see moral hazard, too, in people that drive four wheel drive SUVs.
They feel so in control
once they're behind this tank-like vehicle that studies have
been done as the behavior tends to be riskier.
More people sliding off the road, taking less care in driving their SUVs, thinking
that they're impenetrable once they're behind these massive tank-like vehicles.
We see this too in baseball with the designated hitter rule.
In the American League in the United States,
pitchers don't have to bat.
Whereas in the National League, they still have to bat.
And studies that have been done in the American League, pitchers
are more likely to hit an opposing ballplayer as they pitch.
The likelihood's higher by ten to 15%.
Why?
Because they're less likely to be retaliated against.
They're not going to show up at the plate where the
opposing pitcher has a chance to strike back at them.
so, we see a variety of, moral hazard situations occur.
But they're market responses, to moral hazard.
In the case of healthcare insurance, they're deductables.
A recent study of, the phase-in of Obamacare, for example has noticed that
deductibles have increased from about $3900
on average to $5000 under the insurance
plans that have been provided and, and that component of the Affordable Care Act
will actually serve to make the insured individuals more
conscious of the, their behavior as it concerns their health profile.
And more conscious of the cost they end up incurring for their system.
So there are certain components in contrast to a
few weeks ago, where we looked at expansion of funding.
There are certain
components such as more universal coverage, and higher deductables
that'll serve to lower the cost of healthcare insurance.
There's also, where you can take in to
account somebody's gender, if you're offering car insurance.
And if men are less, safe drivers than women.
Certain observable characteristics. Or you, when you can keep track
of an individual's driving behavior.
That will serve to mitigate the moral hazard problem.
One application where moral hazard comes up is also in
the streets of New York City with taxi cab driving.
Since 1979, owners of taxi cabs have been able to lease out their cabs.
And nowadays, 82% of taxi cabs are operated by lessees.
Where people don't own the cabs, a recent study done by a Cornell
economist, Professor Henry Schneider, shows that we end up with worse outcomes.
Lessees of cabs at 64%, they're 64%
more likely to have traffic violations. 62%
more likely to have accidents. 67% more
likely to fail their vehicle inspections.
And then Professor Schneider finds out too, when you
hold constant the age of the cab, the miles driven.
In the case of lessees of taxi cabs in New York, in
New York City, 21% of their violations he can attribute to moral hazard.
16% of their accidents to moral hazard. 30% of their vehicle inspection failures
to moral hazard.
So whether markets will figure out a way to deal
with this imperfection, so far I haven't heard of when you're
calling for a cab service, whether you can find out whether
the cab is operated by its owner or by a lessee.
But a word, if you're hiring a cab and taxi in New York City.
You're better off hiring somebody where the owner's the
driver as opposed to where a lessee's the driver.
In a similar thing, we find people wash their cars.
They don't wash rental cars.
So similar phenomena.
The care we take when we actually own something as opposed to when we lease it.
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