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.
