Markets with Private Information

2. 12 Markets with Private Information CHECKPOINTS

3. Checkpoint 12.1 Checkpoint 12.3 Checkpoint 12.2 Problem 1 Problem 1 Problem 1 Problem 2 Problem 2 Problem 2 In the news 1 In the news In the news 1 In the news 2 In the news 2 In the news 3

4. Practice Problem 1 An earthquake damaged car factories and decreased the production of popular Japanese cars. The demand for good late-model used cars soared and car dealers scrambled to get their hands on used vehicles. Explain the effect of the earthquake on the price of a good used car and the price of a lemon. CHECKPOINT 12.1

5. Solution The increase in demand for good used cars shifts the demand curve rightward and with no change in supply, the price of a good car rises. At the higher price, the quantity supplied of good cars increases. With a higher price for good cars, dealers have an incentive to fix problems with lemons and offer them for sale with a warranty as good cars. The supply of lemons decreases (lemons and good cars are substitutes in production) and the price of a lemon rises. CHECKPOINT 12.1

6. Practice Problem 2 An earthquake damaged car factories and decreased the production of popular Japanese cars. The demand for good late-model used cars soared and car dealers scrambled to get their hands on used vehicles. If you have a late-model car that you know isn’t a lemon, will you sell it privately or sell it to a dealer? Explain your answer. CHECKPOINT 12.1

7. Solution If you sell your used car privately, you offer it without a warranty. Assuming the potential buyer doesn’t know you, your car without a warranty would be perceived as a lemon. You would not be able to sell your car for the price of the good car that it is. You would sell it to a dealer if he offered you more than the price of a lemon. CHECKPOINT 12.1

8. In the news Colleges seek “authenticity” in hopefuls David Lesesne, Dean of Admissions at Sewanee, a Tennessee liberal arts college, said that students have become less authentic to themselves by trying to be what colleges want, but colleges have done the same. Schools are looking to draw more applicants and students are looking to gain acceptance. As those numbers grow I think that has caused both sides of the equation to lose a little focus on what should be most important: the match. Source: USA Today, August 22, 2007 CHECKPOINT 12.1

9. Do the applicants or the colleges have private information? Give an example of such private information. Does this market have an adverse selection problem? CHECKPOINT 12.1

10. Solution Colleges and students know the grades and test scores, so these are not private information. “Students have become less authentic to themselves” indicates that students try to present themselves as better than they are. The student’s true self is private information. CHECKPOINT 12.1

11. Schools try to draw more applicants by looking like comfortable, friendly, and relaxed places. The true quality of the school is the school’s private information. With both schools and hopefuls having private information, adverse selection occurs in the market for college places and the best match isn’t always achieved. CHECKPOINT 12.1

12. Practice Problem 1 Pam is a low-risk careful driver and Fran is a high-risk aggressive driver. What might an auto-insurance company do to get Pam and Fran to reveal their driver type? CHECKPOINT 12.2

13. Solution The insurance company will offer policies with deductibles that enable drivers to reveal their private information. Pam reveals that she is a low-risk driver by taking a high deductible and low premium. Fran reveals that she is a high-risk driver by taking a low deductible and high premium. CHECKPOINT 12.2

14. Practice Problem 2 Some drivers, such as Pam, are low-risk careful driver and other drivers, such as Fran, are high-risk aggressive driver. On a graph show the deadweight losses that arise in an equilibrium without screening that are avoided in a separating equilibrium with screening. CHECKPOINT 12.2

15. Solution For low-risk careful drivers, by taking a high deductible and low premium, 80 million get insurance for $800 a year compared to 60 million paying $1,000 a year without screening. The gray triangle in in figure shows the deadweight loss avoided with screening from underprovision without screening. CHECKPOINT 12.2

16. For high-risk aggressive drivers, by taking a low deductible and high premium, 40 million get insurance for $1,200 a year compared to 60 million paying $1,000 a year without screening. The gray triangle in the figure shows the deadweight loss avoided with screening from the overprovision without screening. CHECKPOINT 12.2

17. In the news Volvo ends fender benderVolvos equipped with City Safe are less likely to cause rear-end crashes than are comparable vehicles without the safety system. Source: The Sacramento Bee, July 29, 2011 How could auto-insurance companies use the information in the news clip? Is that information private and asymmetric? CHECKPOINT 12.2

18. Solution The insurance companies know whether a car is a Volvo with the City Safe system and can use this information to separate the market by known risk differences. But this information is not private and not asymmetric. CHECKPOINT 12.2

19. In the news Volvo ends fender benderVolvos equipped with City Safe are less likely to cause rear-end crashes than are comparable vehicles without the safety system. Source: The Sacramento Bee, July 29, 2011 How might City Safe create adverse selection and moral hazard? CHECKPOINT 12.2

20. Solution Adverse selection: Drivers who know that their driving style brings a high collision risk are more likely to buy a Volvo with City Safe. Moral hazard: Having bought a Volvo with City Safe driving carelessly is less dangerous, so some drivers become more careless. CHECKPOINT 12.2

21. Practice Problem 1 Describe the asymmetric information problem in the market for health-care services and explain how the problem is dealt with. CHECKPOINT 12.3

22. Solution In the market for health-care services, the suppliers are physicians, other health-care professionals, and hospitals. The demanders are patients and the insurance companies that pay most of the patients’ bills. Asymmetric information arises because medical workers have private information about a patient’s condition, the treatments available, and the cost effectiveness of the treatment they prescribe. They face moral hazard. HMOs with insurance companies selecting and monitoring service providers lessen the moral hazard. CHECKPOINT 12.3

23. Practice Problem 2 What are the sources of inefficiency in the U.S. health-insurance market? CHECKPOINT 12.3

24. Solution The sources of inefficiency in the U.S. market for health insurance are Pre-existing conditions and other serious health risks that are uninsurable, and Underprovision, with 46 million Americans having no health insurance and millions more being underinsured. CHECKPOINT 12.3

25. In the news Your family’s health-care costs: $19,393The average health-care costs of U.S. families who are insured through their jobs is $19,393, up 7.3 percent or $1,319 from last year. Of this increase, workers’ out-of-pocket costs rose 9.2 percent. Payroll deductions for insurance coverage rose 9.3 percent. Employers increasingly offer health plans with larger deductibles to control their own costs and to force workers to use medical care more selectively. Source: CNNMoney, May 11, 2011 CHECKPOINT 12.3

26. How do larger deductibles help employers to control their own costs? Solution Larger deductibles lower the premiums and so lower employers’costs. CHECKPOINT 12.3

27. In the news Your family’s health-care costs: $19,393The average health-care costs of U.S. families who are insured through their jobs is $19,393, up 7.3 percent or $1,319 from last year. Of this increase, workers’ out-of-pocket costs rose 9.2 percent. Payroll deductions for insurance coverage rose 9.3 percent. Employers increasingly offer health plans with larger deductibles to control their own costs and to force workers to use medical care more selectively. Source: CNNMoney, May 11, 2011 Do larger deductibles change the incentive that people face? CHECKPOINT 12.3

28. Solution Larger deductibles strengthen the incentives for: 1. Healthy families to buy health-care insurance. 2. People not to visit the doctor with minor health problems. 3. People with unhealthy lifestyles to try to reform. CHECKPOINT 12.3

29. In the news Your family’s health-care costs: $19,393The average health-care costs of U.S. families who are insured through their jobs is $19,393, up 7.3 percent or $1,319 from last year. Of this increase, workers’ out-of-pocket costs rose 9.2 percent. Payroll deductions for insurance coverage rose 9.3 percent. Employers increasingly offer health plans with larger deductibles to control their own costs and to force workers to use medical care more selectively. Source: CNNMoney, May 11, 2011 CHECKPOINT 12.3

30. How do larger deductibles chosen by employers influence the distribution of health-care costs? Solution Larger deductibles chosen by employers lower their own share of healthcare costs and increase the out-of-pocket costs of their insured employees. CHECKPOINT 12.3