What this lesson teaches
I can explain the causes of market failure: public goods, externalities, information failure, immobile factors and market dominance.
Syllabus 9570, 2.3.2(b). Market Failure and its Causes: Markets may fail in terms of; non-provision of public goods due to non-rivalry and non- excludability; non-socially optimal levels of goods and services due to the presence of externalities, information failure (including asymmetric information), immobility of factors of production, and market dominance
Make a guess
An insurer charges everyone the same premium because it cannot tell healthy and unhealthy people apart. Who is most likely to buy?
- Everyone equally, because the price is the same.
- Mostly people who expect to be ill.
- Mostly healthy people, because they plan ahead.
Show the answer
Mostly people who expect to be ill.
For them the policy is a good deal; for healthy people it is poor value. This is adverse selection, and it pushes premiums up.
When one side of a deal knows more than the other, adverse selection and moral hazard can lead to inefficient outcomes.
Asymmetric information means one party to a transaction knows more than the other.
Adverse selection happens before the deal. In insurance, people know their own health risks better than the insurer. If the insurer charges everyone the same premium, it attracts more high-risk buyers, so premiums rise and low-risk buyers drop out.
Moral hazard happens after the deal. Once insured, people may take fewer precautions, because the insurer bears part of the cost.
Both lead to inefficient outcomes. Singapore uses compulsory health insurance (MediShield Life) to avoid adverse selection, and co-payments to reduce moral hazard.
- Adverse selection
- Hidden information before the deal.
- Moral hazard
- Changed behaviour after the deal.
Worked example: Health insurance
An insurer cannot tell healthy and unhealthy applicants apart.
- Adverse selection: at one average premium, the policy is a bad deal for healthy people and a good deal for unhealthy people, so mostly unhealthy people buy.
- The insurer's costs rise, so it raises premiums, and more healthy people leave.
- Moral hazard: once insured, some people see doctors more often than needed, since they pay only part of the cost.
- Making cover compulsory for everyone and requiring co-payments address each problem.
Watch out for this
Adverse selection and moral hazard are the same thing.
Adverse selection is about hidden information before the deal. Moral hazard is about changed behaviour after it.
Check your understanding
After buying phone insurance, a student becomes careless with their phone. What is this?
- Moral hazard.
- A positive externality.
- Adverse selection.
Show the answer
Moral hazard.
Right. Behaviour changes after the deal because the insurer bears the cost.