GPP 501 Microeconomic Analysis for Public Policy Fall 2017 Given - PowerPoint PPT Presentation

GPP 501 Microeconomic Analysis for Public Policy Fall 2017 Given by Kevin Milligan Vancouver School of Economics University of British Columbia Lecture November 14 th Asymmetric Information: Overview and Theory GPP501: Lecture Nov. 14th 1 of 23

Agenda 1. Overview 2. Adverse Selection 3. Moral Hazard GPP501: Lecture Nov. 14th 2 of 23

Overview The story so far…. What kinds of things do we do collectively through government?  Redistribution to those not doing so well.  Correctives to externalities produced in market economies.  Provision of public goods. But, let’s take a look at the budget of the Government of Canada. GPP501: Lecture Nov. 14th 3 of 23

Government of Canada 2017-18 Budget Elderly+EI+CHT+CST = ~124B in 2017/18. Program Expenses = ~139B. GPP501: Lecture Nov. 14th 4 of 23

US Government = Insurance Company + Army From Ezra Klein, Washington Post. The source of this concept... GPP501: Lecture Nov. 14th 5 of 23

Director’s Law Economist Aaron Director in the 1960s advanced the idea that most government spending was focused on the middle class. From Stigler (1970): “Public expenditures are made for the primary benefit of the classes, and financed with taxes which are borne in considerable part by poor and rich.”  Hypothesis focused on political coalitions — there are more people in the middle; the winning coalition will pick the pockets of others to pay for transfers to them. Q: Is this true? Q: Is there an alternative explanation? GPP501: Lecture Nov. 14th 6 of 23

Social Insurance: A large proportion of government spending is insurance. Not:  Redistribution to those not doing so well.  Correctives to externalities produced in market economies.  Provision of public goods. Q: What is the difference between redistribution and insurance? GPP501: Lecture Nov. 14th 7 of 23

Social Insurance: Why government? Here is a quote from Kenneth Arrow: (AER 1963) “I propose here the view that, when the market fails to achieve an optimal state, society will, to some extent at least, recognize the gap, and nonmarket social institutions will arise attempting to bridge it.” Q: Why might markets fail to achieve optimal state? Q: What assumption about markets might be failing? GPP501: Lecture Nov. 14th 8 of 23

Social Insurance: Why government? An answer: imperfect information.  We have imperfect information about the people, goods, and services transacting in markets.  Over the last 40 years, it has become clear this is central to understanding how/whether markets work. GPP501: Lecture Nov. 14th 9 of 23

Agenda 1. Overview 2. Adverse Selection 3. Moral Hazard GPP501: Lecture Nov. 14th 10 of 23

Adverse Selection: Definition Adverse selection is a “ hidden information ” problem.  One side of the market cannot observe something relevant about the product or the other side of the market.  This could be some characteristic of the person or the product. Why does this matter?  If this problem is severe, markets can disappear. (Death spiral!) Examples:  Quality of a good is unobservable: milk in India; used cars.  The riskiness of a person is unobservable: insurance markets. GPP501: Lecture Nov. 14th 11 of 23

Adverse Selection: Akerlof Lemons “The Market for `Lemons’: Quality Uncertainty and the Market Mechanism,” George A. Akerlof, Quarterly Journal of Economics, Vol. 84, No. 3, 1970. What happens to markets when the quality of a good is unknown?  Studied used car market (bad cars called ‘lemons’).  With quality unknown, people willing to pay an average of what a ‘good’ car and a ‘lemon’ are worth.  But if that offer is lower than value of ‘good’ car, only lemons will be traded.  Market goes into death spiral! GPP501: Lecture Nov. 14th 12 of 23

Adverse Selection: A kerlof Sidebar…  Wrote the paper when age 27, in 1967.  Submitted it to three top economics journals.  It was rejected; called “trivial.”  Finally accepted at QJE in 1970.  Is now among the most-cited papers in economics.  Was specifically cited as the reason for his 2001 Nobel Prize … “ Contribution: Studied markets where sellers of products have more information than buyers about product quality. He showed that low-quality products may squeeze out high-quality products in such markets, and that prices of high-quality products may suffer as a result. ” GPP501: Lecture Nov. 14th 13 of 23

Adverse Selection: Basic Example Imagine there are 1000 used cars in a city. Everyone knows that half are ‘creampuffs’ and half are ‘lemons’.  Imagine sellers will accept $16,000 for a creampuff; $8,000 for a lemon.  Imagine buyers willing to pay $20,000 for a creampuff; $10,000 for a lemon. BUT: buyers can’t tell if the cars are good or not; sellers know. Q: What are buyers willing to pay for a car of unknown quality? GPP501: Lecture Nov. 14th 14 of 23

Adverse Selection: Basic Example Imagine there are 1000 used cars in a city. Everyone knows that half are ‘creampuffs’ and half are ‘lemons’.  Imagine sellers will accept $16,000 for a creampuff; $8,000 for a lemon.  Imagine buyers willing to pay $20,000 for a creampuff; $10,000 for a lemon. BUT: buyers can’t tell if the cars are good or not ; sellers know. Q: What are buyers willing to pay for a car of unknown quality? A: 0.5*20K + 0.5*10K = $15,000. Q: If buyers are offering only 15K, which sellers offer their cars? Q: What happens to the market? GPP501: Lecture Nov. 14th 15 of 23

Adverse Selection: Solutions What are ways around the problem of unobserved quality?  Branding.  Grading.  Signals of quality. For insurance markets, what can be done?  Mandatory participation.  Pooling.  Screening.  Experience rating. GPP501: Lecture Nov. 14th 16 of 23

Agenda 1. Overview 2. Adverse Selection 3. Moral Hazard GPP501: Lecture Nov. 14th 17 of 23

Moral Hazard: Definition Moral hazard is a “ hidden action ” problem.  One side of the market cannot observe something relevant about what the other side of the market is doing. Why does this matter?  It increases costs; which can push sellers out of a market.  Again, market can disappear if problem is severe. Examples:  In physical sports, people playing more violently in presence of safety equipment.  For insurance, people taking less care in cutting costs when covered by insurance. o E.g. car window replacement when covered by insurance… o E.g. flood damage / insurance adjusters… GPP501: Lecture Nov. 14th 18 of 23

Moral Hazard: Simple example Imagine:  Probability of loss is 10%. Cost of loss is $8,000.  So, insurance company is willing to sell car insurance for $800/year.  A consumer is willing to pay $900/year for car insurance. Q: What happens?  Market price of insurance is somewhere between $800 and $900. Market works! Both sides are happy. Now add twist:  Consumer can choose to forego oil changes and save $75/year in costs. Increases cost of loss by $2,000 to $10,000. Unverifiable for insurer. Q: Will consumer choose to save the maintenance costs if not insured? Q: Will consumer choose to save the maintenance costs if insured? Q: What happens to insurance company’s costs and price they need to charge? GPP501: Lecture Nov. 14th 19 of 23

Moral Hazard: Simple example Q: Will consumer choose to save the maintenance costs if not insured? What is benefit of action? Saves $75. What is cost of action? 10% chance of extra $2,000 cost = $200. Will NOT forego maintenance expenses. Q: Will consumer choose to save the maintenance costs if insured? What is benefit of action? Saves $75. What is cost of action? Zero to consumer; $200 to the insurer. YES , chooses to save on maintenance. Q: What happens to insurance company’s costs and price they need to charge? Insurance company’s costs are now 10% of $10,000 = $1,000. Consumer willing to pay $900+$75=$975. Market collapses . GPP501: Lecture Nov. 14th 20 of 23

Moral Hazard: Solutions How can we get over the moral hazard problem?  Increased monitoring: mandate cost-cutting care be taken. o Example: must maintain your car. Must have home alarm. Must look for lowest cost option. o Downside: increased bureaucracy.  Co-payments: you pay the first $X, or the first X%. o Advantage: gives person ‘skin in the game’ o Disadvantage: when copays get large, not much value to insurance! GPP501: Lecture Nov. 14th 21 of 23

Moral Hazard: Peltzman Hypothesis “The Effect of Automobile Safety Regulation,” Journal of Political Economy, Vol. 83, No. 4, 1975. Argument: Increased safety regulation (e.g. seatbelts) led to increased risky behaviour and therefore no lives saved. Q: What do you think? GPP501: Lecture Nov. 14th 22 of 23

Next time…. We will consider the case for social insurance in more detail. We will study the case of unemployment insurance in particular. GPP501: Lecture Nov. 14th 23 of 23