In the modern world, individuals have a lot of incentives. However, just as with anything else, humans are imperfect. In modern macroeconomics, the biggest recurring problem observed due to the imperfection of human incentives is market failure. Market failure is defined as a circumstance in which the allocation of scarce resources efficiently is unsuccessful. This lack of efficiency can be the result of positive and negative externalities, public goods, monopolies dominating the market, factor immobility, and in many cases imperfect information. Imperfect information, also known as asymmetric information is the case of having difference in information that is available to purchasers or the sellers. More often than not, when one party has more information than the other, it uses that information to take advantage of the other party which can cause overall inefficiency hence, market failure. While asymmetric information does not have to lead to market failure every single time, it still provides a high risk of inefficiency. In a perfect world, complete information would prevent market failure. In his book called Economics of the Welfare State, Nicholas Barr says that “Complete information requires at least three types of knowledge: about the quality of the product, about prices, and about the future.” Complete information eliminates all the uncertainty in the situation. However, in real world it is impossible to have perfect information because of dishonesty and selfishness as the human factor. So, one can say that every market has information asymmetry.
There are two terms in economics useful for explaining the context of asymmetric information: adverse selection and moral hazard. By common logic, any party with less information is at a clear disadvantage. Adverse selection is when this phenomenon is present as it occurs when either sellers know more than the buyer or the other way around. Moreover, the presence of asymmetric information can also change the behaviour of either parties resulting in moral hazard. One common example for the problems due to adverse selection is health insurance plans. Insured individuals have more information about their own health conditions compared to the insurer, which can eventually lead to an adverse outcome and ultimately revenue loss for the insurance company. The paper by George Akernof, The Market for Lemons, describes how asymmetric information can lead to market failure with utilizing examples of insurances. According to Akernof, buyer does not know the quality of the product before purchasing and sellers pass the lower-quality products as the high-quality. This case of dishonesty leads the products of high-quality driven out of the market. While Akernof’s paper provides an excellent simple example on the phenomenon, there are many other examples how asymmetric information can lead to market failure in different ways.
The study made by Cutler and Reber on 1998 on the health insurance plans offered to Harvard University employees examines the effects of adverse selection in the insurance market. During the study, the insurance companies were using a technique called the experience rating system to charge the Harvard University for the plans. Experience rating is defined as “charging a price for insurance that is a function of realized outcomes.” This meant that prices were charged from real previous experiences of the individuals. For example, if less sick or low-risk people selected one of the offered plans, the insurance company would charge the university less. A wide variation of plans was offered to the employees. It is worth mentioning that the cost of these plans were shared between Harvard University and their employees which is the main subject of the study. Before 1995, despite the large variation of benefits between the insurance plans, the difference in prices for those plans were mostly covered by the university. This reflected to a very small price divergence between the insurance plans for the employees. Due to the logic of more benefit for insignificant price difference, of the employees selected the more generous plan. In 1995, this system of sharing the insurance cost has changed and Harvard University started to cover the same amount for all the insurance plans. With this change, the price difference was completely taken on by the employees and the premium plans became significantly more expensive than the basic plans for the employees. The study by Cutler and Reber points out the increase of adverse selection caused by the introduced system. Before 1995, there was pooling equilibrium as the majority of employees would choose the premium plans, thus significantly decreasing the insurance company’s overall costs and keeping premium plan prices low. With the new system however, it moved to a separating equilibrium. This meant that the premium plans became more expensive compared to limited basic plans. The result was, the healthy employees who preferred the full insurance plan before, started to favour the less expensive plan due to the large difference in price. This new system in Harvard caused healthy employees to leave the premium plan due to their low willingness to pay as they are aware of being at low-risk. Hence, the percentage of the sick employees in the premium plan increased. As healthier employees left the plan for the lower priced plan, the price of the premium plan has to be increased by the insurance companies in order to compensate for the increasing overall cost. Since the University was still paying the same amount for every plan regardless of the price that is reflected to the employees, the increase in price was once again covered by employees, which led to even more employees leaving the premium plan. By the end of 1998, the price got so high that none of the employees could even afford the premium plan. This is defined as a “death spiral” which is a direct result of adverse selection.
In the insurance market, moral hazard is considered as a substantial problem. If any of the parties in an agreement provides misleading information about their current situation or future actions, and try to take advantage of the lack of knowledge of the other side, this may directly cause market failure. There are numerous examples of issues in the insurance markets that are caused by situations in which the comfort that comes from the insurance benefit can lead to negative behaviour of individuals resulting with adverse outcomes. If people have health insurance, they will be less careful about not getting ill as the drawbacks are much less. For example, if someone has fire insurance for their house; they could be less careful about the precautions against fire. Regarding insurance, a major problem employers have to deal with in most of the jobs with health insurance is difficulty to recognise the difference between real and fake injuries. Unfortunately, there are multiple examples of insurance frauds this kind. Ricci DeGaetano, who was thirty-five years old at the time, slipped and fell during his job as a prison guard in Massachusetts in 1997. As he returned to work after a year, he claimed that this injury was caused by an inmate. He got 82,500 dollars in workers’ compensation claims. However, it eventually came to attention that he was a karate teacher at the time and this new information caused him to be fired and he got charged for fraud. Another similar example is by David Dotson who was a New Orleans police officer. He claimed that he got a shoulder injury during a patrol on April 2001. He was caught when his supervisors saw him giving a television interview as he returned from the World Trade Centre attacks. As they investigated on how his injury allowed him to work with a bucket brigade at Ground Zero, they discovered that David Dotson was actually working as a supermarket security guard at night shift. He was convicted of fraud and sent to prison.