Insurance and Lemons

Atrios is starting a series on insurance markets and common misperceptions about them. Part 1, here, discusses insurance in general and introduces two topics that are crucial to any discussion of insurance: moral hazard and adverse selection. Atrios’ Part 2 is forthcoming, but will address the specifics of health insurance; it should be interesting. And if I had to guess, he’ll be tying it to the current grocery workers strike in California, and perhaps more broadly into an argument for national healthcare.


P.S. Here’s my version of Atrios’ primer:

Adverse selection basically reflects the observation that people will make choices in rational ways. For example, healthy people choose managed care plans; unhealthy choose plans with more extensive coverage. So, managed care companies will have lower costs, at least in part, because they are insuring a non-random sample of patients that is disproportionately healthy. This does not mean that managed care is not efficient, but it means that any study claiming that managed care is more efficient must control for the selection issue.

Moral hazard refers to the observation that people will take more risks when they do not, because of insurance, bear the full costs of that risk. Here’s a simple analogy: consider fire insurance for your home.

For example, adverse selection says smokers will buy more insurance than non-smokers, because the smokers have private information that their house is more likely to burn down. Moral hazard says that smokers are more likely to be careless about leaving lit cigarettes lying around, precisely because they are insured–so much of the cost of that negligence is born by insurers.

UPDATE: Why do I mention “Lemons” in the title? Atrios’ insurance discussions are likely to draw on the famous work of Nobel Laureate George Akerlof and his result from the classic, The Market for Lemons, that asymmetric information can lead to market failure. Akerlof alse recently made this statment:

“I think this is the worst government the US has ever had in its more than 200 years of history It has engaged in extraordinarily irresponsible policies not only in foreign policy and economics but also in social and environmental policy.”