Health Insurance: Asymmetric Information Analysis

Used cars come in a variety of qualities from the worst, the lemons the cars that always are breaking down, to the very best the most reliable cars. The sellers know the quality of their cars, but suppose that the buyers cannot tell which used cars are lemons and which are of good quality. Since the sellers have more information than the buyers, this is a situational concept known as asymmetric information. This model of asymmetric information was described by the economist, George Akerlof, (Ross, 2015). Asymmetric information implies that the information known to one party may be unknown or only partially known or available to another, (Matthews, 2013). Asymmetric information is a fairly new studied concept in economics. Although information

asymmetry can be noted back to the late 1700s, it was not until the 1960s and 1970s that studies and theories were presented. George Akerlof and two other economists analyzed the effects of asymmetric information in their works, and in 2001 were awarded the Nobel Prize in Economics for their contributions, (The Prize in Economic Sciences). Asymmetric information can lead to the complementary problem of adverse selection; furthermore, asymmetric information is a prevalent issue in economics.
Information asymmetry creates adverse selection. Adverse selection is a term used in economics that refers to a process in which undesired results occur when buyers and sellers have access to asymmetric information, (Matthews, 2013). When information in not transparent, adverse selection causes the price and quantity of goods or services in a market to shift. In Akerlof’s 1970 work, "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism” demonstrated that when asymmetric information exists adverse selection occurs. In the Akerlof’s car example, buyers cannot tell the difference between a lemon and good quality car, therefore, the buyers will not be willing to pay more than what an average quality car is worth, (Ross, 2015). Since seeing that the buyers were only willing to pay for average quality, sellers of the highest quality cars exit the market and the highest quality cars will exit the market. This then causes the average quality of cars to fall thus reducing the price the buyers are willing to pay even more. Which then cause the sellers of the next highest quality used cars to drop out of the market as well, (Penuel, Statler, & Hagen). This spiral effect can cause market failure, however, in reality the used-car market is a thriving business because there are mechanisms that are used as solutions to the asymmetric information problem.
Overtime, the market has developed mechanisms to prevent information asymmetry and furthermore adverse selection. Mechanisms such as warrantees, guarantees, branding, and inspections can reduce information asymmetry. These mechanisms allow the consumers to have more transparent information or rather the information is more equally known to both parties. When there is more transparency of information between the buyer and the seller, asymmetric information is reduced, (Nasri, 2013). However, these mechanisms do not work for all cases of asymmetric information.
The car market is not the only market that can be effected by information asymmetry and adverse selection.

Insurance markets have seen the effects of asymmetric information. In health insurance cases, consumers generally have more information about their health than the insurers do, asymmetric information. Health insurance consumers come in a range of health, but to insurance companies, everyone has the same average health. Joseph E. Stiglitz, one of the economists who shared the Nobel Prize in Economics with Akerlof, explained when insurance companies were effected by asymmetric information meaning they became more uncertain about their consumers, the uncertain health insurance premiums needed for high-risk individuals causes all premiums to rise. This forces low-risk individuals out of their preferred insurance

policies.
Solutions to asymmetric information in the insurance market are quite different than the car market. When a person knows more about a car, a person can pay the actual worth of the car. However, when insurance companies know more about the insured, this information can cause rates for that insured to be increased compared to the average and renders health insurance no longer viable. One solution to asymmetric information in the health insurance market is group health insurance through employers. Instead of a person directly buying insurance, the person buys insurance though his/her employer. The insurance company does not have to worry about adverse selection as much because both the insurer and the employer do not know much about the insured; therefore, asymmetric information is less between the employer and the insurer. Also, the employer is generally going to buy health insurance regardless of the employees’ health, (Cowen & Tabarrok, 2012).
Another solution to asymmetric information and adverse selection in health insurance is the Affordable Care Act (ACA) also known as Obamacare.

Market imperfections in the health insurance market create incentives for inefficient levels of coverage. With the ACA, U.S. citizens are required to purchase insurance or pay a fee for declining insurance. The goal of the ACA is to force all the healthy people into the insurance pool to moderate the cost of health insurance. Since asymmetric information causes adverse selection in the insurance market, it is difficult for healthy people to receive actuarially reasonable rates. The ACA is hoping to achieve that all people are to be covered at a reasonable rate. The Council of Economic Advisers finds that the ACA is, “(1) a genuine containment of the growth rate of health care costs, and (2) the expansion of insurance coverage”,( The Economic Case for Health Care Reform). On the contrary, this forced health insurance causes insurance companies to raise rates to cover cost of the increased number of consumers who are unhealthy. Healthy people find that paying the penalty for not having health insurance rather than buying insurance is cheaper. Healthy policyholders began dropping out of the insured pool, and the average health becomes more skewed because the insured pool would become increasingly uncertain with asymmetric information forcing insurers to raise their rates again, (Kuttner, 2014). Evidence that adverse selection is

occurring from ACA can be seen with reports from The National Blue Cross and Blue Shield Association. Blue Cross and Blue Shield is a health insurance provider, and the organization has experienced enrollees of far sicker people causing more use of medical services. This has resulted in premiums rising, (Graham, 2016).
Information asymmetry is prevalent in many economic markets from consumer markets to financial markets. It is important to know that situations of imperfect information can arise because the presence of information asymmetry makes it impossible to make accurate decisions when conducting transactions, (Matthews, 2013). There are multiple tools to reduce imperfect information. Elimination of information asymmetry may not be possible, but understanding the negativity associated from information asymmetry is important.