Question

1. Since you’re an expert on public economics, you’ve been asked to talk to a senator about Social Security.
   1. Define asymmetric information and adverse selection. Explain how each impacts the private market for annuities.
   2. Explain to her two (2) factors that affect the intRAgenerational distribution of Social Security in the United States.
   3. The senator insists that there are no issues with the long-term viability of the program, arguing that current workers will get back the same dollars that they put into the system once they are retired. Is she right? Justify your answer.
   4. The senator asks what could be done to change the viability of Social Security but insists that raising taxes or cutting benefits is politically impossible – as is changing the fundamental structure of the program. Using a formula, explain what her options are.

Answer 1

Answer A:

Asymmetric information, also known as information failure, occurs when one party to an economic transaction possesses greater material knowledge than the other party. This normally manifests when the seller of a good or service has greater knowledge than the buyer.Asymmetric information is the specialization and division of knowledge in society as applied to economic trade. For example, medical doctors typically know more about medical practice than their patients. After all, through extensive education and training, doctors specialize in medicine, whereas most patients do not.

Adverse selection is the difference between the average quality of the population at large and that part of the population which selects into a contract. Although adverse selection is defined as the difference in average (i.e. expected) value between two populations, the competitive nature of equilibria and the fact that productivity and wages are measured in the same units means that the quantity of adverse selection can also be viewed as a difference in prices.

A key feature of this analysis is that we define adverse selection quantitatively–it is the difference between the average quality of the population at large and the average quality of those who select to trade conditional on public information. Since adverse selection is defined conditionally on public information, it is a function of public information and therefore from an ex ante perspective is a random variable. Similarly, the expected value of the market allocation relative to the no trade status quo conditional on public information–the efficiency contribution–is also a random variable. Understanding how asymmetric information impacts on adverse selection and market efficiency therefore amounts to understanding how the joint distribution of adverse selection and efficiency contribution depends on the structure of asymmetric information.