Question

why do insurance markets fail due to asymmetric information and why is there a justification for government intervention?

Answer 1

Asymmetric information refers to the situation where some people have access to information that others do not. It is defined as a market situation in which one party in a transaction has insufficient information about other party which leads to market failure. Asymmetric information generates two types of outcomes that are related to insurance market – moral hazard and adverse selection. Moral hazard can arise when someone's behavior changes based on their access to financial services. An example is when a person who has taken out insurance against their car being damaged will drive less carefully because they know they will not have to pay for it in case of an accident. On the other side when two or more individual are about to enter into an agreement, and one of them happens to have some information that others do not have, this state is refer to as adverse selection. In respect of insurance market, it is impossible for the insurance provider to be sure how risky their customer behavior is. Therefore the insurance provider uses various mechanisms to select potential customers. These methods are naturally imprecise and cause a rejection of some potentially sound customers. These types of outcomes in the insurance market occur due to asymmetric information which leads to market failure.

When there is a moral hazard problem, the government intervention may improve the private sector’s allocation of resources. . Arnott and Stiglitz (1986) showed that a Pareto improvement in the allocation of a resource is possible if the government can subsidize the price of loss-prevention activity.

If the people have asymmetric information then there is a market failure. Government can create pareto- improvement because of mandatory participation. So to get optimal social insurance they have to balance protection with moral hazard.