Question

Explain why insurance markets may fail due to the problem of asymmetric information and why there may be a justification for government intervention.

Answer 1

Asymmetric information is a situation where there is insufficient knowledge about a particular product or service. For exa, a job seeker has sufficient information about his productivity than his prospective employer. He knows what he can do well or what are his skills to accomplish a job, but a prospective employer is unknown about this. Asymmetric information can result in adverse selection, incomplete markets leading to market failure. Examples of markets where asymmetric information is the cause of market failure are insurance market, financial market, labour market, markets for goods with uncertain characteristics like sale of a vehicle etc.

Incase of an insurance market, buyers of insurance have good knowledge about the day-to-day risks they face. But insurance companies may have information only about the average prospective customers. Suppose in an insurance market there are two types of buyers, high and low risk. If the insurance company know about the health of prospective customer then it will set two types of premium. As a rational consumer everybody will opt for high amount of insurance. The high risk customers will buy full insurance as its premium is lower, and the low risk customers will not able to buy the insurance set for them as the premium is higher than the actual premium. This results in low insurance coverage. Similarly, a customer who after buying an insurance increases consumption of tobaco products causing the risk of heart diseases. By knowing this the insurance company charges a high premium and thus making people underinsure. Again there is a situation of market failure due to low level insurance.

To tackle this, the intervention of govt. is highly essential. Govt.may provide social insurance to insure all. But the problem of moral hazard can also be found in govt social insurance programe. People may start neglecting their health, as they are already fully insured by social insurance program. If the social insurance is for certain predictable events, then there would be no additional moral hazards. To handle this the govt. has to inspect market and the tendencies of the consumers, after that fix an insurance amount that suits the demands of the consumers with a fixed premium in addition with updated tax amount. In this case the possibility of additional moral hazards is less.