Question

3.

i) To assist in ensuring adequate and affordable health care for all, the federal government has mandated that health insurers provide health insurance to all, regardless of their physical condition. Insurers may not reject coverage for pre- existing health problems. Explain why this mandate, standing alone, creates tremendous potential for adverse selection problems. ( 5 mark )

ii) Many health and casualty insurance policies require policyholders to pay a certain amount (called a deductible) for claims before the insurer itself will begin to pay. Explain how the existence of deductible reduces the problems of moral hazard. ( 5 mark )

iii) Explain how screening and signaling help overcome the problem of asymmetric information.

iv) With the help of appropriate figure, explain how the aggregate demand curve for public goods is derived. ( 5 mark )

Answer 1

Question 3.

i) The adverse selection refers to the situation when the insurer does not know about the kind of insured party dealing with. Whether the insured is high risky type (that is, who is more likely to prone to health risk) or low-risk type (that is, who is less likely to prone to health risk).

Therefore, if the government mandate to provide insurance to all. Thus, the insurance company will be unaware of the kind of customer that it is dealing with. And it will willing to charge a comparatively high premium for the high-risk type in comparison to the low-risk type. Therefore, the insurance company charges the average premium in the case unaware of kind of insurance policy buyer. And the willingness to pay for the premium of low risky type is less in comparison to high risky type. Thus, charging the average premium, that is, higher than the premium low risky type willing to pay. Therefore, low risky type exists the market and only high risky type participate in the market. And this leads to only selling policies to low risky kind policy buyers, that is the adverse selection.

ii) The deductible is defined as an amount that the policyholder has to pay before receiving the compensation. And the moral hazard is defined as the situation where necessary precaution to minimise losses is not undertaken by the insurance policyholder, this is because they will be paid compensation for the losses and no losses are bare by the insurance purchaser. Therefore, the deductible will link incentive to minimise the losses and take all the necessary precaution by the policyholder because a certain proportion of the loss is also bare by the policyholder. Thus, reduces the moral hazard.

iii) The screening is the method of reducing the case of adverse selection in the case of incomplete information of the kind of employees the employers are interviewing to appoint for the required designation. This can be explained with the help of an example. Suppose a firm wants to recruit high productive employ. And the firm knows the market has both the kinds, that is, highly productive and low productive employees. Thus, a firm can screen the market of employees and can set a certain standard on the basis of which can judge productivity. Suppose a minimum level of education used as a method of screening and then a candidate with the not specified level of education will not be interviewed and not will be hired. And this could reduce the chances of adverse selection.

The signalling is the method by which a seller can distinguish his good quality product from the seller selling bad quality ones. Therefore, able to sell their good quality product, as because of incomplete information with buyers leads to the only bad quality seller participating in the market (this is because the seller is willing to average price which is less than the price at which good quality seller willing to sell). The good quality product seller signals the customer of their good quality by claiming to provide a warranty of the goods that he sold, and the customer is aware of the fact that a good quality seller can only confident that his good will not be impaired and which is why providing warranty for the same. And thus, the good quality purchaser willingness to pay high and good quality sellers are able to sell their product by signalling.

iv) The public good is defined as the good which is non-rivalrous ( that is, the good used by one does not reduce the benefit for others) and is nonexcludable (that is, one can not preclude others from using the good as a public good is common to all). The aggregate demand defined as for the varying level of the public good what the different consumers are willing to pay(that is, the marginal utility to the consumer). The aggregate demand is determined by the vertical summation of the individuals' demand curve for the given level of the public good which is shown below -