Asymmetric Information and Health Insurance

♪ [music] ♪ – [Professor Tyler Cowen]
In the previous video, we introduced the ideas
of asymmetric information, and adverse selection
and we applied those ideas to the used car market. Let’s take those same
basic concepts, and build a basic model
of health insurance. Suppose that potential
health insurance consumers come in a range of states of health. For instance,
the least healthy people might cost about $30,000 a year. That’s these folks here. The most healthy might cost
nothing in healthcare. That’s these folks over here. Now consumers know this information, but by assumption, insurers don’t.>From the insurer point of view, everyone is of the same
average health. Here again, we have
asymmetric information. That is consumers of healthcare have more information about their health status
than insurers do. In this scenario, insurers have to
price the coverage based on the average cost
among all consumers, namely, $15,000. But if the insurance costs $15,000,
then a portion of the market, the relatively healthy people, they will choose not
to buy insurance as the cost of that insurance
is greater to them than the expected benefit. So only part of this market
will buy insurance. The average cost of those
who actually will buy is then not $15,000 but $22,500. In that case,
the insurance company, if it tries to price at $15,000,
loses money. If the insurance company instead
raises the price to $22,500, well, the same dynamic
is actually going to kick in again. That is relatively healthy people won’t find it worth
paying that price. The sicker people still will buy, and that will raise
the expected costs to the insurer,
and thus the price even further. This dynamic continues
until the individual insurance firm finds there is no price
at which it can attract a set of customers with
healthcare costs lower than the price of insurance. This is the same death spiral
we saw before with used cars and it leads to a market failure. As we saw in the used car market, there are several reasons
why reality may differ from the simple model. First, the model we laid out would
predict that the healthy people, those who exercise,
eat their veggies, and buckle their seatbelts would
not buy insurance, while the model is predicting that
the smokers, the mountain climbers, and the motorcycle riders would
buy insurance. Is this true? Mostly no. The people who buy health insurance actually turn out to be
the healthier people as well. Why is that? Well, those who try to avoid risk
by eating well also try to avoid risk
by buying health insurance. Our initial assumption that everyone calculates
costs and benefits in exactly the same way
is too simple. Once you account for the fact that people have differential
tolerances for risk, you can end up having
the healthier people be those who choose to buy
the health insurance. This is called
“propitious selection” where the people who buy
the health insurance are healthier, not sicker than average. This can keep costs low,
and prevent the death spiral. Another possible response
to the adverse selection problem in health insurance
might seem familiar. If you recall,
we saw that services such as CARFAX and Certified Inspections can alleviate
the asymmetric information problem when buying a used car. These services allow
the buyer of the car to have similar information to that possessed
by the seller of the car. The result of this information
is that better cars can sell for more,
and lemons can sell for less. Is there an analogous approach
for people in health insurance? Well, yes. The health of people
can be inspected just as cars are inspected. So while consumers initially
may have more information about their health than what
the insurance companies have, a checkup will allow
the insurance firms to get a better idea of
the consumer’s expected healthcare costs. And that allows
the insurance companies to charge healthy consumers less
and sicker consumers more. In the used car market, that seemed like
a pretty good solution. After all, better cars
should sell for more, and lemons should sell for less. In the health insurance market, that solution might work, but some people feel it is
doubly unfair. Not only are the sick sick, but now they also have
to pay more for their health insurance. Another problem
with inspection is that it might reveal
too much information, thereby rendering health insurance
no longer viable. For instance, let’s say there’s
a very good diagnostic test, and it determines that
a patient A has cancer and then B we know that cancer
will cost $1 million to treat. Well, to insure against that cancer, the price of the policy
has to be about $1 million, but that’s no longer insurance. That’s just presenting the patient
with the bill. Insurance is protecting against
unexpected states of affairs, and it’s a kind of risk pooling, a kind of protecting yourself
against the high bill. But if you’re getting the high bill
no matter what when you’re sick, well, then we’ve lost
those benefits of insurance. Another solution to
the adverse selection problem when used extensively
in the United States is group health insurance
through employers. Most people in America
don’t purchase insurance directly. Instead, their employer
purchases it for them as part of a group plan. The benefit of the system is that
the insurance company doesn’t have to worry about
adverse selection so much The employer doesn’t know much
more about its employees’ health than does the insurance firm. Furthermore, the employer is
going to be buying health insurance for the employees
regardless of their health. So for these reasons,
the adverse selection problem is much weaker with
group health insurance. Group health insurance, however,
does cause other problems. If you lose your job,
you can lose your health insurance. And what we do about retirees? In the United States,
various laws have made health insurance more affordable, and furthermore retirees are insured
by the government under Medicare. So, there are some solutions,
albeit imperfect ones as usual. The most recent approach
to the adverse selection problem was implemented
in the Affordable Care Act, otherwise known as Obamacare. Under the Affordable Care Act, everyone is supposed to buy
health insurance. If you don’t,
you will be fined by law. The idea here is to force
all the healthy people into the pool of those who buy insurance that will moderate the cost
of health insurance, and we will avoid the death spiral. As you can see, although the adverse selection model
is pretty simple, it has lots of applications to some pretty complex
real-world problems. Next up we’ll tackle moral
hazard. See you then. ♪ [music] ♪ – [Announcer] If you want
to test yourself, click “Practice Questions.” Or, if you’re ready to move on,
just click “Next Video.”


  1. Cassius Lives

    January 13, 2016 at 10:49 pm

    what is the link to the previous video about used cars?

  2. Nighferl Matos

    March 28, 2016 at 3:42 pm

    El Telephono de bravo insurance

  3. couturexolivia

    May 21, 2016 at 4:21 pm

    great video!!

  4. P W

    October 22, 2016 at 3:05 pm

    great vid, thanks.

  5. Disthron

    October 27, 2016 at 2:30 pm

    I find this video a bit moot, since health insurance shouldn't exist anyway.

  6. Leo Samhui

    November 18, 2016 at 3:51 am

    now I see what Obamacare is about! thanks!

  7. R. Douglas Barbieri

    December 14, 2016 at 5:10 pm

    I think the makers of this video do not understand how insurance actually works in terms of health care. There never used to be an over-regulated, managed healthcare system in the US–it used to only be catastrophic health insurance. For all other medical needs, one paid out of pocket.

    Like life insurance, the idea is to get a policy when you are young and healthy, and you contribute to a pool that over time is available to you if or when you do get sick. In the event of a very expensive operation that you might have to have, the risk is spread over all of the healthy people that have insurance.

    The ACA is attempting to force into the market what would happen if we had a truly free market in health care insurance, not the regulated and cartelized monstrosity we are faced with today. We don't need an ACA for life insurance, so we certainly don't need one for medical insurance.

    Insurance companies also invest their capital into the stock market. Their income stream is not just limited to underwriting income. This was not discussed in the video, either.

  8. Bsa Renthlei

    January 24, 2017 at 4:43 pm

    very nice ..thnks

  9. Baraa Shammout

    December 26, 2017 at 4:56 am

    very nice , thanks

  10. Bibou SISI

    December 30, 2017 at 12:53 pm

    here's a few tips to consider before you start your own cleaning business
    are you likely to have support from your family?
    Are you someone who is self-motivated?
    Will you stick to your plan?
    Do you have the money to begin?
    (I learned these and the reasons they work on Quintrell Care Plan website )

  11. RobertitoF1

    April 14, 2018 at 12:02 pm

    Surely the way to overcome the problems of group health insurance is tying insurance to membership of a group that is more stable than working for a particular employer. An obvious choice would be citizenship (or residency): if health insurance is provided to everyone who is a citizen (or resident), the problem of losing insurance when you lose your job or retire is eliminated. What's more, since paying taxes is a requirement of citizenship (or residency), you can compel everyone to pay in a manner that is equitable, rather than forcing those can often least afford it (ie. sick people) to pay the most. This is why there is not a single successful private healthcare system in the world, whereas socialised health care is successful in numerous countries.

  12. Malsawmkima Pautu

    July 3, 2018 at 6:11 pm

    Watched your videos a night before a test and i got the highest marks in my class!

  13. John Brooker

    April 24, 2019 at 8:54 pm

    yo theres me on the far left lol

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