Part 5 (1/2)

FIVE

The Inside Story

Jeroue Three Men in a Boat begins with Mr Jeroh a medical dictionary in the British Museum: I came to typhoid fever-read the symptoms-discovered that I had typhoid fever,it-wondered what else I had got; turned up St Vitus's Dance-found, as I expected, that I had that too- began to get interested in my case, and determined to sift it to the bottoue, and learnt that I was sickening for it, and that the acute stage would coht's dis-ease, I was relieved to find, I had only in a ht live for years Cholera I had, with severe complications; and diphtheria I seeh the twenty-six letters, and the only ot was housemaid's knee

If you were Mr Jeroo for a trip up the river, but then he was not an economist My advice in such a situation would be to pick up the phone and buy yourself soenerous medical insurance After all, since you know for sure that you will beexpensive claims, why not pay the premium for the best possible care?

Yet this raises a question If people like Mr Jerome could rush to buy health insurance if and only if they knew they were ill, ould want to insure them?

Inside information This is more than an idle question Economists have known for a while that if one party to a deal has inside information and the other does not, then markets may not work as well as ould hope That makes intuitive sense But it wasn't until an Ae Akerlof published a revolutionary pa-per in 1970 that the profession realized quite how profound and draht be

Akerlof chose as his example the hly competitive, it simply cannot work if sellers know a lot about the quality of their cars and buyers do not To take a stark example, let's say that half the used cars on sale are ”peaches,” and half are ”lemons” The peaches are worth more to prospective buyers than to sellers- otherwise the buyers wouldn't be buyers-say, 5,000 to prospec-tive buyers and 4,000 to sellers The lemons are worthless pieces of junk Sellers knohether the car they're selling is a leuess

A buyer who doesn'tbetween 2,000 and 2,500 would be a reasonable price for a car that has a 50-percent chance of being a peach, and a 50-percent chance of being a lemon The seller would also think this was a fair deal for a 50/50 prospect, but the seller doesn't face a 50/50 prospect: the seller knows for certain whether the car is a peach or a lemon The problem is that a seller with a lemon would bite your hand off if offered 2,500, but a seller with a peach would find it rather insulting Wandering around offering 2,500 for a car, you quickly discover that only lemons are for sale at that price Of course, if you offered 4,001 you would also see the peaches on the o away, and 4,001 is not an attractive price for a car that only has a 50-percent chance of running properly

This isn't just a trivial problees of the mar-ket In this scenario, there is noto sell a peach for less than 4,000, but no buyer is willing to offer thata lemon Sellers don't offer peaches for sale, buyers know that they won't, and in the end the only cars that are traded are worthless le Less extreme as-sumptions about the problem lead to less extreme breakdowns of the market, but the conclusions are similar: if some people know h-quality products may not be traded at all, or not be traded very much

Anyone who has ever tried to buy a secondhand car will appre-ciate that Akerlof was on to so The market doesn't work nearly as well as it should; secondhand cars tend to be cheap and of poor quality Sellers with good cars want to hold out for a good price, but because they cannot prove that a good car really is a peach, they cannot get that price and prefer to keep the car for theht expect that the sellers would benefit from their inside information, but in fact there are no winners: sa this prob-lem is What Akerlof described is not a et ripped off; it's much more serious than that He described a market that should exist and simply doesn't because of the corro-sive force of inside infor with buyers-each trade produces 1,000 of value, be-cause that's the difference between the value to the seller and the value to the buyer If the price is close to 4,000, the buyer gets etstrades happen because the buyers will not buy without proof, and the sellers cannot offer proof

The market for used cars is not the only one affected by inside information Think about furniture in a rented apartment-why is it never built to last? Akerlof's model provides an answer Apart-ments have many noticeable, even obvious, attributes that can influence our decision whether or not to rent-size, location, interior design, and so on But there are also qualities that are difficult to observe-for instance, whether the furniture is du-rable The landlord has little incentive to provide expensive, hard-wearing furniture, since this is not one of the features that potential tenants can recognize before theyto pay (Of course, the landlord ile furniture because he expects the tenants to trash whatever he puts in the flat But that fear is equally an arguet in more durable stuff) As a result, there is a market for rental apartments with flimsy furniture but not a mar-ket for rental apartments with durable furniture

Inside inforet a decent meal in a tourist trap like London's Leicester Square, Times Square in Manhattan, or the Plaka in Athens With few exceptions, the hungry visitor will pay a lot for h prices because they have no sense of where better alternatives, even just a few streets away, ht be found But the tourist-trap phenoh prices If it ould see a wide range of restaurants, charer joints, all kinds of food fro a preh-quality places, whether the good food is fried chicken or fine dining, are sih; tourists will only be reat food from the bad Good restaurants all locate where they are more likely to be ap-preciated by more informed locals The bad ones remainthe ”le that Akerlof is not describing universal ignorance but a situation where one side knows norant about whether a car was a lemon or a peach there would be no proble to pay up to 2,500 for a car that had a 50/50 chance of being a peach; sellers, equally ignorant, would be will-ing to accept any offer over 2,000 Of course they will strike a deal It's only when one negotiator knows too reement becorasp on the facts, econo the ”world of truth” apart, this imbalance in information can completely destroy per-fect markets

Inside information and health insurance Akerlof's ”leh if it applied only to secondhand cars, furnished accommodations, and dubious restaurants in the world's beauty spots Unfortunately, it also daoods-most notably, health insurance

Health insurance is important because illnesses are extremely unpredictable and sometimes cost a lot to treat Not only can some medical treatment be very expensive, it is often impossible to postpone it until a more convenient moment It can also coin-cide with periods of low income because people are more likely to need medical care after retirement, and because those who need medical care may also be too ill to work

So health insurance is a valuable product If the health insur-ance h pree number of uninsured people This will sound very familiar to readers in the United States, wheremedical insur-ance, precisely because of Akerlof's ”lemons” problem

Let's say that people who are likely prone to sickness are ”lemons”; people who are likely to stay healthy are ”peaches” If, like Jerome K Jerome, I suspect myself to be a leoing On the other hand, if you feel fine and all your ancestors lived to be a hundred, then perhaps you will buy medical insurance only if it is extremely cheap After all, you hardly expect to need it

Thanks to Akerlof 's proof that markets whose players have asymmetric information are doomed, we know that the insur-ance ood-quality used cars did You, whose body is a succulent peach, will not find the typical insurance package a good deal; while Mr Jerome and I, whose bodies are bitter little lee with open arms The result is that the insur-ance company only sells insurance to people who are confident they will use it As a result, the insurer loses clients who are un-likely to make claims and acquires the unwanted clients who are likely to make costly claims, and then the insurer has to cut back on benefits and raise pre health now find the insurance is too expensive and cancel it, forcing the in-surance coher to stay in busi-ness More and more people cancel their policies, and in the end only the most sickly of the lemons will buy insurance and at a price that will be nearly impossible to afford

The insurance companies will, of course, try to repair the insur-anceout more information about their cus-tomers Do they smoke? How old are they? Did their parents die of hereditary diseases at the age of thirty-five, or in sports car accidents at the age of a hundred? Withavailable, insurance coly accurate picture of the costs of providing medical insurance to particular individuals Previously the insurance mar-ket was constrained by the presence of inside infor But if insurance coap, they will be willing to provide insurance toused by Starbucks and Wholefoods in chapter 2, but in fact it's a different gaet, it knows its own costs and is siher price for some customers The health insurance companies face a more fundamental task: they don't kno much it will cost to cover the claims of each customer, and if they can't work this out with o bust under the burden of clai is a way of getting a larger slice of the pie by squeezingout about insurance custo trades possible when previously there were none

Unfortunately, the insurance market would be saved at some cost: ould find is that lemons, like Mr Jerome and me, would be able to buy insurance only at enormous rates Peaches like you could pick it up for a nominal sum Both premiums would reflect an actuarially fair rate, which means a rate that covers no more and no less than the likely medical expenses If companies had really accurate inforenetic tests of the future, then soet ill would pay hundreds of thousands of dollars in premiums; but this would hardly be insurance at all

By assessing our individual backgrounds and predicting the cost of providing benefits to each of us, the insurance industry es to stay afloat; if companies did not raise prices for leo out of business The problem is that people who expect to have expensive medi-cal needs-the elderly and the chronically ill, for exaive them much insurance at all Because their premiums are adjusted to take these expenses into account, they will pay more for insurance than they would for the out-of-pocket medical costs they would face with-out insurance

The curious conclusion, which is obvious in retrospect, is that an insurance policy depends on ainst an event like a burglary, a fire, or a medical bill if neither of us has any idea whether it will happen If we could predict the future, insurance would be less If my insurance company could predict fires much better than I could, it would sell me insurance only if I didn't need it And if I knew that my house would burn down, the insurance co norance, then any advance in norance-whether for the insurers, the insured, or both, eaken the basis of insurance Theprospect if ant to give people a chance to protect the le aphorism recommends, ”If life deals you lemons, make lemonade” How can we make leinal example of the market for secondhand cars, both buyers and sellers have an incentive to try to fix the probleet a decent price for their peaches, and buyers want to buy peaches If inside infor the chance of a mutually beneficial deal, both sides ant to find a way to bridge the inforap

Akerlof won the nobel Prize in 2001 for his work on the problem of asymmetric information; he shared it with two econoued that the person with the inforht be able to communicate it in a way that the person without the inforlitz looked at the problem in reverse and explored ways in which the person without the inforht uncover it

Spence realized that it wasn't enough for a seller of peaches simply to say, ”All my cars are peaches,” because talk is cheap A seller of lemons can also say, ”Allthe truth, so the claim itself doesn't carry any infornal of quality would be one that a lemon-seller could not make, or at least, could not afford toan expensive car showroom, an investment affordable only by a business term A peach-seller expects satisfied cus-tomers to return, and to tell their friends about his reliable, trust-worthy cars Over the years the sales would pay for the showroom A lemon-seller couldn't operate like that; instead, he would sell a few overhyped lemons and then have to move someplace where his reputation for dishonesty could not follow

It's for this reason that banks always used to build such iht, who knehether they were depositing their ht operation? Custo to run off with the money do not first clad their branches with bronze and marble This is one reason, too, why you will pay more at an established store than at a market stall if you buy a product about which you lack inside information about quality and durability The estab-lished store will still be there to refund your ives you an assurance that a complaint is less likely to be necessary

Other economists have used Spence's theory to explain enor-ns with no informational content What, after all, is the information contained within a soft-drink advertisement? ”Coca-Cola Real” Pardon? The only inforlean from such an ad-vertisement is that it was expensive to make, and that therefore the Coca-Cola coh-quality products that it always had

Spence hiht choose to pursue a degree in philosophy, which is difficult but does not lead to specific career opportunities, like an econoree assuent workers but can't tell froent assume also that everyone has to work hard to obtain a philosophy degree, but lazy, dumb people find it particularly troublesoent people can prove they're s a philoso-phy degree It's not that lazy, duree but that they wouldn't want to: eh to coh to persuade lazy, du to do this despite the fact that the philosophy degree itself does not improve the candidate's productivity at all It is ree is too much trouble for lazy, dumb people to acquire Since Spence himselfin his idea

Spence proved that one way to bridge the inforap in markets previously hindered by inside infornal their reliability High-quality job applicants, banks, used-car salesmen, and soft-drink manufac-turers may find it hile to spend excessive aree that does not really add to one's qualifications, paying for lavish decorations, buildings, and adver-tising) siuish themselves from low-quality job ap-plicants, banks, used-car salesest that the lemons proble In some variations of Spence's nal were i philosophy was banned, euish between lazy workers and se of their expected productivity The lazy workers would be better off; the se isa philosophy degree And the ee but also have to pay less for them Akerlof showed that inside information could reduce people's ability to find trades thatthose trades possible but also found that the social cost of doing so can be too high

While Spence asked what the inforlitz studied what the uninformed side could do to uncover it He explicitly considered markets for insurance and concluded that the uninformed insurer was not completely helpless in the face of custo to file insurance claims The insurer could offer differ-ent deals, for instance, reducing the pre the deductible This has the effect of reducing the level of insurance: the low preher deductible, which is the amount by which any claim is reduced, means that any claim would pay out less Low-risk customers would be attracted by that kind of deal, because the insurance is cheaper and they don't expect to claih-risk custoher preh deductible will cost them a lot So insurers could persuade different types of customer to reveal their inside infory used by coffee bars in chapter 2 Starbucks offers frills like whipped cream and flavored syrup to persuade customers to reveal whether or not they are price conscious Aetna Insurance offers four different packages to individuals, with deductibles ranging from 500 to 5,000, to entice policy buyers to reveal their predictions for how litz did not conclude that Akerlof's lemons problem could be costlessly solved On the contrary, he showed that in response to inside in-forht deny loans to whole sections of society, fired insiders rather than loages to more workers, and insurance coh-risk individuals Spence and Stiglitz both showed that you can et rid of the bitter aftertaste

Lemons, health care, and the United States The difficulty of solving the lemons problem may explain why the A so badly The United States relies upon private health insurance to providefor medical costs This is unusual: in Britain, Canada, and Spain, for exaovernium, France, Germany, and the Netherlands, medical costs are paid for by a system of ”social insurance”: it is compulsory for most people to buy insur-ance, but insurance premiums are tied by law to income rather than to the risk of a claim

The United States system makes it voluntary to buy insurance, and premiums are linked to risk, not to income But these market-based principles, beloved ofhealth care that makes them happy A recent survey revealed that only 17 percent of respondents in the United States were content with their health-care systeht no substantial reforms were necessary Why the discontent?

The superficial reasons are siely expensive, very bureaucratic, and extremely patchy The expense first: US health care costs a third more, per person, than that of the closest rival, super-rich Switzerland, and that ov-ernment alone spends more per person than the combination of public and private expenditure in Britain, despite the fact that the British government provides free health care for all residents, while the Arainalized (Medicaid) Most Americans worry about health-care costs and would be stunned to discover that the British governovernes to pro-vide free health care for everyone In fact, if you figure in the costs of providing health insurance to governe private health care, the US governhest in the world

Bureaucracy next Researchers at the Harvard Medical School found that the administrative costs of the US system, public and private, exceed 1,000 per person In other words, when you count all the taxes, premiums, and out-of-pocket expenses, the typical American spends as much on doctor's receptionists and the like as citizens of Singapore and the Czech Republic spend on their entire medical care Both places are countries with health out-comes very similar to those in the United States: life expectancy and ”healthy life” expectancy (a statistic that distinguishes a long healthy life and a long life plagued by years of severe disability) are a shade lower in the Czech Republic than in the United States; and in Singapore they are a little higher than in the United States The cost of US bureaucracy is also more than three times the 307 cost per person for the administration of the Canadian health system, which produces noticeably superior health outcoe of the systeether with a job, which reduces the efficiency of the laboranother job up first for fear of being unin-sured Worse, 15 percent of citizens have no insurance coverage of any kind-which should be a stunning statistic for the world's richest economy, but probably isn't because it has been lamented for so many years Compare it to Gere, or to Canada or Britain, where everyone is provided for by the governe Akerlof and his lem-ons, the troubles of the US health-care system should be no sur-prise We should expect a voluntary private insurance syste costs than health insurance (for exahtly expect that they are unlikely to become seriously ill) will drop out of the syste to cover their costs, will raise the pre out more and more people Unlike the very stark lemons model, the market does not completely col-lapse; this is partly becauseto pay forto pay substantially more than an actuarially fair premium

The US spends most on medical care

Percent of GDP

UK japan Italy Germany France Canada US Source: Cutler 2002