Check Your Understanding

1. Question

   Your car insurance premiums are lower if you have had no moving violations for several years. Explain how this feature tends to decrease the potential inefficiency caused by adverse selection.

   The ineffi ciency caused by adverse selection is that an insurance policy with a premium based on the average risk of all drivers will attract only an adverse selection of bad drivers. Good (i.e., safe) drivers will fi nd this insurance premium too expensive and so will remain uninsured. This is ineffi cient. However, safe drivers are also those drivers who have had fewer moving violations for several years. Lowering premiums for only those drivers allows the insurance company to screen its customers and sell insurance to safe drivers, too. This means that at least some of the good drivers now are also insured, which decreases the ineffi ciency that arises from adverse selection. In a way, having no moving violations for several years is a way of building a reputation as a safe driver.

2. Question

   A common feature of home construction contracts is that when it costs more to construct a building than was originally estimated, the contractor must absorb the additional cost. Explain how this feature reduces the problem of moral hazard but also forces the contractor to bear more risk than she would like.

   The moral hazard problem in home construction arises from private information about what the contractor does: whether she takes care to reduce the cost of construction or allows costs to increase. The homeowner cannot, or can only imperfectly, observe the cost-reduction efforts of the contractor. If the contractor were fully reimbursed for all costs incurred during construction, she would have no incentive to reduce costs. Making the contractor responsible for any additional costs above the original estimate means that she now has an incentive to keep costs low. However, this imposes risk on the contractor. For instance, if the weather is bad, home construction will take longer, and will be more costly, than if the weather had been good. Since the contractor pays for any additional costs (such as weather-induced delays) above the original estimate, she now faces risk that she cannot control.

3. Question

   True or false? Explain your answer, stating what concept discussed in this module accounts for the feature. People with higher deductibles on their auto insurance

   1. generally drive more carefully.

      True. Drivers with higher deductibles have more incentive to take care in their driving in order to avoid paying the deductible. The high deductibles are a way of reducing problems with moral hazard.

   2. pay lower premiums.

      True. Suppose you know that you are a safe driver. You have a choice of a policy with a high premium but a low deductible or one with a lower premium but a higher deductible. In this case, you would be more inclined to choose the cheap policy with the high deductible because you know that you will be unlikely to have to pay the deductible. When there is adverse selection, insurance companies use screening devices such as this to infer private information about how skillful people are as drivers.