Market Outcomes and Asymmetric Information Case Study

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Asymmetric Information and Market Outcomes

In the contemporary business environment, the insurance market has faced challenges in dealing with the problems of asymmetric information, adverse selection, and moral hazard. The objective of this study is to discuss the concept the asymmetric information, adverse selection, and moral hazard in the insurance market. The paper also discusses the market responses to asymmetric information, moral hazard, and adverse selection.

Market Response to Asymmetric information

Asymmetric information is a type of situation where one party in a business transaction has superior or more information than other parties. In other words, asymmetric information occurs where sellers have superior or more information than buyers. Although, the reverse may happen in some situations. (Lillo, 2013). Potentially, this type of transaction can be harmful because a party in the transaction can take the advantage of the lack of knowledge of another party. The asymmetric information is problematic in insurance markets where a borrower has superior information than the lenders. For example, in a health insurance market, buyers of health insurance policy always have more information than insurance providers, and able to conceal their health problems to enjoy lower health insurance premium. However, if an insurance provider is able to access information about the health history of a potential customer, and discover that his or her health has deteriorated they will charge them a higher premium. Since the customers are able to conceal their health information, they may avoid a higher premium. This type of transaction is referred as asymmetric information. Typically, asymmetric information can cause a market failure because one of the parties in the transaction does not have adequate information to implement a profitable business transaction. It can be problematic to one party during a business transaction, which can be harmful when sellers have more superior information than buyers or one of the parties takes the advantages of other party lack of knowledge. Moral hazards is another problem of asymmetric information where people with fire insurance may alter their behavior after completing the insurance policy, and likely to commit arson to reap the benefits of the fire insurance.

Signaling is another strategy of addressing the problem of asymmetric information where informed sellers will inform buyers the quality of their product and services. This is particularly important if the motive of a business is to make profits, they should provide adequate and necessary information to the consumer to achieve competitive market advantages. Firms that provide adequate information to consumers are likely to attract an increasing number of customers than firms that do not provide information about their products.

An advancement in information technology has reduced the problems associated with asymmetric information because increased number of people are able to have access to different types of information through the internet. Moreover, the technology can prevent insurance providers falling into a trap of risky buyers since it is now possible to have access to the health history of a potential client online through a third party. Another strategy that can be used to respond to asymmetric information is to increase premium charged. For example, if an individual intends to obtain a life insurance since the insurance provider may not obtain adequate information about the lifespan or health situation of the client, the best strategy is to increase the premium to compensate for the lack of information and offset the risk and uncertainty associated with life insurance.

Analysis of Coca-Cola business conduct reveals that the company has indulged in asymmetric information practice towards their customer. In the United States, the sugar-sweetened soft drink is one of the largest drivers of obesity. However, people who consume soft drink such as Coca-cola are unaware that a "20-ounce bottle of Coca-cola contains over 15 teaspoons of sugar and 240 calories. (Illinois Public Health, 2014 p 1).

Moreover, "there is strong scientific evidence that Sugar-Sweetened Beverage (SSB) consumption is directly linked to obesity and other related, and expensive, chronic illnesses such as type 2-diabetes and cardiovascular disease." "( Illinois Public Health, 2014 p 1).

However, the company is able to cover information about the sugary content of their product through an aggressive marketing campaign and healthy appearing labeling. This is a typical example of information asymmetry, public health education is an effective strategy to overcome this type of information asymmetric.

"Market Response to Adverse Selection"

Adverse selection refers to a situation where buyers have better and superior information than sellers. For example, in the insurance market, people with a deteriorated health will likely to take the life insurance than healthy people.

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Adverse selection is problematic to the insurance providers because buyers always have more information about their health than sellers. (Tomlinson, n.d). However, if only high-risk customer's demand for a life insurance and insurance companies charge an average premium for this type of insurance they will make a loss. Moreover, people living in a high crime environment are likely to insure their cars against theft than people living in a low crime environment. In this situation, if an insurance company charges an average cost they will make a loss. Thus, adverse selection occurs when it is difficult to select the right customer because of information asymmetry. The consequence of adverse selection is that largest percentages of people taking life insurance will be high-risk customers consequently force the low-risk customer to opt taking a life insurance policy because they make consider the premium too expensive. Additionally, people who smoke and do not take a physical exercise are likely to take health insurance policy. (Smith, 2013).

The best strategy that the insurance companies can employ to avoid the problem of adverse selection is to carry out physical health examination for people intending taking health or life insurance. Moreover, the insurance company should investigate the health history of a prospective customer before making a decision about their insurance policy. A medical examination is a form of screening that assists the insurance providers to collect adequate information about the health of a prospective customer thereby eliminating the problem asymmetric information.

Equalizing information and restricting opportunistic behavior are the other market responses to the asymmetric information. To restrict opportunistic behavior, the market should develop a policy where informed people will have no choice but to prevent adverse selection. For example, the government can make a law mandating everybody to buy a health insurance. Many states in the United States have mandated every auto owner to have auto insurance to reduce reckless driving in the United States auto route. Moreover, some firms mandate all employees buy the health insurance. When both healthy and unhealthy people are covered, the insurance provider will be able to address the problem associated with adverse selection.

The market should also use a screening method to assist uninformed people in determining the authenticity of information submitted by informed people. An example of screening is test driving to evaluate the information presented by a potential customer intending to buy the motor accident insurance. Moreover, many banks in the United States use the screening method to evaluate the financial history of a potential borrower. The insurance companies can reduce the problem of adverse selection by collecting information about the health history of potential customers by looking into drinking, and smoking habits of potential customers before offering them a health insurance.

"Market Response to Moral Hazard"

A moral hazard is a circumstance where individuals alter their behaviors after taking an insurance policy and indulge in a risky behavior. For example, an individual who insures his house against a fire outbreak may be less careful with fire after taking the insurance policy. Moral hazard is a problem in the insurance market because some people may behave recklessly after finalizing their insurance policy. For example, a bike without insurance will have 10% chance of being stolen, once the bike is insured, the chance of being stolen will increase to 30% based on the owner nonchalant attitude towards protecting the bike from being stolen. The best strategy to overcome the problem of moral hazard is to ask the customer to make down payment. Moreover, the insurance company can make the claim more difficult, which will make the customer behave carefully after the insurance policy.

Education as a Market Signal

In a contemporary business environment, the market signal is a situation where sellers provide enough information about their product to assist them enjoying competitive market advantages. Essentially, lack of information may make some buyers to underestimate the quality of the product. Under adverse selection, sellers can educate the consumer by signaling the quality of their products through informative advertising.

Market Response when there was Perfect Information

A market with perfect information assumes that all producers and consumers have perfect knowledge about quality, price, and utility of insurance policies. A market with perfect information reduces or eliminates risks and uncertainties associated with a business transaction. A market response to perfect information is the development of uniform prices in the market. For example, the prices of insurance policies will be uniform because the risks and uncertainties….....

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