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UT Knoxville ECON 201 - Information, Risk, and Insurance

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ECON 201 1st Edition Lecture 19Outline of Last Lecture I. Poverty vs. Income InequalityII. The Lorenz Curvea. Definition of Lorenz curveIII. Explanations for Rising InequalityIV. Policies to Improve InequalityV. Poverty Trap and Global Povertya. Definition of poverty trapOutline of Current Lecture I. Information, Risk, and Insurancea. Definition of imperfect informationb. Definition of asymmetric information c. Definition of adverse selectionII. Moral Hazarda. Definition of moral hazardIII. Policy ImplicationsIV. The Government and Social InsuranceCurrent LectureI. Information, Risk, and InsuranceRecall that perfect competition assumes that both buyers and sellers have perfect information. Imperfect information is when a buyer, a seller, or both are uncertain of qualities of what is being bought or sold. Many markets are susceptible to imperfect information, such as the market for used cars or real estate. Asymmetric information is a situation where either the buyer or the seller has more information than the other about what is being exchanged. This can apply to a range of situations, including houses, workers, cars, or food. These buyers and sellers have different access to relevant information, and many of our regulations come from situations where a member of the trade had asymmetric information. An example of this has to do with insurance. Buyers of insurance oftentimes have more information than those providing the insurance. Adverse selection is when people with higher risks than “average” seek out insurance to cover the risks. II. Moral HazardThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.A moral hazard is when a person takes on risk because they believe that they will not have to bear the consequences of the risk outcome (possibly because they have insurance). These people then engage in riskier behavior than they would if they didn’t have insurance. A real life situation of this is the mortgage/banking/finance industry. Mortgages are backed by securities, so for a time many banking and financing industries were paying for “ninja” mortgages – people who had no income, no job, and no assets had mortgages and had no way to pay them back. The companies believed this was not a problem because they were under the assumption that houses and property always increase in value (which is not the case). Soon, big investment banks were having monetary complications, but they did not stop the risky behavior because they believed they were “too big to fail” – the government would bail them out because they were too integral to the economy. They continued engaging in risky behaviors and ultimately the government did let some of them fail. III. Policy ImplicationsAn insurance industry policy can reduce adverse selection and/or moral hazard by the following ways: with home owner’s insurance, they ensure that homes are equipped with fire extinguishers and smoke detectors. With auto insurance, they check the driving record of the person they are insuring and have deductibles (expenses that must be paid out of pocket beforethe company will insure a member). With medical insurance, they have deductibles but also have copayment or coinsurance (the carrier of the insurance has to pay half of the cost of the medical visit).IV. The Government and Social InsuranceIn many cases the government offers insurance to laborers, such as the unemployment insurance, deposit insurance, or worker’s compensation insurance. Unemployment insurance means that you are insured for a certain period of time even if you lose your job. Deposit insurance means your bank deposit is insured up to a certain point. Worker’s compensation insurances gives insurance to workers who are hurt on the


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UT Knoxville ECON 201 - Information, Risk, and Insurance

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