Economics 387
Lecture 9
Asymmetric Information and
Agency
Tianxu Chen
Outline
• Overview of Information Issues
• Asymmetric Information
• Application of the Lemons Principle: Health
Insurance
• The Agency Relationship
• Consumer Information, Prices, and Quality
• Conclusions
OVERVIEW OF INFORMATION ISSUES
Overview of Information Issues
• Adverse selection, a phenomenon in which insurance attracts
patients who are likely to use services at a higher than average
rate, results from asymmetric information because potential
beneficiaries have better information than the insurer about their
health status and their expected demand for health care.
• The possible preference for health care delivery by nonprofit
hospitals and nursing homes has been attributed to patients’ lack
of information and inability to discern quality. For some
patients, a nonprofit status might be taken as reassurance of
higher quality because decisions are made independent of a
profit motive.
Goals for this Chapter
• Introduce information asymmetry, describe its
relative prevalence, and determine its
consequences, especially for insurance markets.
• Describe the agency relationship and examine
some of the problems arising in health care
markets from imperfect agency.
• Examine the effects of imperfect consumer
information on the price and quality of health care
services.
ASYMMETRIC INFORMATION
On the Extent of Information Problems in the
Health Sector
• Certainly information gaps and asymmetries exist in the health
sector. They are perhaps more serious for health care than for
other goods that are important in household budgets.
• However, one should not assert that information gaps preclude
the possibility of having a high degree of competition. In
particular, mechanisms to deal with information gaps should not
be overlooked. These mechanisms include licensure,
certification, accreditation, threat of malpractice suits, the
physician-patient relationship, ethical constraints, and the
presence of informed consumers.
Asymmetric Information in the Used-Car
Market – The Lemons Principle
• Nobel Laureate George Akerlof (1970) is often
credited with introducing the idea of asymmetric
information through an analysis of the used-car
market.
• First, it tells us much about adverse selection and
the potential unraveling of health insurance
markets.
• Second, Akerlof’s example leads right into the
issue of agency.
the Used-Car Market – The Lemons Principle
• Nine used cars to be sold that vary in quality from 0 (a
lemon) to 2 (a mint-condition used car). The nine cars have
respectively quality levels Q given by the cardinally
measured index values of 0,1/4,1/2,3/4,1,5/4,3/2,7/4 and 2.
• The reserve value to the seller=$5000*Q;
• The reserve value to the nonowners=$7500*Q, because they
are more eager for used card and value them.
• Asymmetic information: onowners know only the
distribution of quality but not the quality of each individual
car, will make a best guess that a given car is of average
quality, that is Q=1.
• The auctioneer calls out an initial price of $10000. Fail?
• Now try a price at $7500, the best car quality offered is 3/2,
average quality will be ¾. Only willing to pay $5625. Fail?
Figure 10-1 The Availability of Products of
Different Quality (Uniform Probability of Picking
Each Car)
The Lemons Principle
• When potential buyers know only the average
quality of used cars, then market prices will tend
to be lower than the true value of the top-quality
cars. Owners of the top-quality cars will tend to
withhold their cars from sale. In a sense, the good
cars are driven out of the market by the lemons.
Under what has become known as the Lemons
Principle, the bad drives out the good until no
market is left.
The Lemons Principle
• Now try imperfect versus asymmetric information:
• Both owners and nonowners were uncertain of the
quality, that they knew only the average quality of
used cars on the market.
• The auctioneer calls out an initial price of $10000.
Fail?
• Now try a price at $7500?
• The market exists, and clears (supply equals
demand) if the information is symmetric- in this
case, equally bad on both sides.
APPLICATION OF THE LEMONS
PRINCIPLE: HEALTH INSURANCE
Overview
• Adverse selection applies to markets involving health insurance
and to analyses of the relative merits of alternative health care
provider arrangements.
• Information asymmetry will likely occur because the potential
insureds know more about their expected health expenditures in
the coming period than does the insurance company.
• In this market, the higher health risks tend to drive out the lower
health risk people, and a functioning market may even fail to
appear at all for some otherwise-insurable health care risks.
Figure 10-2 Uniform Probability of Expenditure
(Expected Health Expenditure Levels)
APPLICATION OF THE LEMONS
PRINCIPLE: HEALTH INSURANCE
• The auctioneer attempts a first trial price to
$0 M?
• Now try $1/2 M?
• The remaing insured persons with expected
expenditures $¾ M.
• Market fail.
Inefficiencies of Adverse
Selection
• If the lower risks are grouped with higher risks
and all pay the same premium, the lower risks face
an unfavorable rate and will tend to underinsure.
They sustain a welfare loss by not being able to
purchase insurance at rates appropriate to their
risk. Conversely, the higher risks will face a
favorable premium and therefore over-insure; that
is, they will insure against risks that they would
not otherwise insure against. This, too, is
inefficient.
Evidence of Adverse Selection
• Evidence of adverse selection has been
found in markets for supplemental Medicare
insurance (Wolfe and Goddeeris, 1991) and
individual (nongroup) insurance (Browne
and Doerpinghaus, 1993).
• Cardon and Hendel (2001) found that those
who were insured spent about 50 percent
more on health care than the uninsured.
Experience Rating and Adverse
Selection
• Group insurance can be a more useful mechanism
to reduce adverse selection.
• Group plans enable insurers to implement
experience rating, a practice where premiums are
based on the past experience of the group, or other
risk-rating systems to project expenditures.
Because employees usually have limited choices
both within and among plans, they cannot fully
capitalize on their information advantage.
THE AGENCY RELATIONSHIP
What is the Agency Relationship?
• An agency relationship is formed whenever
a principal (for example, a patient) elegates
decisionmaking authority to another party,
the agent.
• In the physician-patient relationship, the
patient (principal) delegates authority to the
physician (agent), who in many cases also
will be the provider of the recommended
services.
Agency and Health Care
• The perfect agent physician is one who chooses as
the patients themselves would choose if only the
patients possessed the information that the
physician does.
• The problem for the principal is to determine and
ensure that the agent is acting in the principal’s
best interests. Unfortunately, the interests may
diverge, and it may be difficult to introduce
arrangements or contracts that eliminate conflicts
of interest.
CONSUMER INFORMATION, PRICES
AND QUALITY
Overview
• Would relatively poor consumer information
reduce the competitiveness of markets?
• Does increasing physician availability increase
competition and lower prices as traditional
economics suggests?
• What happens to quality?
• How do consumers obtain and use information?
Consumer Information and Prices
• Satterthwaite (1979) and Pauly and Satterthwaite (1981)
introduced one of the most novel approaches to handle
issues involving consumer information and competition.
• The authors identify primary medical care as a reputation
good—a good for which consumers rely on the
information provided by friends, neighbors, and others to
select from the various services available in the market.
• Physicians are not identical and do not offer identical
services.
• Because of this product differentiation, the market can be
characterized as monopolistically competitive.
Reputation Goods
• Under these conditions, the authors show
that an increase in the number of providers
can increase prices.
• The economic idea is that reduced
information tends to give each firm some
additional monopoly power.
The Role of Informed Buyers
• The degree to which imperfect price
information contributes to monopoly power
should not be overemphasized.
• A growing body of literature shows that it is
sufficient to have enough buyers who are
sensitive to price differentials to exert
discipline over the marketplace.
Price Dispersion
• Nobel Laureate George Stigler (1961)
argued that variation in prices will increase
under conditions of imperfect consumer
information.
• Gaynor and Polachek (1994) found that
both patients and physicians exhibited
incomplete information with the measure of
ignorance being one and one-half times
larger for patients than for physicians.
Consumer Information and
Quality
• Consider the consumer’s direct role through the
Dranove and White argument that the physician–
patient relationship enables patients to monitor
providers and encourages physicians to make
appropriate referrals.
• To the extent that many specialists rely on referred
patients, these specialists would seem to have
incentives to maintain quality. Are they also
rewarded with higher prices for higher-quality
services?
Haas-Wilson study
• To the extent that many specialists rely on
referred patients, these specialists would
seem to have incentives to maintain quality.
Are they also rewarded with higher prices
for higher-quality services?
• The evidence shows that patients rely on
informed sources (agents) for information
and that higher quality, as measured by
informed referrals, is rewarded by higher
fees.
Other Quality Indicators
• The National Committee for Quality Assurance
(NCQA), a private accreditation body for HMOs,
issues report cards based on about 50 standardized
measures of a plan’s performance (such as
childhood immunization rates, breast cancer
screening, and asthma inpatient admission rates).
• A key assumption behind efforts like this is that
information about quality will, like price
information, help discipline providers through
patient choices.
Evidence
• Initial evidence on the intended effects of plan
performance ratings brings the report card strategy
into question. Tumlinson et al. (1997) found that
independent plan ratings are relatively unimportant to
consumer choices.
• Chernew and Scanlon (1998), employing multivariate
statistical methods on consumer choice of plans,
confirm that “employees do not appear to respond
strongly to plan performance measures, even when the
labeling and dissemination were intended to facilitate
their use” (p. 19).
More Evidence
• In subsequent work, Scanlon and colleagues (2002)
examined a flexible benefits system introduced by General
Motors in 1996 and 1997 and found that plans with many
above-average ratings were not much more successful in
attracting enrollees relative to plans with many average
ratings.
• Together with other results on plan switching (Beaulieu,
2002), we can conclude that the provision of quality
information does influence consumers, particularly when
the quality ratings are negative.
CONCLUSIONS
• There is little doubt that information gaps,
asymmetric information, and agency
problems are prevalent in provider–patient
transactions.
• Although there is a potential lack of
competition, even wide information gaps do
not necessarily lead to market failure.