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Economics of the Imperfect Information Insurance Market

One aspects of economics I am rather fond of is the insurance market. This is partly because it is one of the few economic models that can be easily adapted to include real-world elements that many models cannot address. In this paper I use the insurance market to show that many of the assumed equilibrium in economics models are actually infeasible when additional constrains, like imperfect information, are considered.

Introduction:
Traditionally, economic theorists have proposed models that disregard any information bias with the purpose of simplifying a situation. This paper analyzes competitive markets in context of the exchange of commodities where at least one of the parties does not have full or equal knowledge. When the concept of imperfect information is applied to various economics models, many of their market equilibriums cease to exist. In context of the insurance market, an equilibrium that disregards information bias often does not exist or would lead to the bankruptcy of a given firm. Although when imperfect information is considered, it is found that there are three equilibria that each rely on a price and quantity, rather than a price alone. Further calculations show that if individuals were willing and able to reveal their information, everyone could be made better off. In absence of high-risk consumers, both the low-risk individuals and firm would benefit, thus identifying high-risk individuals as inducers of one-sided externalities on the system. This parasitic relationship caused by the imperfect information is directly responsible for the pitfall of many economic theories.

If you would like to keep reading, feel free to download the document HERE.

Sources:
1. “Monopoly, Non-linear Pricing and Imperfect Information: The Insurance Market” by Stiglitz J. E.
2. “Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information” by Rothschild M., Stiglitz J.

By Mitchel Gorecki