[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

for the insurance. A private company could offer this insurance since it will collect
enough from selling the insurance to cover the amount it expects to have pay out. 1
Most people would probably find the option of paying $500 to avoid the much larger
cost of the operation a good deal.
But suppose some people know that they are more likely than others to need the
operation. Perhaps, like heart disease, the likelihood of needing surgery is higher if
there is a family history of the disease. Suppose other individuals know they are
extremely unlikely to develop the condition. Now, if an insurance company offers
insurance for $500, all the individuals at high risk will see this as a good deal—they
will purchase the insurance. But the individuals at low risk will not; for them, it is
not worth $500. So the insurance company finds that only the bad risks buy the
insurance—an example of adverse selection.
To continue our example, suppose 50 of our 100 individuals are in the high-risk
group and buy the insurance. The insurance company collects $500 from each, for
a total of $25,000: only half of what is needed to pay for an operation. The insurance
company therefore has to charge $1,000 in order to break even. Given the overall
likelihood of someone in the general population needing the operation (1 in 100), the
insurance company appears to be overcharging; the ratio suggests that $500 is the
fair price. And at the premium of $1,000, the low-risk people find the insurance even
less attractive. They see themselves as providing a large subsidy to the high-risk
individuals. But if the insurance company cannot distinguish between high-risk and
low-risk individuals, the adverse selection effect will force it to charge more. So if
you think you are at low risk for health problems, an insurance plan that does not
require a medical exam is likely to be a bad deal. The adverse selection problem also
explains why health and life insurance companies typically require medical exams—
their incentive is to insure only healthy individuals, or at least to make certain that
the premiums charged reflect the risks.
The Search Problem
A basic information problem is that consumers must find out what goods are available
on the market, at what price, and where. Households must learn about job
opportunities as well as opportunities for investing their savings. Firms, by the same
token, have to figure out the demand curve they face, and where and at what price
they can obtain inputs. Both sides of the market need, in other words, to find out
about their opportunity sets.
In the basic competitive model of Part Two, a particular good sells for the same
price everywhere. If we see what look like identical shoes selling for two different
prices at two neighboring stores—$25 at one and $35 at the other—it must mean
(in that model) that the stores are really selling different products. If the shoes are
in fact identical, then what the customer must be getting is a combination package:
1 For the sake of simplicity, this ignores any administrative cost the firm would have to include in the price
charged to those who buy its insurance.
342 ∂ CHAPTER 15 IMPERFECT INFORMATION IN THE PRODUCT MARKET