2025 H2 Economics Paper 2 Essay 3: Suggested Answers

Asymmetric information occurs when one party in a transaction possesses more relevant information than the other. In health insurance markets, consumers typically know far more about their own health and lifestyle than insurers do. This imbalance creates two distinct problems: adverse selection, which affects who buys insurance, and moral hazard, which affects how insured individuals behave.

Adverse selection. Adverse selection arises before a contract is signed, when high risk individuals have an incentive to buy insurance at prices intended for lower risk individuals. Suppose smokers face a 10 per cent chance of treatment costing $10,000 while non smokers face a 5 per cent chance, so their fair premiums would be $1,000 and $500 respectively. If insurers cannot reliably tell the groups apart, smokers buy at the lower premium designed for non smokers. As more high risk individuals enter a pool priced for low risk buyers, the average probability of illness rises, forcing insurers to raise premiums for the whole group. At the higher premium many non smokers find cover too expensive and exit, which worsens the risk pool and pushes premiums up again in a self reinforcing cycle, sometimes called a death spiral. The pool deteriorates and insurers may restrict cover or withdraw, so a socially desirable level of insurance for low risk individuals is no longer provided.

Moral hazard. Moral hazard arises after insurance is purchased, when individuals change their behaviour because they no longer bear the full marginal cost of treatment. Once insured, the out of pocket price of medical care falls, so consumers may demand more healthcare than is socially optimal. This can occur before the event, through riskier lifestyles, or after it, through unnecessary scans, brand name drugs or longer hospital stays. As utilisation and total claims rise, insurers raise premiums for all policyholders, which discourages healthier, lower risk individuals from staying insured. As they exit, the average risk of the remaining pool rises and premiums climb further, a negative feedback loop that can lead insurers to tighten benefits, exclude treatments or exit, demonstrating how moral hazard too can result in market failure when left unmanaged.

Both problems stem from asymmetric information but operate at different stages: adverse selection distorts who participates, while moral hazard distorts consumption once insured, and in both cases the misallocation can shrink coverage, inflate costs and undermine the market.