Question 3 a) The human immunodeficiency virus (HIV) affects the immune system m

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Question 3 a) The human immunodeficiency virus (HIV) affects the immune system making people with the virus (which causes AIDS) more susceptible to infections and other health problems i) If a health insurance company knew whether a potential applicant for insurance was HIV positive or not, who would likely have to pay a higher premium, someone with HIV or someone who does not? Explain why using 1-2 sentences. ii) If the health insurance company does not know whether a potential applicant is HIV positive or not, is this a moral hazard or adverse selection problem? Briefly explain using 1-2 sentences. b) Your roommate overhears your conversation with another economics student about signaling and screening, and is interested in learning more. How would you explain the difference between signaling and screening to your roommate, who has never taken an economics class before? Give an example of each concept.

Explanation / Answer

a) To answer this question, we need to understand that insurance companies work on the basis of probabilities. That is, if you are being insured for your health, then better your health, lower would be the premium. Why is this? If you are healthy, you are bound to live for a longer period of time, right? You are bound to have fewer visits to the hospital, which means fewer insurance claims, which in turn means fewer payouts the insurance firm has to make. Now, getting to your questions:

i) If the insurance company knew that the applicant had HIV, the premium would be higher than an applicant who does not have HIV. This is because the risks of the applicant applying with HIV are higher and the chances of a claim here are much higher.

ii) This is a case of adverse selection, as adverse selection is when one party has more information than the other which leads to inefficient pricing transfer decisions. In this case, the applicant has more knowledge than the insurance company (as they do not know that the applicant has HIV). It is not a moral hazard problem as moral hazard is only when the party gives incorrect information to the other party concerned, which is not the case here

b) This can be explained using an example that resonates with the common man. For example, my roommate wants to sell his motorbike, and values it at $2000. Let us say John is interested in buying it, and John would actually value it at $2500 if he knew as much as my roommate about the bike.

Now, my room mate will know a lot of things about the bike since he has been using it for years - and he might not be interested in sharing all of this information with the seller for the fear of the seller dropping the value.

Signaling is a process where the seller finds a way to portray information that brings out the quality of his product (which is what my room mate would like to do). Screening is a process where the buyer finds a way to let in only useful information that will help him make an information decision (which is what John would like to do).

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