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CHAPTER 17 • Markets with Asymmetric Information 637 payroll taxes, paid in part by workers and in part by employers (In 2011, 1.45% was withheld from workers’ paychecks and a matching 1.45% was paid by the employers; those rates are scheduled to increase in 2013.) The central feature of Medicare is that participation is mandatory—essentially all workers are part of the program Indeed, mandatory participation is what makes Medicare work, and what distinguishes it from other public and private health care programs To see why mandatory participation is essential, imagine an alternative in which private insurers offer insurance policies to the elderly at a cost of $5,000 per year Remember that there is asymmetric information: people know much more about their health, their lifestyles, and their likely health care needs in the future than insurance companies can possibly know Now think about who will choose to buy the insurance and who will choose to forgo the $5,000 annual expense Those seniors who have chronic diseases or for other reasons expect their health care costs to exceed $5,000 are much more likely to buy the insurance than those who are in excellent health and thus expect lower costs This creates an adverse selection problem: mostly sick people will buy the insurance, which means the insurance company will be lose money and will need to raise the price of coverage, say to $7,000 But this is not a stable outcome, since only those people with relatively poor health who expect healthcare costs above $7,000 will buy coverage, and once again the insurance company will be in the red Each time the insurance company raises its price, some of the healthier remaining customers will drop out, until finally only very sick people will want to buy insurance (This was essentially the situation prior to 1965.) And what happens when some of the uninsured people get sick? Some may be wealthy enough to pay for their medical costs out of pocket But most people are not so wealthy, and they will end up in the emergency room of their local hospital, which is required by law to treat them As a result, the cost of health care for most seniors will be borne by society as a whole, in part through the subsidization of emergency room visits Medicare solves this adverse selection problem All people over 65 participate in Medicare—those expecting low health care costs along with those who expect high costs Of course, the low-cost participants are subsidizing those with high costs But because adverse selection is not a problem with a mandatory program, the overall cost of Medicare is lower than the cost of most private insurance systems Indeed, Medicare has earned a reputation as one of the most successful and efficient public programs in the United States EX AMPLE 17 LEMONS IN MAJOR LEAGUE BASEBALL How can we test for the presence of a lemons market? One way is to compare the performance of products that are resold with similar products that are seldom put up for resale In a lemons market, because purchasers of secondhand products will have limited information, resold products should be lower in quality than products that rarely appear on the market One such “second-hand” market was created some time ago by a change in the rules governing contracts in major league baseball.3 Before 1976, major league baseball teams had the exclusive right to renew a player’s contract After a 1976 ruling declared this system illegal, a new contracting arrangement was created After six years of major league service, players can now sign new contracts with their original teams or become free agents and sign with new teams The availability of many free agents creates a second-hand market in baseball players This example is based on Kenneth Lehn’s study of the free-agent market See “Information Asymmetries in Baseball’s Free-Agent Market,” Economic Inquiry (1984): 37–44
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