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Market Failure or Success

The New Debate

Edited by Tyler Cowen and Eric Crampton

Recent years have seen the development of new theories of market failure based on asymmetric information and network effects. According to the new paradigm, we can expect substantial failure in the markets for labor, credit, insurance, software, new technologies and even used cars, to give but a few examples. This volume brings together the key papers on the subject, including classic papers by Joseph Stiglitz, George Akerlof and Paul David. The book provides powerful theoretical and empirical rebuttals challenging the assumptions of these new models and questioning the usual policy conclusions. It goes on to demonstrate how an examination of real markets and careful experimental studies are unable to verify the new theories. New frontiers for research are also suggested.
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Chapter 12: An empirical examination of information barriers to trade in insurance

John Cawley and Tomas Philipson


12. An empirical examination of information barriers to trade in insurance John Cawley and Tomas Philipson1 Economists have long studied the market distortions that result from the asymmetry of information between well-informed demanders and poorly informed suppliers of insurance. Government regulation and sponsorship of insurance (e.g., Social Security in the United States) is often justified with the claim that such asymmetric information results in adverse selection and underprovision or lack of trade in insurance. Despite the important influence such arguments have had on how economists perceive and analyze insurance markets, there exists little direct evidence on the degree to which asymmetric information limits or affects trade in insurance markets or whether insurers can protect themselves against these problems by underwriting. This chapter attempts to provide such direct evidence for the largest private individual insurance market in the world: life insurance. Of the roughly $2.1 trillion paid in premia for all types of insurance in 1995, more than half (58 percent) was for life insurance. Life-insurance premia constitute 3.6 percent of GDP in the United States in which it is the most widely held financial product, including bank savings accounts; it is estimated that 90 percent of twoadult households have life-insurance coverage.2 Besides its large size, another reason that life insurance is an important market to study is that it has been presented as a prime example of a market saddled with the inefficiency associated with adverse selection.3 In addition, the life-insurance market is particularly useful to analyze because the potentially...

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