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JONATHAN GRUBER: So
today, we're going
to talk about social insurance.
So why do we have this thing
called "social insurance?"
Let's first talk about what
social insurance is, and then
ask why we have it.
So basically,
social insurance is
government-provided
insurance programs.
This is the largest
single category
of government expenditure
in the US today,
is government-provided
insurance programs.
Now, why do we have these?
You might say, well, we
know why we have these.
We learned about uncertainty.
We already talked about how
people dislike uncertainty,
and about how as a
result, insurance
is big business in America.
Private insurance
for health, for auto,
for life, for
property and casualty
adds up to about $1.5
trillion every year.
So we already have big
business of private insurance.
So why does the government
need to get involved?
I mean, after all,
people want insurance
if they're risk averse.
We talked about insurance
markets can work.
And as always in economics,
the question is, what's
wrong with the private market?
What is the market failure
that might generate interest
in government being involved?
And the market failure in
the context of insurance
is a different kind
of market failure
than we've talked about.
We've talked about
market failures
like imperfect competition
as a market failure.
We talked about externalities
as a market failure.
The new kind of market failure
we want to talk about today
is what we call
"information asymmetry."
Information asymmetry,
basically which
is the difference
in the information
available to sellers and to
buyers in a given market.
So far in this course, we sort
of assumed full information.
We've assumed everybody
knows everything.
We weaken that assumption a
little bit with uncertainty,
and say that people don't
know whether they're
going to be sick or
healthy, but they still
knew the probabilities.
Now we weaken it further
by saying not only is
the information imperfect,
but different parties
in a transaction might
have different levels
of information.
And that's going to turn
out to cause market failure.
That information asymmetry
will cause market failure.
Now, the math here
is quite hard, harder
than we do in this class.
So we'll just sort of do
this by an example or two.
And the best example
to start with
is the so-called
"lemons problem"
that was laid out by the Nobel
Prize-winning economist George
Akerlof in 1970, Nobel
Prize-winning economist
and husband of former Fed
Chairman Janet Yellen--
quite a power couple.
And here's what Akerlof
laid out-- he said,
let's look at the
market for used cars.
This is the market for
used cars as of 1970.
There's no CarFax.
There was none of
this information.
In 1970, when you went
to buy a used car,
you sort of went,
and kicked the tires,
and decided if you're
going to buy it.
So this is a classic case
of an information asymmetry,
in that someone selling a car
knows what's wrong with it,
whereas the person
buying the car doesn't.
I'll go sort of kick the
tires and hope for the best.
So basically, in
particular, sellers of cars
might be selling them
because they're not good.
After all, why sell a car?
Maybe because it's
what's called a "lemon."
A lemon is something which is
a poorly performing product,
in this case a car that's
got something wrong with it.
So when you go to buy
a car, you're worried.
You want to buy a car
in the used car market,
but you're worried.
Why is someone selling this car?
You should be.
Why is someone selling this car?
If it's really in good shape,
why would they be selling it?
Therefore, as a
result, Akerlof argued,
there might be a collapse of
the entire used car market.
There might not be
transactions that
happen that can make
both parties better off.
Remember, a market failure is
whenever the private market
fails to maximize welfare.
What that means is
a market failure
arises whatever the
private market does not
deliver all transactions that
make buyer and seller better
off.
And so let's look at
an example of this.
Suppose that I have
a 10-year-old car,
and I keep it in pristine shape.
Hint-- that's not true for me.
I'm terrible at cars, but
imagine I was someone who
wasn't.
I kept my 10-year-old
car in pristine shape.
And let's say that a 10-year-old
car in pristine shape is--
and let's say I'm
trying to sell this car.
And let's say that
I would happily
take $5,000 for this 10-year-old
car that's in pristine shape.
So I would be willing to sell at
$5 K. And let's say that you--
let's say Patricia--
needs that used car,
and she is willing to buy a car
that's in good shape for $6 K.
So my willingness to provide,
willingness to supply, is $5 K.
Her willingness to pay is $6 K.
So that is a transaction
that should happen.
Given the quality of my car,
given that's in good shape,
she is willing to pay
$1,000 more than I'm
willing to sell it for.
So that transaction
should happen,
and it would be
welfare maximizing.
But let's say that most
10-year-old cars are not
in good shape.
Most 10-year-old cars, in fact,
are in kind of crappy shape.
And in fact, for the typical
10-year-old car, to get it up
and running well,
you'd have to throw
$2,000 in once you bought it.
And Patricia knows this.
She knows that for the
typical 10-year-old car,
she would have to put $2,000 in.
So her willingness
to pay is not $6 K,
it's $4 K for an
average 10-year-old car.
Now I say to
Patricia, well, that's
an average
10-year-old car, but I
have a perfect 10-year-old car.
You don't need to
put $2 K into it.
It's good to go.
So why don't we split the
difference and pay $5.5 K.
She says, no way.
You're a damn liar.
I have no way of knowing your
car is better than average.
All I know is the
average 10-year-old car
needs $2,000 of work.
So I'm not going to pay more
than $4,000 for your car.
As a result, Patricia
doesn't buy my car.
And a transaction that would
have made both parties better
off does not happen.
A transaction where there
was full information,
like we have much
more of today--
we can get the entire
record of the car,
all the crashes its been in, how
much care it's taken care of--
that problem would go
away, should go away,
because now, Patricia
could look at my CarFax
and note this, in fact,
is a pristine car.
And she's more willing
to pay the $6,000 for it.
But the bottom line is,
in this world of 1970,
this was a market failure,
because a transaction that
made both parties better
off did not happen because
of imperfect information.
The buyer was
perfectly happy to buy.
Patricia is perfectly
happy to buy my car,
but because I had information
that she didn't and she
was just suspicious that
I was lying, as a result,
that transaction didn't happen.
Now, questions about that?
People understand
it's a market failure.
Now we come to insurance.
The story is flipped.
Now it's not the seller
that has the information.
It's the buyer that
has the information.
In particular, when
you buy insurance,
you know how healthy you are.
You know your genetic history.
You know whether
you're a risk taker.
You know whether you're
around a lot of snotty kids
who might get you sick.
You know a lot of
stuff about yourself
that the insurer doesn't know.
As a result, the information
asymmetry is flipped.
With insurance, the
insurer is worried
that when you come
looking for insurance,
they're worried you're looking
for insurance because you're
sick.
You might be looking
for insurance
because you're risk averse
and that's great for insurers.
We talked about insurance, how
there's essentially a game.
I'm willing to pay a risk
premium so insurers can
make money by selling to me.
But what if I'm not coming to
you because I'm risk averse?
What if I'm coming to you
because I'm a huge skydiving
fan?
And you don't know that.
You might be afraid
to sell me insurance,
because you might
lose money on me.
So let's work out another
example to show this.
Imagine you graduate,
and you decide
a great business model
is to offer health
insurance to recent MIT grads.
You say, look, we're a bunch
of kind of careful nerds.
We're likely not
going to go skydiving.
We're just going to sit
at our desks and work.
Maybe there'll be carpal tunnel
risk, but other than that,
we're a pretty safe bunch.
So I'm going to offer health
insurance to recent MIT grads,
because they're a healthy group.
And let's say suppose that
of every 100 MIT grads,
90 are healthy,
and 10 are sickly.
Let's just suppose
you know those facts.
You know those facts.
You've collected
the data to know
that on average, of every 100
MIT grads, 90 are healthy,
10 are sickly.
You don't know which are which,
but you know the proportions.
And let's say that
with a healthy person
over the next year,
there's a 10% chance
that they will need--
that they will incur a $10,000
charge, and a 90% chance
that they'll have zero costs.
So there's a 10% chance of
a $10,000 cost, 90% chance
they'll have a zero cost.
So your expected cost for
insuring this person is $1,000.
You expect someone like
that will cost you $1,000.
Now suppose for the sickly
guy, there's a 50% chance
that they'll cost you $10 K,
and a 50% chance that they'll
cost you 0.
So your expected costs for
them, the expected costs
for this person, is $5,000.
Do people understand the setup?
There's two types.
I know these facts, but
I don't know who's who.
I just know these facts,
because I'm good at math.
I've done all the
actuarial calculations.
Now, if everyone buys in, now
I'm going to set my price.
What am I doing to
do to the price?
I'm going to say, look, if
everyone buys health insurance,
then I've got my expected
cost is 0.9 times
1,000 plus 0.1 times 5,000.
My expected cost is
1,400, so I expect
to have to spend $1,400 a year.
In fact, on average,
I'll spend $1,400 a year.
With large enough samples, I can
predict that with certainty--
that if everyone buys insurance,
I'll spend $1,400 a year.
So let's say you're risk
neutral, because you're rich,
and so forth.
This is sort of risk
neutral for you.
So you say, look,
I'll just charge--
I'll set a premium of $1,500,
and I'll make $100 per person.
If 100 will buy,
that's $10,000 profit.
That's pretty good.
There are 1,000 kids in
the graduating class.
If 1,000 kids buy, and
I make $100 profit,
then that's $100,000.
That's pretty good
money for a year.
Now, what is wrong
with this calculation?
What, in fact, will happen if
you sell insurance for $1,500?
Yeah.
AUDIENCE: We'll buy insurance.
JONATHAN GRUBER: Well
let's go step by step.
What about sick people?
If you sell $1,500,
what will they do?
AUDIENCE: They'll buy.
JONATHAN GRUBER: Yes, so
if you set up for $1,500,
you are certainly going
to sell to all the sick.
So if you sell
for $1,500, you'll
certainly sell to all the sick.
What about the healthy?
What will determine
whether or not they buy?
Yeah.
AUDIENCE: When the
price is smaller
than the expected amount
they'd have to pay on their own
[INAUDIBLE].
JONATHAN GRUBER: Not
quite, not quite.
There's another piece, too.
Don't forget.
What else?
What else?
It's not just the expected cost.
What else?
AUDIENCE: The risk aversion.
JONATHAN GRUBER: The risk
aversion-- remember, there's
a risk premium that they'll pay.
So whether that
healthy person will buy
or not, if it's just expected
cost, then they wouldn't buy--
the $1,000 expected
cost, buy the $1,500.
But some might be
risk averse and buy.
So let's just say half
the guys are risk averse,
and they're willing to pay
$1,500 for $1,000 expected
costs in half are.
So let's say you end up
selling to all the sick
and half the healthy.
So how much money do you make?
Well, you sell the 60
people at $1,500 each,
so your revenues are $75,000.
You sell to 50 healthy and
10 sick, $75,000 revenues.
What are your costs?
Your costs are-- you have
10 people that are cost you
$5,000, so it's
$50,000, plus 50 people
who are going to cost you
$1,000, plus another $50,000
equals $100,000.
And you've lost money.
You priced at above the
expected total, and lost money.
Why did you lose money?
You lost money because of the
problem of adverse selection--
the problem of we call
"adverse selection."
Adverse selection
is the problem that,
due to information asymmetries,
only the worse risks
will participate in the market.
And that will cause people
selling in the market
to lose money, or
likewise here, the concern
is that only the worst cars
will participate in the market.
And so if people buy
cars, we'll be worse off.
Yeah.
AUDIENCE: Wouldn't
you make $90,000?
JONATHAN GRUBER: No.
You sell to-- you sell $1,500
each, and you sell to--
yes, you're right.
You make $90,000, my bad.
Yes, $1,500 each times
60 people is $90,000.
You still lose money,
but not as much.
Right.
Now, you might say, look,
you're not losing that much.
Your solution-- just
raise the price.
What if you said, fine,
let's just raise the price,
and let's charge
$2,000 a person.
Then that would cover,
because $2,000 a person,
60 will make $120,000,
the costs are $100,000.
You'd be golden, right?
Yeah.
AUDIENCE: [INAUDIBLE]
JONATHAN GRUBER:
Who would you lose?
AUDIENCE: The healthy.
JONATHAN GRUBER: Not the sick.
The sick are
delighted by $10,000.
But once you raise the price,
more healthy people drop out,
because it's higher
than their risk premium.
So what happens is
by raising the price,
you're not necessarily
going to make money.
It depends on how many
healthy people drop out.
So for example, imagine
that you raise it to $2,000,
but now the number of
healthy people that buys
drops to 20 from 50.
Then you lose money again.
So the point is,
you can't actually
solve this problem just
by raising the price,
because there's this what
we call "death spiral."
This is a term called
"death spiral," which
is as you raise the
price, you chase out
the healthier
people, which means
you have to raise
the price more,
which shakes out even
more healthy people.
And you end up in
this death spiral.
So that is the problem
of adverse selection.
And that leads you to say,
you know what, I'm not
going to offer this product.
I can't make money
on it, because if I
set the price, whatever price
I set, I'm going to lose money.
So I'm not going to
offer the product.
Therefore, the
market has failed.
A market that might
have existed--
on average, this was a market
that made people better off,
but the market that might have
existed doesn't does exist.
Yeah.
AUDIENCE: With the death
spiral, wouldn't it
converge like something
equivalent [INAUDIBLE]
market forecasting is
[INAUDIBLE] still [INAUDIBLE]..
JONATHAN GRUBER: Right, so
if you leave this alone--
it's an excellent point--
what should the
new equilibrium be?
The price now should
potentially have chased
all the healthy people out.
And then you price,
but you'd have
to price it, then, at what?
AUDIENCE: $5,000 [INAUDIBLE]
JONATHAN GRUBER:
$5,000 plus something.
So as long as sick
people are risk averse,
you could still make money.
You could still make money
if you sold, say, $5,500
with even modest risk aversion.
Why is that still
a market failure?
AUDIENCE: [INAUDIBLE]
JONATHAN GRUBER: Because there's
all these healthy people who
now can't get health insurance.
So yes, it doesn't mean
the market collapse--
market failures
doesn't necessarily
mean market collapse.
It means a reduction in
welfare, because transactions
that might make some people
better off aren't happening.
Here, you might be
able to offer insurance
for healthy people that
makes them better off,
but you're not.
You're only offering
insurance for the sick.
So it's a market failure,
because healthy people
who might want the insurance end
up being kept out of the market
by adverse selection.
Questions about that?
And that is the
fundamental market failure
we face in insurance markets.
That's why we think private
insurance markets will not
function well.
Because private
insurers-- in some sense
the fundamental
problem is that you're
setting one price for
multiple products.
A great case of
adverse selection
is going to buy fruit
at the beginning
versus the end of the day.
What's the difference?
Buy fruit at the beginning
or the end of the day?
You guys probably don't
buy a lot of fruit,
but try to think about it.
Yeah.
AUDIENCE: Normally, better is
at the beginning of the day.
Then you have--
JONATHAN GRUBER: And
at the end of the day,
in particular, what's left?
AUDIENCE: [INAUDIBLE]
JONATHAN GRUBER:
All the shitty fruit
is left, because
you set one price.
You didn't say good apples
$1.80, shitty apples $1.40.
You said apples, $1.70.
So people come, and
they buy apples.
They go and they feel it.
They feel around.
They find the good ones.
The ones that left are crap.
And that is the adverse
selection problem.
Now, with apples, the
market still exists.
Why?
Because they charge so much they
can live with a few bad apples
being at the bottom,
so to speak--
a few bad apples
being at the bottom.
With health insurance,
if I get one bad risk--
someone, say, who's
really, really sick
and costs $1, million--
I go out of business.
So adverse selection
may not destroy markets.
It doesn't destroy
the apple market,
but it can destroy or
significantly impede
insurance markets.
Questions about that?
Yeah.
Manny.
AUDIENCE: Is there some
way insurance companies
that hassle hospitals, like
lower the prices or they give
them better
discounts so they can
increase the price of people--
JONATHAN GRUBER: Well,
that's a separate issue.
We'll talk about
that next lecture
when we talk about health care.
So that's separate, about
the cost of health care.
This is the reason why
insurance companies
make you fill out a lot
of forms before you go in.
So it's for this reason--
insurance companies are not
powerless against this problem.
They could try to collect as
much information about you
as they can.
As I get more and
more [INAUDIBLE]
can learn more and more
who's healthy, who's sick,
then I can solve this problem.
AUDIENCE: So your
familiar with those
home kits that [INAUDIBLE]
and 23andme will send you.
JONATHAN GRUBER: Yeah, 23andme.
Yeah.
AUDIENCE: So is it
possible that at some point
in the foreseeable
future, those are going
to become part of [INAUDIBLE]?
Those are going to become part
of how insurance is determined,
like if it's in your DNA,
get some condition when
you get old that we can say you
have a preexisting condition
now that hasn't manifested yet?
JONATHAN GRUBER: So
this is a great point.
I was going to talk
about it next time.
I'll talk about it now,
which is in some sense,
we are eventually
moving to a point
where there'll be no
adverse selection.
Now you might say, on
the one hand, that's
because ultimately, we'll
know everything about you
from the moment you're born.
We know your genes.
We won't know if you're a
skydiver, but we'll know--
we'll probably know genes
that determine risk taking.
And we'll charge more for
people who like taking risks.
So the good news is that then,
I can make the market work.
The bad news is in that world,
how would I set my insurance?
AUDIENCE: [INAUDIBLE]
JONATHAN GRUBER:
I would charge--
because what I
would do is I'd say,
your genes say you're healthy,
so I want $1,100 from you.
Your genes say you're sick,
so I want $6,000 from you.
So essentially, insurance
wouldn't exist anymore.
There'd be no insurance.
What is insurance?
Insurance is pooling people
with different probabilities
of adverse events, and letting
us all benefit from the fact
that if it happens to us,
at least we're protected.
Well, if you charge
me my expected cost,
I'm no longer protected.
So here's the example that
makes it perfectly clear,
one of the most famous examples.
Ken Arrow was one of the great
economists of the 20th century,
died recently.
He had his famous
islands example.
Ken Arrow's island example
is the following-- imagine
there's two islands somewhere
in the South Pacific
that are very small, that's
got one farmer on each.
And the farmers know
a hurricane is coming
and it's going to wipe
out one of their islands,
but they don't know which.
They just know one's
getting wiped out.
What will they naturally do?
They'll naturally get
together and say, look,
islands get wiped out, but
let's insure each other.
If I get wiped out, you give
me a bunch of your crop.
If you get wiped out, I'll
give you a bunch of my crop.
That will improve
both our welfare,
because getting wiped
out is going to zero.
You die.
That's a terrible outcome.
So that will improve our
welfare if we insure each other.
Now let's say a weather service
comes along, and provides
information, and
tells you that farmer
A's island is getting wiped
out and farmer B's island is
going to be fine.
What has happened to welfare?
It's gotten worse.
Why?
Because farmer A goes
to farmer B, says
it turns out I'm
going to be wiped out.
Farmer B says, well, see you.
I'm just going to keep
consuming my high level.
Farmer B is somewhat better off.
Farmer A is dead.
Total social welfare has
fallen because the concavity,
because diminishing
market utility.
More information
has made us worse.
We say more is
better in economics.
Once you get into topics
like, this you realize more
is not always better.
More is worse.
More information has
destroyed the insurance market
that might function.
So in fact, this issue
I'm talking about
is becoming paramount
as we move more and more
towards perfect
information environment.
So the kind of government
policies I'm talking about next
become critical as you move
towards that environment.
But first, I want
to make sure we all
understand why the
private markets failed,
why it's a failure.
Now, what can the
government do about this?
What are some potential
government solutions?
And we've tried all of these
in the US and around the world.
Let's talk about
three categories
of government solutions.
The first is subsidization.
The government could
subsidize the purchase
of health insurance.
So for example, what if
the US government said
to all the MIT grads, I'm
going to give you a $400
tax credit that you could have--
or $500 tax credit if
you buy health insurance.
Well, if there's
a $500 tax credit
if I buy health insurance,
and I charge $1,500,
then what's the effective
price now to the healthy guy?
AUDIENCE: [INAUDIBLE].
JONATHAN GRUBER:
$1,000, so he buys.
Even if he's risk
neutral, he buys, as long
as he's a tiny bit risk averse.
So I do sell to everyone.
I make my money.
So one way to solve
this problem is
to basically pay the healthy
people to get into the market.
They can't just give money
to the healthy people.
You've got to give
it to everyone,
because you can't
tell who's healthy.
But if we give
everyone a tax credit,
then we could bring
everyone to the market
and solve this problem.
Well, in fact, we
do this in America.
It's actually perhaps the
largest hidden government
expenditure in
our country, which
is the tax subsidy to
employer-sponsored insurance,
employer health insurance.
The tax subsidy on
employer health insurance--
what do I mean by that?
What I mean is the following--
when MIT pays me in wages,
I am taxed on that, like
the taxation we talked
about a couple lectures ago.
When MIT pays me in
health insurance,
I am not taxed on that.
So what does that mean?
If MIT comes to
me, and they say,
would you like $1,000 raise
or $1,000 orthodontic benefits
for your daughter?
I say, well, $1,000 raise
in today's tax rates,
I'm going to take
home about $550.
If you add up all
the tax I'll pay,
then I'll take home about $550.
$1,000 of orthodontic
benefits for my daughter,
I get the whole $1,000.
So why not?
So I got these cool braces.
They spin and change color.
And every two weeks, she's in
for a different kind of braces.
It's great, because it's free.
So we do subsidize health
insurance in America.
And this amounts
to-- this program
that I just talked about
amounts to almost $300 billion
per year.
We spend almost $300
billion per year
giving a tax break to people
to buy health insurance.
So that's one tactic
we take to try
to solve this problem to get
healthy people into the market.
That's approach one.
A second approach one can
use to try to get people
into the market is a mandate.
Suppose I just pass a
law that says everyone
has to buy health insurance.
Then I've solved the problem.
I know what my expected costs
are if everyone has to buy.
I know my expected
costs are $1,400,
so I know I can make
money at $1,500.
That's easier at one level.
I don't have to spend--
$30 billion is a lot of money.
This cost me $0.
It's harder on another level.
Why?
What's the problem
with that solution?
Yeah.
AUDIENCE: Not having
the money for insurance.
[INTERPOSING VOICES]
JONATHAN GRUBER: Well,
it may not have it.
That's right.
What else?
Yeah.
AUDIENCE: He may not want it.
JONATHAN GRUBER: The healthy
people are going to be pissed.
They're like, look,
if I had chosen not--
you're going to basically--
the mandate only
has an effect if it
changes people's behavior.
But changing people's
behavior means
you're making them
do something they
didn't want to do beforehand.
So the problem with that
the problem with this is you
spend a lot of money.
The problem this is you
piss off healthy people.
The third approach we could do--
there's lots of
examples of a mandate.
Obviously, we know about
the health insurance
mandate that was originally
part of Obamacare.
But that's not the
biggest example.
The biggest example
in the US is what's
called "Workers' Comp
Insurance," which is insurance
that you have for
on-the-job injuries.
If you get hurt at work, your
employer pays money so that you
get reimbursed when you're--
it pays your medical bills
when you get hurt at work
and gives you partial
replacement of your wages.
That is mandated
insurance on all employers
in America, except in Texas.
Texas, they can choose.
Every other state,
it's mandated.
Mandated insurance for
every employer in America.
They have to buy Workers' Comp.
So we've examples of that.
And that's an $80
billion a year program.
That's a big deal.
Finally, we can just
provide the insurance.
That's actually the most
common thing we do in America.
Social Security is our program
that provides insurance
for the elderly, for the costs
for survival after retirement.
Medicare is insurance for
the elderly we provide.
Unemployment
insurance is insurance
we provide against
losing your job.
Disability insurance
is insurance
we provide against having
a career-ending disability.
So this is actually
the most common thing.
Indeed, provision of
social insurance in America
costs almost--
costs more than
private insurance.
So we spend about a trillion
and a half on private insurance
in America.
Social insurance is probably
about $1.7 to $2 trillion,
depending how you measure it.
So actually, this
is the biggest thing
we do is we just
provide insurance,
and that is a very
large solution.
Now once again, what's
the problem with this?
You don't make the
healthy people unhappy,
because everyone, you
just give it to them.
The problem is you have
to spend money on this.
This is $1.7 trillion in taxes
we've got to raise every year.
That's non-trivial.
So basically, each
of these solutions
has potential problems.
So the adverse selection problem
will cause the private market
to fail.
There are potential
government solutions,
but they each have limitations.
This one's pretty expensive,
this one's super expensive,
this one pisses
off healthy people.
Now, you'll note the middle one,
the pissed-off healthy people
is kind of subtle.
You don't see a lot of
healthy people railing
against mandated
[INAUDIBLE] Workers' Comp
like they did against the
health insurance mandate,
because people don't know.
So in some sense, this
one's a little bit subtle,
because people have to know.
Basically, it's sort
of crazy that I'm
paying tax that I'm never
getting hurt at work.
Am I going to have--
what am I going to do, like
slip at my desk or something?
Never going to get hurt at work,
but I pay taxes all the time
just in case someone
else at MIT gets hurt.
Some of the janitorial staff
has a risk of being hurt.
I'm paying taxes in case
the janitor gets hurt.
I should be upset about
that, but I'm not.
And in some sense, it's
about what people know,
what they don't.
So that is the basic argument
for social insurance.
But when we provide
social insurance
despite all these
problems, we enter
into a fundamental
trade-off, which
is, let's decide
we've determined
some optimal government policy.
Let's decide that
the markets failed,
so we're going to do
one of these things
or are some combination of these
things and solve the problem.
The problem is that when
you insure people for risks
you create a new problem
called "moral hazard."
Moral hazard is basically
the adverse behavior that
is encouraged by insurance.
When you insure people, you
encourage adverse behavior.
So the classic
example of this is--
if I have health insurance, I
ride my bike less carefully,
because if I get in a crash--
I'm not crazy.
I certainly don't want
to get in a crash,
but I'm a little
bit less careful
because I know I'm insured
in case I get in a crash.
If I have fire insurance, I
don't buy a fire extinguisher
for my house, because
if it burns down,
I'm just going to get
the money back anyway.
Or if workers have insurance
against losing a job that
pays them when out of work,
they might search less hard
for a new job.
Basically, if I lose my
job and I got nothing,
I'm going to work my ass
off to get a new job.
If I lose my job
and the government
says, well, for 26 weeks,
we'll give you half your salary
while you look for a job, I'll
be a little bit less rushed.
And there's lots of evidence
that moral hazard is a problem.
I comes with two
types of evidence.
The first type evidence
is fun anecdotes.
So the great effect that--
workers' compensation, let's
take that.
Workers' compensation, it's
a program [INAUDIBLE] needed.
Lots of people get hurt at work.
I don't, but lots of
people do get hurt at work.
And so it's a sensible
social insurance program.
The problem is it has a
huge moral hazard component.
And there's fun
examples of this,
like the prison guard
in Massachusetts
who claimed he got
hurt on the job,
collected $82,000 in benefits,
while the whole time running
a karate school and
teaching students karate.
And finally someone
noticed online this guy who
couldn't work was
running a karate school
and doing karate kicks
and stuff online.
So there's all sorts of
fun examples about that.
But more convincing
for economists
is statistical evidence.
And the statistical
evidence is clear
that moral hazard
is a big problem.
For example, if you raise
the benefits people get
under workers' comp, suddenly
they become injured more often
and stay out of work longer.
There's no reason-- injuries
should be because you got hurt.
So how can it be
that suddenly, when
a state raises its
benefits, suddenly,
there's more injuries?
The answer is moral hazard.
When states raise their
unemployment insurance
benefits, more people
leave their jobs and they
stay unemployed longer--
moral hazard.
So the moral hazard
problem is real.
It's an inherent trade-off,
actually not just
with public insurance.
Private insurance,
too-- anytime you
insure people and
something bad happens,
you're providing
less of an incentive
for them to try themselves to
avoid that bad thing happening.
So moral hazard
is a real problem
and it's essentially
the trade-off.
On the one hand, we talked
about why people like insurance.
We talked about why people
like private insurers because
of risk aversion.
We talked about why government
intervention insurance
in markets is necessary.
But that comes with
the trade-off, which
is the more insurance
you provide,
the less people take
care of themselves.
And that's the trade-off.
Now, why do we care?
Let's just sit back and say,
that's an interesting economics
concept, but why do I care?
Why do I care if someone stays
out of work longer, fakes
an injury, or whatever?
Why do I care about this?
Why is this a problem?
It's a problem for two reasons.
There's two costs
to moral hazard.
The first cost to moral
hazard is lower efficiency.
And the best way
to see this is just
to think about the economics
of the consumption/leisure
trade-off.
Think about how I make my
decision of how hard to work.
Basically, if there's no
insurance, no social insurance,
no workers' comp, no
unemployment insurance,
how do I choose
how hard to work?
How do I choose
how hard to work?
How do I do that?
What's the trade-off I consider
in deciding how hard to work?
Yeah.
AUDIENCE: Consumption
versus leisure.
JONATHAN GRUBER:
Consumption versus leisure,
in particular, I
will trade them off
until the marginal value of
the next hour of leisure--
marginal value of leisure--
equals the wage.
Because the marginal value
of leisure is above the wage,
I should work less hard.
That means I'd
rather be at home.
If the marginal value of
leisure is below the wage,
that means I'm just
wasting my time at home.
I should work harder.
So I'll continue to trade
off work and leisure
till the next hour
of leisure makes
me just as happy as the
next hour of working.
And that is the
efficient outcome.
That is the socially
efficient outcome,
because leisure is
not a social bad.
There's nothing
wrong with leisure.
People value leisure.
They should get to trade
off the leisure versus what
they get from working till
they choose the right amount.
That's what makes
society best off.
Now, what happens if I
say, if you sit at home,
you're also going to get a
check from the government?
Now, what's my new equation?
Now, if I work, I
still get the wage.
But what happens
if I sit at home?
I get the marginal value of
leisure plus the government
check.
So now I sit at home until
this equation is true,
which means that I sit at
home until the marginal value
of leisure equals the wage
minus the government transfer.
That means the marginal
value of leisure
will be lower than it would
be without the government
transfer, which
means I work what?
More hard or less hard?
If the marginal value of
leisure is forced down,
that means I'm doing what?
Someone raised their hand.
Yeah.
AUDIENCE: More leisure.
JONATHAN GRUBER: More
leisure, because remember,
there's diminishing marginal
value of everything,
so I'm taking more
leisure, less work.
So the government is
causing me to work less
by essentially saying,
look, I'm going to reward
you more for staying at home.
What does that do?
That means that people work
less than is socially optimal.
This is the social optimum.
This means people are
taking more leisure
and working less than
is socially optimal.
When people work less, that
shifts in the supply curve
and creates a deadweight loss.
Social welfare has fallen.
Let me remind you, it's
not falling because people
take some time off.
Many people on the conservative
side of the spectrum
will act as if work is a virtue.
Work is not a virtue.
The optimal solution is to work
until your value of working
equals your value of leisure.
If you're someone who
has a job that you hate
and doesn't pay well,
and you love watching TV,
you should work less.
That's what's
optimal for society.
But you shouldn't work even
less because the government's
paying you to stay home.
That reduces efficiency.
So that's a problem of moral
hazard is it lowers efficiency.
There is a second
problem, of course,
of moral hazard, which
is if you work less,
then we have to tax people
who do work more to pay
for these programs.
So it raises taxation, raises
the required tax revenues,
raises the tax
revenues required.
Because if you're
sitting at home more,
I've got to make more money
to pay for you to sit at home.
And we know taxation also
causes deadweight loss.
So it's a double win.
I cause you to
stay at home and I
cause other people to have to
pay more taxes to pay for you
to sit at home, which causes
them to work less, too.
There's a second round effect.
As a result, moral hazard
causes inefficiency in society.
And that is the trade-off.
Once again, I told you,
this course is annoying.
We don't give you right answers.
We just tell you trade-offs.
The trade-off here is we need
programs like unemployment
insurance, because otherwise--
let's take the case of
unemployment insurance.
We'll go through
it one more time.
Imagine there's no government
unemployment insurance,
and you said, that's great.
I'll offer private
unemployment insurance.
Well, that's not going to work.
Why?
Because people
know way more than
you do about whether they're
going to lose their job.
If you tried to offer
private insurance,
you'd lose your shirt
because of adverse selection.
So absent government-provided
unemployment insurance,
there would be no
unemployment insurance.
And that would be bad.
That would mean people would
be subject to a risk that
would drive their
consumption to zero.
Remember, most Americans
have no savings.
That mean Americans
would be subject to risk
where if they lost their
job, they would starve.
That's a very bad outcome.
So it is socially
valuable to insure
against unemployment risk.
The private market can't do it
because of adverse selection.
Therefore, there is a
compelling case for government
unemployment insurance.
But with government-provided
unemployment insurance,
that causes people
to sit at home extra
and not work as hard.
And that's the sort
of chain of logic
which teaches you the trade-off.
What this says is optimal
social insurance--
that in these
markets, we're going
to want some social
insurance, but not too much.
We're going to want
enough to protect people
against starving, but
not so much that it
causes people to sit at home.
So for example,
if I told you I'm
going to set up an
unemployment insurance program,
and the way it's going to
work is if you lose your job,
I'm going to pay your
entire wage for as long
as you need until you find
a new job, that would not
be a good idea.
That would cause a huge
amount of moral hazard.
And remember, compare
that program to one
where I'll pay you 50% of your
wage till you find a new job.
Well, 50%, going
from 0% to 50%, 0%
of your wage to 50% of your wage
is a huge consumption smoothing
benefit.
You go from starving to
being able to eat decently.
50% to 100% is an
increase, but not as much.
But 50% to 100% has a
huge moral hazard effect.
So you want something
more towards the middle,
where you're getting people
away from starving, but not
so much that they don't work.
So that's the trade-off.
So let's talk about
that trade in practice.
Let's talk about the US
Social Security program.
The Social Security
program in the US--
Social Security is our biggest
single social insurance program
in the US.
Currently, the Social Security
program is about $800 billion
per year.
That's real money.
That's even more than Jeff
Bezos has, $800 billion a year.
That's more than he's
worth, every year.
What does this program do?
What this program
does, in a nutshell,
is it insures you against
the income loss you're
going to face when you retire.
When people retire,
they suddenly
go from having a lot of
income to having no income.
And basically, the
idea of Social Security
is to make sure you don't
starve when you're old.
So the way it works
is you pay a tax.
And if you ever see a line on
your pay stub that says FICA,
that's what this is for.
You pay a FICA tax.
It is 12.4% of payroll, half
on you, half on your employer.
But it doesn't matter that
half is on your employer,
because we learned two
lectures ago it doesn't
matter who pays the tax.
It's a 12.4% tax.
That's what matters on you.
That money then
provides that when
you retire, starting at
age 62, you get a check
from the government.
And you get a check
from the government
that lasts until you die.
The check from the
government you get
is what's called an "annuity."
An annuity is a payment.
Annuities are the opposite
of life insurance.
Life insurance is money that
your family gets when you die.
Annuity is a regular payment
you get until you die.
The way it works, you pay 12
and 1/2 percent of your income
all the way through your
working life till we turn 62,
or you can collect it later.
You then get a payment
for the rest of your life.
That payment is
typically about half
of what you made when
you were working,
but it's very
progressive, in the sense
that for someone
who's very poor,
it would probably more than
half of what they made.
For someone who's
rich, it would be much
less than half what they made.
It's a progressive payment.
Everyone gets it.
Everyone gets Social Security.
But how much you get from
it depends on your income.
The poorer you are,
the more generous
it is relatively
when you retire.
Now the-- yeah.
AUDIENCE: Is it possible as
life expectancies get larger,
it's going to be harder
to have Social Security
because if you're going to--
JONATHAN GRUBER:
That's a huge problem.
It sounds like you should
definitely be enrolled in 1441.
That's a whole half a
lecture we spend on that.
I don't have time to talk
about it here, but clearly
this is a huge, huge--
so just to give you
a couple numbers just
to keep you up at night.
We all know, we're all
talking about the deficit
is $500 billion.
It's a big deal.
If you ask how much
has America promised
to pay to our senior citizens
over the foreseeable future
minus how much we'll
collected taxes,
we are currently, as a
nation, $75 trillion in debt.
And it's because of the aging
society and things like that.
We've got big problems
coming down the road.
We can talk about
that another time.
But let's focus on the program
itself at a point in time
right now.
So basically, we see here
the moral hazard trade-off.
On the one hand, we
don't want people
to starve when they're old.
On the other hand, if I pay
you once you're retired,
that could cause you to retire.
If I say, once
you're retired you're
going to get a check, 50%
of your wage, you might say,
50% of the wage isn't
that much, but I really
don't like working.
I'd rather just hit the
links at 50% of my wage.
So that's the trade-off.
Now, how do we think about
evaluating that trade-off?
Evaluating that trade-off,
different countries
think about it differently.
In the US, we think about
it in what I would say
is a fairly rational way, which
is let's consider your decision
to retire at 62 versus 63.
The way it works in
the United States
is we say, look, if you work
one year more, since it's
an annuity, you will get
one less year off payment.
If you start at one
year later, you're
going to die the same time,
you get one year less.
So what we do is we pay
you more every month.
Indeed, for every
year you delay,
you get 6.7% more every month,
reflecting the trade-off
that you're going to get it
for a shorter period of time.
And that turns out
to be roughly fair.
Given the expected
life of Americans,
that's a roughly fair trade-off.
Every year you delay
gets 6.7% more.
In Europe, they don't have this.
So every year delay, you just
get less money before you die.
So let's take the example
of the Netherlands.
In the Netherlands,
you can retire at 55
with a benefit that is
90% of what you made.
So if you earned $30,000,
you can retire at 55
with a benefit of $27,000.
And if you decide
to work instead,
you just forego that $27,000.
There's no bump up
of your benefits.
That's just one less
year of $27,000 you get.
So what that means, if
you're in the Netherlands,
your choice is work and
get 30,000 or stay home
and get 27,000.
In other words, it's
sort of like a 90% tax.
Think about it-- by working
relative to staying home,
I'm only keeping 3,000
of the 30,000 I made.
It's basically like a 90% tax.
But that's not all.
How do they pay
for this program?
They tax people.
You can't tax people
who are at home.
You've got to tax workers.
So if you work, you also
have to pay a 45% tax
to pay for this program
and lots of other things.
45% tax is a high tax
rate for everything.
What that means is if you
stay at home, you get 27,000.
If you go to work,
you get 30,000 times
1.55, or about 18,000.
That's 1.6, It's 16, 5.
So your choice is stay at home
and get 27, work and get 16, 5.
Guess what?
No one works.
No one over 55 in the
Netherlands works, like zero.
And they might work on the
black market and ways they
don't report to the government.
But basically, they just sort
of sit around coffee shops
and spend their
retirement money.
So here's a case where they've
made a very different decision
about how to make
this trade-off, which
is it's a pretty sweet life for
the elderly in the Netherlands,
but no one's
working over age 55.
And that's a different way
to resolve this trade-off.
So basically, this illustrates
different design features
of the program.
What makes the
Netherlands program have
much more moral hazard than the
US is the benefits are higher
and they don't increase your
benefits if you work more.
So essentially, these are
little kind of tweaky details
that turn out to matter
enormously for how
we think about the program.
Now, I hope you find
that interesting.
That was a lot to
put in one lecture.
Like I said, if you
find this interesting,
there's the whole third of a
semester in my class 14.41.
So take that.
We can learn a
lot more about it.
