(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 662

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. 2 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.

3
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.