Tuesday, March 29, 2011

Risk-Pricing, Adverse Selection and Moral Hazard

There's an entertaining article in today's edition of The Wall Street Journal that has all kinds of possibilities for the classroom. The article is about subway riders in Scandinavia who ride for free. Instead of buying tickets, they contribute to a pool that pays their fines if they get caught. They've set up a kind of "insurance" pool.

But if we think about it, we have an excellent example of adverse selection. I suspect the only ones who are paying into the pool are those who have no intention of purchasing a ticket and thus know they run the risk of being caught. Once a person has purchased the "insurance", they will likely be even less inclined to pay a fare.

So what keeps the premium from being the same as the amount of the fine? It's the likelihood or risk of being caught. If chances were 100% that you would be caught and fined, the pool would have charge a premium equal to the fine. This scheme can only work as long as enforcement by the authorities is lax enough to keep the premium less than the fare. Once the risk rises to the point where the premium costs more than the fare, it is cheaper to buy the ticket.

There is much more to this issue, as you'll see when you read the article. I'm sure you will see more possibilities. I did. But I hope you will share your ideas.


Matt said...

Love your blog! Some really great stuff here, but I've missed your presence lately. What's happened?

Tim Schilling said...

I've had a couple personal issues to deal with over the past 10 days or so. I should be back in the next few days.

Thanks for asking.