We haven’t had a Beginners post in a long time, but David Kestenbaum’s Planet Money post about traffic court got that part of my brain going again.
Kestenbaum’s story is that he went to traffic court and the judge was a friendly populist, but not an economist:
“The judge went on to say that this was the “people’s court” and explained that if she gave probation on a ticket, no points would appear and the insurance companies wouldn’t find out. ‘This court is not in the business of enriching the insurance companies,’ she said.”
Aha! Kestenbaum, who after a year on Planet Money is an economist, even if his Ph.D. is in physics, points out that whether or not people get points on their licenses doesn’t affect insurance company profits. They need to charge bad drivers more because their loss payments for those drivers will be higher; if they can’t find out who the bad drivers are, they will just raise premiums on everyone.
You can take this line of reasoning further.
- The first-order effect of hiding information from insurers is that those drivers will enjoy lower premiums than they otherwise would have paid.
- The second-order effect is that insurers will raise premiums on all drivers to make up the difference.
- The third-order effect is that fewer people will buy insurance. The reason is that the value of insurance is different for different people; if you are a good driver, insurance is worth less to you than if you are a bad driver. (Let’s leave aside the very real problem that most people think they are good drivers, even though they aren’t.) If the price curve for insurance flattens out (same price for all levels of riskiness), then the price for good drivers will exceed the value of insurance to them, and they will elect to “go bare” (that’s the term used in the commercial insurance world, honest). This is bad because if fewer people are buying insurance, then the economy is producing less than the socially optimal amount of insurance.
- The fourth-order effect is adverse selection. If the good drivers drop out of the pool, the insurance companies know this (they will find out after a year when the accident rates are higher than they would be if all drivers were in the pool), and they will raise rates for everyone left. Now the middling drivers are being overcharged for insurance (the bad drivers are still being undercharged), so then they will drop out, and after another year the insurers will raise rates again. Theoretically this could go on until only one person is being insured, though in practice it obviously doesn’t.
So by this line of reasoning it’s a very, very good thing that bad drivers get points on their licenses and insurers use that information to set premiums.
There are a couple of other angles you can take on this scenario. For example, if only one traffic court judge is behaving this way, then her customers are getting a break, and what you have is a transfer of wealth from every other insured driver in the country to the people in her courtroom.
There. Now you know how to sound like an economist at a cocktail party.
But like much of this kind of economistic speculation, which you will find all over the Internet, including here (hey, at least I’m aware of my shortcomings), is that it rests on a host of implicit assumptions. One of the big assumptions is perfect competition. Perfect competition is what makes things “balance out” all the time. Insurers can’t simply fix premiums arbitrarily high above everyone’s willingness to pay for insurance, because then each individual insurer would have a marginal incentive to lower premiums until all of the profits were competed away. Perfect competition lets you say that more or less nothing will affect an industry’s profits.
But there is no such thing as perfect competition. If you consider a world where some companies happen to be better than others, then things get more interesting. You could argue that giving insurers information about driving violations (points) helps the better insurers, because they will be able to use that data more effectively in their pricing models. You could also argue the reverse: state-assessed points are an easy way for all insurers to get data, and hence they level the playing field; if they couldn’t get that data, then the best insurers would find other ways to predict the likelihood of accidents (credit reports, for example, although that is highly controversial and I believe illegal in some states), which would give them more of a competitive advantage. Without assumptions, things get messier.
Another common assumption is no regulation. In all states, however, drivers are required to buy liability coverage (though not collision and comprehensive), just like in most states companies are required to buy workers’ compensation insurance. When there is a legislated captive market, the third-order effect above doesn’t apply, and the adverse selection problem becomes more complicated (it doesn’t go away as long as people can choose different attributes of their policies, like limits and deductibles).
Then of course there is the assumption of rational actors. Because everyone thinks he or she is a good driver, people underestimate the value of insurance. Or at least, they would underestimate it if they actually thought about it. But they don’t actually try to calculate the value of insurance to them and make a buying decision on that basis – they just buy it from whoever offers them the lowest price for some package of coverages they decide they need based on certain rules of thumb, like “whatever my parents told me to buy the first time I had a car.” Without rational actors, most of this type of cocktail party economics breaks down – but where’s the fun in that?
So now you should be familiar with a large proportion of the arguments made by economists. Extra credit to those who can explain the title.
By James Kwak