Knowledge that Transforms

This paper examines the implications of adverse selection in the private annuity market for the pricing of private annuities and the consequent effects on constrption and bequest behavior. With privately known heterogeneous mortality probabilities, adverse selection causes the rate of return on private annuities to be less than the actuarially fair rate based on population average mortality. However, a fully funded social security system with compulsory participation can offer an implied rate of return equal to the actuarially fair rate based on population average mortality. Thus, since social security offers a higher rate of return than private annuities, consumers cannot completely offset the effects of social security by transacting in the private annuity market. Using an overlapping generations model with uncertain lifetimes, we demonstrate that the introduction of actuarially fair social security reduces the steady state rate of return on annuities and raises the steady state levels of average bequests and average consumption of the young. The steady state national capital stock rises or falls according to the strength of the bequest motive.

ABSTRACT The effects of noise on the world, and on our views of the world, are profound. Noise in the sense of a large number of small events is often a causal factor much more powerful than a small number of large events can be. Noise makes trading in financial markets possible, and thus allows us to observe prices for financial assets. Noise causes markets to be somewhat inefficient, but often prevents us from taking advantage of inefficiencies. Noise in the form of uncertainty about future tastes and technology by sector causes business cycles, and makes them highly resistant to improvement through government intervention. Noise in the form of expectations that need not follow rational rules causes inflation to be what it is, at least in the absence of a gold standard or fixed exchange rates. Noise in the form of uncertainty about what relative prices would be with other exchange rates makes us think incorrectly that changes in exchange rates or inflation rates cause changes in trade or investment flows or economic activity. Most generally, noise makes it very difficult to test either practical or academic theories about the way that financial or economic markets work. We are forced to act largely in the dark.