Adverse selection is often considered a result, rather than a cause of moral hazard, where offering a risk-bearing product creates incentive for demand by the riskiest consumers. Obvious modern examples include offering expensive mortgages to high-risk home buyers, or selling life or health insurance at the same price regardless of consumer demographics. Not charging potentially sick or aged consumers more for health or life insurance sets up a stronger incentive for those customers to purchase than for the young and healthy, and therefore higher risk than the overall average. The resulting higher risk proportion is called 'adverse selection.' If credit costs extra for high-risk borrowers, low-risk borrowers will choose less-expensive product or won't need to borrow in the first place, with the result being a higher likelihood of default for the least able to pay with the highest cost compared to the total group average of all potential consumers. Lawrence Ausubel (1999) demonstrated adverse selection in credit markets before the recent wave of financial 'innovation,' and traces the history of underlying concepts back a century or more in insurance, with Ackerlof's seminal 1970 paper -- ironically here on the market for 'lemons' (used cars) -- demonstrating the result could be exactly the type of rationing that aggravated the modern banking crisis circa 2009. Demonstrating how adverse selection could result from increased regulation in private or public sectors reveals significant economic effects the Globe and Mail glosses over.

Conceptual model

The effects of this type of trade regulation can be modeled using traditional supply and demand curves, on the (positive, northeast) Cartesian plane with units of output on the X axis and price on the Y axis. Demand is generally downsloping for normal (i.e. non-luxury goods), where a normal good is one consumers purchase more of at lower prices or if incomes rise. The opposite is an 'inferior good,' one with a boomerang-shaped preference curve, which consumers buy less of when incomes rise. The supply picture can take numerous forms, but is usually upsloping, where higher prices encourage more production. Economies of scale can cause a series of stepwise plateaus for example; likewise if there is surplus production, demand can start out flat if higher consumption does not generate price increases. Long-run marginal cost (MC) is U-shaped, indicating high unit cost at extremely low and high output, with a minimum that maximizes profit for the firm when the cost of one additional unit equals sales price (revenue) for all units. Monopolists have an incentive to raise price at less output with higher profits but could produce and move more output at lower prices. In that case there is an artificial shortage of that good, at unnecessary cost to the whole society. Imposing external costs through regulation moves the supply curve to the left, reducing output at higher prices. Potential profits go unclaimed and society could be better off producing more. For public goods offered at one price regardless of demand, crowding sets in and shortages or rationing result such that demand also remains unfulfilled. These concepts all rely on standard assumptions like free mobility of labor and capital, unrestricted entry and rational consumers, which are patently questionable.

Analysis

Chase (2010) fails to follow the economic effects of food safety any farther than the tax bill or shelf price, perhaps because those effects ripple far beyond the space allotted for even the week-long series. Likewise an exhaustive demonstration of specific effects on the Canadian economy would exceed this available space, but even a simplified model of the costs and benefits of food safety can demonstrate ramifications beyond the Globe and Mail story.

Chase revises the taxpayer out of his estimate of who will bear cost toward the end of the 2010 article, explaining big producers and retailers who can bear increased regulatory cost will edge smaller firms out, even though comparable U.S. cattle tracking and accountability systems only constitute less than 1% of annual sales (this implies a hasty generalization all exporters will face the same cost proportions, incidentally). The result will be a concentration of supply where non-compliance will result in firm death after the initial government subsidy expires (Chase, 2010). Jessica Leeder elaborates on the incentive to cheat engendered by this threat of higher cost in the subsequent story (2010). Nowhere in the ongoing series does either writer consider the macroeconomic effects to the consumer from increased prices following regulation, and although Chase points out that the dangers of lax oversight include " cancer-causing...

To dioxins in Belgian chocolates," causing "about 250 to 300 recalls of food each year" (2010), neither writer traces the costs of these recalls and health problems beyond 11 million or so cases of "acute gastroenteritis" (Chase, 2010). Including these costs could completely alter the conclusions drawn in the series, especially if cost change fed back across the macroeconomy through adverse selection.
Consider a simplified model where food constituted say 10% of the average consumer's disposable income (DI), where basic health care is provided through taxation and additional, boutique health services and insurance are available in private sector markets. Introduce the important constraint that healthier food is more expensive, but has overall benefits in the long run in lower incidence of obesity; diabetes; heart disease; cancer (Chase, 2010) and the like. This cost of health care includes lost productivity due to illness, which these authors ignore. Likewise imported food is cheaper than domestic substitutes or it would only be imported if there were no substitutes or production capacity. Add the cost of recalls and the result is a perfect storm of adverse selection the Globe and Mail completely overlooks. But what Chase and Leeder also ignore is that better food may in fact constitute a savings for the total economy if the increase in quality reduces health cost enough to offset the effects of increased shelf price. The ultimate outcome would likely depend on the proportion of health care costs to regulatory cost, and whether there were substitutes or not. A wider view demonstrates different possible results.

Say food cost increased to 15% of DI. Absent a pay raise, the consumer would have less to spend on private health care and overall social health would fall as higher overall food prices forced consumption of cheaper, more toxic food imports. Demand for public health care would increase, raising costs and thus taxation, providing even less disposable income for healthier food, pushing down on health quality, resulting in higher demand for health care; and so on ad nauseam, in theory. The most-able to pay would flee the public health care system (they could also afford the healthiest food), which would result in the worst cases falling on the taxpayer, i.e. adverse selection, with a new equilibrium at higher per-unit public health costs especially if healthier food consumption earned lower price for bolt-on insurance. Furthermore, the increased food cost would result in higher wage demands across all employments, resulting in general inflation and lower employment absent further price increases, at the same time tax costs were driven higher for the remaining income earners, which would reduce their spending power and restrict growth, aggravating general macroeconomic contraction unless offset by increasing demand for domestic substitutes (I ignore interest rate and money supply effects for space). Increased demand for domestic substitutes would increase domestic prices and mitigate flight from now higher-priced imports, at a new, higher equilibrium price for all foods if domestic supply was not able to increase enough to prevent domestic price increases. Many goods are imported simply because there are no domestic substitutes, Chase points out (2010), so no supply could offset this shift of the supply curve to the left.

At the same time a higher share of health cost to the total tax bill, especially where personal incomes were falling, would leave less funding for subsidizing private, public or third-party inspection. These inflationary demand forces and laxer oversight of an increasing share of less-healthy food imports would encourage moral hazard, or the taking of risks by producers, where domestic retailers bore the cost of unidentifiable, toxic imported inputs, because Canadian government was powerless to impose penalties in other sovereign countries. This would generate increased recall expense for the taxpayer and the food value chain, exacerbating contractionary forces at the same time intensifying adverse selection and moral hazard feedbacks.

The other side of this story is that if increasing inspection generated more savings in health care, including work days lost, than the aggregate food price increase, and stimulated higher demand for domestic substitutes, just the opposite could happen: Tax burdens could fall, lower-income consumers could afford healthier options, wait times in the health service would fall, leading to lower private medical expense; domestic producers would receive higher demand and thus prices and profit (i.e. more jobs), and moral hazard to impose risk on Canadian consumers for outside firms would be reduced. The Globe and Mail series makes…