Privacy Externalities and Unraveling
I don’t smoke and if I went to buy life insurance tomorrow, I would want to disclose that fact to the insurance company. Insurance is priced based on a pool of risks, and as a nonsmoker, I want to be placed in a different pool than the smokers are in.
But when I reveal that I am not a smoker, I set in motion a chain of inferences which should, on average, have the consequence of revealing that smokers are smokers, even if they never say anything. This is a standard result in information economics—we call it unraveling—and creates what we might think of as a privacy externality: when I reveal information about me, it has the consequence of revealing something about you. My willingness to give up my privacy gives up your privacy too. This will bite most often when one group affirmatively wants to distance itself from a second group.
We might defend this in the smoking context on the notion that absent the waiver of privacy by the nonsmokers, we get pooled risks and non-smokers end up subsidizing the higher expected insurance costs of smokers. Smokers therefore won’t fully internalize the cost of smoking, and we will have too many smokers. Allowing nonsmokers to disclose information about their nonsmoking then turns out to be socially valuable in the way that it better channels the cost of smoking to smokers, but we need to figure out how to account for, if at all, the privacy loss of the smokers.
So a couple of questions. What are your preferences? Fewer smokers or more privacy for smokers? And, if you are a privacy fan, what is the best discussion in the literature of the way in which unraveling creates privacy externalities?