This Document Contains Chapters 24 to 25 Chapter 24 Asymmetric Information: Moral Hazard and Adverse Selection Learning Objectives After completing this chapter, students should: > know what asymmetric information is and recognize it. > understand moral hazard and how it can be overcome. > understand how adverse selection affects market outcomes. > understand how signaling can help overcome problems of asymmetric information. Chapter Outline Moral Hazard Overcoming Moral Hazard by Providing More Information Overcoming Moral Hazard by Creating Better Incentives Adverse Selection Adverse Selection in Health Insurance Inspections or Checkups Group Plans Conscientiousness Signaling as a Response to Asymmetric Information Signaling in the Job Market Signaling in Dating, Marriage, and the Animal Kingdom Is Signaling Good? Takeaway This chapter discusses asymmetric information, which refers to one party in a transaction having more or better information than the other party. Two problems that arise from asymmetric information are moral hazard and adverse selection. Each of these problems is discussed along with ways of overcoming them. Signaling, discussed at the end of the chapter, is another way of overcoming asymmetric information. Teaching Tip: Begin the discussion in this chapter by simply defining asymmetric information and discussing some familiar situations where it arises, such as the used car and insurance markets (or use your own favorite examples). The MRU video Asymmetric Information and Used Cars introduces the topic of asymmetric information using the famous example of “lemons” in the used car market. This video provides a nice opening to the material in this chapter. Asymmetric information also gives rise to the principle–agent problem, which provides another general way to describe these situations. The problem is how to structure incentives so that an agent works in the principle’s best interest even when the agent has information that the principle doesn’t have. The text mentions several examples of principle–agent problems that arise when we rely on individuals with more information than most ordinary people, such as cab drivers, mechanics, and dentists. Teaching Tip: Ask your students to identify the principle and the agent when a person hires a cab driver, mechanic, or dentist. Also, have them identify the common problem in all of these examples. This should lead to a nice discussion of asymmetric information. Once students have a handle on the idea of asymmetric information in general, they will be in a better position to understand the specifics of the moral hazard and adverse selection problems. Another example you can use for principle–agent problems is professional sports. Owners and general managers want to hire the best talent and are usually willing to pay for it. Therefore, it is not uncommon for a player at the end of a contract to perform extremely well in an attempt to secure better terms in the new contract. Once that talent is locked into a long-term contract, what incentive does the player have to continue their hard work? Moral Hazard Moral hazard is the possibility that parties with more or better information may try to exploit their advantage at the expense of their trading partners. The cab driver, mechanic, and dentist who recommend longer routes or unnecessary services are all examples of moral hazard. The text identifies two problems that arise from moral hazard: Wasted resources Refusing service altogether Wasted resources result when too much of a good or service is recommended by the agent. Unnecessary repair work and longer cab routes entail production of unwanted and unneeded goods, thus wasting the economy’s scarce resources. In extreme cases, parties who fear being taken advantage of refuse service altogether to avoid being ripped off. While the breakdown of trade serves as a guarantee against being ripped off, it also prevents potentially beneficial trades. The lost gains from trade are a cost to the economy. The MRU video Moral Hazard introduces the topic of moral hazard and provides several examples. The costs imposed by moral hazard are more serious when the decisions involved are more expensive, longer-lasting, and difficult to reverse. These costs could be avoided if the information asymmetry could be resolved. The text discusses two solutions to moral hazard: Providing more information Reducing the incentive for exploitation Overcoming Moral Hazard by Providing More Information One way to reduce moral hazard is to reduce the information asymmetry that caused the problem in the first place. The text discusses the role of the Internet in providing such information. For example, Angie’s List provides reviews of mechanics, dentists, and so on. This information helps buyers avoid shady characters. In general, the availability of such information has raised the benefit to sellers from having a good reputation. In other words, good reviews bring sellers more business and allow them to charge higher prices. At the same time, the information has raised the cost of having a bad reputation. Sellers who are exposed for ripping off buyers stand to lose a lot of business when the whole world can read about it online. Online restaurant, seller, and product reviews and independent testing agencies such as Consumer Reports are other examples of the type of information that can help eliminate moral hazard. The text also discusses problems that arise with the information itself, as the information becomes more valuable in reducing moral hazard. As online reviews become more valuable, there is the incentive for reviews to be faked. In addition, because information is a public good, too little of it is provided. (See Chapter 19 for more on public goods.) So, while additional information can help reduce moral hazard, the market for information is itself imperfect and cannot eliminate moral hazard. Overcoming Moral Hazard by Creating Better Incentives While providing a buyer with more information is one way to reduce moral hazard, reducing a seller’s incentive to exploit an information advantage is another. One way of reducing the incentive to exploit in principle–agent problems is to separate the selling of the service from the determination of how much is needed. Hiring a house inspector before buying a house and getting a second opinion before a medical procedure are examples. The incentive to exploit information advantages can often be reduced by changing the way agents are compensated. Instead of tying compensation to the amount of service, payment can be made as a flat fee. The text discusses the reduction in the number of cesarean deliveries when obstetricians are paid a salary or flat fee rather than per procedure. Another example of tying incentives to compensation is contingency lawyer fees; the lawyer isn’t paid until and unless he or she wins the case. The MRU video Solutions to Moral Hazard discusses approaches to dealing with the moral hazard problem. Adverse Selection Adverse selection occurs when an offer conveys negative information about the product being offered. The classic example is the used car market. Imagine that there are equal numbers of two types of used cars, lemons (low quality) and plums (high quality). The information asymmetry in this market is that the seller of the used car knows more about its quality than does the potential buyer, and there is no cheap way for buyers to distinguish lemons from plums. The end result is that only lemons will be available for sale in the market. The reasoning goes as follows. If plums are worth $12,000 and lemons are worth $8,000, the buyer who can’t distinguish the two will be willing to pay only the average price, namely (½ × $12,000) + (½ × $8,000) = $10,000. But the sellers of plums will generally not sell their cars for $10,000, so fewer plums are for sale. With fewer plums in the market, the average value of available cars—and the price buyers will pay—falls below $10,000. As price falls below $10,000, the quality of cars offered for sale will fall further, which causes the average price to fall further, and so on. This vicious cycle continues until the plums are eliminated and the market contains nothing but lemons. Of course, few people will be interested in a market for lemons, so the market breaks down completely. This is an example of market failure cause by asymmetric information. The adverse selection here is that the offer to sell a used car implies that the car is a lemon. This extreme result is startling, especially in light of the fact that the used car market is alive and well. The market for used cars works relatively well because of the market institutions, laws, and regulations that have evolved to deal with adverse selection. This includes buyers’ ability to have a mechanic inspect the car before the purchase. Third-party agencies, such as CARFAX, also provide information on the history of used cars. Another practice that provides information to reduce the information asymmetry is to certify used cars. Certification means the car has been inspected, repaired, and refurbished, so that it can be sold with a warranty. The warranty assures the buyer that the car is not a lemon, because the seller will have to pay if it is. The warranty makes the offer to sell credible. A credible promise is one the promiser has an incentive to keep. Teaching Tip: Notice that these solutions to the adverse selection problem in the used car market are similar to the solutions for moral hazard, namely providing more information and changing incentives. This is a nice way to tie together the problems—and solutions—of information asymmetries. Adverse Selection in Health Insurance Another market plagued with adverse selection is health insurance. The adverse selection in this case is that those offering to buy health insurance are those in bad health. The result is analogous to the problem in the used car market. The healthiest individuals will not be willing to pay the average price of health care to cover the group of insured individuals, which causes fewer healthy individuals to buy insurance, which reduces the average health and raises the average price, driving even more of the healthy to leave the market. This “adverse selection death spiral” is depicted with numbers in Figure 24.1 in the text. The end result is that only those in bad health participate in the insurance market. Note the similarity to the spiral that left only lemons in the used car market. As in the used car market, some institutions, laws, and regulations have evolved to help deal with adverse selection in the health insurance market. These include the following: Inspections or checkups, which allow insurance companies to gauge the health of potential buyers and attempt to catch illnesses sooner when they are cheaper to address. If companies can adjust rates accordingly, the death spiral can be avoided. Offering insurance as group plans rather than to individuals. This allows insurance companies to attract more healthy individuals who are part of the group, which also helps to avoid the death spiral. The fact that individuals who are conscientious about their health in general are more likely to buy insurance, even though they are healthier and stand to gain less from having insurance. Insurance companies like conscientious individuals because they lead to positive selection (or propitious selection) rather than adverse selection. Such positive selection can counter the effects of adverse selection in the market. The individual mandate that is part of the 2010 Affordable Care Act. It requires individuals to buy insurance and subsidizes the purchase for poorer individuals. One reason for the individual mandate is to avoid the death spiral by forcing healthy individuals to participate in the market. The health insurance market is also subject to moral hazard: individuals covered by insurance will behave in a riskier manner and demand more services, since they know the insurance company will pay. Other types of insurance are also subject to this moral hazard: drivers with insurance drive less diligently; banks with government backing take on riskier investments. The MRU video Asymmetric Information and Health Insurance discusses asymmetric information, adverse selection, and propitious selection in the market for health insurance. Signaling as a Response to Asymmetric Information A signal is an expensive action that is taken to reveal information. Since signals reveal information, they are especially useful to correct information asymmetries. An expensive signal is generally a more credible signal, since the cost of not keeping the promise will be higher. Signaling in the Job Market The job market is plagued with asymmetric information because it is costly and difficult for employers to determine the quality of job candidates. One way of dealing with this asymmetry is for job candidates to provide a signal of their quality. One such signal is obtaining a college degree. College degrees are costly, but they provide an important message about a person’s intelligence and ability to complete a difficult task. This is why it is often thought that finishing your degree is far more important than what you study. In other words, the ability to finish the degree is more important than what you learn in terms of practical skills. If education is merely a signal, it could also explain why older individuals or those who have been unemployed for a long time find it more difficult to get a job than new graduates do, even when they have similar skills and abilities. The MRU video Signaling discusses signaling and provides a number of examples. Signaling in Dating, Marriage, and the Animal Kingdom This section provides a number of interesting examples of signaling outside of topics usually associated with economics: Criminals often signal their propensities to one another by getting facial tattoos, an irreversible way to display an unwillingness ever to return to “normal” life. Engagement and wedding rings are traditionally made from some of the most expensive materials available on earth—gold and diamonds! That expensive ring becomes even more expensive to the giver if the relationship falls apart. (Note that most courts find that the ring is a gift and need not be returned if the relationship does fall apart.) A woman’s willingness to take her husband’s last name is a signal of commitment because a future divorce will require a name change that could be costly in terms of establishing or keeping a professional reputation. Even in the animal kingdom, the theory of sexual selection suggests the peacock’s tail signals his ability to procreate, as only the healthiest are able to grow large and beautiful tails. In fact, for most birds it is the male that is the more colorful and attractive. It is a costly signal of strength in that it also makes them harder to hide from predators. Takeaway Students should be familiar with situations with asymmetric information as well as the particular problems of moral hazard and adverse selection that result from it. They should understand how these problems affect markets and how information asymmetries can be overcome. For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction:
For Problems in the Section: Watch the MRU video:
Introduction Asymmetric Information and Used Cars
Adverse Selection Asymmetric Information in Health Insurance
Moral Hazard Moral Hazard
Moral Hazard Solutions to Moral Hazard
Signaling as a Response to Asymmetric Information Signaling
Chapter 25 Consumer Choice Learning Objectives After completing this chapter, students should: > know how diminishing marginal utility and the optimal consumption rule is related to the demand curve. > be able to use budget constraints and indifference curves to find a person’s optimal consumption bundle. > understand income and substitution effects and be able to identify them on a graph. > be comfortable applying these tools to issues such as how much Costco should charge for membership and how welfare benefits influence people’s incentives to work. Chapter Outline How to Compare Apples and Oranges The Demand Curve The Budget Constraint Preferences and Indifference Curves Optimization and Consumer Choices The Income and Substitution Effects Applications of Income and Substitution Effects Losing Your Ticket How Much Should Costco Charge for Membership? Labor Supply Labor Supply and Welfare Programs Takeaway Chapter Narrative Most instructors will probably choose not to cover this chapter in a traditional one-semester principles of microeconomics class. However, if you want to introduce your students to budget constraints and indifference curves, this chapter is for you. It has a little bit less of a continuous narrative than some of the others but still manages to apply these tools to a variety of real-world issues, so students can see their usefulness. How to Compare Apples and Oranges Though your students have always been told they can’t compare apples and oranges, this section teaches them they can, by using marginal utility. Marginal utility is the change in welfare (or happiness, or pleasure) brought about by consuming one more unit of a good. Because people put the first unit of a good to its most valuable use, the second unit to the second most valuable, and so on, marginal utility diminishes as a consumer gets more units of a good. This important characteristic of marginal utility is referred to as diminishing marginal utility. Consumers face the problem of deciding how much of their income to spend on different goods, in this case apples and oranges. To get as much utility as possible, consumers should consume each good until the marginal utility per dollar from each good is equal. This is known as the optimal consumption rule. Using subscripts A and O to stand for apples and oranges, the optimal consumption is achieved when: 〖MU〗_A/P_A =〖MU〗_O/P_O . It might be useful to give the students an example of when these marginal utilities per dollar are not equalized and to keep the three cases on the board. What would happen if you could get more utility per dollar spent on oranges than apples? Then obviously you should decrease the number of apples you consume and increase the number of oranges. The marginal utility of each additional orange continues to decrease, and the value of each apple you give up increases. Eventually, the marginal utility per dollar equalizes and you are achieving the most satisfaction you can. Teaching Tip: Students can sometimes be tripped up because of the abstract nature of utility theory. One thing to help students is to have them recall the discussions regarding firm decision making in a perfectly competitive environment. It might help to show the students that the optimal consumption rule is almost identical to the profit maximization rule found in Chapters 11 and 12. Just as profit is maximized by equating all marginal costs, utility is maximized by equating all marginal utilities. Then it should be easy to simply view “utility” as “profit for the consumer.” The Demand Curve The optimal consumption rule also gives you a reason the demand curve slopes downward. Have the students imagine that a person is satisfying the optimal consumption rule. Now increase the price of apples. The equation now is as follows: 〖MU〗_A/P_A describe the benefits of the welfare program. > analyze how the program influences people’s incentives. > use budget constraints and indifference curves to model the choices faced by people in these countries. Instructor Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766
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