CHAPTER 16 (final exam) Flashcards
When does an asymmetric information problem occur?
What problem shows a common manifestation of asymmetric information? what is the general idea of this problem
It occurs when one party knows more about the quality of the good than does the other party
The Lemons problem > market transactions fail to occur because of asymmetric information; this is a market failure
In the lemons problem for a car market, what are good cars and what are bad ones
good cars = plums
bad cars = lemons
Describe what happens in the lemons problem with observable quality (quality attributes are observable to both sellers and buyers) - assume 50/50 lemons and plums
- all of the plums in the markets will sell at a price between what the buyers and sellers value it at (lowest price seller is willing to sell it for and highest price buyers are willing to buy it for)
- trade is smooth! both parties are better off > buyers value the cars more than the former owners, and former owners are happier with the money
- lemons have no value, so none will be sold
Describe what happens in the lemons problem with unobservable quality (sellers know the quality but buyers do not) - assume 50/50 lemons and plums
Buyers know that 50% are lemons and 50% are plums, so they know they have a 50% chance of receiving a lemon > this means that the most they’ll be willing to pay for a car has to change because their expected value is less now
EV = (10,000x0.5) + (0x0.5) = $5000
$5000 is now the most they’re willing to pay > no one with plums wants to sell at this price so they leave the market > sellers with lemons stay in the market so only lemons get sold > eventually buyers will see that it’s only lemons so they all leave too > = MARKET FAILURE - because of asymmetric information, only bad products are dominating and this is an inefficiency
What is adverse selection?
A situation where there are stronger incentives for “bad” types of a product to be involved in a transaction than “good” types of the product
There is asymmetric information between parties of a transaction, where the better-informed party can exploit the other party > occurs before the transaction > informed parties can self-select to maximize their outcome which harms the uninformed party
Is the existence of quality differences a market failure?
No, that is not itself a market failure
But a lack of information / asymmetric information about the quality is a big cause of one
- leads to adverse selection - leads to a market price that offers no incentive for good products to be offered for sale but every incentive for bad products to be offered for sale
Which parties are hurt by information asymmetries?
It hurts not only those with little information but also those with more information
- both sides lose because the lack of complete information prevents trades
- ex. buyers and owners of plums are both hurt despite the owners having complete information
What are some other examples of markets characterized by information asymmetries
- used merchandise sold online
- home improvement
- vehicle repairs
- labour
- insurance
What are the 3 mechanisms for mitigating the lemons problems (adverse selection)
- Address the information asymmetry directly by allowing buyers to observe quality characteristics before a transaction takes place
- third-party examinations of quality (mechanics)
- offering standardized, unbiased information products (ex. AutoCheck) - Punish sellers who misrepresent their lemons as plums (incentives for truthful quality reporting)
- reputation (online feedback)
- warranties and return policies (offered by seller)
ex. Lemon laws mandate warranties and return policies for new and used vehicles in many states - Use incentives to increase the number of plums brought to market (Increasing the Average Quality of Cars Placed on the Market)
- leasing can increase the average quality of used cars by encouraging return, regardless of quality
What are some other mechanisms for mitigating lemons problems beyond the used car market
- Better Business Bureau and Angie’s List (increasing trust between businesses and consumers)
- referrals and references
- Accreditation services (certifications)
Explain the Adverse Selection scenario when the buyer has more information than the seller
The biggest example of this is insurance markets (health, auto, life, others)
- requires the seller to pay the buyer compensation in the event of a covered incident
- buyers have information about their own RISK that sellers don’t have - they can’t determine the quality or the likelihood that a buyer will have claims
- insurance sellers are adversely selected in insurance markets (they are at a higher-risk because they lack full information) > therefore, they will often raise prices for everyone
What are 3 mechanisms for mitigating adverse selection in Insurance markets?
- Group policies:
- tying insurance to employment removes the link between the individual’s riskiness and the decision to purchase insurance
- pooling individuals reduces the effect of any given poor-risk person > spreads risk out bc everyone has to buy it - Screening:
- detailed questionnaires, health exams, driving records, etc. - Denying coverage:
- insurers try to deny coverage to individuals with certain risk factors of pre-existing conditions (main reason behind protections provided in the affordable care act/ Obamacare)
What is a Moral Hazard?
A moral hazard arises when one party to a transaction cannot observe the other party’s behaviour
- when quality is difficult to observe and they are usually protected in some way, a party to a transaction may have a financial incentive to engage in fraud
ex. money managers handling clients’ funds
Explain what adverse selection refers to in insurance markets compared to what moral hazard refers to in in insurance markets
Adverse selection - refers to the problem of deciding who to insure and at what price
Moral hazard - refers to the effect of being insured on the behaviour of an individual > knowing you are insured may make you more willing to take risks, bc you wouldn’t bare the full cost of the loss
Explain the difference between Adverse Selection and Moral Hazard
while they both occur because of asymmetric information in contracts, they differ in timing and nature
- adverse selection occurs BEFORE a contract is formed/a transaction is completed, leading one party to be screwed over
- moral hazard occurs AFTER the contract is in place/the transaction is completed > one party’s behaviour changes due to the protection provided by the contract, potentially increasing risk
What are some examples of moral hazard behaviour in auto insurance for theft
The driver might change their behaviour if they know they’re covered by insurance
Ex.
- parking on the street instead of a garage
- parking in relatively unsafe areas
- not locking the car
What are two other main moral hazard instances outside of insurance markets?
Financial markets:
- between borrowers and lenders
- borrowers’ liability might be limited meaning they may be willing to take unjustified risks with borrowed funds
- or sometimes there are implicit guarantees to large financial institutions that may increase risk taking (ex. financial crisis highlighting the issue of banks being “too big to fail” and believing the government will help them out
Employer-Employee relationship:
- inability to observe all of employees’ activities provides an opportunity and incentive for employees to slack off
What are some market mechanisms that are used to diminish the effects of moral hazard?
Insurance policies mandating actions be taken by the insured
ex. commercial property insurance often requires working smoke detectors and regularly inspected fire extinguishers
Policies can be structured to encourage good behaviour
- some auto insurance deductibles fall after each accident-free year
- life insurance premiums usually fall when efforts are made to improve health (ex. quit smoking)
What are Principal-agent relationships? When is there a principal-agent problem?
Principal-agent RELATIONSHIP = a set of economic transactions that feature information asymmetry between a principal and their hired agent, whose actions the principal cannot fully observe
**Information asymmetry is insufficient to create a principal-agent PROBLEM - there must also be a misalignment between the incentives and preferences of the principal and the agent
ex. employer wants her employees to work as hard as possible, but employees want to do as little as possible without being fired
What is the most common strategy in the real world to deal with principal-agent problems?
Incentive-based pay is the most common strategy (insures that the agent will get a higher value from working hard compared to not working hard which will increase the principal net profits)
The principal has to set up incentives to make it in the agents own best interest to do what the principal wants them to
What is one major result / issue that comes from principal-agent problems?
Good agents or products are not identifiable, and therefore, cannot command or receive their full value
What is signaling?
A solution to the problem of asymmetric information in which the knowledgeable party alerts the other party to an unobservable characteristic of the good
*since quality is not always observable, signals are a market mechanisms that can overcome some problems associated with information asymmetry
How do economic actors often attempt to communicate their quality via a signal? What makes it an effective strategy?
- they would take a costly action in order to indicate something that would otherwise be difficult to observe
** to signal high quality credibly, a signal must be LESS costly for high-quality agents than low-quality agents - only works if the signal action is too costly for low-quality agents to partake in
*has to be incentive-compatible to be an effective strategy
What is the classic signaling example?
Education - specifically getting a degree
- college is difficult - it takes time, money, and ability > by getting a degree, employees can signal to employees that they are productive and possibly receive a higher wage because of it
* important factor is that the cost of getting a degree would be higher for low-productivity workers than for high-productivity workers
ex. if employers will accept a degree as a legit signal and pay those employees a higher wage, it is only effective if it’s incentive-compatible (high-productivity workers must find it advantageous to use college as a signal, and low-productivity workers must find a college degree not worth the effort)
