Economics of Information

Asymmetric Information:

Adverse Selection and Moral Hazard

Chapter 17

Recap

• Until now, we have assumed that both buyers and sellers involved in a transaction possess the same amount of information about the product and the service.

• This is not always true: sometimes buyers have more information, sometimes sellers have more information and sometimes neither party would be well informed about the product and the service.

• The result of asymmetric information is an inefficiency in the market. We’ll see how!

Asymmetric Information

- A situation in which one party (buyer/seller) involved in an economic transaction or a contract has more information than the other party(seller/buyer).

There are two situations:- Adverse Selection (Pre-Contractual asymmetry) - Moral Hazard (Post-Contractual asymmetry)

Adverse Selection

• The situation in which one party to a transaction/contract takes advantage of knowing more than the other party to the transaction/contract.

- Quality of a ‘lemon’ in car market- Riskiness of drivers in car insurance market- Healthiness of people buying health insurance- Skill level of a worker in labor market

Moral Hazard

• The actions people take after they have entered into a transaction/contract that make the other party to the transaction/contract worse off.

- Carelessness on a car with warranty- Riskier driving behavior after purchasing the car

insurance- Unhealthy lifestyle because of the health

insurance- Shirking, slacking after a worker is hired

Asymmetries in the Insurance Market

• Suppose there are two categories of people:– People with good health vs bad health– Premium for good = $1,000, bad = $500– The company charges $750, on average– Problem? ‘good’ don’t buy insurance. The company

charges full price to ‘bad’ ones. It could be the case that they can’t afford either. So the total number of people with health insurance is less.

Example of Inefficient market outcome.

Solution? • Adverse selection Problem

Group Insurance Coverage

• Moral Hazard:

Charge Deductibles

Asymmetries in the Labor Market

• Suppose there are two categories of workers: – Workers with high skills vs low skills– Wage for high = $10/hr, low = $5/hr– Suppose based on education levels, the firm hires

workers deemed high skilled and pays $10. – What happens if the worker does not put as much

effort as a ‘high’ skilled worker would put? – The output is not ‘efficient’ for the wage paid

Another example of market inefficiency due to asymmetric information.

Solution? • Adverse selection Problem

Proof of Education/Training

• Moral Hazard:

Compensations, Incentives, Bonuses