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ECO101Principle of Economics
Chapter 16 The Economics of
Information
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16 The Economics of Information
Chapter Outline
16.1 Asymmetric Information16.2 Hidden Actions: Markets with Moral Hazard16.3 Government Policy in a World of
Asymmetric Information
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16 The Economics of Information
Key Ideas
1. In many markets buyers and sellers have different information, which can lead to market inefficiencies.
2. Asymmetry in information is either due to hidden characteristics or hidden actions.
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16 The Economics of Information
Key Ideas
3. In cases with hidden characteristics, agents canuse their private information to decide whetherto participate in a transaction or a market,causing adverse selection.
4. In cases with hidden actions, an agent can takean action that adversely affects another agent,causing moral hazard.
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16 The Economics of Information
Key Ideas
5. There are both private and government solutionsto reduce the effects of adverse selection andmoral hazard.
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16 The Economics of Information
Evidence‐Based Economics Example:
Why do new cars lose considerable value the minute they are driven off the lot?
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16.1 Asymmetric Information
Asymmetric information
Information available to buyers and sellersdiffers
Hidden characteristicsOne side observes something about the goodbeing transacted that is both relevant for andnot observed by the other party
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16.1 Asymmetric Information
Hidden actions
One side takes actions that are relevant for,but not observed by, the other party
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16.1 Asymmetric InformationHidden Characteristics: Adverse Selection in the Used Car Market
Peach or lemon?
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16.1 Asymmetric InformationHidden Characteristics: Adverse Selection in the Used Car Market
Value to you: $5,000Value to seller: $4,000
Value to you: $0Value to seller: $0
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16.1 Asymmetric InformationHidden Characteristics: Adverse Selection in the Used Car Market
For any given car, how much would you be willing to offer?
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16.1 Asymmetric InformationHidden Characteristics: Adverse Selection in the Used Car Market
Expected value = .5($5,000) + .5($0) = $2,500
If you offer $2,500 to the seller, would he/she accept the offer?
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16.1 Asymmetric InformationHidden Characteristics: Adverse Selection in the Used Car Market
Adverse selection
One agent in a transaction knows about a hidden characteristic of a good and decides whether to participate in the transaction on the basis of this information
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16.1 Asymmetric InformationHidden Characteristics: Adverse Selection in the HealthInsurance Market
Which one will be more likely to want health insurance?
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16.1 Asymmetric InformationMarket Solutions to Adverse Selection: Signaling
Signaling
An action that an individual with private information takes in order to convince others about his information
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16.1 Asymmetric Information
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Evidence‐Based Economics Example:
Why do new cars lose considerable value the minute they are driven off the lot?
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161 Asymmetric Information
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Exhibit 16.1 Price Ranges of New and Used Cars
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16.2 Hidden Actions: Markets with Moral Hazard
Moral hazard
Actions that are taken by one party but arerelevant for and not observed by the otherparty in the transaction
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16.2 Hidden Actions: Markets with Moral Hazard
People with air bags in their cars are more likely to get into accidents.
Why? Two explanations1. Adverse selection—if you know that you are a
bad driver, you are more likely to choose a car that has air bags.
2. Moral hazard—if you are protected from some of the risk of driving, you are more likely to drive recklessly.
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16.2 Hidden Actions: Markets with Moral Hazard
Principal‐agent relationship
The principal designs a contract specifying the payments to the agent as a function of his or her performance, and the agent takes an action that influences performance and thus the payoff of the principal
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16.2 Hidden Actions: Markets with Moral Hazard
In other words, one party (the principal) provides incentives for another party (the agent) to work in the principal’s benefit.
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16.2 Hidden Actions: Markets with Moral Hazard
“There’s no ‘I’ in ‘team’”
Who is he playing for?
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16.2 Hidden Actions: Markets with Moral HazardMarket Solutions to Moral Hazard in the Labor Market: Efficiency Wages
What would make this agent wake up?
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16.2 Hidden Actions: Markets with Moral HazardMarket Solutions to Moral Hazard in the Labor Market: Efficiency Wages
Efficiency wages
Wages above the lowest pay that workerswould accept; employers use them toincrease motivation and productivity
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16.2 Hidden Actions: Markets with Moral HazardMarket Solutions to Moral Hazard in the Insurance Market: “Putting Your Skin in the Game”
1. Deductibles
2. Co‐payments
3. Coinsurance
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16.2 Hidden Actions: Markets with Moral HazardMarket Solutions to Moral Hazard in the Insurance Market: “Putting Your Skin in the Game”
Evidenced‐Based Economics Example:
Why is private health insurance so expensive?
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16.3 Government Policy in a World of Asymmetric Information
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16.3 Government Policy in a World of Asymmetric InformationGovernment Intervention and Moral Hazard
The ACA could lead to a moral hazard problem as risk behavior increases because of insurance coverage. In response, the government could
• Tax risky behavior• Subsidize healthy behavior• Have deductibles or copayments
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16.3 Government Policy in a World of Asymmetric InformationThe Equity‐Efficiency Trade‐off
How do unemployment benefits create a moral hazard problem?
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16.3 Government Policy in a World of Asymmetric InformationCrime and Punishment as a Principal‐Agent Problem
Is this a principal‐agent problem?
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