The Economics of Information Chapter 16 The Economics of Information

Learning Objective Key Ideas 16.1 Asymmetric Information 16.2 Hidden Actions: Markets with Moral Hazard 16.3 Government Policy in a World of Asymmetric Information Key Ideas In many markets buyers and sellers have different information, which can lead to market inefficiencies. Asymmetry in information is either due to hidden characteristics or hidden actions.

In cases with hidden characteristics, agents can use their private information to decide whether to participate in a transaction or a market, causing adverse selection. In cases with hidden actions, an agent can take an action that adversely affects another agent, causing moral hazard. There are both private and government solutions to reduce the effects of adverse selection and moral hazard

The Economics of Information Evidence-Based Economics Example: Why do new cars lose considerable value the minute they are driven off the lot? Asymmetric information Asymmetric information - Information available to buyers and sellers differs Hidden characteristics -- One side observes something about the good being transacted that is both relevant for and not observed by the other party Until this point, assumed that both sides of the market have the same information. In the real world, however, that is often not the case, and sometimes this asymmetry can lead to high societal costs.

Hidden Characteristics: Adverse Selection in the Used Car Market Hidden actions - One side takes actions that are relevant for, but not observed by, the other party. Hidden Characteristics: Adverse Selection in the Used Car Market Adverse Selection can occur when the seller has more information than the buyer, such as in the market for a used car. Peach or lemon? Value to you: $5,000 Value to seller: $4,000 Value to you: $0 Value to seller: $0

Adverse Selection in the Used Car Market For any given car, how much would you be willing to offer? Expected value = .5($5,000) + .5($0) = $2,500 1.If you offer $2,500 to the seller, would he/she accept the offer? 2. The seller of a peach would not accept the $2,500 offer since they value the peach at $4,000 >Understand that only the sellers of lemons would accept this offer since the value of a lemon is $0. The seller of a peach would not accept this offer since he/she values the peach at $4,000. > If the only car that is available for sale is the lemon, that’s the car you will end up buying.Of course, you don’t want to buy a lemon, so if you know that this is the outcome of asymmetric information, you won’t buy a car and the market for used cars will disappear.

$2,500 will only buy the lemon in this case But you don’t want to buy a lemon! If the seller accepts your $2,500 and you know that this is the outcome of asymmetric information, you won’t buy the car. 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. Which one will be more likely to want health insurance? Understand that increasing premiums for high-risk people would be one option. Ask them what effect that would have on insurance coverage for low-risk people. As premiums go up, low-risk people will choose not to have insurance, increasing the cost of insurance even more until no one can afford it.

Adverse Selection in the Health Insurance Market In the case of health insurance, who has superior information? Buyers? Sellers? NOTE: In health insurance markets, there is a similar asymmetry; now, though, buyers of insurance have superior information, because they have a better idea about their health than insurance companies do. Example: high-risk and low-risk individuals *Health insurance will attract a disproportionate number of high- risk individuals *These are the individuals health insurance companies do not want to attract!

Asymmetric Information Market Solutions to Adverse Selection: Signaling Signaling -An action that an individual with private information takes in order to convince others about his information *How can problems associated with adverse selection be dealt with? Even people who don’t own cars (or have ever shopped for one) know about Carfax. Other examples are (1) sellers establishing a good reputation, (2) warranties,(2) requiring a physical in the case of insurance markets. None of these signals would occur if the quality of the product was bad, so signaling restores a functioning market. *How can a warranty be effective in signaling a high-quality product? *Do buyers also engage in signaling?

Asymmetric Information A warranty is an example of signaling, in which an individual with private information takes action—sends a signal—to convince someone without the information that he or his products are high quality. Asymmetric Information Evidence-Based Economics Example: Why do new cars lose considerable value the minute they are driven off the lot?

Asymmetric Information Exhibit 16.1 Price Ranges of New and Used Cars Vehicle Price Range in 2010 2009 Toyota Prius (new) $22,000–24,000 2009 Toyota Prius (dealer certified) $19,000–22,000 2009 Toyota Prius (used) $16,000–20,000 2009 Honda Civic (new) $20,000–24,000 2009 Honda Civic (dealer certified) $16,000–21,000 2009 Honda Civic (used) $12,000–16,000 2009 Ford Fusion (new) $19,000–26,000 2009 Ford Fusion (dealer certified) 2009 Ford Fusion (used) $14,000–18,000 2009 Ford Edge (new) $25,000–33,000 2009 Ford Edge (dealer certified) $24,000–31,000 2009 Ford Edge (used) $21,000–24,000 >The extra price attached to cars purchased at used car dealers as opposed to private individuals indicates that signaling is at work in this market. >In addition, the probability of a car being defective was higher if the seller was a private individual, as opposed to a dealer.

Hidden Actions: Markets with Moral Hazard Moral hazard - Actions that are taken by one party but are relevant for and not observed by the other party in the transaction. >The basic idea with moral hazard is that people take on more risks when they are protected from the consequences of that risk. People with air bags in their cars are more likely to get into accidents. Why? Two explanations Adverse selection—if you know that you are a bad driver, you are more likely to choose a car that has air bags. Moral hazard—if you are protected from some of the risk of driving, you are more likely to drive recklessly.

Hidden Actions: Markets with Moral Hazard People with air bags in their cars are more likely to get into accidents. Why? Two explanations Adverse selection—if you know that you are a bad driver, you are more likely to choose a car that has air bags. Moral hazard—if you are protected from some of the risk of driving, you are more likely to drive recklessly. Note the difference between adverse selection and moral hazard.

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. >In other words, one party (the principal) provides incentives for another party (the agent) to work to the principal’s benefit.

Hidden Actions: Markets with Moral Hazard “There’s no ‘I’ in ‘team’” Who is he playing for? >Part of a college coach’s challenge is to get his players to play together as a team. But the players are interested in racking up individual stats so they look good to NBA scouts, creating a moral hazard situation. >In this case, the player is the agent and the coach is the principal. >How can the principal can encourage the agent to perform in a way that conforms to the principal’s objectives? They should identify things such as emphasizing number of passes or assists, or benching a player that “hot dogs” too much.

>What would make this agent wake up? Hidden Actions: Markets with Moral Hazard Market Solutions to Moral Hazard in the Labor Market: Efficiency Wages >What would make this agent wake up? >What makes an employee an agent—i.e., how are employees’ goals different from those of their employers? Employees could want to work as little as possible, to take a lot of breaks, etc. Principals, of course, are interested in maximizing profit. So the principal’s problem is creating incentives that bring agents’ goals more in line with those of the company.

Solutions to Moral Hazard in the Labor Market: Efficiency Wages Efficiency wages -- Wages above the lowest pay that workers would accept; employers use them to increase motivation and productivity. >Henry Ford increasing the wages of his workers -- an action that caused quite a stir. Explain that the payment of efficiency wages made it more costly for his workers to lose their jobs— their opportunity cost of shirking increased. >Because productivity increased, Ford actually saved money by increasing wages. Because workers would be reluctant to leave, turn-over costs for the employer would decrease as well.

Hidden Actions: Markets with Moral Hazard Market Solutions to Moral Hazard in the Insurance Market: “Putting Your Skin in the Game” In the insurance market, the way to keep policy holders from acting in a more risky manner is to increase the costs to them if they do. These are three majors ways that policy holders can be forced to have “skin in the game,” mitigating their risk behavior. Deductibles Co-payments Coinsurance

Hidden Actions: Markets with Moral Hazard Market 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 >Insurance companies have an asymmetric information problem in that they have a hard time telling with certainty the true health status of policy holders. Harvard University decided to change how it subsidized health insurance for its employees, providing the same subsidy regardless of the level of the plan. >As a result, healthy people opted out of the most expensive plans because they knew their true health status, leaving the relatively unhealthy people at the highest level of coverage. This caused the price of the most expensive plan to go up even more. >Because the cost of private insurance increases, this might be a situation that would benefit from government intervention.

Government Policy in a World of Asymmetric Information >The point of the Affordable Care Act was to stop the concentration of the most sick in the health insurance market driving up prices until the average consumer couldn’t afford health insurance. >By requiring everyone to purchase health insurance, more young people are brought into the health insurance market, which lowers the risk for insurance companies, lowering the price of insurance for everyone. >The ACA (Affordable Care Act) 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

Is this a principal-agent problem? Government Policy in a World of Asymmetric Information The Equity-Efficiency Trade-off >How do unemployment benefits create a moral hazard problem? Note: the relationship between unemployment benefits and moral hazard. If the benefits create a moral hazard problem, why does the government offer benefits at all? What the tradeoff is in this case— are we comfortable with offering no support to the unemployed? Government Policy in a World of Asymmetric Information Crime and Punishment as a Principal-Agent Problem Is this a principal-agent problem? >A relatively small probability of detection (a small police force) combined with a heavy punishment if detected >Helps explain why many small crimes go unpunished but how society still deters more serious crimes

>Two Nobel-prize-winning economists thought of crime as a principal-agent problem, with criminals being the agents with goals that are at odds with the principal (government responsible for maintaining order). >The problem the principal has, then, is to encourage criminals to have goals that are more in line with those of society. The government can alter the expected punishment that criminals would face, by changing the probability that the criminal is caught and/or increasing the punishment of detection. >Which of these strategies would be better—increasing the probability of detection would be expensive since it would require a larger police force. Alternatively, police forces can be small, resulting in a cost savings, with an increase in the punishment if caught. >An increase in punishment (longer sentences) also has costs associated with it, however.