Chapter 12: Information

Informational economics zWhen a person buys medical insurance, the insuring company does not know whether the person is healthy. Nor does it know how well he is going to take care of himself after buying insurance. zThe former type of asymmetry information is called a hidden type problem, or adverse selection problem. zThe latter type of asymmetric information is called a hidden action problem, or moral hazard problem. But the notion of moral hazard has subsequently expanded. zInformation economics is the study of decision makings between agents when their information is asymmetric.

Why called “Adverse Selection”? zAdverse selection refers to a situation where a selection process (here market) results in a pool of products/individuals with economically undesirable characteristics. zWith “hidden type”, either (1) bad products drive out good products or (2) good products subsidize bad products (both receive the same price). zGresham’s law: bad money drives out good. Or, where two media of exchange come into circulation together the more valuable will tend to disappear.

Adverse selection: Used Cars (Lemons) Market Assumption: all of the above is commonly known in the following exercises.

Scenario I: Full Information zSuppose that every buyer and every seller know the type of the car they are negotiating. zThen both good cars and bad cars will be traded. zThere are simply two products (good and bad cars).

Scenario II: No Information zSuppose buyers don’t know the type of the cars they are interested. Also suppose no sellers know the type of the cars they own. Assume all agents are risk neutral. zExpected valuation of a car to buyers= 1/3 * $30K + 2/3 * $20K = $23.33K zExpected valuation of a car to sellers = 1/3 * $25K + 2/3 * $10K = $15K zBoth good cars and bad cars will be traded!

Scenario III: Asymmetric (Unequal) Information zSellers know the types of cars they own. But buyers don’t know the types of cars they are going to buy. zIs a buyer willing to pay at a price greater than $25K (say $26K)? zNo, because there is 2/3 of probability that the car is bad, and the expected valuation to the buyer=1/3*$30K + 2/3*$20K= $23.33K < the price

Scenario III: Asymmetric (Unequal) Information zIs a buyer willing to pay a price of $22K to buy a car? zNo, at such a low price, only bad cars owners will sell their cars. But bad cars are worth only $20K to the buyer. $22K is too high a price. zThe market price is even lower, at $20K or somewhat lower. Only bad cars will be traded. Good cars don’t find a buyer!!! zRemark: What matters is not the amount of information.

Scenario III: Asymmetric Information zGood cars may still find a buyer, if the probability of bad cars in the pool is low. zLet p be such prob. A buyer is willing to pay $25K if (1- p)x$30K + px$20K>$25K, or p<0.5. zGood cars of 2-3 years old will easily find a buyer, while good cars of 10 years old don’t find a buyer

Solving the Problems: zGuarantees & Warranties zLiability Laws zReputation of a store or the manufacturer zExperts--a disinterested party zStandards & Certifications zsignaling by the party who has more information [education, money burning, etc.]

Moral Hazard yWhen a person buys medical insurance, the insuring company does not know whether the person is healthy. Nor does it know how well he is going to take care of himself after buying insurance. yThe latter type of asymmetric information is called a hidden action problem, or moral hazard problem. That is, when people are insured by medical insurance, they tend to exert less effort to take care of themselves than the case they are uninsured. yWhy called moral hazard? People buy insurance for their houses, and then burn them and claim for compensations exceeding the value of their houses. ySolution: deductibles; getting only a fraction of the loss, not the total; compensation in kind