1 Agenda for 15th Class Cleaner Skies Introduction to Information Assignment for Next Class ## Questions to think about /Writing assignment for Group 3 –P. 253ff Qs 4 & 5 –P. 273 Qs 1-3

2 Cleaner Skies

3 Information Efficiency of competition assumes perfect information Imperfect information is a transactions cost –Efficient allocation of resources may be impaired by imperfect information Imperfect information (like externalities) is ubiquitous –When law school and student choose each other Law school doesn’t know how smart or hardworking students are Students don’t know how good school is Law school tries to gather info – admissions process Students try to gather info – US News, campus visits, blogs But information gathering is expensive and imperfect –When promisor breaches May not know how much harm will cause promisee May not know whether judge will find breach or not Judge or jury may not know whether breach intentional or accidental Judge or jury may not know whether promisee could have mitigated damages Discovery and trial try to get answers to these questions, but expensive and not completely accurate

4 The Market & Information Market corrects or mitigates some informational problems –Product markets Consumer Reports, Angie’s List, Amazon consumer reviews, EBay ratings, etc. –Insurance Medical exam before life insurance –Loan markets Credit ratings, loan applications –Schools (see previous slide)

5 Information & the Law Much of law is concerned with information –Litigation is principally about production of information –Much consumer regulation is forced disclosure of information Nutritional labeling Securities Law –Prospectus before initial offering –Quarterly reporting of profits MPG for cars APR for loans and savings instruments –Contract law Limitation of damages to those which are “forseeable” forces promisee with high damages to disclose (Hadley v Baxendale) –Product liability law makes price of product reflect producer’s estimate of expected liability Expected liability likely (otherwise) unknown to consumer –Title recordation in Property law

6 Moral Hazard Insurance context –Insured has suboptimal incentive to take precautions If insured against fire, may not install sprinklers or be as careful with fireplace If have health insurance, may not be as careful to eat right or exercise If have health insurance, may request treatments that unlikely to be effective –Tort law is form of insurance Product liability may make consumers less careful Duty to rescue may make parents (and others) less careful –Government programs are a form of insurance Welfare may dull incentive to work Income tax may dull incentives to work Contracts generally –After contract entered into, party may have incentive to act in way that is detrimental to other party Employee may not work hard Lawyer paid by hour may spend too much time on project Renter may not take good care of apartment

7 Responses to Moral Hazard Gather information –Moral hazard is result of fact that insurer does not know how insured is behaving If insurer knew, then could condition insurance on insured behaving properly –Insurer’s “monitor” insured Fire insurer may inspect home for smoke detectors, brush clearance, roof materials, etc Government monitors welfare recipients, requires job search, etc. Deny insurance if precautions not taken –Comparative/contributory negligence in tort –Insurance exclusion for arson –Fire employees if shirk Build incentive into contract –Insurance seldom covers full cost of hazard So insured has some incentive to take precaution –Employer can make pay proportional to output Government regulation seldom helpful –Government doesn’t usually have superior information –But sometimes can help By using information gathering of criminal law By threatening larger penalties (e.g. imprisonment) E.g. imprisonment for securities fraud

8 Moral Hazard, Coase Theorem, & Externalities Cost of obtaining relevant information is transactions cost –If info could be obtained costlessly, moral hazard wouldn’t exist –Since info is expensive, inefficiency may result Moral Hazard is kind of externality –Insured imposes costs on insurer –Employee imposes costs (or less benefit) on employer –Sometimes not considered an externality, because Insured and insurer are in contractual relationship Employer and employee in contractual relationship

9 Principal-Agent Problem Many situations where one person (agent) works for another (principal) –Lawyer works for client –Employee works for employer –Promisee works for promisor Problem –How get agent to act in interest of principal –Problem is often moral hazard Agent can take actions which adversely affect prinicipal (not work sufficiently hard (shirking), damage equipment, etc.)

10 Prisoners’ Dilemma Suspect 2 ConfessKeep quiet Suspect 1Confess-5, -5-1, -7 Keep Quiet-7, Dominant Strategy. Nash Equilibrium Each suspect imposes negative externalities on the other Parties cannot communicate, so transactions costs high, so parties do not reach efficient result

11 Pollution Externalities Game Firm 2 PolluteInstall Firm 1Pollute-4000, , Install-5000, Almost identical to Prisoners’ dilemma If numbers small, might expect agreement to install pollution control When numbers large, negotiation very difficult –Collective action problem Everyone better off if everyone installs pollution control equipment But each person better off if free rides –Better to not install pollution control equipment, if everyone else does

12 Collective Action Problems Collective Action Problems are ubiquitous –Becoming informed voter, voting –Funding public goods, e.g. fire departments, bridges, national defense –Global warming –Fishing Every collective action problem is also an externalities problem –Sometimes groups can resolve Political lobbying by interest groups Democracy Voluntary organizations Clubs –Often government is only or best solution