1. ECONOMICS FOR BUSINESS (MICROECONOMICS) Lesson 10
Prof. Paolo Buccirossi

2. Table of Contents Adverse Selection Reducing Adverse Selection
Moral Hazard
Using Contracts to Reduce Moral Hazard
Using Monitoring to Reduce Moral Hazard

3. Adverse Selection The Problems of Adverse Selection
If consumers lack relevant information, they may not engage in transactions to avoid being exploited by better informed sellers (adverse selection).
As a result, not all desirable transactions occur and potential consumer and producer surplus is lost.
In extreme cases, adverse selection may prevent a market from operating at all.
Adverse Selection Cases
Two important examples of adverse selection problems are insurance and products of varying quality.

4. Adverse Selection Adverse Selection in Insurance Markets
How would people react to a fair insurance rate (a rate for insurance equal to the average cost of health care for the entire population)?
Unhealthy people—people who expect to incur health care costs that are higher than average—would view this insurance as a good deal and many would buy it.
Healthy people, in contrast, would not buy it because the premiums would exceed their expected health care costs (unless they are extremely risk averse).
So a disproportionately large share of unhealthy people will buy the insurance (adverse selection).
The insurance company’s average cost of medical care for covered people exceeds the population average. The company makes a loss.
Consequences of Adverse Selection in Insurance Markets
Adverse selection results in an inefficient market outcome: few healthy people are insured and insurer’s cost is high. The sum of CS and PS is not maximized.
This outcome could be changed with perfect information: healthy people would buy insurance at a lower premium, but the insurer must first verify they are healthy.

5. Adverse Selection Products of Unknown Quality
Adverse selection often arises because sellers of a product have better information about the product’s quality than the buyer.
In a transaction of a used car, the seller knows whether his car is a lemon, but the buyer cannot know it (hidden characteristic).
Consequences of Unknown Quality
If sellers have more information than buyers, adverse selection may drive high-quality products out of the market (Akerlof, 1970). Why?
Car buyers worry that a used car might be a lemon. They would be willing to pay only relatively low prices that reflect the possibility of getting a lemon.
However, sellers of excellent used cars do not want to sell their cars at such low prices. They do not enter the market.
Adverse selection has driven the high-quality cars out of the market, leaving only lemons.

6. Adverse Selection Lemons Example
2,000 sellers cannot alter the quality of their used cars; 1,000 sellers own a good car, 1,000 sellers own a lemon; 1,000 buyers are willing to pay $4,000 for a lemon and $8,000 for a good car.
The demand curve for lemons, DL, is horizontal at $4,000 in panel a of next Figure, and the demand curve for good cars, DG, is horizontal at $8,000 in panel b.
The reservation price of lemon owners is $3,000, so the supply curve for lemons, SL in panel a, is horizontal at $3,000 up to 1,000 cars, where it becomes vertical (no more cars are for sale at any price).
The reservation price of owners of high-quality used cars is v, which is less than $8,000. Panel b shows two possible values of v. If v = $5,000, the supply curve for good cars, S1, is horizontal at $5,000 up to 1,000 cars and then becomes vertical. If v = $7,000, the supply curve is S2.
Equilibrium with Full & Symmetric Information
In panel a of Figure , the equilibrium in the lemons market (DL=SL) is at e and 1,000 lemons sell for $4,000 each. In panel b, the equilibrium in the good-car market is at E and 1,000 good cars sell for $8,000 each.
This market is efficient: the goods go to the people who value them the most.

7. Adverse Selection
Markets for Lemons and Good Cars

8. Adverse Selection Equilibrium with Incomplete & Symmetric Information
If information is symmetric and buyers and sellers are equally ignorant about the quality of cars, EV = 0.5 x x 4000 = $6,000. A risk-neutral buyer and a seller would transact at $6,000.
This market is efficient: the goods go to the people who value them the most.
Equilibrium with Asymmetric Information
When sellers know the quality but buyers do not, there are two possible equilibria.
If sellers value good cars at v = $5,000 and buyers consider EV = $6,000, all cars are sold at $6,000. The equilibrium points are f and F in Figure . In this case asymmetric information does not cause an efficiency problem, but it does have equity implications.
If sellers value good cars at v = $7,000, they will not sell them at $6,000. Buyers realize good cars cannot be found for less than $7,000. Then, the lemons drive good cars out of the market, only lemons are sold at $4,000 leading to an inefficient equilibrium.

9. Adverse Selection Summary of the Lemons Problem
If buyers have less information about product quality than sellers do, the result might be a lemons problem in which high-quality cars do not sell even though potential buyers value the cars more than their current owners do.
The lemons problem does not occur if the information is symmetric. If buyers and sellers of used cars know the quality of the cars, each car sells for its true value in a perfectly competitive market. If, as with new cars, neither buyers nor sellers can identify lemons, all cars sell at a price equal to the EV.
Varying Quality Under Asymmetric Information
If consumers cannot identify high-quality goods before purchase, they pay the same for all goods regardless of quality.
Firms do not produce top-quality goods if p is the same for High and Low quality.
The outcome is inefficient, assuming consumers are willing to pay more for top-quality goods.

10. Reducing Adverse Selection
Restricting Opportunistic Behavior
One method for solving adverse selection problems is to restrict the ability of the informed party to take advantage of hidden information.
Which type of restriction works best depends on the nature of the adverse selection problem, as we see below.
Mandating Universal Coverage
Health insurance markets have adverse selection because low-risk consumers do not buy insurance at prices that reflect the average risk.
Such adverse selection can be eliminated by providing insurance to everyone or by mandating that everyone buy insurance.
Laws to Prevent Opportunism
Product quality and product safety are known characteristics to sellers but not observed by buyers.
Product liability laws protect consumers from being stuck with nonfunctional or dangerous products.

11. Reducing Adverse Selection
Equalizing Information
Another method for solving adverse selection problems is to provide information to all parties.
There are three methods for reducing information asymmetries: screening, signaling, and third party.
Screening Reduces Adverse Selection
Insurance companies screen potential customers based on their health records or medical exams. They collect information until marginal benefit and marginal cost from the extra information are equal.
Buyers of used cars test or drive the cars, bring a trusted mechanic, or buy only from sellers with good reputation. Reputation is not easy to get in markets where buyers or sellers trade only once, like in tourist areas.

12. Reducing Adverse Selection
Signaling Reduces Adverse Selection
An informed party may signal the uninformed party to eliminate adverse selection. However, signals work only when the recipients view them as credible.
Examples: A firm may distribute a favorable report on its product quality by an independent testing agency; a candidate for life insurance may present a health report signed by a doctor approved by the insurer; education is also a signal.
Third Party Information Reduces Adverse Selection
If the information on quality provided by consumer groups, nonprofit organizations, and government agencies is credible, it can reduce adverse selection.
These groups and organizations also provide standards and certification. If these programs inexpensively and completely inform consumers and do not restrict the goods available, the programs are socially desirable.

13. Moral Hazard Moral Hazard and Adverse Selection
Moral hazard problems come from hidden actions. For instance, renters driving rental cars off-road, workers loafing when the boss is not watching, and lawyers acting in their own interests instead of those of their clients.
We will focus on the insurance market and the principal-agent relationship.
Moral Hazard in Insurance Markets
Many types of insurance are highly vulnerable to hidden actions by insured parties that result in moral hazard problems.
Example: A business insures merchandise in a warehouse against hazards such as fire and theft. If merchandise is not selling, the owner faces a significant financial loss. He may burn down the warehouse and make an insurance claim.

14. Moral Hazard Moral Hazard in Principal-Agent Relationships
Principal-Agent problem or agent problem: when responsibilities are delegated, a principal contracts with an agent to take an action that benefits the principal. If the agent’s actions are hidden, moral hazard may result.
Example: A business owner (principal) hires an employee (agent) to work at a remote site and cannot observe whether the employee is working hard. The employee may shirk by not providing all the services they’re paid to provide.
Reducing Moral Hazard using Efficient Contracts
The principal and agent can agree to an efficient contract: an agreement in which neither party can be made better off without harming the other party.
If the parties to the contract are risk neutral, efficiency requires that the combined profit of the principal and agent be maximized.
If one party is more risk averse than the other, efficiency requires that the less risk-averse party bear more of the risk.
In the previous example, efficiency occurs if the agent works extra hard so total profit is maximized, and if the agent (risk averse party) bears none of the risk.

15. Moral Hazard Moral Hazard & Efficient Contracts: Ice Cream Shop
Paul (principal) owns many ice cream parlors across North America. He contracts with Amy (agent) to manage his Miami shop. Her duties include supervising workers, purchasing supplies, and performing other necessary actions.
The shop’s daily earnings depend on the local demand conditions and on how hard Amy works. Demand can be high or low depending on weather conditions (50%) and Amy can put in normal or extra effort (valued $40 per day).
Paul is risk neutral because he can pull earnings from the many stores he owns. Amy, like most people, is risk averse.
We know an efficient contract requires Amy to bear no risk, but the outcome depends on symmetric and asymmetric information.
Ice Cream Shop Efficient Contract & Symmetric Information
Moral hazard is not a problem if Paul can directly supervise Amy and agree that: Amy earns $200 per day if she works extra hard, but loses her job if she doesn’t.
Amy’s zero risk: She gets $200 independently of weather.
Amy’s incentive to work hard: She nets $160 (200-40), better than being fired.
Paul bears all risk: EV = $200; σ2 = 10,000 (perfect monitoring)
Efficient contract: Profit maximized, risk averse agent bears no risk.

16. Moral Hazard
Ice Cream Shop Profits

17. Moral Hazard
Ice Cream Shop Inefficient Contract & Asymmetric Information
Moral hazard is a problem if Paul cannot observe Amy’s effort. Both agree on a fixed-fee contract: Amy earns $100 per day.
Amy’s zero risk: She gets $100 independently of weather.
Amy’s incentive to work normally: If she works normally, she gets $100. But, if she works hard, she only nets $60 (100-40).
Paul bears all risk: EV = $100; σ2 = 10,000 (fixed wage row in Table )
Inefficient contract: Profit is not maximized, although risk averse agent bears no risk.

18. Using Contracts to Reduce Moral Hazard
Contracts and Correct Incentives
A skillfully designed contract that provides strong incentives for the agent to act so that the outcome is always efficient may solve moral hazard problems.
We will focus on fixed-fee and contingent contracts.
Fixed-Fee Contracts
Amy could pay Paul a fixed license fee to operate Paul’s shop. Paul bears no risk as he receives a fixed fee, Amy bears all the risk and gets the residual profit.
Paul makes $200 with certainty.
Amy’s incentive to work hard: She earns all the increase in expected profit from her extra effort. EVHARD = $160 > -$100 = EVNORMAL, σ2 = 10,000
Efficient contract: Licensing fee profit > fixed wage profit in Table (360 > 200). However, it does not provide efficient risk bearing.
If Amy is nearly risk-neutral, she picks the license fee. If she’s highly risk-averse, she picks the fixed wage.

19. Using Contracts to Reduce Moral Hazard
Contingent Contracts
Many contracts specify that the parties receive payoffs that are contingent on some other variable.
If monitoring is possible, contingency may be the action taken by the agent.
If monitoring is not possible, payoff may be contingent to the state of nature, profit sharing, bonuses & options, piece rates and commissions.
State Contingent Contracts
In a state-contingent contract, one party’s payoff is contingent on only the state of nature (weather conditions determine low and high demand).
Contract: Amy pays a license fee of $100 if demand is low and $300 if demand is high, and keeps all extra earnings (state-contingent row in Table )
Amy’s incentive to work hard: Working normal she nets zero. She must work hard.
Amy bears no risk: EVHARD = $160 = EVNORMAL, σ2 =0.
Paul bears all risk: EV = $200, σ2 =10,000.
Efficient outcome: Profit is maximized, risk averse agent bears no risk.

20. Using Contracts to Reduce Moral Hazard
Profit Sharing
A profit-sharing contract: the payoff to each party is a fraction of the observable total profit (profit sharing row in Table ).
Contract: Paul and Amy agree to split the earnings of the ice cream shop equally.
Amy’s incentive to work hard and risk: EVHARD = $160 > $100 = EVNORMAL, and σ2 = 2,500 for both efforts. She prefers to work hard.
Paul earnings: EV = $200, and he is risk neutral.
Efficient outcome: Profit is maximized but risk averse agent bears risk. Paul prefers this contract to a fixed-fee contract. Amy works hard if her profit share > 20%.
Bonuses
A principal offers the agent a bonus: extra payment if a performance target is hit.
Contract: Paul offers Amy a base wage of $100 and a bonus of $200 if the shop’s earnings (before paying Amy) exceed $300 (wage and bonus rows in Table )
Amy’s incentive to work hard: Working normal she nets $100. Working hard, EVHARD = $160 and σ2 =10,000. Her choice depends on her risk-averse level.
If Amy is nearly risk neutral, she works hard (before last row in Table ).
If Amy is highly risk-averse, she works normal (last row in Table ).
Efficient outcome: Profit is maximized only if Amy is risk neutral.

21. Moral Hazard
Ice Cream Shop Outcomes

22. Using Monitoring to Reduce Moral Hazard
Problem and Monitoring Solution
Moral Hazard Problem: employees who are paid a fixed salary have little incentive to work hard if the employer cannot observe shirking. And if paid by the hour but employer but cannot observe how many hours they work, employees may inflate the number of hours they report working.
It pays to prevent shirking by carefully monitoring and firing employees who do not work hard if the cost of monitoring workers is low enough.
Low Cost Monitoring Practices
Most common types of surveillance: tallying phone numbers called and recording the duration of the calls (37%), videotaping employees’ work (16%), storing and reviewing (15%), storing and reviewing computer files (14%), and taping and reviewing phone conversations (10%).
Nearly 75% of employers monitor and surveillance employees (81% in the financial sector). Firms usually monitor selected workers using spot checks.
A quarter of firms that monitor employees do not tell them.