1. The Economics of Information
Chapter 16
The Economics of Information

2. Chapter 16 Outline 16 The Economics of Information
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.
3. 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.
4. In cases with hidden actions, an agent can take an action that adversely affects another agent, causing moral hazard.
5. There are both private and government solutions to reduce the effects of adverse selection and moral hazard.

3. 16.1 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
NOTE: Until this point, we have been assuming 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 actions -- one side takes actions that are relevant for, but not observed by, the other party

4. 16.1 Asymmetric Information: Hidden Characteristics: Adverse Selection in the Used Car Market
Peach or lemon?
Adverse selection can occur when the seller has more information than the buyer, such as in the market for a used car.
Value to you: $5,000
Value to seller: $4,000
Value to you: $0
Value to seller: $0
Assume that you are risk-neutral, and that half of the cars are peaches and half are lemons.

5. For any given car, how much would you be willing to offer?
16.1 Asymmetric Information: Hidden Characteristics: Adverse Selection in the Used Car Market
For any given car, how much would you be willing to offer?
Expected value = 0.5($5,000) + 0.5($0) = $2,500
If you offer $2,500 to the seller, would he/she accept the offer? Since this is a problem that deals with risk, we solve it in the same way as presented previously, with expected value.
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. You, of course, 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.

6. Which one will be more likely to want health insurance?
16.1 Asymmetric Information: Hidden 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
Which one will be more likely to want health insurance?

7. The buyer has more information than the seller does
The buyer has more information than the seller does. An example of this is the market for insurance.
This creates a problem for health insurance companies since the cost of insuring the high-risk person is much higher than that of insuring the low-risk person. What would you do if you ran the insurance company with this cost difference. (a). increase premiums for high-risk people would be one option. What effect would that 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.
Signaling -- an action that an individual with private information takes in order to convince others about his information
Examples: signal to the other side of the market about their private information: (a) sellers establishing a good reputation, (b) warranties, (c ) 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.
16.1 Asymmetric Information: Market Solutions to Adverse Selection: Signaling

8. Evidence-Based Economics Example:
16.1 Asymmetric Information
Evidence-Based Economics Example:
Why do new cars lose considerable value the minute they are driven off the lot?

9. Exhibit 16.1 Price Ranges of New and Used Cars
161 Asymmetric Information
Exhibit 16.1 Price Ranges of New and Used Cars
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.

10. 16.2 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.
Proposition: 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
Examples of moral hazard—you are more likely to leave your car unlocked if you know you’re insured against theft.

11. 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.
In other words, one party (the principal) provides incentives for another party (the agent) to work to the principal’s benefit.

12. “There’s no ‘I’ in ‘team' "Who is he playing for?
16.2 Hidden Actions: Markets with Moral Hazard
“There’s no ‘I’ in ‘team' "Who is he playing for?
The 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.
Should identify things such as emphasizing number of passes or assists, or benching a player that “hot dogs” too much

13. What would make this agent wake up?
16.2 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.

14. increase motivation and productivity
16.2 Hidden Actions: Markets with Moral Hazard Market 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: increased the wages of his workers -- an action that caused quite a stir.
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.

15. Evidenced-Based Economics
16.2 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
Evidenced-Based Economics
Example:
Why is private health insurance so expensive?

16. 16.2 Hidden Actions: Markets with Moral Hazard Market Solutions to Moral Hazard in the Insurance Market: “Putting Your Skin in the Game”
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.
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.

17. Subsidize healthy behavior Have deductibles or copayments
16.3 Government Policy in a World of Asymmetric Information: Government Intervention and Moral Hazard
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
16.3 Government Policy in a World of Asymmetric Information: The Equity-Efficiency Trade-off
How do unemployment benefits create a moral hazard problem?
Understand the relationship between unemployment benefits and moral hazard. If the benefits create a moral hazard problem, why offer benefits at all? What is the tradeoff is in this case—are we comfortable with offering no support to the unemployed?

18. Is this a principal-agent problem?
16.3 Government Policy in a World of Asymmetric Information: Crime and Punishment as a Principal-Agent Problem
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.
Is this a principal-agent problem?
Which of these strategies do you think would be better—(1). increasing the probability of detection would be expensive since it would require a larger police force. (b). 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.