Chapter 19 – Decisions Involving Private Information

Vocabulary flashcards covering adverse selection, moral hazard, private information, and the key mechanisms and solutions discussed in Chapter 19.

Private Information (Asymmetric Information)

A situation in which one party to a transaction possesses information that the other party does not.

Adverse Selection

A market process in which the mix of participants or products becomes skewed toward those with undesirable characteristics because one side cannot perfectly observe quality or type.

Adverse Selection of Sellers

The tendency for low-quality goods to dominate the market when buyers cannot observe product quality.

Lemon

A low-quality or defective product—classically, a used car with hidden problems.

Adverse Selection of Buyers

The tendency for high-cost customers to dominate the market when sellers cannot observe buyers’ risk or type.

Risk-Averse Person

Someone who dislikes uncertainty and is willing to pay to avoid risk.

Actuarially Fair Insurance

A policy whose expected payout equals the premiums collected on average.

Shared Ignorance

A setting where neither buyers nor sellers possess private information about risk, allowing insurance to function smoothly.

Signal

An action taken to credibly convey private information about quality (e.g., warranties, college degrees).

Credible Signal

A signal too costly for low-quality providers to imitate, so only high-quality providers choose to send it.

Third-Party Verifier

An independent entity that supplies information about product quality (e.g., Carfax, Consumer Reports, Yelp).

Government Regulation (Adverse Selection)

Policies that force disclosure, set minimum standards, or ban low-quality goods to reduce information gaps.

Occupational Licensing

A government requirement that workers obtain a license to prove minimum competence, thereby weeding out low-quality providers.

Insurance Mandate

A rule requiring everyone to purchase insurance, preventing low-risk individuals from opting out and worsening adverse selection.

Contract Screening

Offering multiple contract types (e.g., high vs. low deductibles) so buyers self-select and reveal private information.

Moral Hazard

Changes in behavior that occur when actions are unobservable and the actor is partially insulated from consequences.

Hidden Actions

Behaviors that one party undertakes that the other party cannot observe, creating scope for moral hazard.

Principal-Agent Problem

Conflicts that arise when a principal hires an agent whose actions are not fully observable and whose incentives differ.

Monitoring

Making hidden actions observable (e.g., telematics devices in cars) to curb moral hazard.

Provide Complements

Supplying goods or perks that encourage the desired behavior (e.g., gym discounts with health insurance).

Skin in the Game

Requiring agents to share in the costs or rewards so their incentives align with the principal’s (e.g., security deposits, copays).

Government Rules & Social Norms (Moral Hazard)

Legal penalties and cultural expectations that discourage opportunistic behavior when actions are hidden.

Pick the Right Agents

Selecting partners or employees less likely to exploit information advantages, often through reputation or networks.

Information Gap

The difference between what one party knows and what the other does not in a transaction.

Warranty

A seller’s promise to repair or replace a product, serving as a signal of high quality.