Asymmetric Information

opportunistic behavior

taking advantage of someone when circumstances permit; this leads to market failure

market failure

markets aren’t able to allocate resources efficiently

adverse selection (hidden knowledge)

moral hazard (hidden action)

what are two types of opportunistic behavior?

adverse selection (hidden knowledge)

• opportunities based on “unobservable characteristics”

• happens before the transaction phase

• creates market failures by reducing the size of market or in extreme cases by eliminating market

• “bad quality drives good quality out of the market”

moral hazard (hidden action)

• opportunities are based on “unobservable actions”

• happens after entering the transaction phase

adverse selection

Identify the type of asymmetric information problem: adverse selection or moral hazard

“a person in ill health who purchases disability insurance”

moral hazard

Identify the type of asymmetric information problem: adverse selection or moral hazard

“a person who purchases home insurance & then is less careful”

1. restricting or controlling opportunistic behavior by eliminating the choice for adverse selection

2. equalizing information

what are two methods to mitigate adverse selection?

screening

uninformed takes the action to collect the information held by the informed

signaling

informed takes the action to communicate information with the uninformed

standardization

informed takes action to make standardize quality

1. implementing a method to detect & punish change in behavior

2. eliminating incentives to change behavior or creating incentives to achieve desired behavior

3. connecting payoffs to observable factors when actions cannot be observed

what are the methods to mitigate moral hazard?

adverse selection

Identify the type of asymmetric information problem: adverse selection or moral hazard

Suppose a firm offers its workers a cafeteria plan in which it allows workers to allocate a set amount of fringe benefit money toward specific insurance. Mary, who has five kids needing braces, selects the family dental coverage.

moral hazard

Identify the type of asymmetric information problem: adverse selection or moral hazard

The “too big to fail” theory applies to financial institutions, which are so large and so interconnected that their failure would be disastrous to the greater economic system, and they therefore must be supported by the government through FDIC (Federal Deposit Insurance Corporation). Knowing this, financial institutions engage in a lot of risky loans.

moral hazard

Identify the type of asymmetric information problem: adverse selection or moral hazard

In a television advertisement for AFLAC supplemental health insurance, an ice skater says to his skating partner, “Do you want to try a triple jump?” She responds, “Why not, I have AFLAC.”