Module 11 – Asymmetric Information

Asymmetric information

when one party in a transaction knows something the other does not but would like to know

Two types of asymmetric information

• Hidden characteristics

• Hidden actions

Hidden characteristics

one side knows more about the product or service (adverse selection) 

Hidden characteristics example 

used car market — seller knows the car’s quality better than the buyer

Hidden actions

one party can take unobserved actions that affect the outcome (moral hazard)

Hidden actions example

slacking off at work when your boss isn’t watching

Adverse selection

arises before a transaction occurs — the side with more information participates strategically

Adverse Selection Example: The Market for Lemons

• A high-quality used car is worth $5,000, a lemon is worth $0.

• If buyers can’t tell which is which, they’ll only pay the expected value:
  0.5($5,000) + 0.5($0) = $2,500.

• Sellers with good cars won’t sell for $2,500, but sellers with lemons will.

• Result: Only lemons remain in the market → the market unravels.

This is adverse selection — bad products drive out the good

Expected value

If buyers can’t tell which is which

• 0.5($5,000) + 0.5($0) = $2,500 (Only pay this amount)

Adverse selection real-world examples

Used cars, insurance markets, online scams

Adverse selection solutions

• More information and transparency (e.g., Carfax, customer reviews).

• Technology and reputation systems reduce asymmetric information.

Moral hazard

when people change behavior after a transaction because they don’t bear the full cost of their actions

Moral hazard example

Flood insurance — people build homes in flood-prone areas because insurance covers damages

When insured

people take on more risk since they are insulated from full consequences

• “It’s basically a subsidy for risky behavior.”

Moral hazard health insurance example

a friend goes mountain biking only because he’s covered — riskier behavior due to coverage

Principal

the person hiring (e.g., student hiring a tutor)

Agent

the person being hired (e.g., tutor)

Labor market example (Principal–Agent Problem)

• The agent may shirk or slack off because effort is hard to observe.

• Incentive misalignment between principal and agent.

Principal–Agent Problem Solutions

• Create contracts that align incentives (e.g., performance bonuses, pay-for-results).

• Threat of firing or above-market wages can reduce moral hazard.

The field of personnel economics

studies how to structure incentives to align behavior

Health insurance combines

moral hazard and adverse selection problems

Moral hazard in health insurance

• People with full insurance don’t face true prices → overconsume healthcare.

  • “If something costs less, people consume more of it.”

Moral hazard in health insurance solutions

• Copayments

• Deductibles

• Coinsurance

These don’t eliminate overuse but make patients more cost-consciousx

Copayments

fixed fees per visit (e.g., $20 per doctor visit)

Deductibles

portion paid by the patient before coverage starts (e.g., $5,000 per year)

Coinsurance

patient pays a share of cost (e.g., 20%)

Third-party payer problem

• Doctors get paid more the more they do; patients don’t bear costs directly.

• Only insurers have incentive to limit costs.

• Misaligned incentives between payer (principal) and providers/patients (agents).

Three actors in heath insurance

patients, doctors, and insurers (or government)

Adverse selection in health insurance

• Buyers know more about their health than insurers do.

• Healthier people often drop out if premiums are too high → risk pool worsens.

Adverse selection in health insurance example

• 100 people; costs range $0–$50,000.

• Average = $25,000 → insurer charges $25,000.

• Healthy people drop out → new average = $37,500 → price rises again.

This repeats until the market collapses — the adverse selection death spiral

Adverse selection in health insurance solutions

• Underwriting

• Mandates

Underwriting

insurers assess individual risk (age, habits, prior illness)

Mandates

everyone must buy insurance to maintain balanced risk pools

Adverse selection in health insurance trade-off

Low-risk people feel they’re paying for others’ higher costs

Adverse selection in health insurance lesson

Asymmetric information complicates designing fair, efficient health systems

Signaling

When the party with private information takes a costly action to reveal that information

Signaling Example

A car dealer offering a warranty → signals confidence in product quality

Cheap talk

(just saying “our cars are great”) doesn’t work because it’s costless

Effective signals

must be costly for low-quality types but affordable for high-quality types

Signaling Examples

• Warranties and money-back guarantees.

• Reputation systems, certifications, verified customer reviews

Biological signaling analogy

Peacock’s tail - costly, but signals fitness to mates

Everyday signaling analogy

Flashy cars or luxury spending as signals of wealth or status

Signaling key idea

Cheap talk is easy, but credible signals must be costly or effortful

Signaling in the Education Market Question

Why do more-educated workers earn higher wages?

Two models explain more-educated workers earn higher wages

• Human Capital Model

• Signaling Model

Human Capital Model

• Education makes workers more productive → higher wages.

• Schooling provides skills, knowledge, and productivity-enhancing training.

Signaling Model (Michael Spence)

• Education may not increase productivity — instead, it signals ability.

• Thus, degrees separate high-quality from low-quality workers.

• Employers then use education as a signal of ability, not necessarily productivity.

• Even if college teaches nothing, it can still pay off as a credible costly signal.

High-quality workers

(smart, hardworking) find school easier, so they earn degrees

Low-quality workers

find school more costly and opt out

Signaling in the Education Market Reality

Both effects coexist — education both builds human capital and serves as a signal

Employers interpret degrees

as proof of ability and discipline

Economists still debate

how much of the return to education is due to signaling versus skill acquisition