Lecture 27: Adverse Selection, Moral Hazard

what is the problem with asymmetric information?

one side of the transaction knows more than the other which can lead to adverse selection

what is the probelm with money-back guarantees?

there are situations where it cannot be applied (ex: buying a house)

what are the solutions to adverse selection?

1. free trial

2. warranties

3. lemon laws

4. private institutions

5. public institutions

6. screening

7. signaling

when does a separating equilibria occur?

when information is know about the products and distinctions can be made, two separate markets arise with two separate equilibria

if car insurance becomes voluntary what will happen?

the careful drivers will not buy car insurance and only reckless drivers will be left in the market which increases the equilibrium price

screening

the uninformed side of the market makes the informed side of the market perform a task that reveals information about the uninformed side

what is an example of a screening process?

job interview

signaling

the informed side of the market voluntarily does something to convey a signal to the uninformed side to distinguish them

what is an example of signaling?

getting a bachelor’s degree

if the present value of getting a college degree (at a high standard school) and the cost for Jimbo to attend college is $200,000 and James’s cost to attend college is $320,000, will either of them go to college?

Jimbo will go because his cost to attend is less than the benefit of getting a college degree

Jimbo signals that he is a hard worker

expected value is the same as

expected benefit

moral hazard

any situation/arrangement in which a party has an incentive to behave badly

what does “badly” mean in regards to moral hazard?

to impose risks or costs on others

what is an example of a moral hazard?

seatbelts; seatbelts allow us to drive a little more carelessly and recklesses imposing costs on others (other drivers, pedestrians, cyclists)

what is the problem with moral hazards?

when there is a situation that incentivizes people to behave badly, people act on the incentive

what are solutions to moral hazards?

remove the incentive to behave badly

regulate the moral hazard

what are the problems with the solution for moral hazard?

sometimes it is worse to get rid of the arrangement that incentivizes people to behave badly

regulations are costly

why do banks create a moral hazard?

banks invest other peoples money, the incentive is the invest in high return investments that are riskier because it is not their money

what is the solution to remedy the moral hazard created by banks?

we regulate banks- banks cannot investment depositors money in risky investments, regulated by Fed, FDIC, and Comptroller

what is the problem with the solution for the moral hazard created by banks?

you have to pay for the legal enforcement system

even with regulators the financial system can still fall apart

what is the moral hazard that could arise in the employer and employee situation?

the employer needs to structure payments to employees to incentivize them to work hard and not shirk

shirking

not working hard

why is salary based payment a moral hazard?

no matter how hard someone works they will still get paid- there is an incentive to shirk

how can the moral hazard be remedied for salary based employees? what is the problem with this?

having others evaluate you, show the work of students

it is costly to do this

how can you solve the moral hazard problem in the employer/employee situation?

come up with the right compensation scheme

participation constraint

employer need to offer something enticing to want the employee to work for them

incentive constraint

a compensation scheme that incentivizes the worker to work hard