Micro ch 12 Asymmetric Information

what are the two types of information asymmetry

hidden characteristics

hidden action

what is hidden information

when one side of a transaction knows some characteristic or type of itself which the other does not
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give examples of hidden information and explain

a bum at orchard offering jewelry for sale --> only the seller knows if the jewelry is fake or not, buyers dont

quality of a used car --> only the car owner knows the quality

health condition for life insurance --> only the buyer knows their health conditions

driving habits for car insurance --> only the driver knows if they are good at driving or not -- sellers have less information about the drivers' driving habits
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what is adverse selection

form of market failure resulting from when products of different qualities are sold at a single price because of asymmetric information, so that too much of the low quality product and too little of the high quality product are sold.
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true or false: adverse selection is not a potential inefficiency problem

adverse selection is a potential inefficiency problem
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what are the two potential inefficiency problems that you need to know

adverse selection
moral hazard

when does hidden action occur

when one side of a transaction can take an action that affects the other side but which the other side cannot discretely observe
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give examples of of hidden action and explain each one

driving less carefully once insured --> insurance companies cant see the drivers' driving habits once they are insured

tenured professors that become poor in research --> tenured = long term contract --> less motivated to do research --> bc they are not directly observed by the dean
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what potential inefficiency problem does hidden action cause

moral hazard
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what is moral hazard

the tendency of a person who is imperfectly monitored to engage in dishonest or undesirable behavior

whats the key feature of the adverse selection problem

bad ones drive out the good ones. and as a result, the market disappears
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explain the example: street bum selling rolex watches (fake)

a bum on the street approaches you offering rolex watches for sale - $3000 initially, stating that its genuine --> then offers a 50% discount --> offers a $100 package of a gold ring and the watch

the bum was so eager to sell the rolex watch at such a low price --> this was an indicator that the jewelry was fake
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explain the example: street bum selling rolex watches (genuine)

due to the asymmetric information about the quality of the watch, no one would pay a good price for it

the bum knowing the true quality of the watch, doesnt let it go at a cheap price

but sellers are not willing to buy it at a high price

--> only fake watches will flood the street

--> thus we call such phenomenon adverse selection: bad ones drive out good ones and so the market disappears
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what is the lemons problem

with asymmetric information, low quality goods can drive high quality goods out of the market
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regarding quality uncertainty and the market for lemons, why do used cars sell for less than new cars?

there is asymmetric information about their quality

the seller of the used car knows more about the car than the prospective buyer does. -- can lead to problems such as adverse selection

--> the buyer would be more suspicious of its quality
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which markets are characterised by asymmetric information

the markets for insurance, cars (second hand), financial credit and employment are characterised by asymmetric information about product quality
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what are the two types of cars in the market for lemons (case of used cars)

there are two types of cars:
plums = good cars
lemons = bad cars
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in the market for lemons, when is the transaction successful

the transaction is only successful when the price that the buyers accept is higher than the price that the sellers accept --> buyers are willing to pay more than the price sellers accept, so there are potential gains from the trade

in the market for lemons, what happens if the cars' quality are observable to everyone

all cars are traded

when the quality is fully observable to both sellers and the buyers, both parties are well off, and the market functions well

its a simple transaction --> all the parties would pay the right price
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in the market for lemons, what happens if the cars' quality is unobservable to everyone

this is what happens in reality and it causes a problem

sellers know the quality of the cars but the buyer cannot tell a plum from a lemon before buying

--> buyer will only know the quality of the car after using it for some time

a buyer knows that half the cars are good and the other half are bad
the most a buyer would be willing to pay for any car is 18,000
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in the market for lemons, how do you calculate the most a buyer would be willing to pay for any car

for any car, there is a 50% chance that it is worth 24k and there is a 50% chance that it is worth 12k

(0.5x24,000)+(0.5*12,000) = 18,000
this is the expected value of a car
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in the market for lemons, given the most a buyer is willing to purchase a car, what effect does this have on lemon owners

at 18k, only lemon owners would be willing to sell
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in the market for lemons, given the most a buyer is willing to purchase a car, what effect does this have on plum owners

plum owners will exit the market
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in the market for lemons, explain lemons problem

buyers recognise that any used car available for sale must be a lemon.

they will pay at most 12k and only lemons are sold --> bc plum owners wont sell their car at a low price

lemons crowd out plums from the market --> aka good cars r driven out of the market bc of the bad cars

when there are information asymmetries, potential gains from trade are destroyed
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explain the first source of lemons problem

when a seller tries to sell a bad car, he affects the buyers' perception of the quality of the car on the market.

this lowers the price that they are willing to pay for the average car
--> thus this hurts the people who try to sell good cars
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explain the second source of lemons problem

cars that are more likely to be offered for sale are the ones that people want most to get rid of

the very act of offering to sell the car sends a signal to the buyers about its quality.

if too many low quality cars are offered for sale, it makes it difficult for the high quality cars to be sold
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whats the effect of uncertain quality in a market

uncertain quality reduces the buyers' willingness to pay
leading to more low quality goods and fewer higher quality goods being put in the market
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explain how the lemon problem is also applicable to the insurance market

people who buy insurance know more about their general health than the insurance company

as a result, adverse selection arises

unhealthy people are more likely to want health insurance
--> the proportion of unhealthy people in the pool of insured people increases

this forces the price of insurance to rise --> so that more healthy people who are aware of their low health risks choose not to buy insurance

this further increases the proportion of unhealthy people among the insured --> increases the proportion of unhealthy people among the insured people

therefore, increasing the price of insurance even more

this process continues until most people who want to buy insurance are unhealthy

at this point, insurance becomes v expensive or in the extreme --> insurance companies stop selling insurance (market disappears)
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whats the first solution to the lemon problem for the market for insurance

the govt might take on this role --> provide insurance for all people over the age of ex 65.

this would enable the government to mitigate the problem of adverse selection
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whats the second solution to the lemon problem for the market for insurance

Insurance companies can offer group health insurance policies at places of employment

by covering all workers in a firm, whether healthy or sick, the insurance company spreads risks and therefore reduces the likelihood that large numbers of high risk individuals will purchase insurance
--> lowers risk and makes this business profitable

by providing insurance for a large amount of people, the proportion of unhealthy people will be small and so the insurance company can still make profit due to the smaller proportion of unhealthy people
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which (like name of the problem) problem is the market for credit linked to

the lemon problem
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whats do credit card companies have to consider

how to distinguish high quality borrowers (who pay their debts) from low quality borrowers (who dont)
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explain how the lemon problem arises in the market for credit pt 1

low quality borrowers are more likely than high quality borrowers to want credit, which forces the interest rate up

this increases the number of low quality borrowers, which further forces the interest rate up etc
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explain how the lemon problem arises in the market for credit pt 2

low quality borrowers drive out better quality borrowers, thus adverse selection

low quality buyers know that theyre not going to pay back the money so theyre not scared of signing a contract w high interest
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what happens to the market of credit if the problem isnt solved

The low quality borrowers will take up a large proportion of the market and eventually cause it to end
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how to solve the market of credit problem

computerised credit histories

can eliminate / reduce asymmetric information problem and adverse -- a problem that might otherwise prevent credit markets from operation

without these histories, even the creditworthy would find it extremely costly to borrow money
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is reputation and standardisation important

yes -- the seller knows more about the quality of the product than the buyer does

sellers of high quality goods and services have a big incentive to build a reputation

this will prevent the problem of asymmetric information
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how do you mitigate the adverse selection problem - from the uninformed side

the uninformed side may provide an appropriate incentive scheme which should be clever enough so that the informed side reveals true types

this is called screening
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give an example of screening

different insurance premium based on something observable ex no accident discount

this would help mitigate the adverse selection problem --> help ppl who purchase insurance reveal their type immediately
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how do you mitigate the adverse selection problem - from the informed side

the informed side may want to send a signal about their own type, and when it is believed to be credible, such a signal can resolve the adverse selection problem

this is called signalling
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give an example of signalling

guarantees or warranties for used cars

--> consumers would be worried about the quality of used cars --> providing warranties would mitigate the adverse selection problem
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define market signalling

process by which sellers send signals to buyers conveying information about product quality
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explain the use of screening in auto insurance

if the insurance company cant distinguish good drivers and lousy drivers, it will have a base premium on the average experience

then those w low risk will choose not to insure --> this increases the accident probability of the pool and rates

lousy drivers drive out good drivers and adverse selection problem may occur again
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solutions B to the screening auto insurance case

policy A has a very high initial premium, but if the purchaser does not have accidents the premium will drop substantially in subsequent years.

if the policy holder does have an accident, the premium will remain v high
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solution B to the screening auto insurance case

this policy is priced lower than policy A, but even after an accident, the premium will not fall
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for the screening auto insurance case, why give 2 policies to choose from

the smart policy design can help drivers self select

bad drivers know their driving habits --> easier for them to get into an accident

--> if they purchase A, they will have to pay a high initial premium --> and will have to keep paying this
--> this is not a good deal

bad drivers will find policy B more attractive -- pay the same amount of low premium whether or not they get into an accident

also, if the insurance company sells policy A --> will attract more good drivers
policy b --> attracts more bad drivers
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are there any risks in employment hiring

potential adverse selection risk
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explain signalling in job markets

education as a signal --> used to get around the adverse selection problem in job markets

more productive people (more hardworking etc) are more likely to attain high levels of education in order to signal their productivity to firms and thereby obtain better paying jobs
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what is moral hazard

occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information, thus causing an undesirable outcome
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give examples of moral hazard

insurance market: the insured party's actions are unobserved --> this can affect the insurance firm's profits and thus affect the general insurance premium

people become less careful when theyre insured
--> if my car is insured then ill be less cautious driving

in university: tenured professors are less research productive - bc they feel like their job is safe
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how to solve morally hazardous problems in insurance markets

no accident discount --> incentivises drivers to drive more carefully

deductibles (or excess), copayment --> drivers will have to pay a fixed amount of money first if they get into an accident --> makes them more careful when driving - incentive
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how to solve morally hazardous problems in job markets

performance based salary

university professors: tenured professors are also under performance based salary scheme
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how to solve morally hazardous problems in group assignments at school

peer review

reputation incentive --> lazy - ppl wont want to work w u
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how to solve morally hazardous problems in general

design the right incentive scheme

it should be in the best interest of the informed side to take the desirable action
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principal definition

individual who employs one or more agents to achieve an objective (eg shareholders)
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define agent

individual employed by a principal to achieve the principal's objective (ex hired managers)
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what is the principal agent problem

problem arising when agents (eg firms managers) pursue their own goals rather than the goals of the principals (ex the firms owners)
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principal agent model: who are the shareholders

shareholders (principal) own the firm's assets and assume the risks of doing business
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principal agent model: who do the shareholders hire

shareholders hire managers (agents) to perform the duties of running the business
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principal agent model: what is the asymmetric information

agents (managers) have more information about the action relative to the principal
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principal agent model: what are the problems that the asymmetric information consists of

the agent's action is not directly observable by the principal

the outcome of the action is not completely determined by the agent's actions
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principal agent model: whats may the result be

there is a possibility for the agent tp pursue their own goals, even at the expense of others --> moral hazard problem (or hidden action problem)
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why can asymmetric information between buyers and sellers lead to market failure when the market is otherwise perfectly competitive

asymmetric information leads to market failure bc the transaction price does not reflect either the marginal benefit to the buyer or the marginal cost of the seller

and so the competitive market fails to achieve an output with the price = marginal cost

in extreme cases --> if there is no mechanism to reduce the problem of asymmetric information, the market collapses completely
ex: car case - lemons and plums
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if the used car market is a 'lemons' market, how would you expect the repair record of used cars that are sold compare with the repair record of those not sold

in the market for used cars, the seller has a better idea of the quality of the used car than the buyer

the repair record of a used car is one indicator of its quality

we would expect that, at the margin, cars with good repair records would be kept while cars with poor repair records would be sold

thus, you would expect repair records of used cars that are sold to be worse than those of used cars not sold ie kept by owners
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explain the difference between adverse selection and moral hazard in insurance markets

adverse selection refers to the self selection of individuals who purchase insurance policies

--> people who are less risky than average will, at the margin, choose not to insure
--> people more risky than the average will choose to insure

as a result, the insurance company is left with a riskier pool of policy holders

the problem of moral hazard occurs after the insurance is purchased.

once insurance is purchased, less risky individuals might engage in behaviour characteristics of more risky individuals

if policy holders are fully insured, they have little incentive to avoid risky situations
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can adverse selection and moral hazard in insurance markets exist without the other

an insurance firm may reduce adverse selection without reducing moral hazard, vice versa

collecting information such as a medical history to determine the riskiness of a potential customer helps insurance companies reduce adverse selection.

insurance companies also reevaluate premiums when claims are made --> reducing moral hazard

copayments also reduce moral hazard by creating a disincentive for policyholders to engage in risky behaviour
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describe several ways in which sellers can convince buyers that their products are high quality

some sellers signal the quality of their products through

investment in a good reputation

standardisation of products (eg the use of educational degrees in the labour market)

certification

guarantees

warranties
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describe several ways in which sellers can convince buyers that their products are high quality --> washing machines

offering warranties
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describe several ways in which sellers can convince buyers that their products are high quality --> burger king hamburgers

standardisation of hamburgers
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describe several ways in which sellers can convince buyers that their products are high quality --> large diamonds

certificate that verifies the weight and shape of the stone and discloses any flaws
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why might a seller find it advantageous to signal the quality of a product

firms producing high quality products would like to charge higher prices

to do this, potential consumers must be made aware of the quality differences among brands

can do this thought guarantees and warranties
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how are guarantees and warranties a form of market signalling

low quality producers are unlikely to offer costly signalling devices, consumers can correctly view a guarantee or an extensive warranty as a signal for high quality

--> therefore confirming the effectiveness of these measures as signalling devices
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joe earned a high GPA during his four years of college. is this achievement a strong signal to joe's future employer that he will be a productive worker? why or why not

yes bc GPA is a strong signal to the employer than the employee will perform at an above average level

regardless of what he actually learned, it indicates that joe is able to outperform the majority of its students
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why might managers be able to achieve objectives other than profit maximisation, which is the goal of the firm's shareholders

its difficult and costly for shareholders (the firm's owners) to constantly monitor the actions the firm's managers, and so manager's behaviour is not always scrutinised

therefore, managers have some leeway to pursue their own objectives and not just profit maximisation
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how can the principal-agent model be used to explain why public enterprises, such as post offices might pursue other goals than profit maximisation

managers of public enterprises can be expected to act in the same way as managers of private enterprises -- interest in power -- and profit maximisation

the problem of overseeing a public enterprise is one of asymmetric information

the manager (agent) is more familiar with the cost structure of the enterprise and the benefits to the customers than the principal, a who must elicit cost information controlled by the manager

the costs of eliciting and verifying the information + independently gathering information on the benefits provided by the public enterprise can be more than the difference between the agency's net returns (profits) and realised returns

the difference provides room for slack --> can be distributed to management
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why are bonus and profit sharing payment schemes likely to resolve principal agent problem whereas fixed wage payment will not

with a fixed wage, the agent employee has no incentive to maximise productivity

if the agent employee is hired at a fixed wage to the marginal revenue product of the average employee, there is no incentive to work harder than the least productive worker

bonus and profit sharing schemes involve a lower fixed wage than fixed wage schemes but they include a bonus wage

the bonus can be tied to the profitability of the firm, to the output of the individual employee or to that of the group in which the employee works

these schemes provide a greater incentive for agents to maximise the objective function of the principal
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