Information - chapter 10

10.1. Information Asymmetry

• Complete information: state of being fully informed about the choices that a person and other relevant economic actors face
• Information asymmetry: a condition in which one person knows more than another
  • Asymmetric information creates problems because it allows a person who is more informed to achieve goals at the expense of a person who is less informed
  • If the incentives of both parties are aligned, then the information asymmetry doesn’t matter

10.2. Adverse Selection

• Adverse selection: a state that occurs when buyers and sellers have different information about the quality of a good or the riskiness of a situation; results in failure to complete transactions that would have been possible if both sides had the same information
  • As a result, some buyers and sellers fail to complete transactions that would have been possible if both sides had the same information
  • Relates to unobserved characteristics of people or goods and it occurs before the two parties have entered an agreement

10.3. Moral Hazard

• Agent: a person who carries out a task on someone else’s behalf
• Principal: a person who entrusts someone with a task; also, in finance, the original amount borrowed or invested
• Moral hazard: the tendency for people to behave in a riskier way or to renege on contracts when they do not face the full consequences of their actions
• In contrast to adverse selection, moral hazard has to do with actions
  • Happens after the two parties have entered into an agreement
  • Generally occurs when a principal entrusts an agent with a task, but cannot observe the agent’s actions, as in the employer-employee relationship

10.4. Screening and Signalling

• Screening: taking action to reveal private information about someone else
  • Examples: interviewing job candidates and checking references when hiring, or offering insurance products that appeal to people with different characteristics
  • Works best when there is a way to ensure that the information received is credible since people have an incentive to keep their private information private
• Signalling: taking action to reveal one’s own private information
  • Examples: certifying a used car, getting a university degree, and dressing for success
  • Useful in cases in which the more-informed party would prefer to eliminate the information asymmetry
• For a signal to be credible, it must carry some cost or mechanism that makes it inaccessible or unappealing to those it is meant to exclude
  • Otherwise everyone will use the signal and it will lose its meaning

10.5. Reputations

• The potential to develop a reputation creates an incentive for the more informed party to an exchange to behave in a way that is fair and favourable toward the less-informed party
• Because hidden information often reveals itself over time, people who consistently take advantage of a less-informed party will develop a bad reputation and customers will begin to avoid doing business with them
• A good reputation is a signal that a business or person has treated partners well in the past

10.6. Statistical Discrimination

• Statistical discrimination: distinguishing between choices by generalizing based on observable characteristics in order to fill in missing information
• When specific information is missing, rules of thumb and inferences based on statistical averages can serve as rational decision-making tools
• However statistical averages aren’t necessarily accurate in every situation and neither are inferences made using statistical discrimination
  • Even if they’re the best option when full information is unavailable

10.7. Education and Regulation

• When an information problem is pervasive and has a pronounced negative effect on society, the government will sometimes step in to provide the missing information or require that others reveal private information
• The effectiveness of these interventions depends in how well the government’s requirements are enforced and how well people understand the information they receive
• In a few cases, the government may mandate participation in a market or program to counter a severe adverse selection problem