1The Economics of Information

Outline
Asymmetric Information
Hidden Actions: Markets with Moral Hazard
Government Policy in a World of Asymmetric Information
Key Ideas
1. In many markets buyers and sellers have different information,
which can lead to market inefficiencies.
2. Asymmetry in information is either due to hidden characteristics or
hidden actions.
3. In cases with hidden characteristics, agents can use their private
information to decide whether to participate in a transaction or a market,
causing adverse selection.
4. In cases with hidden actions, an agent can take an action that
adversely affects another agent, causing moral hazard.
5. There are both private and government solutions to reduce the effects
of adverse selection and moral hazard.
Asymmetric Information
 Asymmetric information - information available to buyers
and sellers differs
 Hidden characteristics -- one side observes something
about the good being transacted that is both relevant for and not
observed by the other party
NOTE: Until this point, we have been assuming that both
sides of the market have the same information. In the real
world, however, that is often not the case, and sometimes this
asymmetry can lead to high societal costs.
Hidden actions -- one side takes actions that are relevant for, but
not observed by, the other party
 George Akerlof
• Writing about financial markets in less developed
countries.
• Why there are none (circa 1971).
• Illustrating with used cars.
Asymmetric Information: Hidden Characteristics: Adverse Selection in
the Used Car Market
Peach or lemon?
Adverse selection can occur when the seller has more
information than the buyer, such as in the market for a used car.

Value to you: $5,000 Value to you: $0

Value to seller: $4,000 Value to seller: $0

Assume that you are risk-neutral, and that half of the cars are
 Market for lemons.
• A lemon is a car that is prodigiously prone to
needing repair.
• Used cars.
Asymmetric Information: Hidden Characteristics: Adverse Selection in
the Used Car Market
For any given car, how much would you be
willing to offer?
Expected value = .5($5,000) + .5($0) = $2,500

If you offer $2,500 to the seller, would he/she

accept the offer?

 That only the sellers of lemons would accept this offer since the value of a
lemon is $0. The seller of a peach would not accept this offer since he/she
values the peach at $4,000.
 If the only car that is available for sale is the lemon, that’s the car you will
end up buying. You, of course, don’t want to buy a lemon, so if you know
that this is the outcome of asymmetric information, you won’t buy a car
and the market for used cars will disappear.
Asymmetric Information: Hidden Characteristics: Adverse Selection in
the Used Car Market
Adverse selection -- one agent in a transaction knows
about a hidden characteristic of a good and decides whether
to participate in the transaction on the basis of this
information

Which one will be more likely to want health insurance?

 Adverse Selection
• The good risks drop out.
• Remember Gresham’s law?
• Bad money drives out good
Insurance – complete info
Insurance – adverse selection
Insurance – market unraveled
 Adverse Selection
• Government solution:
• In some countries, government mandates
compulsory universal health insurance
• However, the low risk type is subsidizing the high risk
type
• High risk type is better off
• Low risk type is worse off
 The buyer has more information than the seller does. An example of this is the
market for insurance.
 This creates a problem for health insurance companies since the cost of insuring the
high-risk person is much higher than that of insuring the low-risk person. What
would you do if you ran the insurance company with this cost difference. (a).
increase premiums for high-risk people would be one option. What effect would that
have on insurance coverage for low-risk people: as premiums go up, low-risk people
will choose not to have insurance, increasing the cost of insurance even more until
no one can afford it.

Asymmetric Information: Market Solutions to Adverse Selection: Signaling

Signaling -- an action that an individual with private information takes
in order to convince others about his information

Examples: signal to the other side of the market about their

private information: (a) sellers establishing a good reputation, (b)
warranties, (c ) requiring a physical in the case of insurance
markets. None of these signals would occur if the quality of the
product was bad, so signaling restores a functioning market.
Asymmetric Information
Evidence-Based Economics
Example:
Why do new cars lose
considerable value the minute
they are driven off the lot?
Asymmetric Information

Exhibit 16.1 Price Ranges of New and Used Cars

The extra price a ached to cars purchased at used car dealers as opposed to
private individuals indicates that signaling is at work in this market. In
addition, the probability of a car being defective was higher if the seller was a
private individual, as opposed to a dealer.
Example: Harvard University
• Offered insurance through Group Insurance
Commission (GIC)
• Initially offered two types of plans
o Costly plan with generous benefits (Blue Cross/Shield)
o HMO plan, cheaper, lots of cost sharing

• The generous plan costs a few hundred dollars

more per person than the HMO
• Enrollment in the plans were stable over time
• Mid 1990s, Harvard faced a budget deficit
(10K employees with health insurance)
• In 1994, Harvard adopted 2 cost saving
strategies
o Would now no longer pay the premium difference
between generous plan and the HMO –
employees mst make up the difference
o Aggressively negotiated down benefits and
premiums. Premiums for the HMO fell substantially
o Out of pocket expenses for generous plan
increased
• Who do you anticipate left the generous plan?
• What happened to the characteristics of the
people left in the generous plan?
• What do you think happened to premiums in the
generous plan?
 Sharp rise is OOP
For PPO

Big increase in PPO premiums

And drop in enrollment
 Insurance ‘death spiral’
• Adverse selection in health plan raises rates
• Lower risk patients exit due to increased costs
• Which increases costs
• Vicious circle
Market Signaling

 A Simple Model of Job Market Signaling

 Assume
 Competitive Product Market
 P = $10,000
 Employees average 10 years of employment
 Group I Revenue = $100,000 (10,000/yr. x 10)
 Group II Revenue = $200,000 (20,000/yr. X 10)
Market Signaling

 With Complete Information

 w = MRP
 Group I wage = $10,000/yr.
 Group II wage = $20,000/yr.

 With Asymmetric Information

 w = average productivity
 Group I & II wage = $15,000
Market Signaling

 Signaling With Education to Reduce

Asymmetric Information
 y = education index (years of higher
education)
 C = cost of attaining educational level y
 Group I--CI(y) = $40,000y
 Group II--CII(y) = $20,000y
Market Signaling

 Signaling With Education to Reduce

Asymmetric Information
 Assume education does not increase
productivity
 Decision Rule:
 y* signals GII and wage = $20,000
 Below y* signals GI and wage =
$10,000
 Signaling
B(y) = increase in The education decision
wage associated with How much education
should a person obtain? is based on benefits/cost
each level of education comparison.
Value of Value of
College Group I College Group II
Educ. Educ.

$200K $200K
CI(y) = $40,000y CII(y) = $20,000y

$100K $100K
B(y) B(y)

0 1 2 3 4 5 6 Years of 0 1 2 3 4 5 6 Years of
Optimal choice of College Optimal choice of College
 Signaling
•Benefits = $100,000 •Benefits = $100,000
•Cost •Cost
•CI(y) = 40,000y •CII(yO)= 20,000y
Value of •$100,000<$40,000y* Value of •$100,000>$20,000y*
College •y* > 2.5 College •y* < 5
Educ. •Choose no education Educ. •Choose y*

$200K $200K
CI(y) = $40,000y CII(y) = $20,000y

$100K $100K
B(y) B(y)

0 1 2 3 4 5 6 Years of 0 1 2 3 4 5 6 Years of
Optimal choice of College Optimal choice of College
Signaling

 Cost/Benefit Comparison
 Decision rule works if y* is between 2.5
and 5
 If y* = 4
 Group I would choose no school
 Group II would choose y*
 Rule discriminates correctly
Signaling
Signaling

 Pooling equilibrium:
 Both high and low productivity type
choose not to go to college
 Employer pays 150,000, the average
of the AP and MP of the two types
Market Signaling
 Signaling
• Government solution:
• Signaling could be costly, using up scare resources
• For instance, over education for job market
signaling
• In some countries, government subsidies of
education is restricted to reduce over signaling. In
UK, those pursuing second bachelor degree must
pay full cost
• In US, many universities do not admit second PhD
applicants
• Many countries try to cut down subsidies to
education so that students bear a larger share of
Hidden Actions: Markets with Moral Hazard
Moral hazard -- actions that are taken by one party but are relevant
for and not observed by the other party in the transaction
 the basic idea with moral hazard is that people take on
more risks when they are protected from the consequences
of that risk.
Proposition: People with air bags in their cars are more likely to get
into accidents.
Why? Two explanations
1. Adverse selection—if you know that you are a bad driver, you
are more likely to choose a car that has air bags.
2. Moral hazard—if you are protected from some of the risk of
driving, you are more likely to drive recklessly
Examples of moral hazard—you are more likely to leave your
car unlocked if you know you’re insured against theft.
Hidden Actions: Markets with Moral Hazard
Principal-agent relationship -- the principal designs a
contract specifying the payments to the agent as a function
of his or her performance, and the agent takes an action that
influences performance and thus the payoff of the principal.
In other words, one party (the principal) provides incentives
for another party (the agent) to work to the principal’s
benefit.
Hidden Actions: Markets with Moral Hazard
“There’s no ‘I’ in ‘team’”
Who is he playing for?
 The college coach’s challenge is to get
his players to play together as a team.
But the players are interested in racking
up individual stats so they look good to
NBA scouts, creating a moral hazard
situation.
 In this case, the player is the agent and
the coach is the principal. How can the
principal encourage the agent to
perform in a way that conforms to the
principal’s objectives.
 Should identify things such as
emphasizing number of passes or
assists, or benching a player that “hot
dogs” too much
Hidden Actions: Markets with Moral Hazard: Market Solutions to Moral
Hazard in the Labor Market: Efficiency Wages

What would make this agent wake up?

 What makes an employee an agent
—i.e., how are employees’ goals
different from those of their
employers?
 Employees could want to work as
li le as possible, to take a lot of
breaks, etc. Principals, of course, are
interested in maximizing profit.
 So the principal’s problem is
creating incentives that bring agents’
goals more in line with those of the
company.
Principal agent –
perfect info
Principal agent –
moral hazard 1
Principal agent –
moral hazard 2
Hidden Actions: Market Solutions to Moral Hazard in the Labor Market

Efficiency wages -- wages above the lowest pay that workers would
accept; employers use them to increase motivation and productivity

Henry Ford: increased the wages of his workers -- an action

that caused quite a stir.
 The payment of efficiency wages made it more costly for his
workers to lose their jobs—their opportunity cost of shirking
increased. Because productivity increased, Ford actually
saved money by increasing wages.
 Because workers would be reluctant to leave, turn-over costs
for the employer would decrease as well.
Hidden Actions: Market Solutions to Moral Hazard in the Labor Market

Supervision by other experts

Professionals like physicians, accountants, engineers, financial

analysts, lawyers, etc., are supervised by their own self governing
professional bodies in some countries.

In other countries, these professional bodies are part of the

government structure.

The experts in their own areas can understand and supervise the
actions of their peers better.
Hidden Actions: Market Solutions to Moral Hazard in the Insurance
Market: “Putting Your Skin in the Game”
 In the insurance market, the way to keep policy holders from
acting in a more risky manner is to increase the costs to them if
they do. These are three majors ways that policy holders can be
forced to have “skin in the game,” mitigating their risk
behavior.
1. Deductibles
2. Co-payments
3. Coinsurance Evidenced-Based
Economics Example:

Why is private health

insurance so expensive?
Hidden Actions: Market Solutions to Moral Hazard in the Insurance
Market: “Putting Your Skin in the Game”
Insurance companies have an asymmetric information problem in that they have a
hard time telling with certainty the true health status of policy holders.
 Harvard University decided to change how it subsidized health insurance for its
employees, providing the same subsidy regardless of the level of the plan.
 As a result, healthy people opted out of the most expensive plans because they
knew their true health status, leaving the relatively unhealthy people at the highest
level of coverage.
 This caused the price of the most expensive plan to go up even more. Because the
cost of private insurance increases, this might be a situation that would benefit from
government intervention.
 The point of the Affordable Care Act was
to stop the concentration of the most sick
in the health insurance market driving up
prices until the average consumer couldn’t
afford health insurance.
 By requiring everyone to purchase health
insurance, more young people are brought
into the health insurance market, which
lowers the risk for insurance companies,
lowering the price of insurance for
Government Policy in a World of Asymmetric Information: Government
Intervention and Moral Hazard
The ACA (Affordable Care Act) could lead to a moral hazard
problem as risk behavior increases because of insurance coverage. In
response, the government could
 Tax risky behavior
 Subsidize healthy behavior
 Have deductibles or copayments
Government Policy in a World of Asymmetric Information: The Equity-Efficiency
Trade-off
How do unemployment benefits create a
moral hazard problem?
 Understand the relationship between
unemployment benefits and moral
hazard. If the benefits create a moral
hazard problem, why offer benefits at
all? What is the tradeoff is in this case—
are we comfortable with offering no
Government Policy in a World of Asymmetric Information: Crime and Punishment as a
Principal-Agent Problem
 Two Nobel-prize-winning economists
thought of crime as a principal-agent
problem, with criminals being the agents
with goals that are at odds with the
principal (government responsible for
maintaining order).
 The problem the principal has, then, is to
encourage criminals to have goals that are
more in line with those of society. The
government can alter the expected
punishment that criminals would face, by
changing the probability that the criminal
Is this a principal-agent problem? is caught and/or increasing the
punishment of detection.
 Which of these strategies do you think would be be er—(1). increasing the
probability of detection would be expensive since it would require a larger police
force. (b). police forces can be small, resulting in a cost savings, with an increase in
the punishment if caught. An increase in punishment (longer sentences) also has
costs associated with it, however.
 Hidden Actions: Moral Hazard
Economic relationships often have the form of a Principal
who contracts with an Agent to take certain actions that
the principal cannot observe directly.

Principal Agent Hidden

Action
physician patient exercise
employer employee effort
stockholder manager strategy
insurer insuree caution
bank borrower effort