CHAPTER 17
The Economics of Information
1.
Chapter Summary
2.
Learning Objectives
3.
Chapter Outline
Teaching Tips/Topics for Discussion
4.
Solved Problems
5.
Solutions to Review Questions and Problems and Applications
1. Chapter Summary
The difficulty in correctly pricing insurance policies stems from asymmetric information, which
happens when one party to a transaction has less information than the other party. Asymmetric
information is present in other markets, including the market for used cars, and leads to adverse selection.
Adverse selection occurs when one party to a transaction takes advantage of knowing more than the other
party. The insurance industry is also subject to moral hazard, the tendency of people to change their
actions because they have insurance. Insurance companies can take steps to reduce moral hazard; for
example, by using deductibles and co-payments.
Adverse selection and moral hazard also affect firms and investors in financial markets. For
example, once a firm has sold stocks and bonds it may spend the funds in ways not in the investors’ best
interests. Moral hazard can also be present in labor markets. Once hired, workers may shirk their
obligations and not work hard. Firms may deal with this form of moral hazard by closely monitoring
workers and making their jobs seem more valuable than other jobs.
Information problems can occur in auctions. In some auctions neither the bidder not the seller
has complete information about what is being auctioned. One possible outcome of auctions, the winner’s
curse, occurs when the winning bidder overestimates the value of the item and ends up worse off than the
losers.
2. Learning Objectives
Students should be able to:

Define asymmetric information and distinguish between moral hazard and adverse selection.

Apply the concepts of adverse selection and moral hazard to financial markets.

Apply the concepts of adverse selection and moral hazard to labor markets.

Explain the winner’s curse and why it occurs.
340
The Economics of Information 341
3. Chapter Outline
State Farm Experiences the Hazards of Selling Insurance
1.
In 2004 some insurance analysts were concerned that State Farm Insurance was charging some
of the drivers it insured too low a price. These analysts were concerned that State Farm was not adopting
new pricing models as quickly as other insurance companies were. These models are designed to better
assess the risk involved in insuring drivers with different ages, gender and other characteristics.
►Teaching tips: This chapter opener and “An Inside Look” at the end of the chapter concern
insurance markets. “An Inside Look” examines the aftermath of hurricanes that hit Florida in the
summer of 2004. “Problems and Applications” number 13 is related to the chapter opener.
Asymmetric Information
1.
The difficulty in correctly pricing insurance policies arises from the problem of asymmetric
information.
A. Asymmetric information is the situation in which one party to an economic transaction has less
information than the other party.
I.
Guarding against the effects of asymmetric information is a major objective of sellers
in the insurance market and of buyers in financial markets.
II.
The study of asymmetric information began with the study of used car markets or the
market for “lemons.”
III.
Sellers of used cars have more information about the cars they sell than do buyers.
Most used cars offered for sale will be lemons. This is due to adverse selection.
B. Adverse selection is the situation in which one party to a transaction takes advantage of knowing
more than the other party to the transaction.
C. Used car dealers can take steps to assure buyers they are not selling lemons.
I.
Sellers can offer warranties that guarantee repair or replacement over a certain time
period.
II.
Sellers can build a reputation for selling reliable cars.
D. Buyers of insurance will always know more about the likelihood of the event being insured
against than will insurance companies.
E. Insurance companies cover their costs only if they set the prices (premiums) of their policies at
levels that reflect how many claims for payment the people they have insured are likely to submit.
F. The adverse selection problem can be reduced if people are automatically covered by insurance;
for example, state governments require drivers to have automobile insurance.
G. Adverse selection problems can also be reduced by offering group coverage to large companies.
342 Chapter 17
2.
The insurance market is also subject to moral hazard.
A. Moral hazard is the tendency of people who have insurance to change their actions because of
the insurance, or, more broadly, actions taken by one party to a transaction that are different from
what the other party expected at the time of the transaction.
I.
An example of moral hazard is a firm that has taken out fire insurance may be less
careful about avoiding fire hazards.
II.
Insurance companies use deductibles and co-payments to reduce moral hazard.
►Teaching tips: “Making the Connection” 17-1 explains the significance of adverse selection to
Social Security reform. “Don’t Let This Happen to You!” explains the difference between
adverse selection and moral hazard; “Problems and Applications” number 11 concerns the same
topic.
Adverse Selection and Moral Hazard in Financial Markets
1.
Adverse selection and moral hazard pose problems for firms and investors in markets for stocks
and bonds.
A. Firms know more about their financial situations than investors do.
B. Once a firm has sold stocks and bonds firms it can use the funds in ways that reduce profits.
C. Congress created the Securities and Exchange Commission (SEC) in 1934 to regulate stock and
bond markets.
D. The SEC requires firms to register stocks and bonds they wish to sell, increasing the amount of
information available to investors.
►Teaching tips: “Making the Connection” 17-2 describes how moral hazard explains the
accounting scandals of 2002. “Solved Problem” 17-4 (below) uses one of these scandals as an
example of moral hazard.
Adverse Selection and Moral Hazard in Labor Markets
1.
Economists refer to the conflict between the interests of shareholders and the interests of top
management as a principal-agent problem.
A. The principal-agent problem is caused by an agent pursuing his own interests rather than the
interests of the principal who hired him.
B. Once hired workers may shirk their obligations and not work hard.
C. Firms may reduce shirking through close monitoring.
D. Firms can also employ means to make a worker’s job seem more valuable.
I.
Efficiency wages can be paid. These are higher-than-equilibrium wages used to give
workers an incentive to work harder.
II.
A seniority system rewards higher pay and other benefits to workers who have been
with the firm longer.
The Economics of Information 343
III.
Profit sharing provides workers with a share of the firm’s profits; the harder the
employee works the more profit the firm earns and the higher the employee’s
income.
►Teaching tips: “Solved Problem” 17-1 explains how changes in a firm’s compensation system
can reduce adverse selection and moral hazard. “Problems and Applications” number 12 also
deals with this topic.
The Winner’s Curse: When Is It Bad to Win an Auction?
1.
In some auctions neither the bidder nor the seller has complete information about what is being
auctioned.
A. The winner’s curse is the idea that the winner in certain auctions may have overestimated the
value of the good, thus ending up worse off than the losers.
I.
When there is uncertainty regarding the value of the item auctioned the average
competitive bid is likely to be close to the true value.
II.
The winning bid in an auction will be one that is most optimistic and, therefore,
greater than the true value.
B. The winner’s curse applies to auctions of common-value assets that would be given the same
value by bidders if they had perfect information.
C. The winner’s curse does not apply to auctions of private-value assets when the value to each
bidder depends on the bidder’s own preferences.
►Teaching tips: “Making the Connection” 17-3 explores the possibility of a winner’s curse in
the marriage market. “Making the Connection” 17-4 describes another example of the winner’s
curse through a classroom experiment. “Solved Problem” 17-2 and “Problems and Applications”
number 20 both examine the winner’s curse in auctions.
344 Chapter 17
4. Solved Problems
Chapter 17 includes two Solved Problems to support learning objectives 3 (Apply the concepts of adverse
selection and moral hazard to labor markets) and 4 (Explain the winner’s curse and why it occurs). The
following Solved Problems support this chapter’s other two learning objectives.
Solved Problem 17-3 Supports learning objective 1: Define asymmetric information and distinguish
between moral hazard and adverse selection
The Nub of the Matter (Warning! Content may be unsuitable for sensitive readers!)
Although most people with health and life insurance are honest, insurance companies are always subject
to adverse selection. The consequence of adverse selection is some people change their behavior as a
result of having insurance. Among the most egregious examples of behavioral change are those
involving people who lie about their circumstances or take deliberate actions that endanger their health.
There are reported cases of self-mutilation in order to collect on disability insurance. Perhaps the most
bizarre story concerns a town in Florida that acquired the macabre nickname of “Nub City” in the 1970s.
Over 50 people in the town have suffered “accidents” involving the loss of various organs and
appendages, and claims of up to $300,000 have been paid out by insurers. Their investigators are
positive the maimings are self-inflicted; many witnesses to the “accidents” are prior claimants or
relatives of the victims, and one investigator notes that “somehow they always shoot off parts
they seem to need least.”
Another type of moral hazard involves staging automobile accidents. The following is a brief description
of how this is done.
How do I get started? For a “paper accident” try inflicting “controlled damage” on a couple of
cars with a sledgehammer in a dark parking lot. Insert passengers. Summon a witness. Gather
broken glass in bags for re-use.
That was easy, what next? “Staged” accidents: Buy rustbuckets, insure one and run it into
another one full of recruited claimants-to-be (“cows”). If you’re nice, give them pillows.
…
How do keep from getting caught? Vary your fact patterns. Don’t stamp a doctor’s name on
medical reports months after he’s died. Don’t lose your ledger – needed to keep hundreds of
accidents straight - or your scripts and tip sheets.
Sources: “Moral Hazard and Adverse Selection.”
http://ingrimayne.saintjoe.edu/econ/RiskExclusion/Risk.html
Walter Olsen, “New Trends in Highway Robbery,” Wall Street Journal, December 20, 1996.
The Economics of Information 345
(a) Use the above passage to describe asymmetric information.
(b) Use the passage to distinguish adverse selection and moral hazard.
Solving the Problem:
Step 1: Review the chapter material. You may want to read “Asymmetric Information” since this
problem refers to the material in this section of the textbook which begins on page 536.
Step 2: (a) Asymmetric information is the situation in which one party to an economic transaction has
less information than the other party. Those who are insured obviously have more knowledge of their
circumstances than the companies that insure them. But not all insured parties demonstrate moral hazard.
Step 3: (b) Adverse selection occurs when some try to take advantage of knowing more about their
circumstances than the companies do. This is the case with those who are alleged to commit insurance
fraud. And the guilty parties demonstrate moral hazard which is the tendency for insurance to alter
behavior. The possibility of collecting on an insurance policy is the motivation for self-mutilation and
staging phony automobile accidents.
Solved Problem 17-4 Supports learning objective 2: Apply the concepts of adverse selection and moral
hazard to financial markets
The Fall of the House of Rigas
In early 2002 plans were unveiled for a new corporate headquarters in downtown Buffalo. The $125
million project would house 1,000 workers and serve as a catalyst for other development efforts in the
city’s Inner Harbor area. James Allen, executive director of the Amherst and Erie County Industrial
Development Agencies commented “We need a signature project on the waterfront and this gives us that
project.” Unfortunately, the building project was proposed by Adelphia Communications. On June 24th of
that same year Adelphia filed for bankruptcy. On June 20th of 2005 John Rigas, Adelphia’s founder and
longtime CEO, was sentenced to 15 years for looting the company’s finances and concealing over $2
billion in debt from investors. Rigas’ son Timothy received a 20 year sentence after being convicting on
the same charges as his father: conspiracy, bank fraud and securities fraud. During the Rigas’ trial U.S.
attorney’s accused the Rigas’ of using Adelphia as a “private piggy bank” to pay for such personal
expenses as millions of dollars in cash advances, $13 million to build a golf course, and even 100 pairs of
bedroom slippers. The elder Rigas had even used a company jet to send a Christmas tree to his daughter
in New York City. When he found out the tree was the wrong size he had another tree sent – at company
expense.
346 Chapter 17
Despite being a publicly held firm Adelphia was run like a family business. John Rigas and three of his
sons and one son-in-law held five of the nine seats on the company’s board of directors. The family’s
mismanagement was hidden from investors through fraudulent financial statements. After the collapse of
Internet stock prices, following a rapid climb in the 1990s, and the slowdown of the overall U.S. economy
in 2001, investors began looking more closely at questionable managerial and accounting practices that
made debt-ridden firms such as Adelphia and Enron appear in better financial condition than they actually
were.
Sources: James Fink, “Adelphia Picks HOK for downtown office design,” Buffalo Business First,
January 16, 2002. James Fink, “John Rigas sentenced to 15 years in prison,” Buffalo Business First, June
21, 2005.
“Rigases looted Aldelphia, jurors told” http://www.smh.com.au/articles/2004/03/02/1078191325849.html
(a) What characteristic(s) of Adelphia Communications management structure demonstrates adverse
selection?
(b) Use Rigas family to demonstrate the consequences of moral hazard in financial markets.
Solving the Problem:
Step 1: Review the chapter material. Since this problem concerns the material in “Adverse Selection
and Moral Hazard in Financial Markets” you may want to read this section of the textbook which begins
on page 540.
Step 2: Answer question (a). The strong overall performance of the U.S. economy and financial
markets masked the fraudulent behavior of the Rigas’ during the 1990s. Perhaps most important was the
fact that Rigas family members held a majority of the seats on Adelphia’s board of directors. This meant
that the family had effective control over the company and could prevent other board members from
overruling questionable management practices.
Step 3: (b). It is critically important for investors and analysts to have access to timely and accurate
information regarding a publicly-owned company. Had the true financial condition of the company been
known earlier, the financial markets would have penalized Adelphia with lower stock prices and credit
ratings. The company could have been forced to change the composition of the board or to be sold to
another company.
The Economics of Information 347
5. Solutions to Review Questions and Problems and Applications
Answers to Thinking Critically Questions
1. Having insurance probably won’t affect the odds of being hit by a hurricane, but it could easily affect
the damages from being hit by a hurricane. Someone without insurance will take more precautions. For
example, the person might build a sturdier, more wind-resistant structure.
2. Backing this law might seem compassionate, but waiving the deductible would increase the expected
losses to the insurance companies, who would then charge more for insurance. The higher price would
lead some people to forego insurance altogether.
Answers to Review Questions
1. Asymmetric information is the situation in which one party to an economic transaction has less
information than the other party. For example, in the used car market, the owner of the car knows much
more about its reliability and the quality of its maintenance than does a prospective buyer.
2. Adverse selection occurs when one party to a transaction takes advantage of knowing more than the
other party of the transaction. For example, someone whose building is more likely to burn down is
likely to buy to insurance. Moral hazard occurs when actions taken by one party to a transaction are
different than what the other party expected at the time of the transaction. For example, the odds of a fire
rise after the building is insured because the person with fire insurance does less to avoid fires by, for
example, leaving oily rags in the basement. Adverse selection is the bigger problem in the market for used
cars.
3. Both adverse selection and moral hazard drive up the price of insurance. People with higher odds of
the insurable outcome are the ones who buy the insurance (adverse selection) and having insurance
increases the odds of the insurable outcome occurring because the person no longer tries as hard to avoid
the outcome (moral hazard). Adverse selection and moral hazard may drive the price up so much that
many people don’t want to buy the insurance.
4. Insurers reduce adverse selection by screening applicants to make sure that their odds of suffering the
bad outcome aren’t too high. They reduce moral hazard by requiring the insured party to bear part of the
348 Chapter 17
loss via deductibles and co-payments, thus giving the insured party an incentive to reduce the odds of the
bad outcome occurring.
5. Asymmetric information makes it difficult for small firms to sell stocks and bonds because potential
investors don’t know very much about the firm. Therefore, the investors cannot determine if buying the
stocks or bonds is a good investment.
6. The Securities and Exchange Commission is the federal government agency that regulates the stock
and bond markets. It requires that firms provide potential investors with financial information in an
attempt to reduce the adverse selection and moral hazard problems in this industry. It was established in
1934, shortly after the stock market crash.
7. In 2002 the SEC gained new responsibilities under the Sarbanes-Oxley Act: tightening auditing rules in
an attempt to block insiders from providing fraudulent information about their firms’ performance. The
legislation was passed in the aftermath of several spectacular corporate accounting frauds, including
Enron and WorldCom.
8. The moral hazard problem occurs in the labor market when workers shirk, by not working hard. Firms
attempt to reduce shirking through supervision, the payment of efficiency wages, the use of the seniority
system, profit sharing and other means.
9. The winner’s curse occurs when the winners in certain auctions overestimate the value of the good,
thus ending up worse off than the losers. It isn’t a problem when the item being auctioned has a private
value known to each bidder, but occurs when the item has a common value and there is imperfect
information about this value.
10. The statement makes sense. When no one knows for sure how much oil is in a field, someone is
likely to overestimate the amount, make an excessively high bid for the field, and thus fall victim to the
winner’s curse. The more information that is available, the more precise the estimates will be, so the odds
of overestimating will fall,as will the likelihood of the winner’s curse.
The Economics of Information 349
Answers to End-of-Chapter Problems and Applications
1. Because of the lemons problem you should buy the car only if the advertisement is placed by a car
dealer with a good reputation or by an individual you know well enough to trust, if you can cheaply
determine that it isn’t a lemon (for example, by an inspection), or if you’ll receive a solid warranty against
defects.
2. There are “lemon laws” for autos but not for televisions or toothbrushes because the size of the losses
sustained by buyers of bad cars led to political pressure to pass lemon laws for cars.
3. When you buy fire insurance, you are sharing the risk of a house fire with the other purchases of fire
insurance. Each of you has contributed to the funds the insurance company will use to pay off someone
whose house burns down. Adverse selection undermines the ability of insurance companies to provide
risk sharing services. If the only people who buy insurance policies are people whose houses are likely to
burn down, then risk sharing is not occurring.
4. Perhaps. Some argue that Social Security does not involve offering insurance against difficult to
predict events like a fire or an illness, but that it is more like a program of forced saving for retirement.
Others argue that Social Security is an insurance system that insures against outliving your savings due to
the difficulty of predicting how long you are likely to live after retiring.
5. a. The typical resident of Lawrence expects losses of only $5,000 per year (0.05 x $100,000) due to
fire. So, the typical resident would be unlikely to pay $22,000 per year for fire insurance.
b. You will face a severe adverse selection problem. Only the 500 (5 percent of 10,000) owners who
know their houses will burn down will buy insurance. So, you will pay out 500 x $100,000 =
$50,000,000 and receive only 500 x $22,000 = $11,000,000 in premiums. Your loss will be $39,000,000.
c. In this case it would be very difficult to run a profitable insurance company. For instance, increasing
your premiums is unlikely to solve your problem because it would lead to adverse selection problems.
Only those homeowners who believe their houses had a high probability of burning down would buy
insurance.
6. The system is necessary because society wants someone with enough money to be liable when these
drivers inflict damage on other people. The adverse selection problem means that insurance companies
are generally unwilling to offer insurance to these drivers at any rate. The state government must force
insurance companies to insure these bad drivers because the insurance companies expect to lose money
insuring these drivers, sot they wouldn’t insure them voluntarily.
350 Chapter 17
7. The regulations increase adverse selection problems for insurance companies and drive up the cost of
insurance to most customers, especially those whose risks aren’t high. Insurance companies might
respond to these regulations by refusing to sell insurance policies, and the regulations also lead some
consumers to forego buying insurance.
8. Investors have been unwilling to buy the stocks and bonds of these firms because the adverse selection
problem means that the firms that most want to sell stocks or bonds to investors have been the firms
investors would least want to buy stocks or bonds from, if they knew the true state of the firms’ financial
health.
9. Because he knew that the top managers of corporations had incentives to overstate their reported
earnings.
10. Yes. Congress was motivated to ban these loans because of the difficulty of determining when they
were in the best interests of shareholders and when they weren’t.
11. The statement has moral hazard and adverse selection mixed up.
12. It is difficult for restaurant managers to monitor the performance of servers. Tips give servers an
incentive to provide good service. If tips were outlawed, the income of servers would be likely to fall
because the productivity of servers will decline.
13. Insurers will collect more information and use complicated models to predict accidents if the benefits
of doing so exceed the costs. The benefits have always existed, but computer technology has recently
made the costs fall considerably.
14. Firms would divulge secrets to analysts to reduce the asymmetric information problem. Firms have
an incentive to provide outsiders with enough information that they may be willing to invest in or lend to
the firm.
15. Tenure is designed to give professors an incredible amount of job security, protecting them from the
risks of being fired for their political views, for example. However, tenure can create a large moral
hazard problem. The tenured professor can reduce his or her work level considerably without being fired.
Tenure may also lead to “adverse” selection by encouraging people who value job security the most to
apply for these jobs. Finally, because of the job security, colleges will be able to pay a lower wage than
to otherwise similar employers.
The Economics of Information 351
16. Paying more than the going wage could increase or decrease profits. If employees respond to the high
pay by working harder, being more productive and quitting less frequently, the benefits to the firm of the
paying the above-market wage may exceed the costs. The higher pay may be an efficiency wage, which
gives workers an incentive to work harder. It may be a response to asymmetric information.
17. Because the winner’s curse arises from the winning bidder overestimating how much oil is likely to be
in the field, the company might want to adopt a strategy of bidding an amount less than would be justified
by the company’s best estimate of the amount of oil in the field.
18. The easier it is for bidders to estimate the true value of what they are bidding on, the less likely they
are to fall victim to the winner’s curse. Because Joe’s performance is steady, Cleveland is likely to be
paying him an amount that is justified by his performance. Sam’s performance is more uneven, so
Cincinnati is more likely to have fallen victim to the winner’s curse by overestimating his performance,
and to therefore be paying him a salary that turns out not to be justified by his performance.
19. No, the winner’s curve should not apply in this case because bidders have full information on the
value of what is being auctioned.
20. No. For the winner’s curse to apply, the winner must have overestimated the true value of what is
being bid on. If all bidders have perfect information, then this will not happen.
21. The firm or investors that take over the other firm are suffering from the winner’s curse. The winning
bidder is the one most likely to have overestimated the true value of the firm being taken over.
22. They suffer from the winner’s curse. The publisher that wins the auction is the publisher that has
most overestimated how many copies will be sold of the book being auctioned.
23. Didius Julianus suffered from the winner’s curse. He overestimated the value of winning the auction
to be emperor.
24. The marriage market is probably a combination of the two. There are certain aspects of appearance
and certain personality traits to which most people would assign the same value. On the other hand, not
every one evaluates appearance and personality the same way.