Chapter 16
The Economics
of Information
16 The Economics of Information
Chapter 16 Outline
16.1 Asymmetric Information
16.2 Hidden Actions: Markets with Moral Hazard
16.3 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.
16.1 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
16.1 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 seller: $4,000
Value to you: $0
Value to seller: $0
Assume that you are risk-neutral, and that half of the cars are
peaches and half are lemons.
16.1 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.
16.1 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?
 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.
16.1 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.
16.1 Asymmetric Information
Evidence-Based Economics
Example:
Why do new cars lose
considerable value the minute
they are driven off the lot?
161 Asymmetric Information
Exhibit 16.1 Price Ranges of New and Used Cars
The extra price attached 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.
16.2 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.
16.2 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.
16.2 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 can 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
16.2 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
little 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.
16.2 Hidden Actions: Markets with Moral Hazard Market Solutions to
Moral Hazard in the Labor Market: Efficiency Wages
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.
16.2 Hidden Actions: Markets with Moral Hazard: 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
Evidenced-Based
3. Coinsurance
Economics Example:
Why is private health
insurance so expensive?
16.2 Hidden Actions: Markets with Moral Hazard 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
everyone.
16.3 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
16.3 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
support to the unemployed?
16.3 Government Policy in a World of Asymmetric Information: Crime and Punishment
as a Principal-Agent Problem
Is this 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 caught and/or increasing the
punishment of detection.
 Which of these strategies do you think would be better—(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.