Asymmetric Info Flashcards
What are the two main types of asymmetric information?
Hidden characteristics
Hidden actions
What are hidden characteristics?
A type of asymmetric information
Which is a fact about a person or thing that is known to one party but unknown to others
Example: owner of a used car knows its quality but a potential buyer doesn’t
What are hidden actions?
One person in a transaction can’t observe important actions taken by another party
•Example: a firm’s manager uses a
company jet for personal use without the firm owner’s knowledge
Hidden characteristics and actions give rise to which two types of market failure?
Adverse selection - asymmetric information about a hidden characteristic causes low-quality products to be over-represented in transactions
Moral hazard - an informed person takes advantage of a less-informed person through an unobserved action
What is moral hazard?
an informed person takes advantage of a less-informed person through an unobserved action
Leads to misalignment of private and social incentives and creates market failures
(people taking risks because they know they’re protected),
Example of moral hazard ?
employees shirk; managers pursue goals harmful to a company’s owners; a homeowner pays less attention to fire hazards because he has fire insurance
What is adverse selection?
Asymmetric information about a hidden characteristic causes low-quality products to be over-represented in transactions
It’s a Common problem in markets for second-hand goods
Where is adverse selection common?
Common in second hand markets
Also common problem in insurance markets
➢Examples: Life or health insurance
How does adverse selection cause market failure?
Creates a market failure by reducing the size of a market or eliminating it, preventing desirable transactions
Adverse selection and moral hazard often..
Often rise together (eg insurance)
Market for second-hand card is…?
A well known example of adverse selection
In the second hand car market why might the uninformed not want to deal with the informed. Why?
The uninformed might not wish to deal with the informed because
–People selling second-hand cars will be more likely to try and offload “lemons” (poor-quality cars) than “cherries” (high-quality cars)
So uninformed buyers will only pay a low price because they are likely to end up with a lemon
But this Can crowd out cherries altogether and lead to the market’s partial collapse
3 examples of adverse selection (w graphs)
- Used car market with perfect information
- Used car market with imperfect but symmetric information
- Used car market with imperfect and asymmetric information
What are the ways to reduce adverse selection?
- Government intervention
- Screening
- Signalling
How does government intervention reduce adverse selection?
Government intervention to prevent opportunism by better-informed sellers:
•Product liability laws
•Standards and certification
How does screening reduce adverse selection?
Consumers can avoid lemons if they can obtain reliable information about quality
How does signalling reduce adverse selection
Signalling is:
Actions through which producers of high-quality goods can distinguish themselves from low-quality producers.
By
•Brand names and reputation
•Guarantees or warranties
•Prevents adverse selection only when signal is credible. Often possible if signal is too costly for low-quality firms.
Difference between origin of moral hazard vs adverse selection?
The problem arises from a hidden action, not a hidden characteristic as with adverse selection
Does moral hazard lead to market failure?
Yes sometimes e.g. fire insurance for homes
What is the effect of moral hazard?
Moral hazard causes the alignment of social and private incentives to break down (welfare loss)
•Policyholder would also benefit from absence of asymmetric information!
➢Even in perfect competition, insurance companies need to cover cost and must increase premium with moral hazard
Why does moral hazard keep happening?
the decision maker’s actions cannot be properly monitored
ways to reduce moral hazard
–Insurance: co-insurance or excess/deductible
–Owner/employer – employee relationships: monitoring, performance-based compensation (stock options etc.)
Moral hazard requires ____ solutions than adverse selection
Moral hazard requires different kinds of solutions than adverse selection
Moral hazard vs adverse selection solutions
Adverse selection: create mechanisms to transfer info to uninformed party
Moral hazard: create incentives for the informed party not to undertake harmful hidden actions
Hidden characteristics lead to _____, hidden actions to_____?
Hidden characteristics lead to adverse selection, hidden actions to moral hazard
Both adverse selection and moral hazard lead to…
inefficient market outcomes (market failure)
How do deductibles and copayments reduce moral hazard?
deductibles and copayments in insurance policies requires individuals to bear a portion of the costs. This encourages responsible behavior and discourages excessive risk-taking since individuals have a financial stake in their decisions.
How does monitoring and surveillance reduce moral hazard?
Regular monitoring and surveillance can deter individuals or entities from engaging in risky behavior. This is particularly relevant in financial markets where oversight and regulatory mechanisms can discourage excessive risk-taking.
Why does signalling only work if “signal is credible” what does it mean by this?
However, signaling is effective only when the information being communicated is believable or credible. Sometimes, a signal can be so costly that only high-quality firms are willing to invest in it. For example, if a certification process is expensive, low-quality firms might avoid it, making the certification a credible signal of quality for the firms that do undergo the process.
