Asymmetric Info

Question 1

What are the two main types of asymmetric information?

Answer 1

Hidden characteristics
Hidden actions

Question 2

What are hidden characteristics?

Answer 2

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

Question 3

What are hidden actions?

Answer 3

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

Question 4

Hidden characteristics and actions give rise to which two types of market failure?

Answer 4

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

Question 5

What is moral hazard?

Answer 5

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),

Question 6

Example of moral hazard ?

Answer 6

employees shirk; managers pursue goals harmful to a company’s owners; a homeowner pays less attention to fire hazards because he has fire insurance

Question 7

What is adverse selection?

Answer 7

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

Question 8

Where is adverse selection common?

Answer 8

Common in second hand markets
Also common problem in insurance markets

➢Examples: Life or health insurance

Question 9

How does adverse selection cause market failure?

Answer 9

Creates a market failure by reducing the size of a market or eliminating it, preventing desirable transactions

Question 10

Adverse selection and moral hazard often..

Answer 10

Often rise together (eg insurance)

Question 11

Market for second-hand card is…?

Answer 11

A well known example of adverse selection

Question 12

In the second hand car market why might the uninformed not want to deal with the informed. Why?

Answer 12

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

Question 13

3 examples of adverse selection (w graphs)

Answer 13

1. Used car market with perfect information
2. Used car market with imperfect but symmetric information
3. Used car market with imperfect and asymmetric information

Question 14

What are the ways to reduce adverse selection?

Answer 14

1. Government intervention
2. Screening
3. Signalling

Question 15

How does government intervention reduce adverse selection?

Answer 15

Government intervention to prevent opportunism by better-informed sellers:
•Product liability laws
•Standards and certification

Question 16

How does screening reduce adverse selection?

Answer 16

Consumers can avoid lemons if they can obtain reliable information about quality

Question 17

How does signalling reduce adverse selection

Answer 17

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.

Question 18

Difference between origin of moral hazard vs adverse selection?

Answer 18

The problem arises from a hidden action, not a hidden characteristic as with adverse selection

Question 19

Does moral hazard lead to market failure?

Answer 19

Yes sometimes e.g. fire insurance for homes

Question 20

What is the effect of moral hazard?

Answer 20

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

Question 21

Why does moral hazard keep happening?

Answer 21

the decision maker’s actions cannot be properly monitored

Question 22

ways to reduce moral hazard

Answer 22

–Insurance: co-insurance or excess/deductible

–Owner/employer – employee relationships: monitoring, performance-based compensation (stock options etc.)

Question 23

Moral hazard requires ____ solutions than adverse selection

Answer 23

Moral hazard requires different kinds of solutions than adverse selection

Question 24

Moral hazard vs adverse selection solutions

Answer 24

Adverse selection: create mechanisms to transfer info to uninformed party

Moral hazard: create incentives for the informed party not to undertake harmful hidden actions

Question 25

Hidden characteristics lead to _____, hidden actions to_____?

Answer 25

Hidden characteristics lead to adverse selection, hidden actions to moral hazard

Question 26

Both adverse selection and moral hazard lead to…

Answer 26

inefficient market outcomes (market failure)

Question 27

How do deductibles and copayments reduce moral hazard?

Answer 27

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.

Question 28

How does monitoring and surveillance reduce moral hazard?

Answer 28

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.

Question 29

Why does signalling only work if “signal is credible” what does it mean by this?

Answer 29

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.