chapter 19: asymmetric information Flashcards
Asymmetric information:
A situation in which one party knows more about its own actions or characteristics than another party.
If information is costly to obtain, then it is no longer plausible that buyers and sellers have the same information. Asymmetric information may cause significant problems with the efficient functioning of a market.
- Labor market: Workers know what they are capable of doing, their talent,… employers do not.
Example: The market for lemons
- Outcome with asymmetric information
- None of the plums ever get sold. Even though the willingness to pay is
higher than the willingness to sell. No transactions will take place.
Adverse selection
The low-quality items crowded out the high-quality items because of the high cost of acquiring information.
Adverse selection in health insurance3
There is asymmetric information: Health status is only known to the insured
and not to the insurance company.
For a given insurance premium, health insurance would be more attractive to
an individual who faces a high risk of illness.
An increase in the insurance premium will increase the overall riskiness of the
pool of individuals who buy an insurance policy. The market for health insurance can disappear.
Solutions: Mandatory health insurance, health insurance offered by employees.
moral hazard
is a phenomenon whereby an insured party exercises less care
than he would in the absence of insurance
Insurance companies deal with moral hazard:
- They only pay for damage in cases in which the insured party could demonstrate that his or her recklessness or neglect was not the cause of the accident.
- Different premiums for people who did not yet have an accident.
- Deductable provides incentives for careful driving.
hidden action problem.
Moral hazard refers to situations where one side of the market can’t observe the actions of the other. For this reason it is sometimes called a hidden action problem.
hidden information problem.
Adverse selection refers to situations where one side of the market can’t observe the “type” or quality of the goods on other side of the market. For this reason it is sometimes called a hidden information problem.
Signaling
In the used-car market, the owners of the good used cars would like to signal
the quality of their car to those who might buy it.
Signaling helps to make the market perform better. By offering the warranty or promis to pay the consumer when it is a lemon, the sellers of the good cars can distinguish themselves from the sellers of the bad used cars.
separating equilibrium
since the equilibrium involves each type of worker making a choice that allows
him to separate himself from the other type.
eg., If each able worker chooses education
level e∗ and each unable worker chooses a zero educational level, then no worker has any reason to change his or her behavior.
principal agent problem
occurs when one person (the agent) has to do
something for another person (the principal).
Compensation schemes must be consistent with profit maximization on the part of firms, but they should also provide workers with the incentives to do as well as possible.
What is good for the agent is not (necessarily) good for the principal, and the principal cannot always observe what the agent does.
Pay for performance can alleviate both moral hazard and adverse selection
problems.
- Moral hazard problems may be reduced because well-designed incentive
compensation motivates the employee to work harder. - Adverse selection may be reduced because potential applicants who are a
poor fit may be deterred from applying to the job as they expect that they
will not perform well and thus not be highly compensated.
These findings are confirmed by Lazear (2000) who studies a firm that switched
from a fixed wage to a pay for performance compensation scheme.
- Workers who worked under both compensation schemes were more
productive under the pay for performance scheme. - New hires were more productive than workers who were already at the firm
before the reform.
pareto dominated
A situation is called Pareto-dominated if there exists a possible Pareto improvement. So if a change in resources benefits at least one person while harming no one else.
