LECTURE EIGHT ECONOMICS OF INFORMATION

Question 1

What is moral hazard?

Answer 1

A situation where individuals change their behavior to take more risks after purchasing insurance because they know they’re protected from losses

Question 2

Define adverse selection

Answer 2

A market failure that occurs when one party can’t recognize certain characteristics of the other party due to lack of information leading to poor selection of risks

Question 3

What is the principal-agent problem?

Answer 3

A situation where one person (principal) wants to induce another person (agent) to take action that is costly to the agent, but can’t directly observe the agent’s actions

Question 4

What are two main solutions to moral hazard problems?

Answer 4

1) Supervision/monitoring through hierarchical systems 2) Revenue-sharing plans where workers receive a percentage of revenue generated

Question 5

How do insurance companies typically address moral hazard?

Answer 5

By including deductibles or co-insurance in policies, making policyholders pay a portion of any losses

Question 6

What is an efficiency wage?

Answer 6

A wage that is set above the market-clearing level to incentivize workers not to shirk by making the cost of losing their job higher

Question 7

What is asymmetric information?

Answer 7

A situation where one economic agent knows something that another economic agent doesn’t, potentially causing market inefficiencies

Question 8

How is perfect competition’s assumption about information different from reality?

Answer 8

Perfect competition assumes complete knowledge about all variables, while in reality information is often costly or impossible to obtain

Question 9

What is the formula for expected profit when shirking?

Answer 9

Eprofit (Shirking) = P(w) + (1-p)ŵ, where P is probability of being caught, w is opportunity wage, and ŵ is actual wage

Question 10

What is the formula for expected profit when working?

Answer 10

Eprofit (working) = ŵ - ψ(e), where ŵ is actual wage, ψ is opportunity cost, and e is expected effort

Question 11

What’s the basic principle behind revenue-sharing plans?

Answer 11

Workers receive a percentage of company revenue, theoretically motivating them to work harder without need for monitoring

Question 12

Why might revenue-sharing plans fail to prevent shirking?

Answer 12

Because the cost of shirking is shared among all workers while the benefit goes to the individual, making the individual cost of shirking small

Question 13

How do insurance companies calculate premiums with adverse selection?

Answer 13

They use average probabilities across the population since they can’t distinguish between high and low-risk individuals

Question 14

What makes information gathering efficient according to the notes?

Answer 14

People gather information from cheapest sources first (low-hanging-fruit principle), and typically marginal benefit declines while marginal cost rises

Question 15

What role do sales agents play in markets with incomplete information?

Answer 15

They add economic value by helping goods reach consumers who value them most, potentially increasing total economic surplus

Question 16

How does adverse selection differ from moral hazard?

Answer 16

Adverse selection involves hidden characteristics before a transaction, while moral hazard involves hidden actions after a transaction

Question 17

What is the mathematical representation of a worker’s utility function?

Answer 17

U(w,e) = w – ψ(e), where w is wage and ψ(e) represents the cost of effort

Question 18

Why do insurance companies need to charge more than the expected loss?

Answer 18

To cover administrative costs and protect against the possibility of adverse selection

Question 19

What conditions must be met for a worker not to shirk?

Answer 19

The expected profit from working must exceed the expected profit from shirking: ŵ - ψ(e*) > P(w) + (1-p)ŵ

Question 20

How does incomplete information affect market efficiency?

Answer 20

It can lead to market failures, reduced trade, and the need for mechanisms like monitoring or incentive structures to ensure proper functioning

Question 21

What is the relationship between information and cost?

Answer 21

Information is generally costly to acquire, with diminishing marginal benefits and increasing marginal costs as more information is gathered

Question 22

Why do safe customers pay less for insurance than risky ones?

Answer 22

Because their probability of making claims is lower, making them less costly for insurance companies to cover

Question 23

What role does monitoring play in preventing moral hazard?

Answer 23

It increases the probability of catching shirking behavior, but comes with its own costs that must be balanced against benefits

Question 24

How do deductibles help solve moral hazard in insurance?

Answer 24

They make policyholders share in the cost of losses, maintaining their incentive to be careful despite having insurance

Question 25

What makes monitoring costs inefficient?

Answer 25

The combination of paying efficiency wages and maintaining monitoring staff can become excessively expensive for companies