lesson 12 - assymetric info Flashcards
assymetric info
a situation where one party in a transaction has more info than the other party. leads to market ineffeciencies
adverse selection
Adverse selection occurs when one party in a transaction has more information about the quality of the good or service than the other party. This leads to a situation where only low-quality goods or services are traded, driving high-quality ones from the market. Example: The used car market (lemons problem): Sellers know the quality of their cars better than buyers, leading buyers to offer a lower price that discourages sellers of high-quality cars from entering the market.
Explain Akerlof’s “market for lemons” model. What’s the key result?
when buyers cant differentiate between high and low quality goods, the average quality offered in the market decreases.
- bcoz high quality goods will leave the market as they cant get a fair price
- result = market where primarily low quality goods are traded
affect of adverse selection on insurance markets
ppl who are more likely to need insurance (higher risk) are more likely to buy it
- Insurance companies, facing higher average costs, must charge higher premiums. This discourages lower-risk individuals from buying insurance, further increasing the average risk profile of those insured. This can lead to a “market unraveling,” where only the highest-risk individuals are insured.
statistical discrimination
Statistical discrimination occurs when decision-makers (e.g., employers) use group averages to predict individual characteristics, even when it’s inaccurate. This often leads to discriminatory outcomes for individuals from disadvantaged groups. Example: An employer might be hesitant to hire someone from a group with a statistically lower average productivity, even if the individual applicant is highly qualified.
moral hazard
Moral hazard arises when one party takes more risks because the costs of those risks are borne by another party. Example: After buying insurance, individuals might be less careful because the insurance company will cover potential losses (e.g., driving more recklessly after getting car insurance).
afect on insurance markets by moral hazard
Insurance reduces the cost of risky behavior for the insured. This can lead to increased risk-taking (and higher claims). To offset these increased costs, insurance companies raise premiums, which can lead to market inefficiencies.
Explain the principal-agent problem and its relationship to moral hazard.
The principal-agent problem occurs when one party (the principal) hires another (the agent) to perform a task, but the principal cannot perfectly monitor the agent’s actions. Moral hazard arises because the agent may act in their self-interest (e.g., shirking responsibilities) rather than the principal’s best interest.
solutions and mitigations
-pooling risks
-screening
-monitoring
-signaling
-aligning incentives
reputation and institutaional solutions
pooling risks - adverse selection
Mandating participation in insurance programs (e.g., government-sponsored health insurance) helps to pool risks and reduce adverse selection. By including everyone in the system, it is less likely that only high-risk individuals will participate, resulting in unsustainable premiums.
Screening (Adverse Selection and Moral Hazard)
Screening involves gathering information to distinguish between high and low quality or risk. Examples: Credit checks, background checks, medical exams before issuing insurance.
Monitoring (Moral Hazard)
Monitoring involves observing the actions of the agent to ensure they’re acting in the principal’s interest. Examples: Regular inspections of commercial property (to verify fire safety measures), performance reviews for employees.
Signaling (Adverse Selection)
Signaling involves the informed party taking costly actions to credibly signal their type (high quality or low risk). Examples: Guarantees, warranties, education (as a signal of ability in job markets). The signal must be costly enough to deter the uninformed party from mimicking it.
Aligning Incentives (Moral Hazard)
Designing contracts that incentivize agents to act in the principal’s interest can reduce moral hazard. Examples: Performance-based pay, co-pays and deductibles for insurance.
Reputation and Institutional Solutions
A good reputation can help to overcome adverse selection, as consumers are more likely to trust reputable firms. Lemon laws (mandating warranties) help signal quality and mitigate the lemons problem. Government regulations can also address asymmetric information problems by improving information disclosure or increasing transparency.