Chapter 17 Asymmetric Information
Asymmetric information is a situation in which one side of an economic relationship has better information than the other.
Hidden characteristics are things that one side of a transaction knows about itself that the other side would like to know but does not.
Hidden actions are actions taken by one side of an economic relationship that the other side of the relationship cannot observe.
17.1 Signaling and Screening
Another Look at Price Discrimination
Three conditions must be satisfied for price discrimination to be profitable:
1. The firm must be a price maker.
2. The firm must be able to identify customers with different demands for its product.
3. The consumers must not be able to engage in arbitrage.
Companies may use a signal, an observable indicator of a hidden characteristic, to determine a person’s willingness to pay.
A self-selection device is a mechanism in which an informed party in an economic relationship is offered a set of options, and the choice made by the informed party reveals his or her hidden characteristic. (For example, charging higher prices for flights that don’t include a weekend results in business people revealing themselves.)
Screening is an uninformed party’s attempt to sort the informed parties.
Normative Analysis of Second-Degree Price Discrimination
Second-degree price discrimination can raise the seller’s profit. The effect on consumers is mixed – it’s good for the consumer who would have been priced out of the market, but now can purchase a the good, but bad for a person who would have gotten a lower price, but now pays something higher.
Screening occurs in the real world in airline ticket pricing, as described in the text book example. The same was true of train tickets in the 1850’s.
Competitive Market Signaling
It could be argued that going to college is merely a signal for employers that the student is a highly skilled individual, rather than college being useful because of the skills that are learned there. This signal works because workers differ in their taste for education in a way that is systematically related to ability.
Normative Analysis of Education as a Signal
The only effect of signaling is to change the distribution of income across workers of different types. High and low- ability workers can be differentiated. It has a positive effect on the educated individuals’ income, but a negative effect on other workers’ income. Overall, workers are worse off by the full cost of education.
Is Education Really Just a Signal?
There is considerable anecdotal evidence that the screening model of education has some validity. However, there is also evidence that education is not solely a deadweight loss. The human capital model of education cannot be dismissed.
17.2 Adverse Selection
Adverse selection is the phenomenon under which the uninformed side of a deal gets exactly the wrong people trading with it (i.e. it gets an adverse selection of the informed parties.)
More on Insurance Markets
Two people may have different needs for insurance (e.g. different probabilities of being sued), and their personal probabilities/risks are known to themselves, but not to the insurance agents.
The Full-Information Equilibrium
Under full information, the insurance premium for a high-risk person would be higher than that for a person with lower risks.
The Asymmetric-Information Equilibrium
The equilibrium price under these conditions will be based on the average fair odds line for all people in the market. For those with high risk, the equilibrium price is actuarially unfair in their favor, and they buy as much insurance as they can (complete insurance). Those with less risk face an equilibrium price that is actuarially unfair, not in their favor, so they buy less than full insurance.
The Efficiency Effects of Adverse Selection
In the asymmetric situation, risk averse people are forced to bear risk. Further, asymmetry of information, not just the lack of information, is the key to the problem.
Market Responses to Adverse Selection
Insurance and Testing for AIDS: Some insurance companies want to test for AIDS in order to prevent these people from purchasing insurance (or charge them a higher premium) – testing would identify these high-risk customers, and this would reduce insurance premiums for others.
Group Health Plans: Having automatic enrollment in an employee or other group health plan helps the insurance company to avoid adverse selection, because everyone has to join – not just those likely to have high health-care expenses.
Targeted Insurance Rates: Some companies offer higher rates to teenage drivers, or people who have been in accidents, for example.
Other Markets in Which Adverse Selection is Important
Efficiency wages refers to the practice of raising wages to improve the productivity of the work force. The idea is that by paying a higher wage, a firm gets workers who are on average more productive, which makes the wage increase profitable to the firm. (With low wages, only low-ability workers would apply for the job.)
The Market for Human Blood
If hospitals pay for blood donations, people argue that the people who are driven by profit to donate blood are more likely to have medical issues with their blood than voluntary donors.
Government Responses to Hidden Characteristics
Many Western industrialized nations rely on programs that don’t allow self-selection, such as Social Security – everyone is a part of it. Governments may also help avoid adverse reaction by using information policies – they don’t allow false advertising – which hurts companies with bad products and helps good products, because firms can tell the truth without being suspected of lying.
17.3 Hidden Actions
In situations of hidden actions, the problem is that you cannot observe someone’s actions. You can hire a worker, but you can’t constantly monitor how hard they’re working. These situations exemplify the principle-agent relationship, in which the principle hires a second party, the agent, to perform some task on the principle’s behalf. These situations have three important features:
1. One side of the economic relationship, the agent, takes an action that affects the other side, the principle.
2. The principle cannot observe the action taken by the agent.
3. The principle and the agent disagree on what action is best for the agent to take. (The agent would rather relax, but the principle wants them to work.)
Moral Hazard in Insurance Markets
Moral hazard is another name given to situations of hidden action, because in such cases, the informed side may take the “wrong” action.
Fire Prevention in the Absence of Insurance
Without insurance, a rational decision maker would purchase care (fire proof linens, detectors, etc.) just up to the point where marginal benefit and marginal cost are equal.
Moral Hazard and the Effects of Insurance
When the homeowner purchases insurance, the marginal benefit of care shifts downward. With insurance, the homeowner’s marginal benefit of care is equal to the cost of care at a much lower level – the homeowner undertakes less care when insured.
Efficiency Effects of Moral Hazard
The problem is that the insurance does nothing to reduce the total cost of a fire to society as a whole – total surplus falls because the homeowner takes too little care to prevent the fire.
Co-Insurance and Deductibles
Co-insurance is a provision in insurance policies under which the policy picks up some percentage of the bill for damages when there is a claim. A deductible is a provision in an insurance policy under which the person buying insurance has to pay the initial damages up to some set limit. Co-insurance, or a co-payment, increases the value of investing in care for the homeowner.
The employee’s welfare rises as he shirks more, but the employer’s profit falls – the more the employee shirks, the less effort he devotes to running the firm and maximizing its profit.
The owners’ income is equal to the vertical distance between the profit curve and the employees indifference curve. When the amount of shirking is observable, the owners choose the level of shirking at which this distance is greatest. At this level of shirking, the owners are paying the employee the lowest amount possible to keep him from quitting his job.
A Flat Salary: If the employee receives a flat salary, the opportunity cost of shirking in terms of foregone consumption of all other goods is zero. The only limit on the amount of time spent shirking is the amount of time spent at work.
Performance-Based Compensation: A residual claimant is a party to a contract who gets all of the leftover, or “residual,” profit. The result in the residual claimant is the same one that arises when effort is observable.
(1) Why do people paid on salary do any work? Not everyone considers shirking an economic good – they may take pride in their jobs. Also, there may be some monitoring of employees, or some type of performance pay (at least in raises).
(2) If residual claimant contracts have such good incentive properties, why aren’t all contracts of this form? This has to do mostly with the level of risk that individuals are willing to take on. However, some firms do use incentive pay. A piece rate is a pay scheme under which an employee gets paid a fixed amount for each unit of output (“piece”) that he produces.
Moral Hazard in Product Markets
It’s possible to have moral hazard problems by firms – for example, you pay for a movie without knowing its quality (while the film-makers are aware of quality).
Reputation as a Hostage
One of the most important market responses to the problems of moral hazard is the development of reputations and brand names.
For the threatened loss of reputation to be an effective deterrent to cheating, having a good reputation must allow the firm to earn positive economic profits on future sales.