Chapter 10: Information. In this chapter you will learn: What information asymmetries are, and why they matter for economic decision making; how to differentiate between screening and signaling and describe some applications of each; how reputations can help to solve information problems;...
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Chapter 10
Information
What will you learn in this chapter?
matter for economic decision making
–Adverse selection
–Moral hazard
and describe some applications of each
problems
information problems
overcoming information asymmetry problems
Information: Knowledge is power
• Many times in economic analyses it is assumed
that individuals are fully informed
fully informed about the choices that they and other
relevant economic actors face
availability, and prices of comparable goods when
engaging in transactions
• Rarely do individuals have perfectly complete
information
acceptable choices
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Information asymmetry
• When one person knows more than the other
during an agreement, information asymmetry
occurs.
• When one person knows much more than the
other, that person can achieve what he wants
at the other’s expense.
are not aligned
Information asymmetry
• Two important types of information asymmetry
are:
–Adverse selection: Occurs prior to completing an
agreement when buyers and sellers have different
information about the quality of a good or the riskiness
of a situation
•Relates to unobserved characteristics.
–Moral hazard: The tendency for people to behave in a
riskier way or to renege on contracts when they do not
face the full consequences of their actions after an
agreement has been made
•Relates to actions of those involved in the agreement.
Adverse selection and the lemons problem
• An example of adverse selection is the lemons
problem in the used‐car market.
characteristics of their cars than potential buyers
have the same information as the seller
•Buyers will be suspicious that the car may be a lemon.
•Buyers will not pay as much unless certain of its quality.
underpaid
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Adverse selection and the lemons problem
• What happens if sellers refuse to be underpaid?
• If buyers can’t distinguish lemons from high quality cars, the
cars cannot be segmented and only one price exists
• Sellers of high quality used cars won’t accept less than fair‐
market value for their cars and won’t sell
• This unravels the market, as buyers perceive average quality
decreasing, and the price lowers; as the price lowers, the
sellers of the next highest quality cars choose to not sell
• As this process continues, with the price continually falling and
sellers choosing not sell their car, market failure occurs
Active Learning: Combating adverse selection
How is adverse selection combatted in the used car
market?
Principal–agent problems and moral hazard
• Asymmetric information can also cause problems after
selection has occurred and two parties have entered an
agreement.
• The problem occurs when one person in the agreement does
not face the full consequences of their actions
–One example is the principal‐agent problem, when a person called a
principal entrusts someone else, called an agent, with a task.
– Employers ( principal ) make an agreement with employees ( agents ) to
do a set of tasks.
– Employees have an incentive to not work as hard as they can.
– Employers may find it costly to monitor employees’ efforts.
• Moral hazard is the tendency for people to behave in a riskier
way or to renege on contracts when they do not face the full
consequences of their actions
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Active Learning: Combating moral hazard
How is moral hazard combatted in the principal‐agent
problem?
Solving information problems
• Many information asymmetries can be
rectified.
• The question is whether the cost is worth
acquiring more information.
costly
• Many times the cost of obtaining the missing
information is less than the benefit of being
informed.
Solving information problems
–Screening: Reveals private information
–Signaling: Taking action to reveal one’s own private
information
–Reputation: If interactions occur multiple times, parties can
use their past history to indicate that the other party has
full information
–Statistical discrimination: Generalizing based on observable
characteristics to fill in missing information
–Regulation: The government requires information
disclosure or requires participation in a market
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Summary
sometimes they don’t have enough information to
make good decisions
that individuals have perfect information
–Information asymmetry can allow one person to take
advantage of another
–In other cases, markets may fall apart because people are
afraid to trade with one another
derail what appear to be clever programs or business
models
–Screening and signaling are among the ways to correct
these inefficiencies