The Economics of Asymmetric Information



The Economics of Asymmetric Information – Mankiw p. 599

In many situations in life, information is asymmetric: One person in a transaction knows more about what is going on than the other person. This possibility raises a variety of interesting problems for economic theory. Some of these problems were highlighted in our description of the theory of efficiency wages. These problems, however, go beyond the study of unemployment.

The worker-quality variant of efficiency-wage theory illustrated a general principle called adverse selection. Adverse selection arises when one person knows more about the attributes of a good than another and, as a result, the uninformed person runs the risk of being sold a good of low quality. In the case of worker quality, for instance, workers have better information about their own abilities than firms do. When a firm cuts the wage it pays, the selection of workers changes in a way that is adverse to the firm.

Adverse selection arises in many other circumstances. Here are two examples:

1. Sellers of used cars know their vehicles’ defects, whereas buyers often do not. Because owners of the worst cars are more likely to sell them than are the owners of the best cars, buyers are correctly apprehensive about getting a ‘lemon’. As a result, many people avoid buying cars in the used car market.

2. Buyers of health insurance know more about their own health problems than do insurance companies. Because people with greater hidden health problems are more likely to buy health insurance than are other people, the price of health insurance reflects the costs of a sicker-than-average person. As a result, people with average health problems are discouraged by the high price from buying health insurance.

In each case, the market for the product – used cars or health insurance – does not work as well as it might because of the problem of adverse selection.

Similarly, the worker-effort variant of efficiency-wage theory illustrates a general phenomenon called moral hazard. Moral hazard arises when one person, called the agent, is performing some task on behalf of another person, called the principal. Because the principal cannot monitor the agent’s behaviour, the agent tends to undertake less effort than the principal considers desirable. The term moral hazard refers to the risk of dishonest or otherwise inappropriate behaviour by the agent. In such a situation, the principal tries various ways to encourage the agent to act more responsibly.

In an employment situation, the firm is the principal and the worker is the agent. The moral-hazard problem is the temptation of imperfectly monitored workers to shrink their responsibilities. According to the worker-effort variant of efficiency-wage theory, the principal can encourage the agent not to shirk by paying a wage above the equilibrium level because then the agent has more to lose if caught shirking. In this way, high wages reduce the problem of moral hazard.

Moral hazard arises in many other situations. Here are some examples:

• A homeowner with fire insurance buys too few fire extinguishers. The reason is that the homeowner bears the cost of the extinguisher while the insurance company receives much of the benefit.

• A babysitter allows children to watch more television than the parents of the children prefer. The reason is that more educational activities require more energy from the babysitter, even though they are beneficial for the children.

• A family lives near a river with a high risk of flooding. The reason it continues to live there is that the family enjoys the scenic views, and the government will bear part of the cost when it provides disaster relief after a flood.

Possible Solutions to the problem of Asymmetric Information

Second – hand Car Market

Some used car dealers offer guarantees to shift the risk from the buyer to the seller, but this does little to help private parties trying to buy or sell used cars. To help solve the problem, some governments have passed ‘Lemon Laws’ to protect used car buyers from unscrupulous sellers, and regulatory bodies can provide product information and investigates consumer complaints. Buyers can also find information in publications like Consumer Reports, which provides quality, safety and other information on a wide variety of products.

Insurance market

The task for health insurance companies is to provide incentives for people to reveal how healthy they really are. One technique is to require a medical examination, but this may put off applicants who only fear that they might not be healthy. Another strategy is to offer insurance with the lure that no one will be turned down – but such policies inevitably contain a clause (in fine print) saying that benefits are greatly reduced in the first few years of coverage. In this case the insurance company is betting that if people have reason to believe that they are going to die soon, they will die quickly.

Finance market

A particularly interesting agency problem is the potential conflict between shareholders and debt holders. When creditors lend funds to the firm, they charge interest rates based on the riskiness of the firm’s existing assets, capital structure, and other factors. Suppose that management, in the interest of the shareholders, takes on a new and especially risky project. If the project is a failure, the shareholders and bondholders will share in the losses, but if the project is successful, only the shareholders will gain. High profits benefit shareholders through higher dividends, but the return on debt capital is fixed, so bondholders will receive none of these benefits.

To solve the shareholder/creditor conflicts, creditors often protect themselves with agreements that restrict the actions of the firm. The manager/shareholder agency problem can be solved by paying managers with share dividends and other performance incentives; this makes the goals of managers and shareholders more consistent. Many firms also take actions to monitor management behaviour or design organisational structures that place limits on managerial actions.

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download