HO2e Micro Ch17

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2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien, 2e.

Fernando & Yvonn Quijano

Prepared by:

Chapter

17

The Economics

of Information


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2 of 21 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien, 2e.

Why Does State Farm

Charge Young Men So

Much More Than Young

Women for Auto Insu rance?

17.1 Define asymmetric information

and distinguish between adverse

selectionand moral hazard.

17.2 Apply the concepts of adverse

selection and moral hazard to

financial markets.

17.3 Apply the concepts of adverse

selection and moral hazard to

labor markets.

17.4 Explain the winners curseand

why it occurs.

Learning Objectives

In the market for insurance,

asymmetric information leads

to two problems: adverse

selection and moral hazard.


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2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien, 2e. 3 of 21

Asymmetric Information

LearningObjective 17.1

Asymmetric information A

situation in which one party to

an economic transaction has less

information than the other party.

Adverse Selection and the Market for Lemons

Adverse selection The situation

in which one party to a transaction

takes advantage of knowing morethan the other party to the

transaction.


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Reducing Adverse Selection in the Car Market:

Warranties and Reputations

1 New cars that need several major repairs

during the first year or two after the date of

the original purchase may be returned to

the manufacturer for a full refund.

2 Car manufacturers must indicate whether

a used car they are offering for sale was

repurchased from the original owner as

a lemon.

Some states have passed lemon laws to help

reduce information problems in the car market.

Most lemon laws have two main provisions:


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Asymmetric Information in the Market for Insurance

Asymmetric information problems are particularly

severe in the market for insurance.

Buyers of insurance policies will always know

more about the likelihood of the event beinginsured against happening than will insurance

companies.


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Reducing Adverse Selection in the Insurance Market

To reduce the problem of adverse selection, insurance

companies gather as much information as they can on

people applying for policies.

People applying for individual health insurance policiesor life insurance policies usually need to submit their

medical records to the insurance company.


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Does Adverse Select ion Explain Why Som e

People Do Not Have Health Insu rance?

Makingthe

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Moral Hazard

Moral hazard The actions

people take after they have

entered into a transaction that

make the other party to

the transaction worse off.

Dont Let This Happen toYOU!Dont Confuse Adverse Selection with Moral Hazard


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Adverse Selection and Moral Hazard

in Financial Markets


In response to investor complaints after the

stock market crash of 1929, Congress

established the Securities and ExchangeCommission(SEC) to regulate the stock and

bond markets.

The SEC requires that firms register stocks or

bonds they wish to sell with the SEC and

provide potential investors with aprospectusthat contains all relevant financial information

on the firms.

Reducing Adverse Selection and Moral Hazard

in Financial Markets


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Using Government Pol icy to Reduce

Moral Hazard in Investm ents

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The government has intervened to

increase the confidence of investors

in the securities traded on the New

York Stock Exchange and in other

financial markets.


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Adverse Selection and Moral Hazard in Labor Markets


Principalagent problemA problemcaused by agents pursuing their own

interests rather than the interests of

the principals who hired them.

Efficiency wages.

Seniority system.

Profit sharing.

Firms have several ways to make a workersjob seem more valuable:


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SolvedProblem 17-3

Changing Workers Compensation to

Reduce Adverse Selection and Moral Hazard


Compensation that depends

on how much workers sell will

reduce adverse selection andmoral hazard.


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The Winners Curse: When Is It Bad to Win an Auction?


Winners curse The idea that the winner in certain

auctions may have overestimated the value of thegood, thus ending up worse off than the losers.

FIGURE 17-1

Oil Company Bids to Drill

Off the Louisiana Coast


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1 In competitive bidding, the winner tends

to be the player who most overestimates

true tract value.

2 He who bids on a parcel what he thinks it

is worth will, in the long run, be taken tothe cleaners.

i Obj i 1 4


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Is There a Winners Curse

in the Marriage Market?

Makingthe

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A life of bliss or the winners curse?

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Does the winners curse indicate that the

winner of every auction would have been

better off losing?

No, because the winners curse appliesonly to auctions of common-valueassets

such as oil fieldsthat would be given the

same value by all bidders if they had

perfect information.

When Does the Winners Curse Apply?

L i Obj ti 17 4


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SolvedProblem 17-4

Auctions, Available Information, and the Winners Curse


When the bidders lack full

information, the bids are

farther apart, and farther fromthe true value of the item.

L i Obj ti 17 4


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Pacific Telesis Uses the Winners Curse

to Its Own Advantage

Fear of the winners curse affected the bidding in auctions

for wireless service in California.

L i Obj ti 17 4


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Want to Make Some Money?

Try Auct ion ing a Jar of Coins

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The highest bidder on this jar of

coins could lose money.


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An Inside LOOK Should Bad Credit Increase

Your Car Insurance Rate?

Your Money: Bad Credit Can Inflate Car Insurance Premiums


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G O

Adverse selection

Asymmetric information

Moral hazard

Principalagent problem

Winners curse

K e y T e r m s

Documents

HO2e Micro Ch17