Information Economics

Dr. Katherine Sauer A Citizens Guide to Economics ECO 1040

Overview: I. Information Asymmetry II. Private Solutions

I. Asymmetric Information - a situation where parties have a difference in their access to relevant knowledge

What was the Hope Scholarship Program?

Why was it doomed to fail?

What does this have to do with information?

When information asymmetry is too large, markets may not function properly.

2 Basic Types of Asymmetric Information 1. Hidden Actions One partys behavior cannot be fully observed by another party. 2. Hidden Characteristics A feature of a product or person is unknown to another party.

1. Hidden Actions When someones actions are not fully observable by another party, problems can arise.

Moral Hazard is when a party protected from risk behaves differently than it would behave if it were fully exposed to the risk. - tendency to act less carefully when not bearing full consequences of an action

Examples: - a person with automobile insurance may be less cautious about locking car may park in more dangerous areas because: negative consequences of vehicle theft are partially the responsibility of the insurance company

- a renter may be less diligent about checking their residence for mold may be less careful about keeping the carpets clean because: they arent the long run owners

Moral Hazard is a key feature of the principal-agent problem.

2. Hidden Characteristics Some of the characteristics of a person or object can not be fully observed. - person has a pre-disposition to cancer - used car has a transmission that is about to fail

Adverse Selection is the tendency for the mix of unobserved attributes to become undesirable from the standpoint of the uninformed party. Explain adverse selection using the market for lemons.

Example: People who have health issues are also the ones who most want health insurance. - from the point of the insurance firm, there is adverse selection of people to insure

How is information asymmetry present in the health care market?

Hidden Actions vs Hidden Characteristics A person who is not fully monitored may take actions that are undesirable from the point of view of the uninformed party. - hidden action - principle-agent type problems A person or product may have an inherent quality that is viewed as undesirable from the point of view of the uninformed party. - hidden characteristic - adverse selection problems

II. Private Solutions 1. Signaling is an action taken by an informed party to reveal private information to an uninformed party.

Examples: - college degree - Car Fax report for used vehicle - the clothes you wear - branding by businesses

How does branding help consumers?

How does branding help firms?

2. Screening is an action taken by an uninformed party to induce an informed party to reveal information.

Examples: - take a used car to a mechanic before buying - insurance gives you choice of deductibles - employer advertises that they do mandatory drug testing

Additionally, the uninformed party could provide incentives for the informed party to act in a certain way.

Problem: renters not taking good care of apartment - the main reason is because they dont have any longterm stake in the property - charging a security deposit gives renters an incentive to care for the apartment

Problem: a cashier might pocket cash and not ring in the sale - the key feature of an illegitimate transaction is the lack of a receipt - a simple sign giving customers an incentive to alert management if they dont get a receipt solves the problem - knowing this, the cashier probably wont steal the money

Problem: people with insurance are not as careful with their belongings - the main reason is because the individual doesnt bear the full consequence if something happens - insurance companies require to you pay a deductible if you file a claim - because you are responsible for part of the bill, you are more likely to be conscientious in your filing of claims

Signaling vs Screening Signaling is an action that the informed party undertakes in the attempt of conveying information to an uninformed party. - advertising - your resume - clothes you wear Screening is an action that the uniformed party undertakes in the attempt of learning more about the informed party. - undergo a physical before you can buy life insurance - job ad lists a college degree as a qualification

Summary: Imbalanced information can cause problems. Hidden actions and hidden characteristics are two types of information asymmetry. Signaling and screening are two ways that parties try to solve information asymmetry issues.

What did you learn today?

Please explain 2 concepts from todays class.