Slide 1Econ 410: Micro TheoryApplications of Asymmetric InformationFriday, October 12th, 2007Slide 2Asymmetric Information What are some possible solutions to problems of asymmetric information? Pooling Risks Example – Group Health Insurance Risk is spread over a large “pool” of people Reputation and Standardization Reputation - People “hear” about restaurants or stores that have good or bad service/quality Standardization - Chains that keep production the same everywhere Examples - McDonald’s, Starbucks, SearsSlide 3Asymmetric Information Example – Major League Baseball Before 1976, a player’s team was the only group allowed to renew a player’s contract Does asymmetric information exist about baseball players? Baseball teams might have more information about their players than others Free agents What are they? Are free agents “lemons”? Slide 4Asymmetric Information Are free agents “lemons”?268.917.234.67Free Agents103.49.684.76Renewed Players165.412.554.73All PlayersPercent ChangePost ContractPre ContractDays on Disabled List per Season Free agents have a significantly higher disability rate than renewed players Indication of a “lemons” market268.917.234.67Free Agents103.49.684.76Renewed Players165.412.554.73All PlayersPercent ChangePost ContractPre ContractDays on Disabled List per SeasonSlide 5Market Signaling Signaling is another way the market can find a solution to problems of asymmetric information. What is signaling, anyway? A way for sellers to convey information to buyers about their product. Who can be considered a “seller”? Examples of signaling Dressing well for a job interview Obtaining a degreeSlide 6Market Signaling A signal is weak if it is easy to send Example – Wearing a suit to a job interview may be a weak signal, because unproductive employees could also dress well. A strong signal must be easier for high quality sellers to give than low quality sellers Example – Academic ability and worker productivity A GED or a high school degree?Slide 7Market Signaling What might be some other examples of market signaling? Warranties Firms use warranties as a signal to identify high quality and dependability Warranties can be a strong signal, because the cost of warranties to low-quality producers is too high Are extended warranties signaling or insurance?Slide 8Moral Hazard As we have discussed, asymmetric information exists in the insurance industry People know more about personal risks than insurance companies do Moral hazard occurs when an individual is not held accountable for the full cost of their actions An individual may act differently in a situation depending on whether or not they are insuredSlide 9Moral Hazard Examples of Moral Hazard in Insurance If my home is insured, I might be less likely to lock my doors or install a security system If my health insurance fully covers visits to the Student Health Center, I might schedule more doctor appointments than if the visits weren’t free Other examples of Moral Hazard The Fed?Slide 10Moral Hazard Why is moral hazard a problem? Example – Fire Insurance Suppose State Farm wants to insure a warehouse worth $100,000 The owners of the warehouse can take precautions to prevent a fire If they take precautions, Pr(Fire) = ½% If they do not take precautions, Pr(Fire) = 1% What are the incentives for the warehouse owners if… ? Taking precautions is costly The owners of the warehouse are fully insuredSlide 11Moral Hazard Suppose the insurance company cannot monitor to see if precautions are taken How will they determine premiums? With the program, an actuarially fair premium would be: 0.005 x $100,000 = $500 But, once insured, owners no longer have an incentive to take precautions The probability of a loss increases to 1% In order to avoid an expected loss, the insurance company must raise premiums to at least $1000Slide 12Moral Hazard Why else might moral hazard be a problem? Situations involving moral hazard could alter the ability of markets to allocate resources efficiently Example – The demand for health care If there is no moral hazard, let the marginal cost of health care be equal to MCH But, increasing doctor visits as a result of moral hazard will increase insurance premiums and the total cost of careSlide 13Moral HazardVisits per Year$101Marginal cost to the patientper visit$25$50$100D = MBMH2(w/moral hazard)• Health insurance companies cannot always measure if a doctor visit is necessary. • When insured, the marginal cost of a visit decreases and the number of visits increases to 5 per year – an inefficient allocation.5MH1(no moral hazard)3Slide 14The Principal-Agent problem Employees are usually better informed about their work productivity than owners are The principal-agent problem arises when agents (employees) pursue their own goals, rather than the goals of the principal (firm).  Employees could pursue their own goals even at a cost of reduced profits for the firmSlide 15The Principal-Agent problem The principal-agent problem in the “real world” Only 16 of 100 largest corporations have individual family or financial institution ownership exceeding 10% Asymmetric information makes monitoring management costly What do companies do about this problem? Incentive schemes – aligning the goals of employees and firms Careful monitoringSlide 16For next time… We’ll begin our discussion of Chapter 18 by talking about externalities Make sure you have read… Section 17.2 of your text.  Note: Because we have not discussed production yet, do not worry about understanding the formal economic model in great detail. For next time, read: The September 20thWall Street Journal article Sections 17.3, 18.1, and pp. 627-630 of your