Chapter 22 Definitions Information Asymmetry A difference in access to relevant knowledge Insurance Customer pays premiums to insurance company no matter what happens Insurance company pays benefits to customer if some measurable Examples of social insurance adverse event occurs Social Security Unemployment Insurance Disability Insurance Workers Compensation Medicare Medicaid Hidden Action into his job Hidden Characteristic Ex A worker knows more than his employer about how much effort he puts Ex A seller of a used car knows more than the buyer about the car s condition In each case the uninformed party the employer the car buyer would like to know the relevant information but the informed party the worker the car seller may have an incentive to conceal it Moral Hazard Tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behavior Can be avoided by Better Monitoring High Wages Delayed Payment Agent A person who is performing an act for another person called the principal Principal A person from whom another person called the agent is performing some act Adverse Selection A tendency for the mix of unobserved attributes to become desirable from the standpoint of an uninformed party Problem arises when one sellers knows more than the other Ex Used Car Market Insurance Labor Market INVISIBLE HAND DOES NOT WORK Asymmetric Information and Adverse Selection Sellers of used cars know the vehicle very well Buyers do not Sellers might be selling because the car is a lemon Buyers might avoid the used car market because they can t trust sellers People who sell good used cars will typically get less than the car is worth People with good used cars to sell will be unwilling to sell them Only cars being sold really are lemons This reduces demand even more Vicious cycle Market may collapse entirely In used car market the seller knows more than the buyer In insurance markets the buyer often knows more than the seller Signaling An action taken by and informed party to reveal private information to an uninformed party The informed party the firm the student uses the signal to convince the uninformed party the customer the employer that the informed party is offering something of high quality The signal must be less costly or more beneficial to the person with the higher quality Screening When and uninformed party takes action to induce the informed party to reveal private information product Risk Premium amount that customer is willing to pay for insurance above and beyond the actuarially fair price The private market can sometimes deal with the information asymmetries on its own using a combination of signaling and screening Political Economy Public Choice The study of Government using the analytic methods of economics VOTING Majority gets its way for society Condorcet Paradox The failure of majority rule to produce transitive preferences Transitivity If A beats B and B beats C then A should beat C Unanimity If everyone prefers A to B then A should beat B Independent of Irrelevant Alternatives The ranking between any 2 outcomes A should not depend on whether some third outcome C is also available No Dictators There is no person who always gets his way regardless of everyone and B else s preference voting is efficient Arrow s Impossibility Theorem Mathematical result showing that no form of Median Voter Theorem Mathematical result showing that if voters are choosing a point along a line and each voter wants the point closest to his preferred point the majority rule will pick the most preferred point of the median voter EXACTLY IN THE MIDDLE OF THE DISTRIBUTION Median voters most preferred outcome beats all challengers Average preferred outcome Preferred outcomes number of voters Modal outcome The one preferred by the greatest number of voters Behavioral Economics Subfield of economics that integrates the insights of psychology Homo Economicus Rational Homo Sapiens Complex Satisficers Make decisions that are good enough Human Decision Making People are overconfident People give too much weight to a small number of vivid observations People are reluctant to change their minds Ultimatum Game 2 players given 100 while one splits it up to see if the other will take his offer
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