Chapter 22Definitions: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 measurableadverse event occurs.Examples of social insurance:Social SecurityUnemployment InsuranceDisability InsuranceWorkers’ CompensationMedicareMedicaid▪ Hidden Action:Ex: A worker knows more than his employer about how much effort he puts into his job.▪ Hidden Characteristic: 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 PaymentAgent- A person who is performing an act for another person, called the principalPrincipal- A person from whom another person, called the agent, is performing some actAdverse 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 otherEx: Used Car Market, Insurance, Labor Market▪ INVISIBLE HAND DOES NOT WORKAsymmetric Information and Adverse SelectionSellers 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 productScreening- When and uninformed party takes action to induce the informed party to reveal private informationRisk 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 screeningPolitical Economy (Public Choice)- The study of Government using the analytic methods of economicsVOTING▪ Majority gets its way!Condorcet Paradox- The failure of majority rule to produce transitive preferencesfor societyTransitivity- If A beats B, and B beats C, then A should beat CUnanimity- If everyone prefers A to B then A should beat BIndependent of Irrelevant Alternatives- The ranking between any 2 outcomes Aand B should not depend on whether some third outcome C is also availableNo Dictators- There is no person who always gets his way, regardless of everyoneelse’s preference Arrow’s Impossibility Theorem- Mathematical result showing that no form of voting is efficientMedian 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 votersBehavioral Economics- Subfield of economics that integrates the insights of psychology▪ Homo Economicus- Rational▪ Homo Sapiens- Complex▪ Satisficers- Make decisions that are good enoughHuman Decision Making▪ People are overconfident▪ People give too much weight to a small number of vivid observations▪ People are reluctant to change their mindsUltimatum Game- 2 players given $100 while one splits it up to see if the other willtake his
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