Chapter 10: Information. In this chapter you will learn: What information asymmetries are, and why they matter for economic decision making; how to differentiate between screening and signaling and describe some applications of each; how reputations can help to solve information problems;...
Chapter10 Information â2014byMcGrawHillEducation Whatwillyoulearninthischapter? ã Whatinformationasymmetriesare,andwhythey matterforeconomicdecisionmaking Adverseselection – Moral hazard • How to differentiate between screening and signaling and describe some applications of each • How reputations can help to solve information problems • How statistical discrimination might be used to solve informationproblems ã Theusesandlimitationsofeducationandregulationin overcominginformationasymmetryproblems â2014byMcGrawHillEducation Information:Knowledgeispower ã Manytimesineconomicanalysesitisassumed thatindividualsarefullyinformed – Individuals have complete information when they are fully informed about the choices that they and other relevant economic actors face – For example, buyers and sellers understand the quality, availability, and prices of comparable goods when engaging in transactions • Rarely do individuals have perfectly complete information – Often they have sufficient information to make acceptable choices – Sometimes it may lead to poor outcomes © 2014 by McGraw‐Hill Education Information asymmetry • When one person knows more than the other during an agreement, information asymmetry occurs • When one person knows much more than the other, that person can achieve what he wants at the other’s expense – This occurs only because both parties’ incentives arenotaligned Ifbothpartiesincentivesarealigned,then informationasymmetriesdonotmatter â2014byMcGrawHillEducation Informationasymmetry ã Twoimportanttypesofinformationasymmetry are: – Adverse selection: Occurs prior to completing an agreement when buyers and sellers have different information about the quality of a good or the riskiness of a situation • Relates to unobserved characteristics – Moral hazard: The tendency for people to behave in a riskier way or to renege on contracts when they do not facethefullconsequencesoftheiractionsafteran agreementhasbeenmade ã Relatestoactions ofthoseinvolvedintheagreement â2014byMcGrawHillEducation Adverseselectionandthelemonsproblem ã Anexampleofadverseselectionisthelemons problem in the used‐car market – Used car sellers know more about the characteristics of their cars than potential buyers – Test drives won’t necessarily reveal quality of a car – Buyers of used cars are aware that they do not have the same information as the seller • Buyerswillbesuspiciousthatthecarmaybealemon ã Buyerswillnotpayasmuchunlesscertainofitsquality Usedcarsellersthatprovidehighqualitycarsare underpaid â2014byMcGrawHillEducation Adverseselectionandthelemonsproblem • What happens if sellers refuse to be underpaid? • If buyers can’t distinguish lemons from high quality cars, the cars cannot be segmented and only one price exists • Sellers of high quality used cars won’t accept less than fair‐ market value for their cars and won’t sell • This unravels the market, as buyers perceive average quality decreasing,andtheprice lowers;asthepricelowers,the sellersofthenexthighestqualitycarschoosetonotsell ã Asthisprocesscontinues,withthepricecontinuallyfallingand sellerschoosingnotselltheircar,marketfailureoccurs â2014byMcGrawHillEducation ActiveLearning:Combatingadverseselection Howisadverseselectioncombattedintheusedcar market? â2014byMcGrawHillEducation Principalagentproblemsandmoralhazard ã Asymmetricinformationcanalsocauseproblemsafter selectionhasoccurredandtwopartieshaveenteredan agreement. ã Theproblemoccurswhenonepersonintheagreementdoes not face the full consequences of their actions – One example is the principal‐agent problem, when a person called a principal entrusts someone else, called an agent, with a task – Employers (principal) make an agreement with employees (agents) to do a set of tasks – Employees have an incentive to not work as hard as they can Employersmayfinditcostlytomonitoremployeesefforts ã Moralhazardisthetendencyforpeopletobehaveinariskier wayortorenegeoncontractswhentheydonotfacethefull consequencesoftheiractions â2014byMcGrawHillEducation ActiveLearning:Combatingmoralhazard Howismoralhazardcombattedintheprincipalagent problem? â2014byMcGrawHillEducation 10 Solvinginformationproblems ã Manyinformationasymmetriescanbe rectified ã Thequestioniswhetherthecostisworth acquiringmoreinformation Solvinginformationasymmetriesmaybeextremely costly ã Manytimesthecostofobtainingthemissing informationislessthanthebenefitofbeing informed â2014byMcGrawHillEducation 11 Solving information problems • There are a few ways to solve information asymmetries – Screening: Reveals private information – Signaling: Taking action to reveal one’s own private information – Reputation: If interactions occur multiple times, parties can use their past history to indicate that the other party has full information – Statistical discrimination: Generalizing based on observable characteristics to fill in missing information – Regulation: The government requires information disclosure or requires participation in a market • In all of these solutions, they must not be easily faked © 2014 by McGraw‐Hill Education 12 Summary • People make decisions based on what they know, but sometimes they don’t have enough information to make good decisions • One of the key assumptions behind perfect markets is that individuals have perfect information – Information asymmetry can allow one person to take advantage of another – In other cases, markets may fall apart because people are afraid to trade with one another • Problems like adverse selection and moral hazard can derail what appear to be clever programs or business models – Screening and signaling are among the ways to correct these inefficiencies © 2014 by McGraw‐Hill Education 13 ... â2014byMcGrawHillEducation 10 Solvinginformationproblems ã Manyinformationasymmetriescanbe rectified ã Thequestioniswhetherthecostisworth acquiringmoreinformation Solvinginformationasymmetriesmaybeextremely... arenotaligned Ifbothpartiesincentivesarealigned,then informationasymmetriesdonotmatter â2014byMcGrawHillEducation Informationasymmetry ã Twoimportanttypesofinformationasymmetry are: – Adverse selection: Occurs prior to completing an ... Manytimesthecostofobtainingthemissing informationislessthanthebenefitofbeing informed â2014byMcGrawHillEducation 11 Solving? ?information? ?problems • There are a few ways to solve? ?information? ?asymmetries –