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3. 17 CHAPTER The Economicsof Information In the market for insurance, asymmetric information leads to adverse selection and moral hazard. Prepared by: Fernando Quijano

4. 17 Chapter OutlineandLearning Objectives CHAPTER The Economicsof Information

5. 17.1 LEARNING OBJECTIVE Define asymmetric information and distinguish between adverse selection and moral hazard. Asymmetric Information Asymmetric information A situation in which one party to an economic transaction has less information than the other party. Adverse Selection and the Market for “Lemons” Adverse selection The situation in which one party to a transaction takes advantage of knowing more than the other party to the transaction.

6. 17.1 LEARNING OBJECTIVE Define asymmetric information and distinguish between adverse selection and moral hazard. Asymmetric Information Reducing Adverse Selection in the Car Market:Warranties and Reputations Some states have passed “lemon laws” to help reduce information problems in the car market. Most lemon laws have two main provisions: New cars that need several major repairs during the first year or two after the date of the original purchase may be returned to the manufacturer for a full refund. Car manufacturers must indicate whether a used car they are offering for sale was repurchased from the original owner as a lemon.

7. 17.1 LEARNING OBJECTIVE Define asymmetric information and distinguish between adverse selection and moral hazard. Asymmetric Information Asymmetric Information in the Market for Insurance Asymmetric information problems are particularly severe in the market for insurance. Buyers of insurance policies will always know more about the likelihood of the event being insured against happening than will insurance companies.

8. 17.1 LEARNING OBJECTIVE Define asymmetric information and distinguish between adverse selection and moral hazard. Asymmetric Information Reducing Adverse Selection in the Insurance Market To reduce the problem of adverse selection, insurance companies gather as much information as they can on people applying for policies. People applying for individual health insurance policies or life insurance policies usually need to submit their medical records to the insurance company.

9. 17.1 LEARNING OBJECTIVE MakingtheConnection Define asymmetric information and distinguish between adverse selection and moral hazard. • Does Adverse Selection ExplainWhy Some People Do Not Have Health Insurance? Some economists have argued that adverse selection may be an important explanation for the significant percentage of people lacking health insurance in the United States. • YOUR TURN:Test your understanding by doing related problems 1.10 and 1.11 at the end of this chapter.

10. 17.1 LEARNING OBJECTIVE • YOUR TURN:Test your understanding by doing related problems1.13 and 3.3 at the end of this chapter. Define asymmetric information and distinguish between adverse selection and moral hazard. Asymmetric Information Moral Hazard Moral hazard The actions people take after they have entered into a transaction that make the other party to the transaction worse off. Don’t Let This Happen to YOU!Don’t Confuse Adverse Selection with Moral Hazard

11. 17.2 LEARNING OBJECTIVE Apply the concepts of adverse selection and moral hazard to financial markets. Adverse Selection and Moral Hazard in Financial Markets Reducing Adverse Selection and Moral Hazard in Financial Markets In response to investor complaints after the stock market crash of 1929, Congress established the Securities and Exchange Commission (SEC) to regulate the stock and bond markets. The failure of a number of large financial firms and the steep decline in stock prices from 2007 to 2009 made it clear that information problems still exist in financial markets.

12. 17.2 LEARNING OBJECTIVE MakingtheConnection Apply the concepts of adverse selection and moral hazard to financial markets. Moral Hazard, Big Time: Bernie Madoff’s “Ponzi” Scheme To economists, the lesson of the Madoff case was that to cope with moral hazard, investors need to be sure they understand how their funds are being invested (many of Madoff ’s investors didn’t) and to remember that if the return on an investment seems too good to be true, it probably is. Bernard Madoff perpetrated a Ponzi scheme that bilked investors of many billions of dollars. • YOUR TURN:Test your understanding by doing related problem 2.6 at the end of this chapter.

13. 17.3 LEARNING OBJECTIVE Apply the concepts of adverse selection and moral hazard to labor markets. Adverse Selection and Moral Hazardin Labor Markets Principal–agent problem A problem caused by agents pursuing their own interests rather than the interests of the principals who hired them. Firms have several ways to make a worker’s job seem more valuable: • Efficiency wages. • Seniority system. • Profit sharing.

14. 17.3 LEARNING OBJECTIVE 17-3 Solved Problem • YOUR TURN:For more practice, do related problem 3.4 at the end of the chapter. Apply the concepts of adverse selection and moral hazard to labor markets. Changing Workers’ Compensation to Reduce Adverse Selection and Moral Hazard Compensation that depends on how much workers sell will reduce adverse selection and moral hazard.

15. 17.4 LEARNING OBJECTIVE Explain the winner’s curse and why it occurs. The Winner’s Curse: When Is It Bad to Win an Auction? Winner’s curse The idea that the winner in certain auctions may have overestimated the value of the good, thus ending up worse off than the losers. Why were the winning bidders in government auctions of oil fields disappointed with their profits? “In competitive bidding, the winner tends to be the player who most overestimates true tract value.” “He who bids on a parcel what he thinks it is worth will, in the long run, be taken to the cleaners.”

16. 17.4 LEARNING OBJECTIVE Explain the winner’s curse and why it occurs. The Winner’s Curse: When Is It Bad to Win an Auction? FIGURE 17-1 Oil Company Bids to DrillOff the Louisiana Coast In 1967, seven oil companies bid to drill on land off the Louisiana coast. The bids by oil companies differ widely because the amount of oil contained in any particular tract of land up for bid is very uncertain. The company that has the most optimistic estimate is likely to win the auction. It is also likely to be disappointed in the profits it earns from the tract.

17. 17.4 LEARNING OBJECTIVE MakingtheConnection Is There a Winner’s Cursein the Marriage Market? Explain the winner’s curse and why it occurs. if your estimate of how desirable someone is as a marriage partner is much higher than other people’s estimates, you have a good chance of marrying that person—but also a good chance of discovering later that your estimate was wrong. A life of bliss or the winner’s curse? • YOUR TURN:Test your understanding by doing related problem 4.7 at the end of this chapter.

18. 17.4 LEARNING OBJECTIVE Explain the winner’s curse and why it occurs. The Winner’s Curse: When Is It Bad to Win an Auction? When Does the Winner’s Curse Apply? Does the winner’s curse indicate that the winner of every auction would have been better off losing? No, because the winner’s curse applies only to auctions of common-value assets—such as oil fields—that would be given the same value by all bidders if they had perfect information.

19. 17.4 LEARNING OBJECTIVE 17-4 Solved Problem Explain the winner’s curse and why it occurs. Auctions, Available Information, and the Winner’s Curse When the bidders lack full information, the bids are farther apart, and farther from the true value of the item. • YOUR TURN:For more practice, do related problem 4.5 at the end of this chapter.

20. 17.4 LEARNING OBJECTIVE MakingtheConnection Want to Make Some Money?Try Auctioning a Jar of Coins Explain the winner’s curse and why it occurs. Fill a jar with coins. Let a group of people—everyone in your economics class?—inspect the jar. Then auction off the jar: Whoever makes the highest bid gets the jar. In an experiment conducted by Max Bazerman of Harvard University and William Samuelson of Boston University, the students’ average estimate of the value of the coins or paper clips in the jar was too low—just $5.13. Despite this, the average of the winning bids in the 48 auctions for the jars was $10.01, so on average the high bidders lost $2.01. These MBA students had fallen victim to the winner’s curse. The highest bidder on this jar of coins could lose money. • YOUR TURN:Test your understanding by doing related problem 4.10 at the end of this chapter.

21. AN INSIDE LOOKat Policy >> Pay Less for Car insurance! (But We’ll be Watching How You Drive) Bill Would Allow Insurance to Offer Pay-as-You-Drive Plan Information lowers price and increases quantity in the insurance market.

22. KEY TERMS Adverse selection Asymmetric information Moral hazard Principal–agent problem Winner’s curse