Economics 410 Managerial Economics Tuesday September 7, 1999 Moral Hazard Adverse Selection

Game Theory Asymmetric Information Moral Hazard Adverse Selection I. Incentive Contracting

Game Theory Moral Hazard I. Incentive Contracting

Game Theory I. Incentive Contracting What is “Moral Hazard?” Post-contractual behavior (normally behavior adverse to the interests of the other party)

Examples of Moral Hazard Fire Insurance Term Life Insurance (?) Health Insurance Economics 410

Examples of Moral Hazard The Labor Market? Tenure? Shirking?

Game Theory Moral Hazard Adverse Selection I. Incentive Contracting

Game Theory I. Incentive Contracting What is “adverse selection?” A choice made available to an entire group is chosen only by those to whom it appeals

Game Theory I. Incentive Contracting The choice made is typically “adverse” to the interests of the agent providing the choice “adverse selection”

Examples of “Adverse Selection” Interest Rates on Loans Health Insurance Term Life Insurance Wage Rates

So, What’s The Point about “Adverse Selection” Explains some economic phenomena that are otherwise not explainable –Excess loan demand at current rates –Not charging the highest rate possible Explains “universal” coverage concepts –Everyone in the firm in the health plan –Those who don’t need insurance subsidize those who do need insurance –Insurance companies want all of your business because a bad health risk might not be a bad fire insurance risk Incentive for “screening” –Members of USTA or Golf Associations

Game Theory Asymmetric Information Moral Hazard Adverse Selection I. Incentive Contracting

Sometimes Hard To Tell Which May Be Operating Volvo Owners Have More Traffic Accidents –Moral Hazard? –Adverse Selection? Commerce Students Get High Grades –Moral Hazard? –Adverse Selection?

One More Game The Prisoner’s Dilemma Two Robbers Get Caught Decision: Confess or Don’t Confess

Consequences If both confess, they each receive 10 year sentence If neither confess, they each get 3 year sentence If one confesses but not the other, the one who confesses goes free, but the other receives a 20 year jail term.

Possibilities Confess Don’t ConfessDon’t 3 yrs 10 yrs Free 20 yrs Free

Significance of Prisoner’s Dilemma Individual’s maximizing behavior may lead to suboptimal results for the group Implications in biology and other fields

The End