Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 21 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.

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 21 Asymmetric Information Reducing Adverse Selection in the Car Market: Warranties and Reputations 1 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. 2 Car manufacturers must indicate whether a used car they are offering for sale was repurchased from the original owner as a lemon. Some states have passed “lemon laws” to help reduce information problems in the car market. Most lemon laws have two main provisions:

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 21 Asymmetric Information 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. 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.

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 21 Does Adverse Selection Explain Why Some People Do Not Have Health Insurance? Making the Connection

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 21 Asymmetric Information Moral hazard The actions people take after they have entered into a transaction that make the other party to the transaction worse off. People with health insurance go to the doctor more often than they would without insurance. After a company obtains fire insurance for its warehouse, it is less careful about avoiding fire hazards. A firm sells stocks and bonds, then opens an unneeded office in Paris to which managers make frequent trips – or the managers could just steal the funds.

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 21 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 SEC requires that firms register stocks or bonds they wish to sell with the SEC and provide potential investors with a prospectus that contains all relevant financial information on the firms. Reducing Adverse Selection and Moral Hazard in Financial Markets

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 21 Using Government Policy to Reduce Moral Hazard in Investments Making the Connection The government has intervened to increase the confidence of investors in the securities traded on the New York Stock Exchange and in other financial markets.

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 21 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. Oil Company Bids to Drill Off the Louisiana Coast

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 21 The Winner’s Curse: When Is It Bad to Win an Auction? 1 “In competitive bidding, the winner tends to be the player who most overestimates true tract value.” 2 “He who bids on a parcel what he thinks it is worth will, in the long run, be taken to the cleaners.”

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 21 The Winner’s Curse: When Is It Bad to Win an Auction? 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. When the bidders lack full information, the bids are farther apart, and farther from the true value of the item. The winner’s curse does not occur in private value auctions (such as most auctions on ebay).