© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Fernando & Yvonn Quijano Prepared by: Chapter 17 The Economics of Information

2 of 21 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Why Does State Farm Charge Young Men So Much More Than Young Women for Auto Insurance? 17.1Define asymmetric information and distinguish between adverse selection and moral hazard. 17.2Apply the concepts of adverse selection and moral hazard to financial markets. 17.3Apply the concepts of adverse selection and moral hazard to labor markets. 17.4Explain the winner’s curse and why it occurs. Learning Objectives In the market for insurance, asymmetric information leads to two problems: adverse selection and moral hazard.

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 Learning Objective 17.1 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. 4 of 21 Asymmetric Information Learning Objective 17.1 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. 5 of 21 Asymmetric Information Learning Objective 17.1 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.

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 21 Asymmetric Information Learning Objective 17.1 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.

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 21 Learning Objective 17.1 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. 8 of 21 Asymmetric Information Learning Objective 17.1 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

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 21 Adverse Selection and Moral Hazard in Financial Markets Learning Objective 17.2 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. 10 of 21 Learning Objective 17.2 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. 11 of 21 Adverse Selection and Moral Hazard in Labor Markets Learning Objective 17.3 Principal–agent problem A problem caused by agents pursuing their own interests rather than the interests of the principals who hired them. Efficiency wages. Seniority system. Profit sharing. Firms have several ways to make a worker’s job seem more valuable:

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 21 Solved Problem 17-3 Changing Workers’ Compensation to Reduce Adverse Selection and Moral Hazard Learning Objective 17.3 Compensation that depends on how much workers sell will reduce adverse selection and moral hazard.

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 21 The Winner’s Curse: When Is It Bad to Win an Auction? Learning Objective 17.4 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. FIGURE 17-1 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. 14 of 21 The Winner’s Curse: When Is It Bad to Win an Auction? Learning Objective “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. 15 of 21 Learning Objective 17.4 Is There a Winner’s Curse in the Marriage Market? Making the Connection A life of bliss or the winner’s curse?

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 21 The Winner’s Curse: When Is It Bad to Win an Auction? Learning Objective 17.4 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 Does the Winner’s Curse Apply?

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 21 Solved Problem 17-4 Auctions, Available Information, and the Winner’s Curse Learning Objective 17.4 When the bidders lack full information, the bids are farther apart, and farther from the true value of the item.

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 21 The Winner’s Curse: When Is It Bad to Win an Auction? Learning Objective 17.4 Pacific Telesis Uses the Winner’s Curse to Its Own Advantage Fear of the winner’s curse affected the bidding in auctions for wireless service in California.

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 21 Learning Objective 17.4 Want to Make Some Money? Try Auctioning a Jar of Coins Making the Connection The highest bidder on this jar of coins could lose money.

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 21 An Inside LOOK Should Bad Credit Increase Your Car Insurance Rate? Your Money: Bad Credit Can Inflate Car Insurance Premiums

Chapter 17: The Economics of Information © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 21 Adverse selection Asymmetric information Moral hazard Principal–agent problem Winner’s curse K e y T e r m s