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notes_107 - Lecture Notes The most important development in...

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Lecture Notes The most important development in economics in the last forty years has been the study of incentives to achieve potential mutual gain when the parties have different degrees of knowledge. (Ken Arrow, Nobel Laureate in Economic Sciences) 1 What is Asymmetric Information and why it matters for Economics? Information is asymmetric in situations where one agent knows something that an- other agent does not. Asymmetric information affects agents’ behavior in many eco- nomic contexts, for example, when a firm knows more about the potential rewards of a business project than a bank that finances this project; a credit card owner knows more about her ability and willingness to repay her debt than the bank that issues this card; a seller of a used car (or any other durable good) is better informed about its quality than a buyer of this car; a customer knows her taste for a good or a service better than the firm that supplies and prices it; an employee knows his ability and his work ethics better than a firm that hires him; a person knows more about her health than a company that provides her life insurance or sells her an annuity (the annuity is a financial contract opposite to a life insurance: the buyer makes a lump-sum payment and gets an income flow as long as she lives); a person knows more about his driving habits than the company that provides his auto insurance. Asymmetric information has two general effects on economic behavior: adverse selection and moral hazard . Adverse selection arises when better-informed agents use their knowledge before signing a contract with a less-informed party. For example, a seller of used car may accept a low price but only if he knows that his car has a bad quality (that is, a “lemon”); a person may accept a credit card with a very high interest rate but only if she knows that she is likely to default on the card debt; a person may buy extensive health insurance but only if she knows that her health is likely to deteriorate soon;
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a business traveller may travel in a cheaper coach class rather than in the more expensive and luxurious first-class. On the other hand, moral hazard arises when agents take some hidden actions after signing a contract with a less-informed party. For example, a person may change his driving habits after buying a full auto insurance; a person may use a firm’s computers, printers etc. for her own private gain. Note that in order to promote his or her self-interest, the better-informed party may rely on lying and cheating. Economists usually assume that people are unscrupu- lous about such behavior, and would agree with Machiavelli 1 who writes A wise ruler, therefore, cannot and should not keep his word when such an observance of faith would be to his disadvantage and when the reasons which made him promise are removed. And if men were all good, this rule would not be good; but since men are a contemptible lot and will not keep their promises to you, you likewise need not keep yours to them.
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