Managerial Economics

Asymmetric Information, Adverse Selection & Moral Hazard

By Vasantharajan S Taranpreet Kaur Pankaj Kumar Shubham Mukharya Swapnil Bhosale Sec - B

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Table of Contents
1. Asymmetric Information 1.1 Causes of Asymmetric Information 1.2 Consequences of Asymmetric Information 1.3 Relation to Markets 2. Adverse Selection 2.1 Causes of Adverse Selection 2.2 Consequences of Adverse Selection 2.3 The Lemons Problem 2.4 Solutions to the Lemons Problem 2.5 Conclusion 2.6 General Solution to Asymmetric Information 3. Moral Hazard 3.1 History 3.2 Common Examples of Moral Hazard 3.3 Moral Hazard in the Insurance Industry 3.4 Ways to Reduce the Problem of Moral Hazard 4. Principal-Agent Problem 4.1 When Does This Problem Arise??? 4.2 Solution to Reduce Principal-Agent Problem 5. Signalling 5.1 Illustration with Interview Example 5.2 Key Factors of Signalling 6. Screening 6.1 Examples

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1.Asymmetric Information
Asymmetric information is an imbalance in the quality or quantity of information possessed by two or more people. Some people simply have more information than others. This asymmetry is a direct consequence of efficient information search. Because the acquisition of information, like the production of any good, uses scarce resources and incurs an opportunity cost, no one knows everything and everyone is ignorant about something (usually most things). In particular, those who stand to benefit more are rationally motivated to incur greater cost and thus obtain more information.

1.1 Causes of Asymmetric Information

Asymmetric Information can arise due to a number of factors. The following is a classification of the most probable causes of Asymmetric Information.

1.1.1 Addiction
Hardcore smokers and drug addicts maybe so addicted that they didnt even realize the possible health problems they may be facing in near future. By the time they are aware, it could be too late already

1.1.2 Misleading information

Companies that sell junk food often use persuasive advertisement to lure kids into consuming unhealthy stuffs. It may come along with free toys, interesting animation and of course making those kids in the advertisement look so cool when eating it. As such the demand for junk food can increase and the consumption will be more than optimal

1.1.3 Uncertainties of costs and benefits

Benefit: Information provides different benefits to different people. Most people
receive little benefit knowing the wages paid to computer programmers in India. However, this information is bound to be extremely beneficial to a student majoring in computer programming. There are quite a number of young people who choose to drop out from school and start working at young age. That is because they see the short term monetary reward from working. However, they may not realize the potential private benefits accrued to them in the long run. Another will be savings for retirement. Many young people choose to enjoy while young and start saving at later age. The problem is, they are unaware of the danger of getting into debts due to excessive spending. Also they are unaware of the point where they need to kick start savings.

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Cost: The acquisition of information requires the use of scarce resources and thus
incurs a cost. This means that everyone stops short of obtaining complete information. It's just not worth the cost; it's not worth the effort. And because people benefit differently from information, some pursue more search effort, and have more information, while others do less and end up with less.The bottom line is that those who stand to benefit most from information are willing to incur the necessary search cost. And those who benefit less are not.

1.2 Consequences of Asymmetric Information

The unequal distribution of information throughout the economy gives rise to three related problems -- adverse selection, moral hazard, and the principal-agent problem. Asymmetric information can result in market inefficiency that limits the quality of goods exchanged in a market (adverse selection). It can also lead to a discrepancy between who benefits from an action and who incurs the cost (moral hazard). And it can cause a disconnection in the objectives of an agent authorized to represent a principal and the principal who is unaware of the specific actions of the agent (principal-agent problem).

1.3 Relation to Markets

Asymmetric information shows up in most market exchanges. Rarely do both sides of the market have equal information about the good exchanged. Because they produce or at least have control of the good, sellers generally have better information than the buyers. Sellers are more likely to know the pros and cons of the good, the features and defects, and what it can do and what it can't. Buyers, in contrast, are likely to be less familiar with the good. They often gain possession of the good only after purchase and any information obtained about the good prior to purchase is usually limited to that provided by the seller. Asymmetric information is particular important in the financial markets. Stock prices are based in large part on the information buyers and sellers have about productivity and profitability of the company. Those with better information are usually more successful at "buying low and selling high." The financial market for insurance also relies heavily on accurate information. For example, the insured generally have better information about their own health than the health insurance providers. The employment of labour is another market where asymmetric information plays a key role. Employees have more information about their own skills, talents, and productivity than do employers.

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2.Adverse Selection
A market process where undesired results occur when both buyers and sellers have asymmetric information. As a consequence Bad products or services are more likely to be selected by the buyer. It is also called Negative Selection or Anti-Selection. It arises when the lack of information limits the quality of goods exchanged.

2.1 What Leads To Adverse Selection?

Some people (buyers) give more importance to acquire the information and some do not. So, all buyers have different information depending on their degree of intent to acquire information. An average buyer always has less information when compared to the seller. Thus, lack of equal distribution of information gives advantage to the seller who knows everything about the product. Sellers know more than the buyers which gives rise to Adverse Selection.

2.2 Consequence of Adverse Selection

Sellers have complete or more accurate information of the product. Buyers have relatively less accurate information of the product. So, buyers are likely to offer lower price for the product. Since majority of the buyers offer a low price for the product the seller is unable to keep up his profit margin. So in order to reduce the cost the sellers compromise on quality. To state simply, since the buyers keep offering low price for the product, the sellers are discouraged from offering good quality products in the market. The result of this is the existence of Market of low quality products.

2.3 The Lemons Problem

2.3.1 Introduction to the Lemons Problem
Timely, relevant information is crucial for functional, efficient markets. However, in certain industries and for some credence goods, consumers may not be able to thoroughly evaluate the goods or services they are thinking about purchasing. Credence Goods are types of goods with qualities that cannot be observed by the consumer after purchase, making it difficult to assess its utility. Typical examples of credence goods include expert services such as medical procedures, automobile repairs and dietary supplements. This leads to the possibility of the lemons problem. We'll look at this problem in detail and provide some tips for resolving it.

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2.3.2 The Problem Statement

The lemons problem theory states that certain industries are susceptible to asymmetric information, which can lead to a decrease in product price because the buyer is unsure about any potential problems that the asset might have, and will thus demand a deep discount. Asymmetric information occurs when a seller has more or better information than a buyer. The lemons problem theory makes reference to unsuccessful investments that, like lemons, leave a bitter taste. The most common use of the term "lemon" is when it is applied to low-quality cars offered for sale in a used car market.

2.3.3 Illustration with Example of Used Cars Market

To understand how asymmetric information can produce a market of mostly lowquality goods and services, consider a used car market with only one type of car. One group of sellers is offering automobiles in good shape for $13,000, and another group is selling lowquality automobiles, or lemons, for $7,000. The average price that a buyer would be willing to pay for a car from this market is $10,000 ([$13,000 + $7,000]/2).

At a $10,000 average price point, only the sellers of low-quality cars will be willing to sell. Because sellers of high-quality cars want $13,000, most will not be willing to sell for $10,000. So this market would deal primarily in lemons, thus reducing overall product quality.

In addition to certain industries that are susceptible to asymmetric information, specific products or services known as credence goods are also prone to lemon problems. The utility of credence goods is difficult for a consumer to assess. Therefore, the value of such an item may be unclear, both before and after a consumer has purchased it.

It is reasonable to assume that consumers are able to judge the value of goods such as food, office supplies and appliances. However, it is difficult for consumers to fully value credence goods and services such as automobiles, dietary supplements and healthcare because of asymmetric information, leading to the possibility of the lemons problem. In terms of an auto purchase, for example, the numerous problems facing the vehicle might not surface immediately after the purchase.

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2.4 Solutions to the Lemons Problem

2.4.1 Guarantees and Warranties
Guarantees and warranties benefit both the firm, by attracting customers with an assurance of higher quality goods and services, as well as consumers who, in the case of receiving a faulty product, can return the item or have it replaced. Almost all electronic device makers, for example, offer warranties.

2.4.2 Industry Standards

Firms may set requirements to produce goods and services that meet industry standards, thus attracting customers who might not be able to properly evaluate the industry's products and services. This method is practiced most often by high-quality producers of goods and services who wish to differentiate themselves from low-quality producers.

2.4.3 External Product Certification

Similar to creating industry standards, firms may attain external product certification so that consumers can rely on expert verification of the quality of their goods and services.

2.4.4. Consumer Protection Regulation

In many industries and governments act to address asymmetric information by implementing consumer protection laws designed to set a standard by which all firms must legally comply. For example, credit card issuers are subject to consumer protection laws set forth by the government.

2.4.5. Liability Laws

Liability laws are a part of consumer protection regulations as established by the government. Firms may be subject to penalties and fines if minimum industry standards are not met.

2.4.6. Licensing
Licensing falls under consumer protection regulations as well. A firm, such as a public utility, might require a license by the government to sell certain goods and services.

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2.4.7. Social Regulation

Social regulation is a significant measure taken by government when other consumer protection laws fail to provide adequate regulatory functions. Oversight of a nation's banking industry is a type of social regulation designed to protect everyone.

2.5 Conclusion
When consumers aren't able to fully assess the things they are purchasing, there is always a chance they are going to get a lemon. Access to information, coupled with other market and regulatory solutions, can reduce the probability of the lemons problem and increase product quality and overall consumer satisfaction.

2.6 General Solution to Asymmetric Information

There are almost always going to be situations where consumers will not be able to make an educated purchasing decision, increasing the probability of the lemons problem. Asymmetric information and the lemon market problem are prevalent in many industries, most prominently in the automobile, banking, healthcare, pharmaceutical and professional services industries.

2.6.1 Increase the Amount of Information

Fortunately, there are solutions to the problem of asymmetric information. Among these solutions, increasing the access to information is paramount. Giving consumers greater access to information directly addresses the problem of asymmetric information. It is nearly impossible to provide every consumer with all the information they need to make an informed purchase decision in each instance, but if consumers can obtain enough information to make an educated decision, overall product quality can be increased, along with aggregate consumer satisfaction. Consider once again the previous example of a used car market. A consumer without access to any external information would most likely have to rely on the word of the dealer. Access to information, such as a website, helps address the problem of asymmetrical information. Consumers may be able to check a dealer's track record on a website or they could find a list of local mechanics who can examine the used car before the purchase is made. If previous buyers are able to post comments on the website, new buyers may be forewarned about an unscrupulous dealer selling lemons. Consumers could even educate themselves regarding basic mechanical and electrical issues that could be problematic in a low-quality car.

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3.Moral Hazard
Moral hazard is a situation where a party tends to take risks because the costs that could incur will not be felt by the party taking the risk. The party is more willing to take risks as the potential costs will be taken cared by the other party. It arises because an individual or institution does not take the full consequences and responsibilities of its actions, and hence has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions. It is a special case of information asymmetry, in which one party in a transaction has more information than another. It occurs when the party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk. As a result, the insured party tends to behave inappropriately from the perspective of the party with less information. Moral hazard also arises in the principalagent problem. In principal agent problem, the party which performs on behalf of the other party is known as agent and the other party is known as the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately if the interests of the agent and the principal are not aligned.

3.1 History
The term was first used in 17th. Earlier it was used as a negative which meant fraud or immoral behaviour. But in 1960s, some economists renewed the study and used the term to describe inefficiencies that can occur when risks are displaced or cannot be fully evaluated, rather than a description of the ethics or morals of the involved parties. Economist Paul Krugman described moral hazard as "any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.

3.2 Common Examples of Moral Hazard

3.2.1 Not installing a smoke alarm because you have fire insurance
When you have fire insurance for your home or work place, you tend to become careless and dont install fire alarm as you feel that the insurance company will pay for any miss happening that takes place.

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3.2.2 Roughly driving a rental car

When you are driving someone elses car or any other vehicle for that matter, you drive roughly you dont own that vehicle. If anything happens to that vehicle, you are not the one who has to bear the repairing costs.

3.2.3 Driving roughly as you have car insurance

When you have insurance for your vehicle, you tend to drive roughly on the road as the insurance company will pay if any accident takes place.

3.2.4 Being careless as a doctor because you have malpractice insurance

When a doctor has malpractice insurance, he becomes a bit careless and doesnt perform his job with full dedication and concentration.

3.3 Moral Hazard in Insurance Industry

In insurance industry, moral hazard occurs when the behaviour of the insured person changes in a way that raises costs for the insurance company, since the insured party no longer bears the full costs of that behaviour. For example, because the insured person no longer bear the cost of medical services, he has an added incentive to ask for pricier and more elaborate medical service, which would otherwise not be necessary. In these instances, he has a tendency to over consume, simply because he no longer bears the full cost of medical services.

3.3.1 Types of behaviours of the insured person

Ex ante moral hazard
In this case, insured person behaves in a more risky manner, resulting in more negative consequences that the insurer must pay for. For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurer. After purchasing fire insurance, some may tend to be less careful about preventing fires.

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Ex post moral hazard

It is the reaction to the negative consequences of risk, once they have occurred and once insurance is provided to cover their costs. In this case, insured person does not behave in a more risky manner that results in more negative consequences, but he/she do ask the insurer to pay for more of the negative consequences from risk as insurance coverage increases. For example, without medical insurance, some may forgo medical treatment due to its costs and simply deal with substandard health. But after medical insurance becomes available, some may ask an insurance provider to pay for the cost of medical treatment that would not have occurred otherwise.

3.4 Ways to reduce the Problem of Moral Hazard

3.4.1 Deductible
In an insurance policy, deductible is the amount of expenses that must be paid out of pocket before an insurer will pay any expenses. Deductibles are used to deter the large number of trivial claims that a consumer can be reasonably expected to bear the cost of. By restricting its coverage to events that are significant enough to incur large costs, the insurance firm expects to pay out slightly smaller amounts much less frequently, incurring much higher savings. As a result, insurance premiums are typically cheaper when they involve higher deductibles. For example, phone companies offer replacement plans, with deductible set at the level of wholesale price of the phone. As added benefit to them, the customer does not switch to different company as they often do with new phone purchase. Several deductibles can be set by the insurer based on the cause of the claim. For example, a single housing insurance policy may contain multiple deductible amounts for loss or damage arising from theft, fire, natural calamities, evacuation etc.

3.4.2 Coinsurance
Co-insurance is a policy provision under which the insured and the insurance company share the total cost of covered services after the deductible has been met set as fixed percentages. For example, the two parties can divide the cost in 75-25% ratio. This means that if the total cost is Rs 1000, then insurance company will pay Rs 750 and the insured person will pay Rs 250. A deductible is commonly used together with coinsurance. In this case, the insured person would pay the deductible amount first and after that the person would have the leftover coinsurance amount.

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4. Principle Agent Problem

It is the problem concerning the difficulties in motivating one party (agent), to act in the best interests of another ("principal") rather than in his or her own interests. Principals create incentives for the agent to act as the principal wants, because the principal faces information asymmetry and risk with regards to whether the agent has effectively completed a contract. The principal-agent problem can be associated as part of agency theory. It has similarities to game theory in that the "rules" are changed to favour specific actions favoured by the principal. Principal-agent problem is a particular game-theoretic description of a situation. There is a player called a principal, and one or more other players called agents with utility functions that are in some sense different from the principal's. The principal can act more effectively through the agents than directly, and must construct incentive schemes to get them to behave at least partly according to the principal's interests. The principal-agent problem is that of designing the incentive scheme. The actions of the agents may not be observable so it is not usually sufficient for the principal just to condition payment on the actions of the agents.

4.1 When Does This Problem Arise???

When one party is being paid by another to do something, whether in formal employment or in a negotiated deal (such as paying for household jobs or car repair) or the two parties have different interests and asymmetric information especially. When activities that are useful to the principal are costly to the agent, and Where elements of what the agent does are costly for the principal to observe.

Common cases where this problem arises are Restaurant owner & waiter Software company & salesman Auto manufacturer & customer leasing a car Insurance company & insured

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The principal-agent problem is also pervasive in financial institutions and markets Shareholders and CEOs, CEOs and traders, Shareholders and bank creditors, and Between banks and their clients.

4.2 Solution to the Principal-Agent Problem

The suggested remedies to reduce the Principal-Agent Problem is Monitoring by the principal In most circumstances, market participants find ways to mitigate this principal-agent problem. In the case of simple tasks, monitoring by the principal may be enough. Unfortunately, many tasks are too complex to be monitored effectively by the principal. Comprehensive monitoring can also be too expensive. To amend the contract between the principal and the agent so as to align their interests. Examples of this are second-hand car dealers offering warranties, bonds carrying covenants, bank bonuses being paid in deferred equity rather than cash etc. This approach is not perfect either. There are limits to how perfectly a contract can align interests and agents will arbitrage imperfect contracts to maximize their own interests The Option to Walk Away If the loss due to information asymmetry is too large despite all available contractual arrangement, then the principal always retains the option to walk away. For example, lets replace the used-car seller with a fruit-seller. Even if a buyer of fruits has no knowledge of fruit quality, the seller will not sell him lemons as the buyer can always walk away. The seller is incentivized to maximize profits over the series of sales rather than one sale.

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5.Signalling
The concept of signalling in the field of economics has to do with the transfer of information from one party to another, often in order to achieve some sort of mutual satisfaction or arrangement. When explaining the way that signalling occurs, the party that is transmitting the information is often referred to as the agent. The party that receives and evaluates the information is usually understood to be the principal.

5.1 Illustration with Interview Example

One of the classic illustrations of how signalling works involves an individual who is seeking employment. In order to attract the attention of an employer, the prospective employee may choose to engage in signalling as a means of gaining the attention of the employer. This segment of the process often begins with the crafting of the resume. If the information on the resume generates sufficient interest, then the employer will often schedule an interview and seek to broaden his or her knowledge base about the prospective employee.

At the interview, the prospect assumes the role of agent and seeks to build on the rapport already established through the resume. This will involve emphasizing certain facts that are relevant to the position and the general goals of the company. Essentially, the agent is taking true data and presenting it in the most attractive manner possible.

In turn, the employer assumes the role of principal and receives the information. As the information is received, principals assimilate and evaluate the data. At the end of this process, the principal can extend an offer of employment to one agent, as well as inform other agents that there is no need for further information and the position is now filled.

5.2 Key Factors in Signalling

One of the key components of ethical signalling is that only true and correct information is provided by an agent to a principal. While the agent may choose to downplay some data while spotlighting other information that he or she believes is of more interest to the principal, honesty is essential if the conveyance or signal of information is to be considered successful.

Signalling is understood to be part of a broader process that is often referred to as contract theory. Concerned with achieving a balance between rewards and competency employed in a process, the activity of signalling is very important in order to employ contract theory to the advantage of all parties involved.

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6.Screening
Screening in economics refers to a strategy of combating adverse selection, one of the potential decision-making complications in cases of asymmetric information. The concept of screening was first developed by Michael Spence (1973. For purposes of screening, asymmetric information cases assume two economic agentswhich we call, for example, Abel and Cainwhere Abel knows more about himself than Cain knows about Abel. The agents are attempting to engage in some sort of transaction, often involving a longterm relationship, though that qualifier is not necessary. The "screener" (the one with less information, in this case, Cain) attempts to rectify this asymmetry by learning as much as he can about Abel. The actual screening process depends on the nature of the scenario, but is usually closely connected with the future relationship. Screening is different from signalling, where the informed agent moves first.

6.1 Examples
1. Buyer employs a mechanism for sorting commodities offered by sellers Buyer having a used car inspected prior to purchase Employer offering internships prior to employment Banks might ask potential borrowers for their financial history, job security, reason for borrowing, assets, education, experience and so on. 2. Screener is not always the seller By screening buyers based on their characteristics, sellers can create separate markets and practice price discrimination 3. In some cases, buyers rely on another firm or consumer (third parties) for screening A consumer may acquire her dentist, house painter, doctor, or maid through a recommendation from another consumer Or a firm may screen commodities and sell information to potential buyers Magazine Consumer Reports is in the business of screening commodities 4. The dating and flirting that goes on every day is a form of screening, where people use a large variety of cues to avoid undesirable mates.