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  1. 1. Adverse Selection and MoralHazardMay 10, 2013
  2. 2. Announcements• If you haven’t gotten exam back – it’s nowwith economics undergrad office• Remember: homework due Monday morning!• Class next Friday cancelled for Sun God.
  3. 3. Last Class• Roles of information:– show-rooming– search / gambles– asymmetric information & lemons
  4. 4. Learning Goals for Today• Describe the two features of a credible signal.• List many types of statistical discrimination.• Compare and contrast adverse selection andmoral hazard.
  5. 5. How Do You Credibly Signal Quality?• The lemons problem we just looked at could have been avoided if theowners of good cars could have credibly signaled their quality.• How do you credibly signal quality?• In other words, what must be true about the signal itself for it to becredible?
  6. 6. How Do You Credibly Signal Quality?• The lemons problem we just looked at could have been avoided if theowners of good cars could have credibly signaled their quality.• How do you credibly signal quality?Signal Must be Costly Signal cost lower when quality high``costly to fake’’ ``not costly if truthful’’
  7. 7. Examples1. How can people selling cars signal that their cars are high quality?– Offer warranty.– Costly, but less costly (on average) for people with good cars.2. How can workers signal to employers that they are highlymotivated?– High college GPA– Costly, but less costly for highly motivated people.
  8. 8. Examples3. How can sellers of any product signal that their product is high quality?– Expensive advertising– Costly, but less costly for good products that generate repeat sales.4. How do real estate agents signal their ability to potential clients?– Drive a nice car– Costly, but less costly for successful (higher earning) agents.
  9. 9. Being seen driving an expensive car is a goodway for which professional to signal theirabilities?A. carpenterB. realtorC. political officeholderD. major league baseball playerE. there is more than one answer
  10. 10. Statistical Discrimination• Statistical discrimination: the practice of making judgments aboutthe quality of people, goods and services based on the groups towhich they belong.• In the presence of imperfect information, economic agents willhave an incentive to statistically discriminate.• Examples
  11. 11. Which of the following is a solution to statisticaldiscrimination in hiring?A. a minimum wageB. punishing workers who are consistently lateC. federal guarantees for maternity leaveD. not hiring college grads with low grades
  12. 12. Adverse Selection• Adverse selection: the pattern in which insurance tends to bepurchased by those who are most costly for companies to insure.• Any situation in which informed buyers (or sellers) make purchasing(or sales) decisions based on their unobservable characteristics in away that negatively affects those who are less uninformed .• Leads to inefficient outcomes—markets can “unravel”.
  13. 13. Moral Hazard• Moral hazard: the tendency for people to expend less effortprotecting those goods that are insured against damage or theft?• Can increase the cost of insuring people—if it’s bad enough, moralhazard could make it impossible for companies to profitably insurepeople.13
  14. 14. Clark just bought a new car and was required bystate law to purchase full insurance coverage.The moral hazard problem suggests Clark willA. usually try to find a save place to park his car toavoid break-insB. be careful to lock his car alwaysC. drive carefully in trafficD. park his car in his garage during bad weatherE. park outside regardless
  15. 15. In addition to mandatory insurance coverage, Clark purchases asupplementary plan. Compared to the rate for the mandatoryplan, he probably paysA. moreB. about the same given he is a maleC. about the same given he is over 30 years oldD. about the same given he shows his clean driving record
  16. 16. How Do Adverse Selection and MoralHazard Affect the Insurance Market?• Insurance companies typically offer a menu of insurance prices.– (a) High deductible, low premium: You cover first $1000 indamages and pay $30 per month.– (b) Low deductible, high premium: You cover first $500 indamages and pay $50 per month.• The deductible helps alleviate moral hazard.• The price structure helps alleviate adverse selection by enabling theinsurance company to distinguish between good (a)and bad (b)drivers.