Review Questions

1. Contrast market situations with complete and asymmetric information. What is an example of a market with complete information?

   In a market with complete information—such as a perfectly competitive market—all parties in an economic transaction know the relevant information. Markets with asymmetric information are perhaps more common. These are markets in which one party knows more than the other party in the economic transaction.

2. What characteristics of a market can create the lemons problem?

   The lemons problem arises in markets in which the seller knows more about the quality of the good than does the buyer.

3. Define adverse selection. Why does the lemons problem result in adverse selection?

   Adverse selection is the offering of a disproportionately high number of low-quality to high-quality goods on the market. In a market with the lemons problem, buyers cannot tell the difference between low- and high-quality goods prior to purchase, and the price they are willing to pay for high-quality goods is below the price at which sellers are willing to part with high-quality goods; therefore, adverse selection results.

4. How can warranties reduce the lemons problem in an economic market?

   Warranties serve as a signal to potential buyers that a product is of relatively high quality. This is because the seller of a low-quality good isn’t going to offer a warranty—it’s too expensive for him to offer a warranty on a product he knows is a lemon.

5. How can insurance companies mitigate the problems of adverse selection?

   In the insurance market, buyers (potential insurance holders) know more about their likelihood to file claims than do the insurance companies. A variety of solutions to this asymmetric information problem that results in adverse selection of buyers into the insurance market include:

   1. Group policies, which pool together a group of people with a wide array of risks

   2. Screening, which vets potential insurance holders for the likelihood that they will file claims

   3. Denying coverage, such as what happens to people with preexisting health conditions in the health insurance market

6. What is moral hazard? Describe the example of moral hazard in the insurance market.

   Moral hazard arises when one party in an economic transaction cannot observe the other party’s behavior. Moral hazard is a particular problem in insurance markets where policyholders, once insured, make fewer efforts to avoid the bad outcomes that insurance will now cover.

7. How can insurance providers use incentives to reduce moral hazard in the insurance market?

   Insurance companies take a range of actions to mitigate moral hazard. They may specify certain actions that a policyholder must take in order to be covered, such as installing smoke detectors. Practices such as good driver policies give policyholders incentives to take actions to reduce risk. Lastly, deductibles, copayments, and coinsurance directly connect the policyholder’s payoff to the insurer’s payoff.

8. What market characteristics can create problems in a principal–agent relationship?

   Two main market characteristics combine to create principal-agent problems. First, the principal (e.g., employer) must be unable to fully observe the agent’s (e.g., employee’s) actions. Second, the self-interests of the principal and agent must not align.

9. How can principals reduce the problems associated with principal–agent relationships?

   Principals want to align their agents’ incentives with their own. To do so, principals can compensate agents in such a way that they face the same incentives the principals would face if they were making the agents’ choices for them. Payment structures such as commissions, piece rates, and annual bonuses are designed with this goal in mind.

10. How can signaling be used to reduce asymmetric information in a market?

    Signaling is a situation in which a knowledgeable party communicates an unobservable characteristic to the other party. This communication of information can resolve the asymmetric information problem in many markets.

11. How can education be used as a signal in the job market?

    In the classic signaling model, education is a costly action that has no impact on an individual’s productivity yet can reveal information about that worker to potential employers. Because it is too costly for low-productivity workers to pursue, only high-productivity workers obtain a degree. On the job market, that degree serves as a signal of the individual’s productivity to potential employers.

12. Name two examples of signals other than education. How do these examples reduce asymmetric information?

    Signals may be used in all facets of life. Purchasing an engagement ring would signal your commitment to marriage. Parking an expensive car in your driveway would let your neighbors know of your wealth. And, wearing a nice suit to work gives your employer an idea of just how seriously you take your job.