20.3 Private Information: What You Don’t Know Can Hurt You

Private information is information that some people have but others do not.

Markets do very well at dealing with diversifiable risk and with risk due to uncertainty: situations in which nobody knows what is going to happen, whose house will be flooded, or who will get sick. However, markets have much more trouble with situations in which some people know things that other people don’t know— situations of private information. As we will see, private information can distort economic decisions and sometimes prevent mutually beneficial economic transactions from taking place. (Sometimes economists use the term asymmetric information rather than private information, but they are equivalent.)

Why is some information private? The most important reason is that people generally know more about themselves than other people do. For example, you know whether or not you are a careful driver; but unless you have several accidents on your driving record or a spotless record, your auto insurance company does not. You are more likely to have a better estimate than your insurance company of whether or not you will need an expensive medical procedure when you travel outside of Canada. And if you are selling a buyer your used car, you are more likely to be aware of any problems with it than the buyer is.

But why should such differences in who knows what be a problem? It turns out that there are two distinct sources of trouble: adverse selection, which arises from having private information about the way things are, and moral hazard, which arises from having private information about people’s actions.

Adverse Selection: The Economics of Lemons

Suppose that someone offers to sell you an almost brand-new car—purchased just three months ago, with only 3000 kilometres on the odometer and no dents or scratches. Will you be willing to pay almost the same for it as for a new car direct from the dealer?

Probably not, for one main reason: you cannot help but wonder why this car is being sold. Is it because the owner has discovered that something is wrong with it—that it is a “lemon”? Having driven the car for a while, the owner knows more about it than you do—and people are more likely to sell cars that give them trouble.

You might think that the fact that sellers of used cars know more about them than the buyers do represents an advantage to the sellers. But potential buyers know that potential sellers are likely to offer them lemons—they just don’t know exactly which car is a lemon. Because potential buyers of a used car know that potential sellers are more likely to sell lemons than good cars, buyers will offer a lower price than they would if they had a guarantee of the car’s quality. Worse yet, this poor opinion of used cars tends to be self-reinforcing, precisely because it depresses the prices that buyers offer. Used cars sell at a significant discount because buyers expect a disproportionate share of those cars to be lemons.

Even a used car that is not a lemon would sell only at a large discount because buyers don’t know whether it’s a lemon or not. But potential sellers who have good cars are unwilling to sell them at a deep discount, except under exceptional circumstances. So good used cars are rarely offered for sale, and used cars that are offered for sale have a strong tendency to be lemons. (This is why people who have a compelling reason to sell a car, such as moving overseas, make a point of revealing that information to potential buyers—as if to say “This car is not a lemon!”)

The end result, then, is not only that used cars sell for low prices and that there are a large number of used cars with hidden problems. Equally important, many potentially beneficial transactions—sales of good cars by people who would like to get rid of them to people who would like to buy them—end up being frustrated by the inability of potential sellers to convince potential buyers that their cars are actually worth the higher price being asked. So some mutually beneficial trades between those who want to sell used cars and those who want to buy them go unexploited.

Adverse selection occurs when an individual knows more about the way things are than other people do. Private information leads buyers to expect hidden problems in items offered for sale, leading to low prices and the best items being kept off the market.

Although economists sometimes refer to situations like this as the “lemons problem” (the issue was introduced in a famous 1970 paper by economist and Nobel laureate George Akerlof entitled “The Market for Lemons”), the more formal name of the problem is adverse selection. The reason for the name is obvious: because the potential sellers know more about the quality of what they are selling than the potential buyers, they have an incentive to select the worst things to sell.

Adverse selection does not apply only to used cars. It is a problem for many parts of the economy—notably for insurance companies, and most notably for health insurance companies.

Suppose that a health insurance company were to offer a standard supplementary health policy to everyone with the same premium. The premium would reflect the average risk of incurring a medical expense not covered by a provincial health insurance plan. But that would make the policy look very expensive to healthy people, who know that they are less likely than the average person to incur this type of medical expense. So healthy people would be less likely than less healthy people to buy the policy, leaving the health insurance company with exactly the customers it doesn’t want: people with a higher-than-average risk of needing supplementary medical care, who would find the premium to be a good deal.

In order to cover its expected losses from this sicker customer pool, the health insurance company is compelled to raise premiums, driving away more of the remaining healthier customers, and so on. Because the insurance company can’t determine who is healthy and who is not, it must charge everyone the same premium, thereby discouraging healthy people from purchasing policies and encouraging unhealthy people to buy policies.

As we discussed in Chapter 18, adverse selection can lead to a phenomenon called an adverse selection death spiral as the market for supplementary health insurance collapses: insurance companies refuse to offer policies because there is no premium at which the company can cover its losses. Because of the severe adverse selection problems, governments in many advanced countries assume the role of providing health insurance to their citizens. As we saw in Chapter 18, provincial and territorial governments, through their health services insurance plans and drug benefit programs like the Quebec Health Insurance Plan and the Quebec Drug Insurance Fund, now disburse 70% of the total payments for medical care in Canada.

Adverse selection can be reduced through screening: using observable information about people to make inferences about their private information.

In general, people or firms faced with the problem of adverse selection follow one of several well-established strategies for dealing with it. One strategy is screening: using observable information to make inferences about private information. As we discussed in Chapter 18, if you apply for supplementary health insurance, you’ll find that the insurance company will demand documentation of your health status in an attempt to “screen out” sicker applicants—people they will refuse to insure or will insure only at very high premiums. Auto insurance companies also provide a very good example of the use of screening to reduce adverse selection. They may not know whether you are a careful driver, but they have statistical data on the accident rates of people who resemble your profile—and use those data in setting premiums. A 19-year-old male who drives a sports car and has already had a fender-bender is likely to pay a very high premium. A 40-year-old female who drives a minivan and has never had an accident is likely to pay much less. In some cases, this may be unfair: some adolescent males are very careful drivers, and some mature women drive minivans as if they were CF-18s. But nobody can deny that the insurance companies are right on average.

Adverse selection can be diminished by people signalling their private information through actions that credibly reveal what they know.

Another strategy to counter the problems caused by adverse selection is for people who are good prospects to do something signalling their private information—taking some action that wouldn’t be worth taking unless they were indeed good prospects. For example, reputable used-car dealers often offer warranties—promises to repair any problems with the cars they sell that arise within a given amount of time. This isn’t just a way of insuring their customers against possible expenses; it’s a way of credibly showing that they are not selling lemons. As a result, more sales occur and dealers can command higher prices for their used cars when they offer warranties.

A long-term reputation allows an individual to reassure others that he or she isn’t concealing adverse private information.

Finally, in the face of adverse selection, it can be very valuable to establish a good reputation: a used-car dealership will often advertise how long it has been in business to show that it has continued to satisfy its customers. As a result, new customers will be willing to purchase cars and to pay more for that dealer’s cars.

Moral Hazard

In the late 1970s, major North American cities experienced an epidemic of suspicious fires that appeared to be deliberately set. Some of the fires were probably started by teenagers on a lark, others by gang members struggling over turf. But investigators eventually became aware of patterns in a number of the fires. Particular landlords who owned several buildings seemed to have an unusually large number of their buildings burn down. Although it was difficult to prove, police had few doubts that most of these fire-prone landlords were hiring professional arsonists to torch their own properties.

Why burn your own building? These buildings were typically in declining neighbourhoods, where rising crime and middle-class flight had led to a decline in property values. But the insurance policies on the buildings were written to compensate owners based on historical property values, and so would pay the owner of a destroyed building more than the building was worth in the current market. For an unscrupulous landlord who knew the right people, this presented a profitable opportunity.

The arson epidemic became less severe during the 1980s, partly because insurance companies began making it difficult to overinsure properties, and partly because a boom in real estate values made many previously arson-threatened buildings worth more unburned.

The arson episodes make it clear that it is a bad idea for insurance companies to let customers insure buildings for more than their value—it gives the customers some destructive incentives. You might think, however, that the incentive problem would go away as long as the insurance is no more than 100% of the value of what is being insured.

But, unfortunately, anything close to 100% insurance still distorts incentives—it induces policyholders to behave differently than they would in the absence of insurance. The reason is that preventing fires requires effort and cost on the part of a building’s owner. Fire alarms and sprinkler systems have to be kept in good repair, fire safety rules have to be strictly enforced, and so on. All of this takes time and money—time and money that the owner may not find worth spending if the insurance policy will provide close to full compensation for any losses.

Of course, the insurance company could specify in the policy that it won’t pay if basic safety precautions have not been taken. But it isn’t always easy to tell how careful a building’s owner has been—the owner knows, but the insurance company does not.

The point is that the building’s owner has private information about his or her own actions, about whether he or she has really taken all appropriate precautions. As a result, the insurance company is likely to face greater claims than if it were able to determine exactly how much effort a building owner exerts to prevent a loss. The problem of distorted incentives arises when an individual has private information about his or her own actions but someone else bears the costs of a lack of care or effort. This is known as moral hazard.

Moral hazard occurs when an individual knows more about his or her own actions than other people do. This leads to a distortion of incentives to take care or to exert effort when someone else bears the costs of the lack of care or effort.

To deal with moral hazard, it is necessary to give individuals with private information some personal stake in what happens so they have a reason to exert effort even if others cannot verify that they have done so. Moral hazard is the reason salespeople in many stores receive a commission on sales: it’s hard for managers to be sure how hard the salespeople are really working, and if they were paid only a straight salary, they would not have an incentive to exert effort to make those sales. As described in the following Economics in Action, similar logic explains why many stores and restaurants, even if they are part of national chains, are actually franchises, licensed outlets owned by the people who run them.

Insurance companies deal with moral hazard by requiring a deductible: they compensate for losses only above a certain amount, so that coverage is always less than 100%. The insurance on your car, for example, may pay for repairs only after the first $500 in loss. This means that a careless driver who gets into a fender-bender will end up paying $500 for repairs even if he is insured, which provides at least some incentive to be careful and reduces moral hazard.

A deductible in an insurance policy is a sum that the insured individual must pay before being compensated for a claim.

In addition to reducing moral hazard, deductibles provide a partial solution to the problem of adverse selection. Your insurance premium often drops substantially if you are willing to accept a large deductible. This is an attractive option to people who know they are low-risk customers; it is less attractive to people who know they are high-risk—and so are likely to have an accident and end up paying the deductible. By offering a menu of policies with different premiums and deductibles, insurance companies can screen their customers, inducing them to sort themselves out on the basis of their private information.

As the example of deductibles suggests, moral hazard limits the ability of the economy to allocate risks efficiently. You generally can’t get full (100%) insurance on your home or car, even though you would like to buy it, and you bear the risk of large deductibles, even though you would prefer not to. The following Economics in Action illustrates how in some cases moral hazard limits the ability of investors to diversify their investments.

FRANCHISE OWNERS TRY HARDER

Franchise owners face risk, which motivates them to work harder than salaried managers.

When Canadians go out for a quick meal, they often end up at one of the fast-food chains—McDonald’s, Harvey’s, Burger King, and so on. Because these are large corporations, most customers probably imagine that the people who serve them are themselves employees of large corporations. But usually they aren’t. Most fast-food restaurants—for example, 99.5% of Tim Hortons outlets and 85% of McDonald’s outlets—are franchises. That is, some individual has paid the parent company for the right to operate a restaurant selling its product; he or she may look like an arm of a giant company but is in fact a small-business owner.

Becoming a franchisee is not a guarantee of success. You must put up a large amount of money, both to buy the licence and to set up the restaurant itself (to open a Taco Bell, for example, cost $1.1 million to $1.7 million, excluding land or lease costs, in 2010). And although McDonald’s takes care that its franchises are not too close to each other, they often face stiff competition from rival chains and even from a few truly independent restaurants. Becoming a franchise owner, in other words, involves taking on quite a lot of risk.

But why should people be willing to take these risks? Didn’t we just learn that it is better to diversify, to spread your wealth among many investments? The logic of diversification would seem to say that it’s better for someone with $1.7 million to invest in a wide range of stocks rather than put it all into one Taco Bell. This implies that Taco Bell would find it hard to attract franchisees: nobody would be willing to be a franchisee unless they expected to earn considerably more than they would as a salaried employee with their wealth invested in a diversified portfolio of stocks. So wouldn’t it be more profitable for Tim Hortons or Taco Bell simply to hire managers to run their restaurants?

It turns out that it isn’t, because the success of a restaurant depends a lot on how hard the manager works, on the effort he or she puts into choosing the right employees, on keeping the place clean and attractive to customers, and so on. Could Tim Hortons get the right level of effort from a salaried manager? Probably not. The problem is moral hazard: the manager knows whether he or she is really putting 100% into the job; but company headquarters, which bears the costs of a poorly run company-owned restaurant, does not. So a salaried manager, who gets a salary even without doing everything possible to make the restaurant a success, does not have the incentive to do that extra bit—an incentive the owner does have because he or she has a substantial personal stake in the success of the restaurant.

In other words, there is a moral hazard problem when a salaried manager runs a Tim Hortons, where the private information is how hard the manager works. Franchising solves this problem. A franchisee, whose wealth is tied up in the business and who stands to profit personally from its success, has every incentive to work extremely hard.

The result is that fast-food chains rely mainly on franchisees to operate their restaurants, even though the contracts with these owner-managers allow the franchisees on average to make much more than it would have cost the companies to employ store managers. The higher earnings of franchisees compensate them for the risk they accept, and the companies are compensated by higher sales that lead to higher licensing fees. In addition, franchisees are forbidden by the licensing agreement with the company from reducing their risk by taking actions such as selling shares of the franchise to outside investors and using the proceeds to diversify. It’s an illustration of the fact that moral hazard prevents the elimination of risk through diversification.

Quick Review

  • Private information can distort incentives and prevent mutually beneficial transactions from occurring. One source is adverse selection: sellers have private information about their goods and buyers offer low prices, leading the sellers of quality goods to drop out and leaving the market dominated by “lemons.”

  • Adverse selection can be reduced by revealing private information through screening or signalling, or by cultivating a long-term reputation.

  • Another source of problems is moral hazard. In the case of insurance, it leads individuals to exert too little effort to prevent losses. Moral hazard gives rise to the use of features like deductibles, commissions, and franchises, which work to reduce moral hazard and help create a more efficient allocation of risk.

Check Your Understanding 20-3

CHECK YOUR UNDERSTANDING 20-3

Question 20.4

Your car insurance premiums are lower if you have had no moving violations for several years. Explain how this feature tends to decrease the potential inefficiency caused by adverse selection.

The inefficiency caused by adverse selection is that an insurance policy with a premium based on the average risk of all drivers will attract only an adverse selection of bad drivers. Good (that is, safe) drivers will find this insurance premium too expensive and so will remain uninsured. This is inefficient. However, safe drivers are also those drivers who have had fewer moving violations for several years. Lowering premiums for only those drivers allows the insurance company to screen its customers and sell insurance to safe drivers, too. This means that at least some of the good drivers now are also insured, which decreases the inefficiency that arises from adverse selection. In a way, having no moving violations for several years is building a reputation for being a safe driver.

Question 20.5

A common feature of home construction contracts is that when it costs more to construct a building than was originally estimated, the contractor must absorb the additional cost. Explain how this feature reduces the problem of moral hazard but also forces the contractor to bear more risk than she would like.

The moral hazard problem in home construction arises from private information about what the contractor does: whether she takes care to reduce the cost of construction or allows costs to increase. The home-owner cannot, or can only imperfectly, observe the cost-reduction effort of the contractor. If the contractor were fully reimbursed for all costs incurred during construction, she would have no incentive to reduce costs. Making the contractor responsible for any additional costs above the original estimate means that she now has an incentive to keep costs low. However, this imposes risk on the contractor. For instance, if the weather is bad, home construction will take longer, and will be more costly, than if the weather had been good. Since the contractor pays for any additional costs (such as weather-induced delays) above the original estimate, she now faces risk that she cannot control.

Question 20.6

True or false? Explain your answer, stating what concept analyzed in this chapter accounts for the feature.

People with higher deductibles on their auto insurance:

  1. Generally drive more carefully

  2. Pay lower premiums

  3. Generally are wealthier

  1. True. Drivers with higher deductibles have more incentive to take care in their driving, to avoid paying the deductible. This is a moral hazard phenomenon.

  2. True. Suppose you know that you are a safe driver. You have a choice of a policy with a high premium but a low deduct-ible or one with a lower premium but a higher deductible. In this case, you would be more likely to choose the cheap policy with the high deductible because you know that you will be unlikely to have to pay the deductible. When there is adverse selection, insurance companies use screening devices such as this to make inferences about people’s private information about how skillful they are as drivers.

  3. True. The wealthier you are, the less risk-averse you are. If you are less risk-averse, you are more willing to bear risk yourself. Having an insurance policy with a high deduct-ible means that you are exposed to more risk: you have to pay more of any insurance claim yourself. This is an implication of how risk aversion changes with a person’s income or wealth.

The Agony of AIG

AIG (American International Group) was once the largest insurance company in the United States, known for insuring millions of homes and businesses and managing the pension plans of millions of workers.

But in September 2008, AIG acquired a much more notorious reputation. It was at the epicentre of the crisis sweeping global financial markets because major commercial and investment banks were faced with potentially devastating losses through their transactions with AIG. Fearful that a chaotic bankruptcy of AIG would panic the already distressed financial markets, the U.S. Federal Reserve stepped in and orchestrated the largest corporate bailout in U.S. history, paying a total of US$182 billion to satisfy claims against AIG. In return, American taxpayers became owners of nearly 80% of AIG. The company was essentially nationalized. How did things go so wrong?

AIG’s problems originated not in its main lines of business—property insurance and pension management—but in its much smaller Financial Products Division, which sold credit-default swaps, or CDS. A CDS is like an insurance policy for an investor who buys a bond. A bond is simply an IOU—a promise to repay on the part of the borrower (the person or company that issued the bond). But any IOU carries with it the possibility that the borrower will default and not pay back the loan. So bond investors who wish to protect themselves against the risk of default purchase a CDS from a company like AIG. Later, if the borrower defaults, bond investors collect an amount equal to their losses from the company that issued the CDS.

During the mid-2000s, Joseph Cassano, the head of AIG’s Financial Products Division, sold hundreds of billions of dollars worth of CDSs. They were bought by investors in mortgage-backed securities—bonds created by combining thousands of American home mortgages. As homeowners paid their monthly mortgages, the owners of the mortgage-backed securities received payments of the interest earned and the portion of principal repaid on those mortgages.

For several years AIG earned billions in premiums from selling CDSs, making the Financial Products Division its most profitable department. And there were virtually no costs involved because mortgage defaults were low and the Financial Products Division was based in London, England. Its location meant that AIG was not required to abide by U.S. insurance regulations to set aside capital to cover potential losses—despite the fact that AIG, the parent company, was headquartered in the United States. As Cassano stated in 2007, “It is hard for us … to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions.” Cassano was so confident in his strategy and fearful of outside meddling that he prevented AIG’s American auditors from inspecting his books, leaving AIG’s management and shareholders in the dark about the risks they faced.

Yet the hard-to-see scenario appeared in 2008 in cataclysmic form when the U.S. housing market crashed. As mortgage defaults surged, investors in mortgage-backed securities incurred huge losses and turned to AIG to collect. But with no capital to cover claims, AIG faced bankruptcy until the U.S. government stepped in.

Investment banks, such as Goldman Sachs, had made huge profits by putting together low-quality mortgage-backed securities with high likelihoods of default and then insuring them with AIG. Despite an outcry, Goldman’s claims were paid in full by the government because their transaction with AIG was entirely legal.

QUESTIONS FOR THOUGHT

Question 20.7

Did AIG accurately assess the default risk that it insured? Why or why not?

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Did AIG accurately assess the default risk that it insured? Why or why not?

Question 20.8

What did AIG assume about the probabilities of defaults by different homeowners in the U.S. housing market? Were they wrong or right?

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What did AIG assume about the probabilities of defaults by different homeowners in the U.S. housing market? Were they wrong or right?

Question 20.9

What are the examples of moral hazard in the case? For each example, explain who committed the moral hazard and against whom and identify the source of the private information.

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What are the examples of moral hazard in the case? For each example, explain who committed the moral hazard and against whom and identify the source of the private information.

Question 20.10

Cite an example of adverse selection from the case. What was the source of the private information?

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Cite an example of adverse selection from the case. What was the source of the private information?