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1. Asymmetric Information Chapter 23

2. Introduction • Managers (insiders) of firms can increase their profit by taking actions based on insider information (information that is not available to public) • If insiders obtain positive (negative) information about a company, they buy (sell) the company’s stock with expectation that stock’s price will rise (fall) when positive (negative) information is publicly announced • Such insider trading of securities is illegal • However, incorporating information not known by all agents in market pricing is generally legal • When selling a commodity, agents are not legally required to provide full disclosure of information on a commodity • Previously, we generally implicitly assumed or explicitly stated symmetry in market information as a characteristic of market structure • Assumed all agents had costless access to this information • Symmetry existed with both buyers and sellers having the same market information • For example, one of the explicit characteristics of perfect competition is agents’ perfect knowledge

3. Introduction • In general, market information is costly, and this cost may vary between buyers and sellers • Resulting in asymmetric information held by agents • One set of agents may be more knowledgeable about a commodity than another set • Information cost may vary among agents as a result of differences in education and experience about commodity • Examples include • A firm possessing limited information about a potential worker’s abilities • A used car buyer not having complete repair and maintenance history on an auto • An insurance company not knowing risky behavior of a potential insurer • When commodities are homogeneous and their characteristics are readily available • Cost of determining these characteristics is small • Assumption of market symmetry would generally hold • For example, symmetric information generally holds for commodity futures market • Where, except for delivery dates, all futures contracts on same commodity have identical characteristics

4. Introduction • In contrast, asymmetric information will generally exist for heterogeneous commodities with characteristics that are costly to determine • An example is the vehicle market • Condition of a vehicle is difficult to determine without costly testing • Heterogeneous nature of used vehicles prevents a general determination of a vehicle’s condition based on examination of other like vehicles • A major consequence of asymmetric information is possible disappearance of markets • Which result in an inefficient allocation of resources

5. Introduction • Aim in this chapter is to demonstrate how missing markets and associated efficiency losses result in presence of asymmetric information • Asymmetry in information generates two types of outcomes • Adverse selection • Where one agent’s decision depends on unobservable characteristics that adversely affect other agents • Use used-automobile market to illustrate missing market and resulting market inefficiencies • We discuss mechanisms of signaling and screening as second-best Pareto-efficient mechanisms for addressing these inefficiencies • Moral hazard • A contract is signed among agents with one agent being dependent on unobservable actions of other agents • Using a principal-agent model, we derive inefficient level of precaution taken by agents • Evaluate mechanisms (such as coinsurance) designed to address inefficiencies

6. Introduction • Asymmetric information is relatively new area for applied economic analysis • In 1970 George A. Akerlof was first to address problems and solutions associated with adverse selection • Knowledge of moral hazard has been around since advent of insurance in 18th century • However, only recently have applied economists investigated ramifications of moral hazard on economic efficiency • Asymmetric information in a market can result in market inefficiencies • If information concerning characteristics of a commodity is not freely available, inefficient allocations may result • One type of asymmetric information is called adverse selection (also called hidden information) • An informed agent’s decision depends on unobservable characteristics that adversely affect uninformed agents • Classic example is market for used cars • Assume used cars can be grouped by quality into two groups • Within each group, used cars are homogeneous and are associated with a single price • Comparing vehicles between groups, they are heterogeneous in quality and thus are not valued by identical prices • In a free (symmetric) information case, two heterogeneous groups of commodities (used cars) would have separate markets with associated prices p1 and p2

7. Lemons Market • Generally, sellers of a used car know vehicle’s history • Can determine its market price at zero or very minimal cost • In contrast, buyers do not have this knowledge • Cost of determining information for each group of used cars is prohibitive • Without information, buyers may base their market price determination on average quality of used cars available • Asymmetry in information results in buyers only willing to pay up to average price of used cars available, p • At average price sellers would be willing to supply only • QS = qj(pj) • pj ≤ p • qj(pj) is supply of used cars in group j • Above-average used cars, associated with pj > p, will not be offered for sale • Sellers would be unwilling to supply their cars for less than vehicle’s market value

8. Lemons Market • Buyers realize above-average used cars will not enter market at average price • So average quality of used cars offered in market is less than average quality of used cars available • They will adjust downward their willingness-to-pay for used cars offered in the market • Only sellers who value their cars below this new lower price will supply vehicles • Average quality of used cars offered in market will once again decline • Tâtonnement process will continue until only lowest-quality group of used cars are offered and sold in market • When only lowest-quality group is offered for sale, any asymmetry in information vanishes • With symmetric information, buyers’ and sellers’ expected prices match and only a market for lowest-quality group exists • Missing markets for other groups of used cars represent market failure • These lowest-quality cars are popularly referred to as lemons • Market failure associated with adverse selection is called the lemons problem

9. Lemons Market • In Figure 23.1, lemons problem is illustrated for two quality groups of used vehicles, reliable cars, , and lemons,  • Curves S and S are supply curves for lemons and reliable cars, respectively • Supply curve for reliable cars is above lemons curve • Indicates sellers of reliable cars are only willing to supply these higher-valued vehicles at prices above the lemon • Demand curves for lemons and reliable cars are represented by D and D, respectively • Buyers are willing to pay a higher price for reliable compared with lemons • So reliables demand curve is above lemons demand curve • Given free information, market is able to discriminate between these two types of cars • So market-clearing prices exist for both reliables and lemons markets • Equilibrium price and quality for reliables are p and * and for lemons p and *

10. Figure 23.1 Lemons problem

11. Lemons Market • Asymmetric information in form of adverse selection prevents buyers from freely distinguishing reliable cars from lemons • Buyers may know proportion of automobiles that are reliable and lemons • But are unable to distinguish quality of a given automobile • Overall market demand, QD, facing sellers will be horizontal sum of lemons and reliables demand curves • Total supply of cars, QS, is horizontal sum of lemons and reliables supply curves • Resulting equilibrium price and quantity are p' and Q' • Loss in ability of market to distinguish between reliables and lemons • Results in number of lemons offered on market increasing from * to S' and number of reliables declining from * to S'

12. Lemons Market • Demand for lemons decreases from * to D' and demand for reliables increases from * to D' • Imbalance within markets will result in some buyers who expect to receive a reliable car instead receiving a lemon • As buyers realize ratio of reliables to lemons is declining in market, they will adjust their expected quality downward • Participation in number of buyers wanting a reliable car will decline as expectation of obtaining a reliable car in market decreases • Resulting downward shift in demand curve further drives reliable cars out of market • Further erodes demand for reliable cars • Tâtonnement process will continue until buyers only expect lemons to be supplied, so their market demand curve is D • Such a market will then supply * automobiles at a price of p*, and a missing market will exist for reliable cars • Market is unable to allocate both supply of reliables and lemons efficiently to buyers • It is unable to price discriminate across quality differences

13. Lemons Market • An efficient allocation would result in quality discrimination • Buyers would have market choice of purchasing either reliable cars or lemons • Without market ability to quality discriminate, some buyers may by chance purchase a reliable car • But these may not be buyers with highest willingness-to-pay • Failure of market to allocate commodities based on willingness-to-pay results in an inefficient allocation • Cause of this missing market and inefficient allocation of resources is an externality between sellers of reliable cars and lemons • As illustrated in Figure 23.1, as number of sellers offering lemons increases • Buyers’ expectations regarding quality of vehicles in market is affected • Price buyers are willing to pay declines • Adversely affects sellers of reliable cars by preventing them from selling their vehicles and improving efficiency • Externality between sellers for reliable cars and lemons has distributional implications • Owners of lemons may receive more than their automobile is worth and owners of reliable cars less • Buyers possessing limited information generally benefit sellers of lemon products

14. Lemons Market • Problem of adverse selection exists in other markets • For example, in insurance market buyers of insurance know more about their general health than any insurance company • Unhealthy consumers are more likely to buy insurance • Because healthy consumers will find cost of insurance too high • Tâtonnement process will continue until only unhealthy consumers purchase insurance • Will make selling insurance unprofitable • Another example is labor market • Workers’ potential productivity is unobservable by a hiring firm • But workers themselves know their productive capabilities • Tâtonnement process will result in only less-productive workers being hired • Market failure resulting from adverse selection explains • Why a new automobile declines in value once it is driven off lot • Why insurance is so high for a previously uninsured driver or a person with no medical history • Why salaries start low with a potential for frequent raises once a person is hired

15. Second-Best Mechanism Designs • U.S. health care costs are nearly double that of other nations and outpace inflation • Firms and workers are faced with rising premiums and cutbacks in coverage • A national health insurance program can avoid inefficiencies of adverse selection in health care • By making purchase of insurance compulsory • Unhealthy citizens benefit from insurance premiums below their expected health costs • Healthy citizens can purchase insurance at lower rates • Such a government policy is called cross-subsidization • Healthy consumers pay a portion of health care for unhealthy consumers • One justification in favor of Medicare for elderly • By providing insurance for all elderly, adverse selection is eliminated • However, without knowing agents’ private information, obtaining Pareto-optimal allocation is not possible • Acquiring such information is costly • So only a constrained or second-best Pareto optimum can be obtained

16. Second-Best Mechanism Designs • In general, insurance companies can avoid adverse selection by offering group health insurance plans at places of employment • Called pooling—both healthy and unhealthy consumers are pooled together • Insurance premiums are based on average cost of health care • Adverse selection is eliminated by requiring all employees to participate • Government agencies can improve functioning of markets by providing free information or requiring product information prior to sale • Many government agencies currently provide information useful for making market decisions • Examples include U.S. State Department cautioning tourists about visiting a particular region, USDA publishing situations and outlooks for agricultural commodities • An example of requiring product information is FDA’s requirement for food labeling on processed foods

17. Signaling • Both buyers and sellers can potentially benefit from creating markets that were missing due to adverse selection • Provides incentives for developing market mechanisms to mitigate market failure associated with adverse selection • Signaling • Mechanisms that transfer information from informed agent to uninformed agent • Naive signal on part of a buyer • Asking sellers quality of a commodity—for example, asking a used car dealer condition of a car • Cost of such a signal could be high if signal is inaccurate and commodity is purchased • An example of a particularly weak signal • Where cost of providing a signal is the same for all sellers regardless of quality of their product • Appearance can be another weak signal

18. Signaling • For a strong signal, a signal must have an associated lower cost for sellers offering relatively high-quality commodities • Compared with cost for sellers offering poor-quality commodities • Examples of strong signals used by firms are reputation and standardization • Firms offering higher-quality commodities have an advantage over other firms in establishing a reputation for quality • For example, construction subcontractors can provide a signal for quality construction by developing a list of satisfied customers • One problem with reputation as a signaling device • Delay associated with establishing a reputation • Problem may be partially avoided • By supplementing reputation with guarantees and warranties as explicit signals of product quality • For example, in 1980s, as a counter to Japanese auto manufacturers’ reputation for producing quality cars • U.S. manufacturers offered extended 100,000-mile warranties as a signal of improved quality

19. Signaling • Such signals are useful in cases where buyers lack information on quality of some commodity that they do not purchase on a regular basis • For regularly purchased commodities that vary in quality • Firms will attempt to standardize commodities they are offering to signal quality • For example, a fruit and vegetable wholesaler will attempt to always offer same quality of produce • Through standardization, sellers send a strong signal that buyers can expect a quality product from them • Some firms advertise such standardization as a market signal • In general, a signaling mechanism will be employed by informed agents • Agents are not always the seller • Agent could be an antique dealer purchasing items for his shop • Through experience, dealer will have a greater knowledge about market than sellers • A reputable dealer could employ signaling mechanisms to separate him from unreputable dealers

20. Signaling • Concept of signals was first developed by Michael Spence in a labor market context • A strong signal of a person’s labor productivity is education • Education generally improves a person’s productivity • However, even if it did not, it is still a strong signal of productivity • Any admission requirements to a university or college will only result in higher-quality individuals entering the institution • “Quality in quality out” is signal sent to employers • Consumers, firms, and government agencies have also used gender, race, color, religion, and national origin as signals for labor productivity • But these signals, besides being illegal in U.S., are generally weak • Exceptions are when insurance companies target insurance rates by such characteristics as age and gender • Some segments of society may feel use of such discriminatory signals is morally wrong and thus should always be illegal

21. Signaling • Economic theory does not pass judgment on morality of signals • But it does provide a framework for determining economic consequences of restricting such signals • Theory would indicate that a government restriction on one signal would result in firms adopting related signaling mechanisms to maintain profits • For used car market, reliable car dealers will be able to offer signals • For instance, in form of warranties • At a lower cost than lemon dealers, as illustrated in Figure 23.2 • Lower warranty cost will result in lemon dealers being unable to compete in offering warranties • Thus, only reliable dealers offer warranties

22. Figure 23.2 Signaling

23. Signaling • Through these signals market for used vehicles can now be separated into two markets • Lemons and reliables • Market equilibrium for lemons is Pareto efficient by corresponding to free-information equilibrium (p*, *) • Market supply and demand curves for lemons did not shift • Introduction of a signal for reliable cars established a separate market for lemons • Market supply curve for reliable cars shifts up from S to S' • Represents increased cost associated with offering warranties • As a result of supply shift, equilibrium quantity of reliable cars is below free-information quantity of * • Equilibrium price of p' is above free-information price of p* • Results in a deadweight loss area of CAB

24. Signaling • Such a market equilibrium is called a separating equilibrium • It segments pooled market for lemons and reliables into two markets • However, this is only a second-best Pareto-efficient outcome • Because in markets with free information, sellers do not incur extra expense of signals • Deadweight loss of removing inefficiency • Cost of removing externality • Both producer and consumer surplus loss • Proportion of costs paid by buyers and sellers depends on relative elasticities of supply and demand for reliable cars • In long run, as elasticity of supply becomes more elastic • Larger proportion of signal cost is passed on to buyers

25. Screening • Top three techniques to prevent used car scams • Have a mechanic inspect vehicle • Run a Vehicle History Report • Will reveal if vehicle was flooded, rebuilt, salvaged, stolen, or totaled • Never sign anything stating “as is, no warranty” • Obtain at least a 30-day warranty • Symmetric information associated with free information results in a Pareto-efficient allocation • Pareto preferred to an allocation with signals • However, signals can be a second-best Pareto-efficient outcome if they result in a separating equilibrium, which improves efficiency • Not all signals do this • Weak signals resulting in a pooling equilibrium • Signals of different quality sellers cannot be differentiated • Do not separate markets so market efficiency is not improved • Buyers may attempt to distinguish or screen various commodities offered

26. Screening • Screening exists when a buyer employs a mechanism for sorting commodities offered by sellers • Examples of screening are • Buyer having a used car inspected prior to purchase • Employer offering internships prior to employment • In general, screening is employed by uninformed agent • Can be either buyer or seller • For example, price discrimination, discussed in Chapter 13, is a form of screening • Seller does not have information on buyers’ willingness-to-pay for commodity • By screening buyers based on their characteristics, sellers can create separate markets and practice price discrimination

27. Screening • In some cases, buyers rely on another firm or consumer (third parties) for screening • For example • 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 • Major third parties for screening are government agencies providing market information

28. Screening • Consider used car market • Potential buyers may screen vehicles by having them inspected • As illustrated in Figure 23.3, cost of screening will shift demand for both lemons and reliable cars downward • From D to D' for lemons market and from D to D' for reliable market • Resulting separating-equilibrium prices, p' and p', are lower than free-information equilibrium prices, p* and p* • Separating-equilibrium quantities, ' and ', are lower than free-information equilibrium quantities, * and * • Cost of screening is sum of deadweight losses in lemons market (shaded area CAB) and reliable market (shaded area DEF) • Both signaling and screening have potential for reducing asymmetric information and yielding a second-best Pareto-efficient outcome • Cost of reducing asymmetric-information externality • Cost of signals or screening may offset any market efficiency gains • They may or may not improve social welfare

29. Figure 23.3 Screening

30. Principal-Agent Models • Concept of moral hazard • Developed from study of insurance market • An insurer has no control over policyholder not taking precautions toward reducing probability of an insured event from occurring • Term moral hazard (also called hidden actions) is derived from condition that a policyholder may take wrong (immoral) action by not taking proper precautions • For example, an auto insurance firm has no control over hidden action of a policyholder leaving car keys in an unlocked car • Moral hazard lasts over life of some established agreement • Moral hazard may result if purchase of a commodity establishes future returns or utility of an agent being dependent on actions of another agent • Moral hazard is not restricted to issuance of insurance • It generally exists whenever one agent (principal) depends on another agent (agent) to undertake some actions • If agent’s actions are hidden from principal, asymmetric information is present • Market inefficiencies may result

31. Principal-Agent Models • In general, contracts establishing such dependence are designed to mitigate potential moral hazard problems • Problems in designing contracts result from principal-agent problem • Examples include • Owners of a firm who are unable to observe a manager’s work ethic • Instructor’s inability to observe how hard a student is actually studying • In these examples, agents have ability to hide actions • Uninformed principal wants to provide informed agent with efficient incentives for fulfilling contract

32. Pareto Efficiency with No Moral Hazard • As an illustration of no moral hazard, assume agents face an expected loss associated with some event • Examples are losses from fire damage to their business or an auto accident • Without any insurance, consumers face full cost of some negative event, which reduces their welfare • Can mitigate negative impact by taking precaution • An increase in level of precaution can both reduce likelihood of event occurring and magnitude of loss when event does occur • An objective of a consumer is to determine optimal level of precaution, P • Assume total cost of precaution at first increases at a decreasing rate and then increases at an increasing rate with level of precaution (Figure 23.4) • A basic level of precaution offers a great deal of protection with little increases in cost • Examples are driving with traffic instead of against it, locking your car when shopping • At basic level of precaution, precaution costs are increasing but at a decreasing rate • At some point an additional level of precaution will result in costs increasing at an increasing rate

33. Figure 23.4 Total and marginal cost curves for precaution

34. Pareto Efficiency with No Moral Hazard • If TC(P) is total cost function for precaution • Then TC'(P) > 0 and at first TC"(P) < 0 and at some precaution level TC"(P) > 0 • For example, at first a great deal of fire protection can be purchased with a small investment in a smoke detector • For additional protection, fire extinguishers can be purchased at a higher cost per unit • Followed by a sprinkler system at an even higher cost per unit • Associated with a given level of precaution is an expected loss • Expected loss is probability of event occurring times total loss • Objective of a consumer is to determine efficient level of precaution that minimizes overall cost (sum of expected losses and cost of precaution) • F.O.C. is • TC'(P) = -EL'(P) • TC'(P) is marginal cost, MC(P) • -EL'(P) is marginal benefit of precaution, MB(P) • Marginal benefit is reduction in expected losses associated with an increase in precaution

35. Pareto Efficiency with No Moral Hazard • EL'(P) < 0, so marginal benefit, -EL'(P), is positive (Figure 23.5) • Optimal level of precaution, P* • Where marginal cost equals marginal benefit • If marginal benefit is greater than marginal cost • An increase in precaution would reduce EL(P) more than increase in TC(P) • So overall costs fall • If marginal benefit is less than marginal cost • A decrease in precaution would reduce TC(P) by more than increase in EL • So overall cost will fall • Optimal level of precaution is illustrated in Figure 23.6 • Positively sloping marginal precaution-cost curve represents assumption of increasing per-unit precaution cost • Negatively sloping marginal precaution-benefit curve represents assumption of decreasing reduction in expected loss as precaution increases • At P*, where marginal benefit equals marginal cost • Overall costs are minimized • To left (right) of P*, marginal benefit is greater (less) than marginal cost • Consumer has an incentive to increase (decrease) precaution

36. Figure 23.5 Expected losses

37. Figure 23.6 Pareto-efficient precaution level with no moral hazard

38. Insurance Market with No Moral Hazard • As discussed in Chapter 18, a risk-averse agent will not voluntarily take on additional risk • Will seek out opportunities for avoiding risk • Insurance allows an agent to shift risk of a negative event onto another agent (an insurance company) • In event of a loss, such as a flood, an insurance company compensates agent for loss • Assume contract (policy) between principal (insurance company) and agent (consumer) is actuarially fair insurance • If consumer can purchase insurance covering full expected loss for a given level of precaution • Consumer no longer suffers a loss from a negative event, EL = 0 • However, consumer must pay premium, which, for actuarially fair insurance, is equal to EL • Assuming no moral hazard, insurance company will want to design a policy where expected payout varies by level of precaution a consumer takes

39. Insurance Market with No Moral Hazard • Premiums would be higher for a low level of precaution by a consumer • Decline as level of precaution increases • Let A(P) represent insurance premium, so A'(P) < 0 • A"(P) > 0 • Consumer is still faced with problem of determining optimal level of precaution that minimizes overall cost of taking precaution and now paying insurance premium • F.O.C. is • TC'(P) = -A'(P) • Consumer equates marginal precaution cost, TC'(P), to marginal precaution benefit, -A'(P) • Marginal precaution benefit is additional savings in premium costs from an additional increase in precaution • As illustrated in Figure 23.6, with no moral hazard and actuarially fair insurance • Results in same level of precaution as in no-insurance case • In general, assuming agents gain some utility from having an insurance company assume risk (assuming agents are risk averse) • Then P*, with insurance, is a Pareto-efficient level of precaution

40. Insurance and Moral Hazard • Unfortunately, Pareto-efficient level of precaution is generally not possible • Hidden level of precaution by consumers makes cost of designing an insurance policy where premiums are based on every level of precaution prohibitive • In extreme case of moral hazard, where insurance company cannot at all determine level of precaution • Insurance premium would not be a function of consumer’s precaution level • Assuming insurance company sets premium at Pareto-efficient level of precaution, P*, consumer’s objective is • Optimal solution is for consumer to not take any precaution, P = 0 • Zero level of precaution increases risk of negative event occurring • Results in insurance company having to pay higher-than-expected claims • This is root of terminology “moral hazard” for insurance company (principal)

41. Insurance and Moral Hazard • Unless insurance company can design policies that provide incentives for consumers to take precaution • Tâtonnement process will result in no insurance company able to pay all its claims from revenue generated by premiums • Inefficiency of zero precaution associated with moral hazard is represented by deadweight loss, area ABC, in Figure 23.6 • Tâtonnement process toward an equilibrium can also result in instances where agents are overinsured • For example, due to falling property values or a failing business, an agent may realize that level of insurance is more than property is worth • If this information is hidden from insurance company (adverse selection) • Hidden action of not taking any precautions to prevent fire or even causing business to burn down can increase returns • For this reason, in fire investigations owners are always possible suspects

42. Coinsurance • Deadweight loss associated with moral hazard can be reduced by inducing consumers to take some precaution • One type of inducement, employed by many health insurance companies, is coinsurance • Require consumer to pay some percentage of cost, so insurance company pays less than 100% of loss • Actual percentage paid varies, but a common rate is for an insurance company to pay 80% and consumers to pay remaining 20% • As percentage of loss a consumer pays increases, less risk is shifted to insurance company and consumer is more willing to take precaution • Consumers will tend to seek lower-cost treatments rather than alternative higher-cost treatments

43. Coinsurance • If, for example, consumer pays 20% of cost along with a fixed premium A, then consumer’s objective is • F.O.C. is • =0.2EL'(P) = TC'(P) • As illustrated in Figure 23.7, marginal benefit curve tilts downward and intersects marginal cost curve at second-best Pareto-efficient equilibrium level of precaution PO > 0 • Deadweight loss is reduced from area ABC to DEC • Only when moral hazard can be eliminated will a Pareto-efficient solution P* exist

44. Figure 23.7 Coinsurance

45. Deductibles • Writing insurance policies with deductibles is another option insurance companies employ for increasing agents’ precaution level • Require agents to incur all loss up to some dollar limit • For example, if an auto insurance policy has a $500 deductible provision • First $500 in damages is paid by car owner, and insurance company pays any remaining damages • Generally, the higher the deductible, the lower will be the insurance premiums • Insurance companies will incorporate deductibles into their policies when agents’ basic level of precaution is so low that insurance companies cannot earn normal profits • For example, without some deductible for auto insurance, our roadways could take on a bumper-car atmosphere • Resulting in dramatic insurance premium increases with few if any consumers willing to be insured

46. Deductibles • With deductible provision, optimal level of precaution for a consumer is determined by • DA is level of deductible • Maximum cost a consumer will incur is deductible DA • However, if overall cost of precaution plus expected losses is less than DA • Consumer can lower his cost below DA • F.O.C. for minimizing cost is • TC'(P) = -EL'(P) • If DA > min[TC(P) + EL(P)], yielding optimal level of precaution P* (Figure 23.6) • If DA < min[TC(P) + EL(P)], a zero level of precaution, P* = 0, is optimal level • With DA as lowest possible level of cost • Expenditures on precaution will not result in any additional benefits

47. Deductibles • Deductibles allow consumers to insure against large losses • But be responsible for any relatively small expected losses below deductible • Reduces deadweight loss associated with moral hazard • As DA increases, deadweight loss is reduced, as consumers will likely choose no-insurance level of precaution, P* • Consumers who are more willing to take risk will self-insure by seeking higher insurance deductibles • However, with increases in DA, risk-averse consumers are worse off since they are less able to shift this risk to another agent (insurer) • Other options available to insurance companies for increasing agents’ precaution level are • Combinations of coinsurance and deductibles • Subsidizing preventive care • Health insurance policies will generally • Have both deductibles and coinsurance provisions • May also offer preventive care such as annual physical examinations and routine blood tests at reduced cost

48. Employer and Employee Relations • Moral hazard exists whenever asymmetric information in the form of hidden actions is prevalent in a principal-agent agreement • For example, moral hazard can exist between an employer (principal) and an employee (agent) • Unless an employer can constantly monitor productivity of employees • Employees can engage in leisure while working (shirking) by reducing their level of effort • For example, employees’ surfing the Net has become a major form of shirking • Asymmetric information on level of employees’ productivity creates inefficiencies • An objective of employers is to design contracts that provide employee incentives directed at improving productivity and reducing shirking

49. Pareto Efficiency with No Moral Hazard • Major incentive for employees’ effort is compensation they receive for supplying their labor, in form of wage income • Assuming symmetric information (no moral hazard) • Can determine Pareto-efficient level of employee effort, E* • By considering employer’s objective function and an employee’s participation constraint • No moral hazard implies that an employer can observe an employee’s level of effort • Assume employer determines labor contract and employee can then either accept or reject contract

50. Pareto Efficiency with No Moral Hazard • An employer is concerned with productivity of an employee • Denoted by production function q = f(E) • q is some output level • Given a per-unit output price of p and wage rate based on an employee’s effort w(E) • Employer’s objective is maximizing profit from this employee • Employee has a cost of increasing effort in form of total opportunity cost from lost shirking, TCE(E) • Let MCE(E) represent marginal cost of effort • So MCE(E) = TCE(E)/E • In general, as illustrated in Figure 23.8, this marginal opportunity cost is U-shaped

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